• EE is decision assistance tool by which one method will be

chosen as the most economical one.

• Engineering economics is Systematic evaluation of the
economic merits of proposed solutions to engineering
problems
• Engineering economy, quite simply, is about determining the
economic factors and the economic criteria utilized when one
or more alternatives are considered for selection
Example

3
 Why Is Engineering Economics Important?
• Engineers DESIGN things and perform PROJECTS
• Therefore, engineers must be concerned with the economic
aspects of designs that they recommend, and projects that they
perform

1. To evaluate and compare the economic value of a given

alternatives.

Example

2. Basis-Cash Flow Analysis

 To now which project or alternative has better net cash flow
using the concept of time value of money b/c
a. Cash flow occurring at different time
b. Designs with different durations
4
What Kinds of Questions Can Engineering Economics
Answer?
• Engineering economics is needed for many kinds of decision
making
– Example: Buying a car
• Alternatives:
– Not buying
– Buying with $18,000 now, or
– Buying for $600 per month for 3 years
• Which is better?
• It will help you make good decisions:
• In your professional life
• (Regardless of whether you go into the private or public
sector)
• And in your personal life!
• Knowledge of engineering economics will have a significant
5
impact on you personally!
 Basic principles in engineering economics
Quantifying alternatives for easier decision making

• Individuals, small-business owners, large-corporation presidents, and

government agency heads are routinely faced with the challenge of
making significant decisions, when selecting an alternative over
another.
• These are decisions of how to invest the funds, capital, of the company
and its owners.
• The usual factors considered may be once again economic or non-
economic, as well as tangible and intangible. However, when
corporations and public agencies select one alternative over the other,
the financial aspects, return on invested capital, social considerations,
and time frames often increase substantially over those for an individual
selection.

6
Con....
• In order to quantify and compare as many aspects a proposal as
possible, a common denominator for most purpose is the
birr/dollar value. For this reason most of the significant attributes
of a project are reduced to a birr value wherever possible.
• It is essential to convert the prospective output and input items
enumerated in the definition step into receipts and disbursements
at specified dates.
• This phase consists of appraising the unit value of each item of
output or input and determining their total amounts by
computation.
• On completion, each alternative should be expressed in terms of
definite cash flows occurring at specified dates in the future, plus
an enumeration of qualitative considerations that are impossible to
reduce to monetary terms. For such items, the term irreducible is
often employed. 7
• An Alternative:
 Is a stand-alone solution(an individual way) for a given
solution. For example: Method of transportation, buying or
renting house
 In engineering practice, there are several ways of
accomplishing a given task, and it is necessary to be able to
compare them in a rational manner so that the most economical
alternative can be selected.
 Alternatives in Engineering are;
• Asset purchase cost (First Cost);
• The expected life of the Asset;
• The yearly costs of maintaining the asset (Operating and
Maintenance);
• The expected resale value (Salvage value); and
8
• Interest rate.
 After the facts and all the relevant estimates have been
collected, an Economic Alternative is determined.
• Evaluation Criteria:
– To compare the different methods of accomplishing a given
object, it is necessary to have an Evaluation Criteria.
– In EE, currency (dollars, rupees, etc) are used as a basis for
judging the alternatives.
– In addition to currency, Intangible Factors such as the
effect of a process change on employee morale (human
factor).
• When the alternative available have approximately the same
equivalent cost, the non-quantifiable, or intangible factors may
be used as the basis for selecting the best alternative.

9
 Time value of Money
Basic assumption:
– Given a fixed amount of money, and
– A choice of having it now or in the future,
– Most people would prefer to have it sooner. Why?
Reasons:
1. Most people prefer current consumption
2. To account opportunity cost( at least the interest payment )
 Money makes Money;
 For items of an alternative which can be quantified in terms of
dollars, it is important to recognize the concept of the Time
value of Money.
 This is the most important concept in EE.
 The change in the amount of money over a given time period is
called the Time value of money.
 The manifestation of the Time value of money is termed Interest 10
• Interest
– Interest is a measure of the increase between the original sum
borrowed or invested and the final amount owed or accrued.
– Interest may be defined as the time value of money --- it is the
money or consideration that is paid by the borrower for the use
of money provided by the lender.
– It may be thought of the return that may be obtained when
capital is invested in a productive concern.

