CpE-ECON211 - Engineering Economics

Chapter Two
Cost of Money
2.1. Interest

Interest is what you pay the bank for your car loan or your unpaid credit card balance. Interest is
what the bank pays you for the money in your savings account. Interest is a rental fee for money.
Interest is a fee paid or a fee earned for the use of money.

Engineering economy generalizes this definition. Interest is the return on capital. Capital is the
invested money and resources. Whoever owns the capital should expect a return on it from
whom ever uses it. For example, if a firm owns the capital and invests it in a project, then the
project should return that capital plus interest as cost savings or added revenues.

When you borrow from the bank, you pay interest. When you loan money to the bank by
depositing it, the bank pays you interest. When a firm invests in a project, that project should earn
a return on the capital invested.

This interest is typically expressed as an annual interest rate. That rate equals the ratio of
the interest amount and the capital amount. For example, if $100 is borrowed for a year and $5 in
interest is paid at the year‘s end, then the interest rate is 5% (= $5/$100). If the amount borrowed
and the amounts of interest paid are doubled, then the interest rate is still 5%, since $10/$200 =
5%.

When the bank owns the capital, a loan document will state the interest rate. When the owner of
the capital buys shares in a firm, the interest is earned through dividends and increasing share
values. The return to the shareholder is less certain, but it is still the earning power of money. It is
still interest.

Similarly, when a firm or an individual invests money or resources in an engineering project, that
project must earn a return on the invested capital. This return is earned by increasing
future revenues and/or by decreasing future costs.
 CpE-ECON211 - Engineering Economics

Interest is used to calculate the time value of money, and it is crucial to the practice of
engineering. A history of engineering economy shows the parallel development of engineering and
engineering economy.

Interest= Ending amount - Beginning amount = Amount owed now- Principal

Interest rate is a percentage added to an amount of money over a specified length of time.
Interest rate (%) = Interestadded per tim eunit
Principal
*100%
The interest rate that is appropriate depends on many factors, including risks, security, economic
conditions, regulations, and time frame.

Interest paid Interest earned

Interest rate Rate of return

- Lent money
Borrowed money - Saved ―
- Invested

Definition of Terms

P=Value or amount of money at a time designated as the present time t=0. Initial deposit,
Investment made at t=0.

F= Value or amount of money at some future time.

A= Series of equal consecutive end of period amounts of money

n= Number of interest periods (year, month, day).

 CpE-ECON211 - Engineering Economics

i= interest period per time period(percent per year, percent per month).

t= stated time period (years, months, days).

Simple Interest:With simple interest, the interest calculated for years 2, 3, . . . is based on the
initial deposit. No interest is computed on the accrued interest. In Equation 2.1, the interest rate is
simply multiplied by the number of years. Simple interest should not be used in engineering
economy problems. Its principal use is in short-term loans, but compound interest is the norm even
then.

F = P(1 + Ni) (2.1)

A bank account, for example, may have its simple interest every year: in this case, an account with
$1000 initial principal and 20% interest per year would have a balance of $1200 at the end of the
first year, $1400 at the end of the second year, and so on.

t Pi End of Year

0 1000

1 200 1200

2 200 1400

Compound Interest:is interest paid (earned) on any previous interest earned, as well as on the
principal borrowed (lent). The standard assumption is that interest is computed on the current
balance, which includes accrued interest that has not yet been paid. This addition of interest to the
principal is called compounding.Savings accounts, loans, credit cards, and engineering
economy rely on this assumption. In Equation 2.2, the number of years is a power of the factor that
includes the interest rate.

F = P(1 + i )N (2.2)

This formula is developed as shown below,

 CpE-ECON211 - Engineering Economics

Table 1: Development of equation 2.2

Period Beginning of period value End of period value

1 P P(1+i)

2 P(1+i) P(1+i) (1+i)

3 P(1+i)2 P(1+i)2(1+i)

… … …

N P(1+i)N-1 P(1+i)N

A bank account, for example, may have its interest compounded every year: in this case,
an account with $1000 initial principal and 20% interest per year would have a balance of $1200
at the end of the first year, $1440 at the end of the second year and soon.

t Beginning of year (1) Pi (2) End of Year =(1)+(2)

0 1,000

1 1,000 200 1,200

2 1,200 240 1,440

2.2. Cash Flow Diagrams

Cash flow diagrams show thetiming and amountof expenses andrevenues

forengineeringprojects. It describes inflow and outflow of money overtime.
The picture of how much money is spent or received and when is a cash flow diagram.This
diagram summarizes an engineering project‘s economic aspects.

The cash flow diagram‘s horizontal axis represents time. The vertical axis represents money, and
arrows show the timing and amount of receipts and expenses. Positive cash flows are receipts (those
arrows point up). Negative cash flows are expenses (those arrows point down).
 CpE-ECON211 - Engineering Economics

(+) UP

(-) Down

Below also shows that in some cases, the diagram can simply be reversed depending on which
viewpoint is taken. The depositor and the bank have opposite perspectives on cash in and cash out
for the initial deposit and the final withdrawal.

More complex cash flow diagrams involve more than two parties. For example, labor expenses are
paid to employees, machine purchases to a manufacturer, and power purchases to a utility
company, while revenues are received from customers. These complex diagrams are not mirror
images, because each party sees a different set of cash flows.

Categories of Cash Flows:The expenses and receipts due to engineering projects usually fall
into one of the following categories. Costs and expenses are drawn as cash outflows (negative
arrows), and receipts or benefits are drawn as cash inflows (positive arrows).
First cost ≡ expense to build or to buy and install
Operations and maintenance (O&M) ≡ annual expense, which often includes
electricity,labor, minor repairs, etc.
Salvage value ≡ receipt at project termination for sale or transfer of the equipment(can be
a salvage cost)
 CpE-ECON211 - Engineering Economics

Revenues ≡ annual receipts due to sale of products or services

Overhaul ≡ major capital expenditure that occurs during the asset‘s life
Prepaid expenses ≡ annual expenses, such as leases and insurance payments, thatmust be
paid in advance
Timing of Cash Flows:For money‘s time value, there has to be an assumption for when cash flows
occur. Cash flows could be assumed to occur at the beginning, middle, or end of the year, or they
could be distributed throughout the year. In fact, tables of engineering economy factors have been
constructed for all of these assumptions. This course and normal practice assume end- of-period
timing for most cash flows.

Example:An earth moving company is considering purchase of a piece of heavy equipment. The
cash flow diagram for the following anticipated cash flows:

First cost=$120,000

Operating & maintenance cost=$30,000 per year

Overhaul cost=$35,000 in year 3

Salvage value=$40,000 after 5 years

 CpE-ECON211 - Engineering Economics

Examples of cash flow diagram for different payment types are presented as follow;
Multiple Payment Series
:Uniform (Equal) or
Single Payment Series
F Unequal

0 1 2 N
P

Gradient Payment Series:

Linear and Geometric

2.3. Single Payment Series

The basic formula relating the two single-payment quantities, P and F, was used and developed in
Section 2.1. Developed for compound interest and the relationship is shown in Equation 2.2, F
= P(1 + i)N. In each period, interest at rate i is earned so that end-of-period quantities are (1 + i)
times the beginning-of-period quantities.

