Chapter 4

Evaluating a Single Project

The objective of Chapter 4 is to discuss

contemporary methods for determining project
profitability.
 Proposed capital projects can be evaluated
in several ways.

• Present worth (PW)

(PW) ‫•قيمتها الحالية االستحقاق‬
• Future worth (FW)
(FW) ‫•قيمتها في المستقبل‬
• Annual worth (AW) (AW) ‫•قيمتها السنوية‬
• Internal rate of return (IRR) (IRR) ‫•معدل العائد الداخلي‬
• External rate of return (ERR) )ERR( ‫•معدل العائد الخارجي‬
• Payback period ‫•فترة االسترداد‬
To be attractive, a capital project must provide a
return that exceeds a minimum level established
by the organization.
This minimum level is reflected in a firm’s
Minimum Attractive Rate of Return (MARR).
 The present worth method.

The present worth (PW) is found by discounting all cash

inflows and outflows to the present time at an interest rate
that is generally the MARR.

A positive PW for an investment project means that the

project is acceptable (it satisfies the MARR).
Example:
Consider a project that has an initial investment of $50,000
and that returns $18,000 per year for the next four years. If
the MARR is 12%, is this a good investment?

PW = -50,000 + 18,000 (P/A, 12%, 4)

PW = -50,000 + 18,000 (3.0373)

PW = $4,671.40 → This is a good investment!

Evaluation of New equipment Purchase Using PW
A piece of new equipment has been proposed by engineers to increase the productivity
of a certain manual welding operation. The investment cost is $25,000, and the
equipment will have a market value of $5,000 at the end of a study period of five years.
Increased productivity attributable to the equipment will amount to $8,000 per year after
extra operating costs have been subtracted from the revenue generated by the additional
production.
A cash-flow diagram for this investment opportunity is given below. If the firm's MARR is
20% per year, is this proposal a sound one? Use the PW method.
Present Worth of a Space-Heating - system
A retrofitted space-heating system is being considered for a small office building.
The system can be purchased and installed for $110,000, and it will save an
estimated 300,000 kilowatt-hours (kWh) of electric power each year over a six-
year period. A kilowatt-hour of electricity costs $0.10, and the company uses a
MARR of 15% per year in its economic evaluations of refurbished systems. The
market value of the system will be $8,000 at the end of six years, and additional
annual operating and maintenance expenses are negligible. Use the PW method to
determine whether this system should be installed.
Solution
To find the PW of the proposed heating system, we need to find the present
equivalent of all associated cash flows. The estimated annual savings in electrical
power is worth 300,000 kWh x $0.10/kWh $30,000 per year. At a MARR of 15%,
we get
PW(15%) = -$110,000 + $30,000 (P/A, 15%, 6) + $8,000 (P/F, 15%, 6)
= -$110,000 +$30,000 (3.7845) + $8,000 (0.4323) = $6,993.40.
Since PW(15% > O, we conclude that the retrofitted space-heating system should
be installed.
 Assumptions of the PW method

1. It is assumed we know the future with certainty.

2. It is assumed we can borrow or lend money at the
same interest rate.
Bond value is a good example of present worth.
Two type of payments:
1. A series of periodic interest payments will be received until the
bond is retired.
2. A single payment when the bond is retired or sold. )Bond’s
maturity date is reached )

Face, Par, or value = Bond value (received after N periods )

Redemption or disposal price = bond value
Bond rate = nominal interest per interest period
N = number of periods before redemption
i = bond yield rate per period
Stan Moneymaker Wants to buy a Bond
Stan Moneymaker has the opportunity to purchase a certain U.S. Treasury bond
that matures in eight years and has a face value of $10,000. This means that Stan
will receive $10,000 cash when the bond's maturity date is reached. The bond
stipulates a fixed nominal interest rate of 8% per year, but interest payments are
made to the bondholder every three months; therefore, each payment amounts to
2% of the face value.
Stan would like to earn 10% nominal interest (compounded quarterly) per year on
his investment, because interest rates in the economy have risen since the bond
was issued. How much should Stan be willing to pay for the bond?
Bond value = 10,000$
Bond rate = 8% / 4 = 2% per 3 months (quarter)
i = 10% / 4 = 2.5% per 3 months (quarter)
N = 8×4 = 32 quarters.
Uniform received payments = Bond value × Bond rate
= 0.02 ×10,000 = 200$ per quarter