– In the case of invested money at some time in the past;

• Interest = Total amount accumulated – Original investment

– In the case of borrowed money at some time in the past;

• Interest = Present amount owed – Original loan
 Interest Calculations
• When interest is expressed as a % of the original amount per unit time, the result is
an Interest Rate. Interest rates are normally quoted in % for a period of 1 year or
less.
• Symbols and their definition
• P = the principal, a sum of money invested in the initial year or a present sum of
money;
• i = interest rate per unit of time expressed as a decimal;
• n = time, the number of units of time over which interest accumulates;
• F = a compound amount, a sum of money at the end of n units of time at interest
i made up of the principal plus the interest payable or value or sum of money at
some future time;
• A = uniform series end-of-period payment or receipt that extends for n periods;
• S = the salvage or resale value at the end of n years; and
• I = simple interest, the total sum paid for the use of the money at simple interest.
• Interest = Principal x interest rate x time
I= P*i*n
12
 Simple and Compound Interest

• Simple Interest
– If the amount to be deposited in the bank is $10,000 and the
bank is offering 2.5% per year simple interest, then at the
end of first year interest payable by the bank will be;
I = P*i*n
I = 10000 x 2.5/100 x 1
I = $250 (for the first year).
– Similarly the interest for the second and subsequent year
will also be $250 per year, until interest rate changes.
– Simple interest is rarely used in Engineering Economics
Studies, except where very short periods of time are
involved.

13
 Simple and Compound Interest
• Compound Interest
 If a sum of $1000 is invested at 5% per year interest rate,
 At the end of the first year interest of $50 will be added to
the initial sum of $1000.
F = P + Pi
F = P (1+i)
 If the interest is allowed to remain invested with the capital
at the same rate of interest, it will itself earn interest.
 At the end of the second year the interest due will be 5% of
$1050 ($52.50).
F = P (1+i) + P (1+i)I
F = P (1+i) 2
 Cash-Flow Diagrams
• Every person or company has cash receipts (income) and cash
disbursements (payments / costs) which occur over a particular
time span.
• These receipts and disbursements in a given time interval are
referred to as Cash-flow.
• Positive cash-flow represents receipts and negative cash-flow
represents disbursements.
• The solution of EE problems is facilitated by preparing
diagrams representing the movement of cash over time.
• In cash flow diagram a horizontal line is used as the time scale
and vertical arrows are used to indicate direction in which the
cash flows.
 Cash-flow Diagram

• Upward arrows are used to indicate positive cash flows or cash

coming in (receipts).
• Downward arrows are used to indicate negative cash flows or
cash going out (payments).
• It is important to understand the meaning and construction of
the Cash-flow diagram, since it is valuable tool in problem
solution.
Cash Flow

2 4
1 3
Time (Years)

17
Important elements for cash flow diagram.
1. A time interval divided into an appropriate number of equal periods
2. All cash outflows (deposits, expenditures, etc.) in each period
3. All cash inflows (withdrawals, income, etc.) for each period

Cash inflows:
Revenues
Salvage value
Cash outflows:
First cost of asset
Operation cost
Periodic maintenance costs
Taxes

18
 •Revenue
+ Cash inflow •Salvage value
•Operating cost reduction`

Time
•First cost of asset
•Operation cost
•Periodic maintenance costs - Cash outflow
•taxes

19
Example on Single Payment Compound Amount Factor
(SPCAF)
• If $150 is deposited in a bank for 5 years at a compound interest rate of 6%
per year. What is the amount in the account at the end of the 5 years?
Solution F=?

P= $150; i= 6%(0.06); n= 5years; F=?? 1 2 3 4 5

i= 6%
Using formula of SPCAF
$150
n
F = P (1+i) = P (F|P, i%, n)
F= 150(1+0.06)5
F= $220. 73

20
 Exercise Problems
• Exercise:
1. The Get-Rick-Quick (GRQ) company invested $1,00,000 on May 1 and
withdrew a total of $1,06,000 exactly one year later. Compute (a)the interest
gained from the original investment and (b) the interest rate from investment.
2. Joe Bilder plans to borrow $20,000 per one year at 15% interest. Compute (a)
the interest and (b) the total amount due after one year.
3. If you borrow $1000 for 3 years at 6% per year simple interest, how much
money will you owe at the end of 3 years.
4. If you borrow $1000 for 3 years at 6% per year compound interest, how much
money will you owe at the end of 3 years. Construct the cash-flow diagram also.
5. (a) Calculate the amount of money that must have deposited one year ago for
you to have $1000 now at an interest rate of 5% per year. (b) Calculate the
interest that was earned in the same time period.
6. The Hot-Air company invested $2500 in a new air compressor 7 years ago.
Annual income from the compressor was $750. During the first year, $100 was
spent on maintenance, a cost that increased each year by $25. the company plans
to sell the compressor fro salvage at the end of next year for $150. Construct the
cash flow diagram for the piece of Equipment.