Period Beginning of period value End of period

value
1 P P(1+i)

2 P(1+i) P(1+i) (1+i)

3 P(1+i)2 P(1+i)2(1+i)
 CpE-ECON211 - Engineering Economics

… … …

N P(1+i)N-1 P(1+i)N

The format of the engineering economy factors is (X/Y,i,N). This is often read aloud as ―find X
given Y at i over N periods‖ or as ―X given Y.‖ The X and Y are chosen from the cash
flow symbols, P, F, A, and G. If Y is multiplied by the factor, then the equivalent value of X results
(for N years at i per year). Thus, it may be useful to think of the multiplication as clearing
fractions, where the Ys cancel and X is left. So, to convert from a cash flow in year 10 (an F) to an
equivalent present value (a P), the factor is (P/F,i,10).

Equation 2.2 is the basis for two inverse factors represented as, (F/P,i,N) and (P/F,i,N). The first is
called the compound amount factor, since it compounds a present amount into the future with the
factor (1 + i)N. Equation 3.1 is basically the right-hand side of Equation 2.2.

(F/P,i,N) = (1 + i)N (3.1)

The second is the present worth factor. It discounts a single future value in period N to a present
worth. Equation 3.2 is the inverse of Equation 3.1.

(P/F,i,N) = (1 + i)–N (3.2)

Factors for P and F

 CpE-ECON211 - Engineering Economics

Multiple Payment Series: Uneven

2.4. Uniform Series

This section develops the formula to convert from a uniform series (A) to a present worth (P).
This formula is combined with the earlier (F/P,i,N) formula to produce the (F/A,i,N) formula.

A uniform series is identical to N single payments, where each single payment is the same and
there is one payment at the end of each period. Thus, the (P/A,i,N) factor is derived algebraically
by summing N single-payment factors, tom. The derivation of Equation 3.3 is shown below
P = A[(1 + i)N– 1]/[i(1 + i)N] (3.3)

The easiest way to derive Equation 3.4, which connects the uniform series, A, with the future
single payment, F, is to multiply both sides of Equation 3.3 by (1 + i)N.

(1 + i)N P = A[(1 + i)N– 1]/i

F = A[(1 + i)N– 1]/i (3.4)

P = A[ 1/(1 + i)1 + 1/(1 + i)2 +…+1/(1 + i)N–1 + 1/(1 + i)N]

(1 + i)P = A[1/(1 + i)0 + 1/(1 + i)1 + 1/(1 + i)2 +…+1/(1 + i)N–1]

(1 + i)P – P = A[1/(1 + i)0 – 1/(1 + i)N]

 CpE-ECON211 - Engineering Economics

i P = A[1 – 1/(1 + i)N]

= A[(1 + i)N – 1]/(1 + i)N]

P = A[(1 + i)N – 1]/[i(1 + i)N]

Equations 3.3 and 3.4 are each the basis for two factors tabulated in Appendix C. The
series present worth factor, (P/A,i,N), and the capital recovery factor, (A/P,i,N), as shown in
Equations
3.5 and 3.6, are inverses based on Equation 3.3. The capital recovery factor‘s name comes from
asking, ―How much must be saved or earned in each period, A, to recover the capital cost of the
initial investment, P?‖

(P/A,i,N)= [(1 + i)N– 1]/[i(1 + i)N] (3.5)

(A/P,i,N)= 1/(P/A,i,N)
= i(1 + i)N/[(1 + i)N–1] (3.6)

The series compound amount factor, (F/A,i,N), and the sinking fund factor, (A/F,i,N), as shown in
Equations 3.7 and 3.8, are inverses based on Equation 3.4. The name of the sinking fund factor
comes from an old approach to saving enough funds to replace capital equipment, which would
cost F after N years. In each period, an amount, A, would be placed in a savings account (called a
sinking fund), and then, after N years, a total of F would have accumulated through deposits and
interest.

(F/A,i,N) = [(1 + i)N– 1]/i (3.7)

(A/F,i,N) = 1/ (F/A,i,N)
= i / [(1 + i )N– 1] (3.8)
 CpE-ECON211 - Engineering Economics

Example: If $10,000 is borrowed and payments of $2000 are made each year for 9 years, what is
the interest rate?

• Either solve the equation or use tables for interest factors and find that the interest
rate is between 13% and 14%. These capital recovery factors,

(A/P,.13,9) = 0.1949 and (A/P,.14,9) = 0.2022 include the value of .2.

• We interpolate for the value of i.

i = 0.13 + (0.2 – 0.1949)(0.14 – 0.13)/(0.2022 – 0.1949) = 13.7%

2.5. Gradient Payment Series

2.5.1. Linear Gradient Series

A typical application of linear gradient is: ―Revenue is $4000 the first year, increasing by $1000
each year thereafter.‖ The linear gradient is the $1000- per-year change in cash flows. The $4000
per year is an annuity or uniform annual series. For the first period, the linear gradient‘s zero
cash flow is added to the uniform series‘ cash flow of $4000. In the second period, the total cash
flow is $4000 + $1000. In the third,it is $4000 + 2($1000). This is why the tabulated
linear gradient series begins with a zero cash flow for period 1.

The linear gradients have cash flows of zero at the end of the first period. The first nonzero cash
flow occurs at the end of period 2, and an N-period arithmetic gradient has N – 1 nonzero cash
flows, which change by G per period. A common mistake is to visualize an arithmetic gradient
series as N – 1 periods long. The arithmetic gradient series is N periods long, but the first period
has zero cash flow.
 CpE-ECON211 - Engineering Economics

1 i n- 1 i - in -
1
in - 1 P G
F G
i2 n

n 2
i i
1

G P / G, i%,n
G F/
G,i%,n

Gradient as composite

Example 1: A consulting engineer is considering two investment alternatives (A and B) having

cash flow alternative shown below.Assume an equivalent i=10%
 CpE-ECON211 - Engineering Economics

Alternative A: is an investment in a land development venture. Several other limited partners are
considering purchasing land, subdividing it, and selling land parcels over a 5 years period (an
increase in land value is anticipated)
 CpE-ECON211 - Engineering Economics

Alternative B: is for computer and the software required providing specialized computer-design
capabilities for clients. The engineer anticipates that competition will develop quickly if his plan
proves successful; a declining revenue profile is anticipated.
50
40 k k 50 k

1 2 3 4
5 100,0
00 40 k

30
k
Alterna2t0ivke A
Alterna3ti0vekB 20 10 k
10 k k

A PV A B PV B
1 3 4 5
2
1000,0 (100,000) (100,000) (100,000) (100,000)
00

1 10,000 9,090.91 50,000 45,454.55

2 20,000 16,528.93 40,000 33,057.85

3 30,000 22,539.44 30,000 22,539.44

4 40,000 27,320.54 20,000 13,660.27

5 50,000 31,046.07 10,000 6,209.21

PV 6,526 20,921

Since alternative B has a greater positive net present value it is a better recommendation.