P = 10,000 (P/F, 2.5%, 32) + 200 (P/A, 2.5%, 32) = 8907.6$

Current Price and Annual Yield of Bond Calculation
A bond with a face value of $5,000 pays interest of 8% per year. This bond will be
redeemed at par value at the end of its 20-year life, and the first interest payment
is due one year from now. (a) How much should be paid now for this bond in order
to receive a yield of 10% per year on the investment?
(b) If this bond is purchased now for $4,600, what annual yield would the buyer
receive?

(a) Bond value = 5,000$. Bond rate = 8% per year. i = 10% per year.
N = 20 quarters.
Uniform received payments = Bond value × Bond rate
= 0.08 ×5,000 = 400$ per year
P = 5,000 (P/F, 10%, 20) + 400 (P/A, 10%, 20) = 4148.4$
(b) P = 4600$ find i?
4600 = 5,000 (P/F, i%, 20) + 400 (P/A, i%, 20)
By trial and error, i = 8.9%
 Capitalized worth CW

• Capitalized worth is the present worth of all revenues or

expenses over an infinite length of time.
• If only expenses are considered this is sometimes referred
to as capitalized cost.
• The capitalized worth method is especially useful in
problems involving endowments and public projects with
indefinite lives.

As N becomes very large, (P/A) = 1/i. So,

CW = outflow - A(1/i).
Determining the Capitalized Worth of an Endowment
Suppose that a firm wishes to endow an advanced biological processes laboratory at
a university. The endowment principal will earn interest that averages 8% per year,
which will be sufficient to cover all expenditures incurred in the establishment and
maintenance of the laboratory for an indefinitely long period of time (forever). Cash
requirements of the laboratory are estimated to be $100,000 now (to establish it),
$30,000 per year indefinitely, and $20,000 at the end of every fourth year (forever)
for equipment replacement.
(b) What amount of endowment principal is required to establish the laboratory and
then earn enough interest to support the remaining cash requirements of this
laboratory forever?

A = 30,000 + 20,000 (A/F, 8%, 4) = 34,438$

CW = -100,000 – 34,438 (P/A, 8%, infinity )
= -100,000 – 34,438/.08 = -530,475$
 Future Worth (FW)

• FW is based on the equivalent worth of all cash

inflows and outflows at the end of the study period at
an interest rate that is generally the MARR.

• Decisions made using FW and PW will be the same.

A positive FW for an investment project means that the project
is acceptable (it satisfies the MARR).
 Annual Worth (AW)

• Annual worth is an equal periodic series of dollar

amounts that is equivalent to the cash inflows and
outflows, at an interest rate that is generally the
MARR.
• The AW of a project is annual equivalent revenue or
savings (R) minus annual equivalent expenses (E),
minus annual capital recovery (CR) amount.
• Capital Recovery CR is the annual equivalent cost of the
capital invested.
• The CR covers the following items.
– Loss in value of the asset.
– Interest on invested capital (at the MARR).
• The CR distributes the initial cost (I) and the salvage value (S)
across the life of the asset.

