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Engineering Econ Module 3.2

The document discusses basic economic study methods essential for evaluating engineering or business projects that require significant capital investments. It outlines various evaluation techniques, including Present Worth (PW), Future Worth (FW), and Annual Worth (AW), to assess the viability and profitability of projects based on cash flows and interest rates. Examples illustrate how to apply these methods to determine the economic justification of proposed investments.

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14 views9 pages

Engineering Econ Module 3.2

The document discusses basic economic study methods essential for evaluating engineering or business projects that require significant capital investments. It outlines various evaluation techniques, including Present Worth (PW), Future Worth (FW), and Annual Worth (AW), to assess the viability and profitability of projects based on cash flows and interest rates. Examples illustrate how to apply these methods to determine the economic justification of proposed investments.

Uploaded by

ivan
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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3.

2 BASIC ECONOMIC STUDY METHODS:

Engineering or business
projects require huge
capital investments.
Economy studies are
necessary
to be conducted to
establish whether a
proposed capital
investment and its
associated expenditures
can be
recovered over time in
addition to a return on the
capital that is attractive in
view of risks involved and
opportunity costs of the
limited funds. The
concepts of interest and
money-time relationships
are quite
useful in arriving at the
investment decision
Engineering or business
projects require huge
capital investments.
Economy studies are
necessary
to be conducted to
establish whether a
proposed capital
investment and its
associated expenditures
can be
recovered over time in
addition to a return on the
capital that is attractive in
view of risks involved and
opportunity costs of the
limited funds. The
concepts of interest and
money-time relationships
are quite
useful in arriving at the
investment decision
Engineering or business projects require huge capital
investments. Economy studies are necessary to be conducted to establish
whether a proposed capital investment and its associated expenditures
can be recovered over time in addition to a return on the capital that is
attractive in view of risks involved and opportunity costs of the limited
funds. The concepts of interest and money-time relationships are quite
useful in arriving at the investment decision.

Since different projects involve different patterns of capital


investment, revenue or savings cash flows and expenditure or
disbursement cash flows, no single method is perfect for making economy
studies of all types. Therefore, financial analysts and economists employ a
variety of evaluation techniques to assess the viability and profitability of
diverse projects, selecting methods such as Net Present Value (NPV),
Internal Rate of Return (IRR), Payback Period, and Profitability Index based
on the specific characteristics and objectives of each individual project.

Basic Methods or patterns for making economic studies:

a. Present Worth (PW): The total worth of cash flows at the present
moment.

Present worth is one of the ways to compare alternatives. It is


most frequently used to determine the present value of future money
receipts and disbursements. In the future, income and costs are known,
and then using a suitable interest rate, the present worth can be
calculated. In present worth analysis, careful consideration must be
given to the time period covered by the analysis. Usually, the task to
be accomplished has a time period associated with it. Accordingly, the
analysis of each alternative must be considered for this period of time,
which is named as described before the analysis period of the planning
horizon.

In present worth analysis, the alternative with the maximum present


worth (PW) of benefits minus present worth of cost is always selected.
This criterion is called the net present worth criterion (NPW). As such,
NPW =PW of benefits - PW of costs

3.2.1 Present Worth Comparison of Equal-Lived Alternatives

Example 3.1: Make a present-worth comparison of the equal-service


life projects for which costs are shown below, if = 10%. Which project
would you select?

Project A Project B
First cost, P $2,500,000 $3,500,000
Annual operating cost, $900,000 $700,000
A
Salvage value, F $200,000 $350,000
Project service life 5 5
(years)
Project A Project B

$200,000 i=10% $350,000


i=10%
1 2 3 4 1 2 3 4
0 5 0 5

$2,500,000
A=$900,000 $3,500,000 A=$700,000

Solution:
PA = $2,500,000 + $900,000 (P/A, 10%, 5) – $200,000 (P/F, 10%, 5)
= $5,788,000
PB = $3,500,000 + $700,000 (P/A, 10%, 5) – $350,000 (P/F, 10%, 5)
= $5,936,000
Project A should be selected since PA < PB

Example 3.2: A truck, whose price is $18,600, is being paid for in 36


uniform monthly installments, including interest at 10 percent. After
making 13 payments, the owner decides to pay off the remaining balance
of the purchase price in one lump sum. How much is the lump sum?

Solution:

In problems like this the lump sum is the present worth of all the
future (unpaid) payments. So, to solve the problem compute the
payment and then compute the PW of the unpaid payments at the
stated interest rate.