Example 2: Maintenance cost for a particular production machine increase by $1000/yr over the
5 year life of the equipment. The initial maintenance cost is $3000. Using an interest rate of 8 %
compounded annually, determine the present worth equivalent for the maintenance cost.
 CpE-ECON211 - Engineering Economics

2.5.2. Geometric Gradient Series

The last section presented factors for an arithmetic gradient, G, that changed by a constant
amount each period. The real world often has cash flows that have a constant rate of
change. This type of cash flow is a geometric gradient (also known as an escalating series). A salary
that increases 6% per year is increasing geometrically, just as a market demand that decreases 15%
per year is decreasing geometrically.

Many geometric gradients come from population levels where changes over time are best
modeled as a percentage of the previous year. The percentage or rate is constant over time, rather
than the amount of the change, as in the arithmetic gradient.

Consider an engineer whose starting salary is $30,000 per year, with an expected increase of 6%
per year for the next 15 years. Six percent of $30,000 is $1800, and an arithmetic gradient of
$1800 leads to a final salary of $55,200. However, as shown on the geometric curve of Exhibit
3.23, a constant 6% rate of increase leads to a final salary of $67,827. Thus, a geometric gradient
leads to a final salary that is 23% larger than that of an arithmetic gradient.

The difference between arithmetic and geometric gradients is greater for larger rates of change and
longer time periods. For a short time interval at a low percentage change, it may not matter which
model we use. Often, the geometric model will be more accurate, and the simpler arithmetic
model might be misleading.
 CpE-ECON211 - Engineering Economics

Example: Assume you receive an annual bonus and deposit it in a saving account that pays 8
percent compounded annually. Your initial bonus is 500 birr and the size of your bonus increases
by 10% each year. Determine how much will be in the fund immediately after your 10th deposit.

A1=500, i=8%, g=10%, and n=10 years

F= 10,870.44

P= 10,870.44/(1.0810)=5,035.12
 CpE-ECON211 - Engineering Economics

Cash flow 0 500 550 605 666 732 805 886 974 1072 1179
End of
Year(n) 0 1 2 3 4 5 6 7 8 9 10

Economic Factors
 CpE-ECON211 - Engineering Economics

2.6. Economic Equivalence

Equivalence adjusts for the time value of money. Equivalence means that different cash flows at
different times are equal in economic value at a given interest rate. For instance, $100 deposited at
year 0 and the $127.63 in the savings account at year 5 were equivalent at 5% per year.

Equivalence uses an interest rate or discount rate to adjust for the time value of money. Since $1
today and $1 a year from now have different values, this adjustment must occur before the cash
flows can be added together.

One way to understand equivalence is through a loan. Money is borrowed, interest accrues on the
unpaid balance, payments are made, and eventually, the loan is repaid and the payments stop. The
initial borrowing and the payments are equivalent at the loan‘s interest rate.

There are certain rules that one should follow to make these calculations;

They need to have a commontimebasis;

Equivalence is dependent on interest rate; and
Equivalence is maintainedregardless of anything.

Example: What single sum of money at t=0 is equivalent to the cash table below.

PA2 P
2

A2 =100
PA1
P1
0

1 2 3 4 5 6 7 8
P=P400 +PA1+P A2

A 1=100P =-400(P/F,10%,1)
400

400 PA1=[100(P/A,10%,3)(P/F,10%,1)]
PA2=[100(P/A,10%,3)(P/F,10%,5)]
P=16.85
 CpE-ECON211 - Engineering Economics

Exercise

1. Using an 8% discount rate, what uniform series over five periods, [1,5], is equivalent to the
cash flow given in Figure 1.

Figure 1

2. For what interest rate are the two cash flows shown in Figure 2 equivalent ?

3. Consider two investment choices that both require an initial out flow of 20, 000 birr and
expected revenue as shown by respective cash flow diagrams. Which one should be chosen?
I = 10%

Choice 1

4. Define and clarify with examples

– Nominal interest rates and

– Effective Interest rates

 CpE-ECON211 - Engineering Economics

Chapter Three
Economic Evaluation

3.1. Present worth and Future analysis

3.1.1. Present Worth Analysis

The PW measure is easy to understand, easy to use, and matched to our intuitive understanding of
money. The very name, present worth, conjures an image of current value. More formally,
present worth (PW) is the value at time 0 that is equivalent to the cash flow series of a proposed
project or alternative.

Engineering economists and this text often use present worth (PW), present value (PV), net
present worth (NPW), and net present value (NPV) as synonyms. Sometimes the net is
included to emphasize that both costs and benefits have been considered.

Present worth is easy to use because of the sign convention for cash flows. Cash flows that are
revenues are greater than zero, and cash flows that are costs are less than zero. Thus, the standard
for a desirable PW is PW > 0. (PW = 0 represents economic indifference, and a PW < 0 should be
avoided if possible.)

Present worth is an attractive economic measure, because we have an intuitive feel for the
result‘s meaning. We have an image of what $100, $1000, or $1,000,000 is worth right now. A
similar intuitive feel for future dollars is difficult to develop

Standard Assumptions: The present worth measure is commonly applied by making the
following assumptions:

i. Cash flows occur at the end of the period, except for first costs and
prepaymentslike insurance and leases.
ii. Cash flows are known values. These known values are certain, or deterministic,values.
iii. The interest rate, i, is given.
iv. The problem‘s horizon or study period, N, is given.
 CpE-ECON211 - Engineering Economics

These assumptions imply that a problem can be summarized as a cash flow diagramplus
an interest rate. These assumptions often simplify reality. Nevertheless, the conclusions of
the engineering economic analysis are generally not affected. These simplifications also imply that
we need a sense of proportion. If the first cost and total revenues are in the tens of millions of
dollars, then a PW of $100,000 may be better thought of as plus or minus 0. The uncertainty in the
data is probably larger than 1% of the tens of millions.

a) Evaluation of a Single Project using present worth analysis

Step 1: Determine the interest rate that the firm wishes to earn on its investments. The interest rate
you determine represents the rate at which the firm can always invest the money in its
investment pool. This interest rate is often referred to as either a required rate of return
or a minimum attractive rate of return(MARR). Usually this selection is a policy decision made
by top management. It is possible for the MARR to change over the life of a project. but for now
we will use a single rate of interest when calculating PW.
Step 2: Estimate the service life of the project.
Step 3: Estimate the cash inflow for each period over the service life.
Step 4: Estimate the cash outflow for each period over the service life.
Step 5: Determine the net cash flows for each period (net cash flow = cash inflow - cash
outflow).
Step 6: Find the present worth of each net cash flow at the MARR. Add up these present-worth
figures; their sum is defined as the project's PW.