Equivalent Uniform Annual Cost (EUAC) = CR + E

Example:
A corporate jet costs 1,350,000$ and will incur 200,000$ per year in
fixed cost )maintenance,… ( and 277$ per hour variable cost
)fuel,…(. The jet will be operated 1200 hours per year for five
years and then sold for 650,000$. The jet revenues 1000$ per hour.
The MARR is 15% per year.
1. Revenue, R = 1000$ × 1200 = 1,200,000$ per year
2. Expense, E = 200,000$ + 277$ ×1200 = 532,400$ per year
3. Capital Recovery,
CR = 1,350,000(A/P, 15%, 5) – 650,000(A/F, 15%, 5)
= 306,310$ per year
4. Annual Worth, AW = R – E – CR = 361,290$ per year
5. Equivalent Uniform Annual Cost,
EUAC = E + CR = 838,710$ per year
 Present Worth of a Space-Heating System
A retrofitted space-heating system is being considered for a small office
building. The system can be purchased and installed for $110,000, and it will
save an estimated 300,000 kilowatt-hours (kWh) of electric power each year
over a six-year period. A kilowatt-hour of electricity costs $0.10, and the
company uses a MARR of 15% per year in its economic evaluations of
refurbished systems. The market value of the system will be $8,000 at the
end of six years, and additional annual operating and maintenance
expenses are negligible. Use the AW method to determine whether this
system should be installed
1. Revenue, R = 300,000 × 0.1 = 30,000$ per year
2. Expense, E = 0 $
3. Capital Recovery,
CR = 110,000(A/P, 15%, 6) – 8,000(A/F, 15%, 5)
= 28,148.4$ per year
4. Annual Worth, AW = R – E – CR = 1,851.6$ per year
5. Equivalent Uniform Annual Cost,
EUAC = E + CR = 28,148.4$ per year
 Internal Rate of Return

• The internal rate of return (IRR) method is the most widely used
rate of return method for performing engineering economic
analysis.
• It is also called the investor’s method, the discounted cash flow
method, and the profitability index.
• If the IRR for a project is greater than the MARR, then the
project is acceptable.
• The IRR is the interest rate that equates the equivalent
worth of an alternative’s cash inflows (revenue, R) to the
equivalent worth of cash outflows (expenses, E).
• The IRR is sometimes referred to as the breakeven interest
rate.
The IRR is the interest i'% at which

The method of solving for the i'% that equates revenues

and expenses normally involves trial-and-error
calculations, or solving numerically using mathematical
software.
Economic desirability of a project using the IRR Method
AMT, Inc., is considering the purchase of a digital camera for the maintenance of
design specifications by feeding digital pictures directly into an engineering
workstation where computer-aided design files can be superimposed over the
digital pictures. Differences between the two images can be noted, and corrections,
as appropriate, can then be made by design engineers. The capital investment
requirement is $345,000 and the estimated market value of the system after a six-
year study period is $115,000. Annual revenues attributable to the new camera
system will be $120,000, whereas additional annual expenses will be $22,000. You
have been asked by management to determine the IRR of this project and to make
a recommendation. The corporation's MARR is 20% per year. Solve first by using
linear interpolation and then by using a spreadsheet.

-345,000 + 115,000(P/F, i, 6) + 98,000(P/A, i, 6) = 0

OR -345,000(F/P, i, 6) + 115,000 + 98,000(F/A, i, 6) = 0
OR -345,000(A/P, i, 6) + 115,000(A/F, i, 6) + 98,000 = 0
 -345,000 + 115,000(P/F, i, 6) + 98,000(P/A, i, 6) = 0
Try i = MARR = 20%
-345,000 + 115,000×0.3349 + 98,000×3.3255 = 19,412.5
Try i = 25%
-345,000 + 115,000×0.2621 + 98,000×2.9514 = -25,621

20% 19,412.5
i − 25 20 − 25
i% 0 =
0 − −25621 19412.5 − −25621
25% -25,621

i = IRR = 22.1% per year

A piece of new equipment has been proposed by engineers to increase the
productivity of a certain manual welding operation. The investment cost is
$25,000, and the equipment will have a market (salvage) value of $5,000 at
the end of its expected life of five years. Increased productivity attributable
to the equipment will amount to $8,000 per year after extra operating costs
have been subtracted from the value of the additional production. Use a
spreadsheet to evaluate the IRR of the proposed equipment. Is the
investment a good one?
Recall that the MARR is 20% per year.
-25,000 + 5,000(P/F, i, 5) + 8,000(P/A, i, 5) = 0
Try i = 20% -25,000 + 5,000×0.4019 + 8,000×2.9906 = 934.3$
Try i = 25% -25,000 + 5,000×0.3277 + 8,000×2.6893 = -1847.1
20% 934.3
i − 25 20 − 25
i% 0 =
0 − −1847.1 934.3 − −1847.1
25% -1847.1