A = 418,600(A/P, 0.83%, 36)

= 18,600[(0.00833(1+00833)36) / ((1+00833)36 - 1)]

= $ 600.22

After 13 months: 36 – 13=23 payments remain

P = 600.22(P/A, 0.83%, 23)


-600.22[((1+00833)23 - 1) / (.00833(1 + 00833)23)]

=$ 12,515.45

b. Future Worth (FW) Method - based on the concept of equivalent


worth of all cash flows at the end of the planning horizon (study
period) at an interest rate that is generally the MARR.
FW(i %) = F0(1 + i)n + F1(1 + i)n - 1 + F2(1 + i)n - 2 + ….. + Fk(1 +
i)n - k + . .+ . . . . . + Fn(1 + i)0
where:
i = effective interest rate, or MARR, per compounding period
k = index for each compounding period (0 ≤ k ≤ n)
Fk = future cash flow at the end of period k
n = number of compounding periods in the planning horizon
(i.e., study period, service life, etc.)

The FW method is very useful in capital investment decision


situations because the primary objective of all time value of money
method is to maximize the future wealth of the owners of a firm.

Conditions: a) If Net Future Worth, NFW ≥ 0, project is justified


economically.

Example 3.3: 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. If the company’s


MARR is 20%, is this proposal acceptable?
A A A A A=8,000
CFD:
Sv=5,000

1 2 3 4 5

I=25,000 i=20%

Solution:
NFW = FWI + FWA + FWSv
NFW = I(1 + i)n + A [(1 + i)n – 1] + Sv
(i)
NFW = - 25,000(1.20)5 + 8,000[(1.20)5 – 1]
+ 5,000
(0.20)

NFW = 2,324.8 > 0, therefore investment is acceptable.

c. Annual Worth (AW) Method – similar to PW and FW except that


cash flows are in equal/uniform annual series of amount.

The AW of a project is an equal annual series of amounts for a


stated study period that is equivalent to the cash inflows and outflows
at an interest rate that is generally the MARR.
AW(i %) = Annual equivalent of all cash flows
Conditions:
a) If Net Annual Worth, NAW ≥ 0, project is justified economically.
An AW of zero means that annual return exactly equal to the MARR
has been earned.
b) If revenues are absent, we call it ‘equivalent uniform annual cost’
(EUAC). A low-valued EUAC is preferred to a high-valued EUAC.
Example 4) Given the
previous example 2, is
this proposal
acceptable using NAW
method?
Example 4) Given the
previous example 2, is
this proposal
acceptable using NAW
method?
Example 3.4: Given the previous example 3.3, is this proposal acceptable
using NAW method?

CFD:
A A A A A=8,000

Sv=5,000

1 2 3 4 5

i=20%
I=25,000

Solution:
NAW = AWI + AWA + AWSv
Reference:
Engineering Economy | PDF (slideshare.net)
Engineering Economic Analysis (Week 4) Basic Methodologies of Engineering
Economic Analysis.pdf
Engineering Economy (engmohannadb.github.io)
pdf.pdf (engmohannadb.github.io)
Econ 101E(Hand-out 3)2019- Basic Economy Study Methods - Econ 101E(Hand-out 3)
Module 6, 7 &amp; 8 - Studocu
Module 3- Economic Study Methods - ECONOMIC STUDY METHODS I. LESSON TITLES
The Minimum Attractive - Studocu
[1] A Textbook of Engineering Economics: Damodar Adhikari, First Edition,
Dreamland Publication Pvt. Ltd. Kathmandu, Nepal, 2019.
[2] Engineering Economy: William G. Sullivan, James A. Bontadelli & Elin M. Wicks,
Eleventh Edition, Pearson Educations, Inc. 2000.
[3] Engineering Economics: James L. Riggs, David D. Bedworth and Sabah U.
Randhawa, Fourth Edition, Tata McGraw Hill Education Private Limited, New Delhi,
India, 2004.
[4] Engineering Economics: Jose A. Sepulveda, William E. Souder and Byron S.
Gottfried, Tata McGraw – Hill Publishing Company Limited, New Delhi, India, 2005.
[5] Contemporary Engineering Economics, Chan S. Park Second Edition, Addison-
Wesley Publishing Company, 1997.
[6] https://www.investopedia.com/terms/r/rateofreturn.asp (viewed on December
2023).

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