In order to evaluate projects one need to use discountedcashflowtechniques (DCF). One of these
is the method of netpresentworth (NPW) or netpresentvalue (NPV).

PW costs = Ci+ CSn(P/A, i ,n)

PW incomes = In (P/A, i, n) + S (P/F, i, n)

NPW(NPV) = PW incomes - PW costs

 CpE-ECON211 - Engineering Economics

Step 7: In this context, a positive PW means that the equivalent worth of the inflows is greater than
the equivalent worth of the outflows, so the project makes a profit.Therefore, if the PW (i) is
positive for a single project, the project should be accepted; if it is negative, the project should be
rejected. The process of applying the PW measure is implemented with the following decision rule:

If PW(i) > 0, accept the investment.

If PW(i) = 0, remain indifferent.
If PW(i) < 0, reject the investment.

Comparing More Than One Alternative

Note that the foregoing decision rule is for evaluation of a single project for which you
can estimate the revenues as well as the costs. The following guidelines should be used
for evaluating and comparing more than one project:

1. If you need to select the best alternative, based on the net-present-worth criterion, select the
one with the highest PW, as long as all the alternatives have the same service lives.
Comparison of alternatives with unequal service lives requires special assumptions,
as will be detailed in section
2. As you will in some cases, comparison of mutually exclusive alternativeswith the same
revenues is performed on a cost-only basis. In this situation,you should accept the project
that results in the smallest PW of costs,or the least negative PW (because you are
minimizing costs, rather thanmaximizing profits).

Guidelines for Selecting a Minimum Attractive Rate of Return (MARR)

Return is what you get back in relation to the amount you invested. Return is one way to evaluate
how your investments in financial assets or projects are doing in relation to each other and to the
performance of investments in general. Let us look first at how we may derive rates of return.
Conceptually, the rate of return that we realistically expect to earn on any investment is a
function of three components:

risk-free real return,

inflation factor, and
 CpE-ECON211 - Engineering Economics

risk premium(s).

Suppose you want to invest in a stock. First, you would expect to be rewarded in some way for not
being able to use your money while you hold the stock. Second, you would expect to be
compensated for decreases in purchasing power between the time you invest and the time your
investment is returned to you. Finally, you would demand additional rewards for having taken the
risk of losing your money if the stock did poorly. If you did not expect your investment to
compensate you for these factors, why would you tie up your money in this investment in the first
place?

In present-worth analysis, we assume that all the funds in a firm's treasury can be placed
in investments that yield a return equal to the MARR. We may view these funds as an investment
pool. Alternatively, if no funds are available for investment, we assume that the firm can borrow
them at the MARR from the capital markets. In this section, we will examine these two views when
explaining the meaning of MARR in PW calculations.

Example: Your Company is looking at purchasing a front-end loader at a cost of $120,000. The
loader would have a useful life of five years with a salvage value of $12,000 at the end of the fifth
year. The loader can be billed out at $95.00 per hour. It costs $30.00 per hour to operate the frontend
loader and $25.00 per hour for the operator. Using 1,200 billable hours per year determine
the net present value for the purchase of the loader using a MARR of 20%. Should your company
purchase the loader?

Solution

The hourly profit [HP] on the loader equals the billing rate less the operation cost and the cost
of the operator.

HP = $95.00 – [$30.00+ $25.00] = $40.00 per hr

Annual Profit = $40.00/hr x [1,200 hr/yr] = $48,000/yr. The cash flow diagram;
 CpE-ECON211 - Engineering Economics

The present value of the annual profits [PAP ] by using USPWF:

PAP = $48,000[(1+0.20)5-1] / [0.20(1+0.20)5] = $143,549

The PAP is positive because it is a cash receipt.

The present value of the salvage value [PSV] by using SPPWF

PSV = $12,000/(1+0.20)5 = $4,823

The PSV is positive because it is a cash receipt.

The present value purchase price [PPP] of the loader = purchase price. Because the net present
value is measured at the time of the initial investment.

The PPP is negative because it is a cash disbursement.

NPV = PAP + PSV + PPP

Because the NPV is greater than zero, the purchase of the front- end loader will
produce a return greater than the MARR and your company should invest in the front-end
loader.

When comparing two alternatives with positive net present values, the alternative with the
largest net present value produces the most profit in excess of the MARR.

b) Present Worth Analysis of Alternatives with Different-life Span

When the present worth method is used to compare mutually exclusive alternatives that
have different lives, then the PW of the alternatives must be compared over the same number of
years and end at the same time.A fair comparison can be made only when the PW values represent
costs (and receipts) associated with equal periods ( if not shorter lived alternatives will be
favored though they may not be economically favorable).

The equal-period requirement can be satisfied by comparing the alternatives over a period
of time equal to the least common multiple (LCM) of their lives.The LCM approach automatically
makes the cash flows for all alternatives extend to the same time period.
 CpE-ECON211 - Engineering Economics

For example, alternatives with expected lives of 2 and 3 years are compared over a 6-year time
period. And alternatives with expected lives of 2, 4 and 5 years are compared over a 20-year time
period

Such a procedure requires that some assumptions be made about subsequent life cycles of the
alternatives. The assumptions of a PW analysis of different-life alternatives for the LCM method
are as follows:

The service provided by the alternatives will be needed for at least the LCM of years
The selected alternative will be repeated over each life cycle of the LCM in exactly the
same manner
The cash flow estimates will be the same in every life cycle

Example: Your company needs to purchase a dump truck and has narrowed the selection down to
two alternatives. The firstalternative is to purchase a new dump truck for $65,000. At the end of
the seventh year the salvage value of the new dump truck is estimated to be $15,000. The
second alternative is to purchase a used dump truck for $50,000. At the end of the fourth year the
salvage value of the used dump truck is estimated to be $5,000. The annual profits, revenues less
operation costs, are $17,000 per year for either truck. Using a MARR of 18% calculate the net
present value for each of the dump trucks. Which truck should your company purchase?