i = IRR = 21.68% per year

 $8000 $8000 $8000 $8000 $8000
$5000

0 1 2 3 4 5

$25000
Do You Know What Your Effective Interest Rate Is
In 1915, Albert Epstein allegedly borrowed $7,000 from a large New York bank on
the condition that he would repay 7% of the loan every three months, until a total
of 50 payments had been made. At the time of the 50th payment, the $7,000 loan
would be completely repaid. Albert computed his annual interest rate to be
[0.07($7,000) 4]/$7,000 = 0.28 (28%).
(a) What true effective annual interest rate did Albert pay?
(b) What, if anything, was wrong with his calculation?

A = 0.07 × 7000 = 490$

7000 - 490(P/A, i, 50) = 0 (P/A, i, 50) = 14.2857
i = 6% (P/A, 6%, 50) = 15.7619 i−7 6−7
=
i = 7% (P/A, 7%, 50) = 13.8007 14.2857 − 13.8007 15.7619 − 13.8007

i = IRR = 6.75% per three months = 27% yearly

 .0675  4 
M 4
 r 
i = IRR = 1 +  − 1 = 1 +  − 1 = 29.86% per year
 M  4 
$7000

0 1 2 3….... 50

490 490 490 490

Be Careful with "Fly -by-Night" Financing!
The Fly-by-Night finance company advertises a "bargain 6% plan" for
financing the purchase of automobiles. To the amount of the loan being
financed, 6% is added for each year money is owed. This total is then
divided by the number of months over which the payments are to be made,
and the result is the amount of the monthly payments. For example, a
woman purchases a $10,000 automobile under this plan and makes an initial
cash payment of $2,500. She wishes to pay the $7,500 balance in 24
monthly payments:

What effective annual rate of interest does she actually pay?

 -7500 + 350(P/A, i, 24) = 0 (P/A, i, 50) = 21.4286
i = 1% (P/A, 1%, 24) = 21.2434
i = 0.75% (P/A, 0.75%, 24) = 21.8891

i = IRR = 0.93% per month = 11.16% yearly

 .0093  12 
12

i = IRR = 1 +  − 1 = 11.75% per year

 12 
 External Rate of Return (ERR)

• The IRR assumes revenues generated are reinvested at

the IRR—which may not be an accurate situation.

• The ERR takes into account the interest rate, ε,

external to a project at which net cash flows generated
(or required) by a project over its life can be reinvested
(or borrowed). This is usually the MARR.

• If the ERR happens to equal the project’s IRR, then

using the ERR and IRR produce identical results.
 The ERR procedure
• Discount all the net cash outflows to time 0 at ε% per
compounding period.
• Compound all the net cash inflows to period N at ε%.
• Solve for the ERR, the interest rate that establishes
equivalence between the two quantities.
P = 25,000$
F / P = (1+ i ) N
F = 8000(F/A, 20%, 5) + 5000 = 64,532.8
2.5813 = (1 + i )5
F/P = 64,532.8/25,000 = 2.5813 i = ERR = 20.88%
P = 10,000 + 5,000(P/F, 15%, 1) = 14,348$ F / P = (1+ i ) N
F = 5000(F/A, 15%, 5) = 33,712$ 2.3496 = (1 + i )6
F/P = 33,712/14,347.8 = 2.3496 i = ERR = 15.3%
 Payback Period

Simple payback period (θ ) is the smallest value of θ (θ ≤ N) for

which the relationship below is satisfied.

Discounted payback Period (θ' ): future cash flows are discounted

back to the present at a MARR, so the relationship to satisfy
becomes
 Problems with the payback period method.

• It doesn’t reflect any cash flows occurring after θ, or θ'.

• It doesn’t indicate anything about project desirability
except the speed with which the initial investment is
recovered.
• Recommendation: use the payback period only as
supplemental information with one or more of the other
methods in this chapter.