Solution

The present value of the annual profits for either truck is determined by using USPWF:

PAP = $17,000 [(1+0.18)28–1]/0.18[1+0.18]28] =17,000*5.502

= $93,527

Alternative 1[New]: The PSV for the new dump truck is determined by summing the PSVs
occurring in years 7, 14, 21, and 28. The present value for each salvage value is calculated
using SPPWF as follows:
 CpE-ECON211 - Engineering Economics

The PPP for the new dump truck is determined by summing the present value of purchase prices
occurring in years 0, 7, 14, and 21. The present value for each purchase price is calculated using
SPPWF as follows:

The NPV for the purchase of the new dump truck is calculated as follows:

NPV [New] = $93,527 + $6,797 + [ -$93,822] = +$6,502

Alternative 2[Used]: The PSVs for the used dump truck is determined by summing the present
value of salvage values occurring in years 4, 8, 12, 16, 20, 24, and 28. The present value for each
salvage value is calculated using SPPWF as follows:
 CpE-ECON211 - Engineering Economics

The PPPs for the used dump truck is determined by summing the present value of purchase
prices occurring in years 0, 4, 8, 12, 16, 20, and 24. The present value for each purchase price is
calculated using SPPWF as follows:

The net present value [NPV] for the purchase of the used dump truck is calculated as
follows:
 CpE-ECON211 - Engineering Economics

NPV = $93,527 + $5,275 + [ -$102,257] = -$3,455

The new truck has the highest NPV; therefore, your company should purchase the new
truck.

c) Alternatives with Infinite lives: Capitalized equivalence method

A special case of the PW criterion is useful when the life of a proposed project is perpetual or the
planning horizon is extremely long (say, 40 years or more). Many public projects such as bridges.
Waterway constructions, irrigation systems, and hydroelectric dams are expected to generate
benefits over an extended period of time (or forever). In these situations a PW analysis would have
an infinite analysis period. This analysis is called capitalized equivalence method. A capitalized
cost is the present sum of money that would need to be set aside now, at some interest rate,
to yield the funds required to provide the service indefinitely.

Capitalized equivalent (CE) is the present (at time zero) worth of cash inflows and outflows. CE
analysis is very useful to compare long-term projects.In other words, CE is a single amount
determined at time zero, which at a given rate of interest, will be equivalent to the net difference
of receipts and disbursements if the given cash flow pattern is repeated in perpetuity (in
perpetuity the period assumed is infinite).

Mathematically, CE = A x (P/A, i, n=∞)

= A x [((1+i)∞-1)/ i(1+i)∞]= A/i

Example:A city plans a pipeline to transport water from a distant watershed area to the city. The
pipeline will cost $8 million and have an expected life of seventy years. The city anticipates it will
need to keep the water line in service indefinitely. Compute the capitalized cost assuming
7% interest.
 CpE-ECON211 - Engineering Economics

Solution
We have the capitalized cost equation P = A/i, which is simple to apply when there are end-of-
period disbursements A. in this case, the $8 million repeats every 70 years. We can find A first
based on a present $8 million disbursement.
A = P(A/P, i, n) = $8,000,000(0.0706) = $565,000
Now, the infinite series payment formula could be applied for n =∞ :
Capitalized cost P = A / i = 565,000 / 0.07 = $8,071,000

Example:A new computer system will be used for the indefinite future, find the equivalent value
now if the system has an installed cost of $150,000 and an additional cost of $50,000 after 10 years.
The annual maintenance cost is $5,000 for the first 4 years and $8,000 thereafter. In
addition, it is expected to be a recurring major upgrade cost of $15,000 every 13 years. Assume
that i = 5% per year.

Solution

Draw the cash flow diagram for two cycles.

CC1=-150,000-50,000(P/F,5%,10)-5,000(P/A,5%,4)-(8,000/0.05)(P/F,5%,4)

=-150,000-50,000(0.6139)-5,000(3.5460)-160,000(0.8227)=-330,057

Convert the recurring cost of 15,000 every 13 years into an annual worth A, for the first 13 years.

A1= -15,000(A/F,5%,13) = -847

The same value, A1=-847, applies to all the other 13 years period as well.
 CpE-ECON211 - Engineering Economics

A1
CC2 -16,940
847

i 0.05
CC=(-330,057)+(-16,940)= - 346,997

d) Comparing more than two alternatives using Incremental Net Present Value [INPV]

Step 1: Order the alternatives by increasing initial capital investment.

Step 2: Find a base alternative [current best alternative]: Cost alternatives: the first alternative in
the ordered list [the one with the least capital investment].

Step 3: Evaluate the difference between the next alternative and the current best alternative. If
the incremental cash flow is positive, choose the next alternative as the current best alternative.
Otherwise, keep the current best alternative [i.e. negative] and drop the next alternative from
further consideration.

Step 4: Repeat Step 3 until the last alternative is considered. Select the current best alternative as
the preferred one.

3.2. Future Worth (Net Future Value) Method

A corollary to the present value and net present worth is the future value and the net future worth
(NFW).

In this method all cash inflows and outflows of a given project (having a given project life) are
brought to time n. If the difference between the inflows minus the outflows is positive then the
project is acceptable.

NFW>0, Accept the investment

NFW=0, Remain indifferent to the investment

NFW<0, Reject the investment

Future worth analysis calculates the future worth of an investment undertaken.If it is to

compareamong various projects, the onehavingmore positive value is economically the
bestalternative.
 CpE-ECON211 - Engineering Economics

Example: your company is looking at purchasing the front-end loader at cost of $120,000. The
loader would have a useful life of five years with a salvage value of $12,000 at the end of the fifth
year. The annual profit of loader [revenue less operation cost] is $48,000. Determine the future
worth for the purchase of the loader using a MARR of 20%. Should your company purchase
the loader?

Solution

The future value of the purchase price is determined by using SPCAF as follows:

FPP = $120,000 [1+0.20)5=$120,000*2.4883= - $298,598

The future value of the purchase price is negative because it is a cash disbursement.

The FW of the annual profits is determined by using USCAF as follows:

FAP = $48,000* [(1+0.20)5 -1] / 0.20 = $48,000*74416=$357,197

FAP = $48,000* [(1+0.20)5 -1] / 0.20 = $48,000*74416=$357,197

The FW of the annual profits is positivebecause it is a cash receipt.

The future value of the salvage value is equal to the salvage value because the future value is
measured at the end of the study period. The FW of the salvage value is positive because it is a
cash receipt.

The future worth for purchasing the loader equals the sum of the future values of the individual
cash flows and is calculated as follows:

FW = - $298,598 + $357,197+ $12,000= $70,599 > 0

So, it is attractive for the company to purchase

 CpE-ECON211 - Engineering Economics

3.3. Payback Period Analysis

The payback period equals the time required for net revenues from a project to ―pay back‖ its
initial cost. Because it is simpler than discounted cash flow techniques, it was once the
most common technique for evaluating projects. However, this is no longer true.

If a project‘s net revenues are the same each period, then the payback period is easy to calculate.
For example, a machine costs $8K to buy, and it saves $800 per month in costs. In this case, the
payback period is $8K/$800 per month, or 10 months.

Payback period analysis is an approximate, rather than an exact, economic analysis calculation.
Often used as a screening technique/ preliminary analysis tool. May or may not select the correct
alternative.All the economic consequences beyond the payback period are completely ignored. It
is based on two forms:

Ignoring TVOM, with 0% interest: conventional PB method

With an assumed interest rate : discounted payback analysis

It is important to note that PBA is not an end to itself, but rather a method of screening
out certain obvious unacceptable investment alternatives before progressing to an analysis of
potentially acceptable ones.

Compare PBP Vs maximum acceptable PBP.

The main problems with payback period are:

Payback ignores the time value of money.

Payback ignores receipts and costs that occur between payback and the
project‘stime horizon. Some writers have described this as ignoring a project‘s life.

Payback ignores cash flows that occur after the payback period. One project may have a short
payback period, but its positive cash flows may end shortly thereafter. Other projects may have
somewhat longerpayback periods that are followed by years or decades of positive cash flows.
 CpE-ECON211 - Engineering Economics

Ignoring cash flows that occur after payback can cause an evaluation to ignore overhaul costs and
environmental reclamation expenses. In addition, working capital is difficult to account for.
Similarly, evaluation of projects with staged development is unreliable using payback period.

The payback periods are often stated with a decimal or fractional year. Even though problems are
drawn and analyzed assuming end-of-period cash flows, in most cases costs and revenues occur
throughout the year

Example: Payback period:

a) Ignoring TVOM(i=0%)
b) Perform Discounted payback at i=10%

i=0%

E.O.Y CF Cumulative CF

0 -30,000 -30,000

1 -4,000 -34,000

2 15,000 -19,000

3 16,000 -3,000

4 8,000 5,000

5 8,000 13,000

13,000

PBP =3.375 years

.i=10%

CF (P/F,i%,t) Dis. Inc Accum. Disc. Amts.

E.O.Y
(1) (2) (3)=(1)*(2) (4)=Cuml. Sum of (3)

0 -30,000 1 -30,000.00 -30,000

 CpE-ECON211 - Engineering Economics

1 -4,000 0.9091 -3,636.36 -33,636.36

2 15,000 0.8265 12,396.69 -21,239.67

3 16,000 0.7513 12,021.04 -9,218.63

4 8,000 0.6806 5,464.11 -3,754.52

5 8,000 0.6209 4,967.37 1,212.85

PBP =4.76 years

At 10% the PB is b/n years 4 and 5 (4.76 years).

At 0% the PB is b/n years 3 and 4 (3.375 years).

Example: Suppose the company requires a rate of return of 15%. Determine the period
necessary to recover both the capital investment and the cost of funds required to support the
investments given the cash flow (Column 2)in table below.

Period CF Cost of fund 15% Cumulative CF

0 (85,000) 0 (85,000)

1 15,000 -85,000*0.15=-12,750 (82,750)

2 25,000 -82,750 *0.15=-12,413 (70,163)

3 35,000 -70,163*0.15=-10,524 (45,687)

4 45,000 -45,687*0.15=-6,853 (7,540)

5 45,000 -7,540*0.15=-1,131 36,329

6 35,000 36,329*0.15=5,449 76,778

The project must remain in use for about 4.2 years in order for the company to cover the cost of
capital and also recover the fund invested in the project
 CpE-ECON211 - Engineering Economics

Interpretation of PBA

A managerial philosophy is: a shorter payback period is preferred to a longer payback period. It
is not a preferred method for final decision making – rather, use as a screening tool.

Example: Three investments are available but only one can be purchased.
CF CF CF
E.O.Y
(1) (2) (3)

0 -10,000 -10,000 -10,000

1 5,000 5,000 2,500

2 5,000 4,000 2,500

3 0 3,000 2,500

4 0 2,000 2,500

5 1,000 1,000 12,500

Solution
CF CF CF C.C.F
E.O.Y C. C.F (1) C. C.F (2)
(1) (2) (3) (3)

0 -10,000 -10,000 -10,000 -10,000 -10,000 -10,000

1 5,000 -5,000 5,000 -5,000 2,500 -7,500

2 5,000 0 4,000 -1,000 2,500 -5,000

3 0 0 3,000 2,000 2,500 -2,500

4 0 0 2,000 4,000 2,500 0

5 1,000 1,000 1,000 5,000 12,500 12,500

PBP 2yrs 2.33yrs 4yrs

PW(10%) -701.39 2,092.13 5,686.18

 CpE-ECON211 - Engineering Economics

PBP: 1>2>3

PW: 3>2>1

Shorter payback period is preferred to a longer payback period.

Not a preferred method for final decision making – rather, use as a screening tool.
Accum. Disc. Amts.
CF Dis. Inc
E.O.Y Cumulative C.F. P/F,i%,t(2) (4)=Cuml. Sum of
(1) (3)=(1)*(2)
(3)

0 -10,000 -10,000 1 -10,000 -10,000

1 2,000 -8,000 0.9259 1,851.85 8,148.15

2 6,000 -2,000 0.8573 5,144.03 -3,004.12

3 8,000 6,000 0.7938 6,350.66 3,346.54

4 4,000 10,000 0.7350 2,940.12 6,286.66

5 1,000 11,000 0.6806 680.58 6,967.25

PB is b/n years 2 and 3 (2.45 years=3years). The C.F of years 4 and 5 are not used in
the calculations.

None of the cash flows AFTER the payback period are considered.
 CpE-ECON211 - Engineering Economics

3.4. Annual Equivalent Worth

The annual equivalent worth (AE) criterion provides a basis for measuring investment worth by
determining equal payments on an annual basis. Knowing that any lump-sum cash amount can be
converted into a series of equal annual payments, we may first find the net present worth of the
original series and then multiply this amount by the capital-recovery factor:

AE(i) = PW(i)(A/P. i, N). (6.1 )

We use this formula to evaluate the investment worth of projects as follows:

Evaluating a Single Project: The accept-reject decision rule for a single revenue project is as
follows:

If AE(i) > 0, Accept the investment.

If AE(i) = 0. Remain indifferent to the investment.

If AE(i) < 0, Reject the investment.

Notice that the factor (A/P, i, N) in Eq. (6.1) is positive for -1 < i < m. which indicates that the
AE(i) value will be positive if and only if PW(i) is positive. In other words, accepting a project that
has a positive AE(i) value is equivalent to accepting a project that has a positive PW(i)
value. Therefore, the AE criterion provides a basis for evaluating a project that is consistent with
the PW criterion.

Comparing Multiple Alternatives: As with present-worth analysis, when you compare

mutually exclusive service projects that have equivalent revenues. You may compare them on a
cost-only basis. In this situation, the alternative with the least annual equivalent cost (or
least negative annual equivalent worth) is selected.

Example: A firm is considering which of two devices to install to reduce costs. Both devices have
useful lives of 5 years with no salvage value. Device A costs $1000 and can be expected to result
in $ 300 saving annually. Device B costs $1350 and will provide cost saving of $300 the first year
; however, saving will increase $50 annually, making the second year saving $350, the
 CpE-ECON211 - Engineering Economics

third year savings $400, and so forth. With interest at 7%, which device should the firm
purchase?

Device A

AWA= -1000(A/P, 7%, 5)+300 = -1000(0.2439)+300= $ 56.11

Device B 0.07(1.07)
(A/P,7%,5) 5 0.2439
5
1.07
AWB= -1350 (A/P, 7%, 5)+300 + 50(A/G, 7%, 5) 1

=-1350(0.2439) +300+ 50(1.865)=$ 64

(1.07) 5 (1 5 *
0.07)
Installing Device B results larger benefit. (A/G,7%,5) 1.865
0.07[(1.07)5
1]

Example: Three alternatives are being considered for improving an operation on the assembly line
along with the ―do-noting‖ alternative. Equipment costs vary, as do the annual benefit of
each in comparison to the present situation. Each Plan has a 10-year life and a salvage
value equal to 10% of its original cost. For interest of 8% which plan should be adopted?

Plan A Plan B Plan C

Installed cost of equipment 15,000 25,000 33,000

Material & labor saving per yr. 14,000 9,000 14,000

Annual operating expenses 8,000 6,000 6,000

End-of –useful life saving value 1,500 2,500 3,300

Plan A Plan Plan C

B

Equivalent uniform annual benefit (EUAB) 14,000 9,000 14,000

Material & labor per yr. 104 172 228
Salvage value (A/F, 8%, 10)=0.069‘‘‘
 CpE-ECON211 - Engineering Economics

EUAB= 14,104 9,172 14,228

Equivalent uniform annual cost (EUAC) 2,235 3,725 4,917
Installed cost (A/P, 8%, 10) 8,000 6,000 6,000
Annual operating cost

EUAC= -10,223 -9,725 -10,917

EUAW= EUAB-EUAC = 3,869 -553 3,311

Example: Your company needs to purchase a dump truck and has narrowed the selection down
to two alternatives. The first alternative is to purchase a new dump truck for $65,000. At the end
of the seventh year the salvage value of the new dump truck is estimated to be $15,000. The
second alternative is to purchase a used dump truck for $50,000. At the end of the fourth year the
salvage value of the used dump truck is estimated to be $5,000. The annual profits, revenues less
operation costs, are $17,000 per year for either truck. Using a MARR of 18% calculate
the
annual worth for each of the dump trucks. Which truck should your company purchase?

Alternative 1[New]
The useful life is seven years, which is used as the study Alternative 2[Used]
period for the new truck. 4 4

7 7 APP = $50,000[0.18(1+0.18) ] / [(1+0.18) 1]

APP = - $65,000 [0.18(1+0.18) ] / [(1 0.18) -1]

= - $17,054 = -$18,587
7
A = $15,000(0.18) / [ (1+0.18) -1] 4

SV ASV = $5,000(0.18)/ [(1+0.18) -1]=$959

= $1,235 The annual equivalent for purchasing:

AE [New] = - $17,054 + $1,235 + $17,000 AE[Used] = - $18,587 + $959 + $17,000

=$1,181 = -$628
AE[New]>AE[Used]: purchase the new truck.
 CpE-ECON211 - Engineering Economics

3.5. Internal Rate of Return

The internal rate of return (IRR) is based only on a project‘s cash flows, which is the basis of
the internal. As the interest rate that makes the PW = 0, it is the project‘s rate of return. Since the
PW = 0, all other equivalent measures calculated at the IRR, such as the EAW, also equal zero.

For the IRR to exist, both costs and benefits must be defined. If only a project‘s benefits
are defined, then the PW and EAW are positive for all interest rates. If there are only costs, then
the PW and EAW are always negative. Only if there are costs and benefits can the PW and EAW
= 0 for some interest rate.

Along with the PW and AE criteria, the third primary measure of investment worth is rate of
return. As shown in Chapter 5, the PW measure is easy to calculate and apply. Nevertheless,
many engineers and financial managers prefer rate-of-return analysis to the PW method, because
they find it intuitively more appealing to analyze investments in terms of percentage rates
of return rather than in dollars of PW. Consider the following statements regarding an investment's
profitability:

This project will bring in a 15% rate of return on the investment.

This project will result in a net surplus of $10.000 in terms of PW.

Neither statement describes the nature of an investment project in any complete sense. However,
the rate-of-return figure is somewhat easier to understand, because many of us are so familiar with
savings and loan interest rates, which are in fact rates of return.

Many different terms are used to refer to rate of return, including yield (e.g., yield to maturity,
commonly used in bond valuation), internal rate of return and marginal efficiency of capital.
We will first review three common definitions of rate of return. Then we will use the definition of
internal rate of return as a measure of profitability for a single investment project throughout the
text.
―The rate of return on an investment is the amount of profit it makes, often shown
as a percentage of the original investment.‖
 CpE-ECON211 - Engineering Economics

―The interest rate charged on the unrecovered project balance of the investment such that the
payment schedule makes the unrecovered project balance equal to zero at the end of
the investment‘s life.‖
―It is the break even interest rate which equates the present worth of a project‘s cash outflows
to the present worth of cash inflows.‖

NPW=PW of benefits- PW of costs=0

The rate of return (ROR) for a series of cash flows is that particular value, i*, of the interest rate
for which the NPV vanishes.
Plot the NPV as a function of i, the curve will cross the i-axis at i*.
Trial and error, i-values for which the NPV is slightly positive and slightly negative, and
interpolate linearly between them for i*.
Use Newton-Raphson iteration method or another numerical technique NPV for i, with
the left side replaced by zero. [The value of i that makes the NPV equation zero.]

Steps for Computing IRR

1. Assume a trial rate of return (i*).
2. Counting the cost as negative and income as positive, find the equivalent net worth of
all costs and incomes.
3. If the equivalent net worth is positive then the income from the investment is worth more than
the cost of investment and the actual percentage return is higher than the trial rate, and vice
versa
4. Adjust the estimate of the trial rate of return and go to step 2 again until one value of i is found
that results in a positive equivalent net worth and another higher value of i is found with
negative equivalent net worth.
5. Solve for the applicable value of i* by interpolation

Example: Determine the IRR for the given cash flow.

Year 0 1 2 3 4

Cash Flow -1000 400 370 240 220

 CpE-ECON211 - Engineering Economics

NPW=PWbenefits – PWcost= 0
NPW = -1000 + 400 (P/F, i*,1) + 370 (P/F, i*,2) + 240 (P/F, i*,3) + 220 (P/F, i*,4)=0
Assuming i* = 10%
NPW = -1000 + 400(0.9090) + 370 (0.8264) + 240(0.7513)+ 220 (0.6830) = 0
We find that i*= 10% which is a special interest rate that has vanished the net present worth of
the given cash flow to zero. Thus i*=10% is the IRR.
This indicates that the company earns (charges) a 10% rate of return on the funds that remains
internally invested in the project. Since it is a return internal to the project, we refer to it as the
internal rate of return, or IRR.

i=10% is the IRR

Unrecovered 10% Return onInvestment Unrecovered

Cash
Investment at Unrecovered Repayment at Investment at
E.O.Y Flow
beginning of Yr. Investment E.O.Y. E.O.Y.
(1)
(2) (3)=(1)*i (4)=(1)+(3) (5)=(1)+(4)

0 -1000 - - - -1000
1 400 -1000 -100 300 -700
2 370 -700 -70 300 -400
3 240 -400 -40 200 -200
4 220 -200 -20 200 0

This means that the project under consideration brings in enough cash to pay for itself in 4 years
and also to provide the company with return of 10% on its invested capital

Case of a Single Sign-Reversal

When CFo< 0 and CFj> 0 (j > 0), i.e., when there is just one reversal of sign in the sequence CFo,
CF1, CF2, . . . , CF, the NPV is a monotone decreasing function of i, and so i* is uniquely
determined. Moreover, at this unique ROR, the FW and EUAS are zero.

Example: The cash flows associated with a milling machine are CF o= -$50,000. CFj
=
$15,000 (j = 1,. . . ,5). Determine the economic acceptability of this machine at interest rates of
(a) 10%, (b) 15%, and (c) 20% per year (all compounded annually).
 CpE-ECON211 - Engineering Economics

(a) NPV= -50,000+15,000(P/A,10%,5)= -$50,000+$15,000(3.7908)= $6,861.80

(Economically acceptable investment)

(b) NPV= -50,000+15,000(P/A,15%,5)= -$50,000+$15,000(3.3522)= $282.33

(Barely acceptable)

(c) NPV= -50,000+15,000(P/A,20%,5)= -$50,000+$15,000(2.9906)= -$5,140.82

(Not economically justifiable)

By linear interpolation between the results of (b) and (c):

0 - 282.33
i* 15% * 20%
15%
5140.82 282.33
i*
15.26%

Case of a Multiple Sign-Reversals

When the sequence CFo, CF,, CF2,. . . , CF, shows more than one reversal of sign, it is possible
that NPV = 0 for several values of the interest rate; there could thus be several rates of return.

Example: For a project with the given series of cash flows, determine the NPV at annual interest
rates 0%, 5%, 10%, 20%, 30%, 50%, and 70%.

E.O.Y 0 1 2 3 4 5

CF, 1000 -3 0 6 6 0 -10

For the given flows, solve:NPV= -$3000 + $6000(P/A, i % 2)(P/F, i%, 1) - $10 000(P/F, i %, 5)

Evaluation at the specified interest rates gives the points which are plotted.
 CpE-ECON211 - Engineering Economics

i(%) 0 5 10 20 30 50 70

NPV ($) -1000 -210 257 620 588 128 -407

NPV ($)
From a graph of the results, find the rate(s)
1000
ofreturn.
500

0 i=7% and i=54%

0 20 40 60 80
-500

-1000

-1500

If we use the PW method with MARR=15%, we would obtain:

E.O.Y 0 1 2 3 4

CF -3000 0 6000 6000 0 -10, 000

(P/F , I , n) 1 0.8696 0.7561 0.6575 0.5718 0.4972

PW -3000 0 4,536.86 3,945.10 0 -4,971.77

NPW 510.19

PW(15%)=510.19 > 0 This verifies the project is acceptable.

Flaws in Project ranking by IRR

Under NPW, NFW or AE analysis: the highest worth figure was preferred. ―Total
investment approach‖.

Unfortunately, the analogy does not carry over to IRR analysis. The project with the highest IRR
may not be the preferred alternative.
 CpE-ECON211 - Engineering Economics

Example: Suppose you have two mutually exclusive alternatives, each with a 1year service life.
One requires an investment of $1000 with a return of $2000 and the other requires $5000 with a
return of $7000.

Already solved IRR and NPW(MARR=10%) as show on table below.

n A1 A2
Assuming you have enough money in
0 -1000 -5000 your investment pool to select either
one, which one would you choose?
1 2000 7000

IRR 100% 40%

PW(10%) 818 1,364

Based on NPW measures A2 is preferred. But based on IRR A1 is preferred

We notice inconsistency of ranking:

NPW, NFW and AE are absolute (dollar) measures of investment worth.

IRR is a relative(percentage) measure and cannot be used in the same way.(i.e., IRR ignores the
scale of the investment)

Incremental Investment Analysis

For a pair of mutually exclusive project A and B, with B defined as a more costly option, we may
rewrite B as:

B=A+(B-A), B has two cash flows: (1) same CF as A and (2) the incremental component
(B-A).

Therefore, the only situation in which B is preferred over A is when the ROR in the incremental
component (B-A) exceeds the MARR.
 CpE-ECON211 - Engineering Economics

For two mutually exclusive project, ROR analysis is done by computing the internal rate
of return on incremental investment (IRRD) between the projects. Since we want to consider
increments of investment, we compute the cash flow for the difference between the projects by
subtracting the cash flow for the lower investment project(A) from that of the higher investment
project (B). Then:

IRRB-A> MARR, select B

IRRB-A = MARR, select either one

IRRB-A< MARR, select A

Example

Alternative A:Withdrawal of 1000. Remaining 4000continues to earn 10%. After a year

you will receive 2000 from external investment and 4,400 form the investment pool.With
an investment of 5000 in 1 year you will have 6400(4400+2000).

PW(10%) = -5000+6400(P/F,10%,1)=818

Alternative B:Withdrawal of 5000 leaving no money in the investment pool. After a year you will
receive 7000 from external investment.Your total wealth changes from 5000 to 7000 in a year.

PW(10%)=-5000+7000(P/F,10%,1)=1,364

n A B B-A

0 -1000 -5000 -4000

1 2000 7000 5000

IRR 100% 40% 25%

PW(10%) 818 1,364 545

 CpE-ECON211 - Engineering Economics

If you decide to take more costly option, you would want to know that this additional
investment can be justified at the MARR. The 10%MARR implies that you can always earn that
return from other investment;

For B by investing the additional $4000 you would make an additional $5000, which is
equivalent to earning at a rate of 25%.

Exercise

1. A construction engineer has been asked to recommend an excavator for acquisition.

Three alternatives have been identified, having the characteristics shown on table below. If
MARR
is 12% which alternative would you recommend?

Excavator Useful life Initial Annual Salvage value

alternative investment operating
(Years) cost ($)
($)

A 4 15,500 8,750 2,500

B 5 20,250 5,850 3,000

C 6 30,750 3,175 3,250

2. What is MARR, how it is determined, what is considered in trying to determine the MARR?
3. An individual wants to start a small-scale painting business. To economize the start up
business, he decides to purchase some used painting equipment. He has two mutually
exclusive options, which he expects to fold up the business in three years,
a) Do most of the painting by himself by limiting his business to only residential painting jobs
(B1) or
b) Purchase more painting equipment and hire some helpers to do both residential and
commercial painting jobs that he expects will have a higher equipment cost, but provide
higher revenue as well (B2).

Given the cash flow for the mutually exclusive alternatives presented below which project would
he select at MARR=10%.
 CpE-ECON211 - Engineering Economics

n B1 B2

0 -$3,000 -$12,000

1 1,350 4,200

2 1,800 6,225

3 1,500 6.330

4. Consider the following three sets of mutually exclusive alternatives.

n D1 D2 D3

0 $2,000 $1,000 $3,000

1 1,500 800 1,500

2 1,000 500 2,000

3 800 500 1,000

Which project would you select based on rate of return on incremental investment , assuming
that MARR=15%
CEng5211 - Engineering Economics Lecture note February 2020