21
 Single Payment Present Worth Factor (SPPWF)
• Expression of Single Payment Compound Amount Factor
(SPCAF) will yield the future amount F of an initial
investment P after n years at interest rate i.
• Formula of SPCAF is re-arranged so as to express P in terms
of F, I, n then
P = F[1/ (1+i)n] = F(P|F, i%,n)
• Factor 1/ (1+i)n or (P|F, i%,n) is referred to as the Single
Payment Present Worth Factor (SPPWF)

22
 Example

• An investor’s bank investment shows a credit of $345 as a result

of a small investment made 10 years previously. Interest rate
over this period has been 2.5%. What was the original
investment?
F=$345
Solution 2 4 6 8
10

F= $345 i= 2.5%
P=?
I = 2.5%
n= 10 years
Using the P = F[1/ (1+i)n] = F(P|F, i%,n)
P= 345/(1+0.025)10
P= $269.5

23
How much a family invest now to provide a lump sum of $1000
for school fees at the end of each 6years, 8years and 12years from
now if interest is at 5percent. F=$1000
F=$1000 F=$1000

• Solution 2 4 6 8 10
12
i= 5%
P=?

Present worth of 1000 in 6years’ time = 1000/(1+.05) 6 =$746.20

Present worth of 1000 in 8years’ time = 1000/(1+.05) 8 =$676.80
Present worth of 1000 in 6years’ time = 1000/(1+.05) 12 =$556.20
Total Present worth to be invested now: $1979.80

24
Nominal and Effective Interest Rate

• Nominal Interest Rate (NIR):

– Where an annual rate is mentioned, but compounding is
carried out for a period other than one year is known as
NIR.
• Effective Annual Interest Rate (EAIR):
– The actual annual interest rate which results from
compounding over periods of less than one year is know as
EAIR.

25
 Uniform Series of Payments

• Four ways in which principal sum P, or a compound amount

F, and number of periods of time n, can be linked together with
a Uniform Series of end-of-period payments A, for any given
interest rate i.
• A series of equal payments made at the end of equal periods is
known as an Annuity.
• First Case
– A payment A can be made at the end of each of n periods at
interest rate i and the payments allowed to gather interest
when a final sum F will be accumulated.
– F is the sum of the compound amounts of each individual
payment.
26
 Derivation (Uniform Series Compound Amount Factor
(USCAF)
• An amount invested at the end of first period will earn interest for (n-1) years.
• Final value after n periods will be A(1+i) n-1
• Compound amount of 2nd period’s payment = A(1+i) n-2
• Compound amount of 3rd period’s payment = A(1+i) n-3
• Final payment which earns no interest =A
F= A(1+i) n-1 + A(1+i) n-2 + A(1+i) n-3 + …….+ A
F= A[(1+i) n-1 + (1+i) n-2 + (1+i) n-3 + …….+ 1]
Multiply both sides by (1+i) and then subtract F
F(1+i)-F= A[(1+i) n + (1+i) n-1 + (1+i) n-2 + ….+ (1+i)]-F
F(1+i)-F=A[(1+i) n +(1+i) n-1 +(1+i) n-2 + …+(1+i)]-A[(1+i) n-1 + (1+i) n-2 + (1+i) n-3
+ …….(1+i)+ 1]
F(1+i)-F= A[(1+i) n + (1+i) n-1 + (1+i) n-2 + ….+ (1+i)]-F
F(1+i)-F=A[[(1+i) n +(1+i) n-1 +(1+i) n-2 + …+(1+i)]-[(1+i) n-1 + (1+i) n-2 + (1+i) n-3
+ …….(1+i)+ 1]]
iF = A [(1+i)n -1]
F= A [(1+i)n -1]/i = A(F|A, i%, n)
• The expression (F|A, i%, n) is known as Uniform Series Compound Amount Factor
(USCAF). 27
Con....

F=?

1 2 3 n-1 n
0

28
Uniform Series Sinking Fund Deposit Factor (USSFDF)
• Second Case
• If Uniform amount, A, to be invested at the end of each period
to produce a specific amount at the end of n periods, can be
calculated for a given interest rate.
• A fund into which such payments are made is known as a
Sinking Fund and the calculated by;
A= F [i / (1+i)n -1] = F(A|F, i%, n)
• The expression (A|F, i%, n) is known as Uniform Series
Sinking Fund Deposit Factor (USSFDF).

A=?

0 1 2 3 n-1 n

29
F
Uniform Series Capital Recovery Factor (USCRF)
• Third Case
• If an amount P, is set aside at the beginning of a specific time it
will be possible to withdraw a sum A from it at the end of a
number of shorter periods within that time.
• In this case, the interest rate i, will apply to the amount
remaining after each withdrawal.
• The amount P required to give a set number of withdrawals
under these conditions can be calculated by using;
A = P[i(1+i) n/((1+i)n-1)] =P(A|P, i%, n)

• Above equation is know as Uniform Series Capital Recovery

Factor (USCRF).
• It is frequently used and has special significance is EE.
30
 Uniform Series Present Worth Factor (USPWF)

• Fourth Case
• The present worth of the uniform series can be determined by
considering each A value as a future worth F in the single
payment present worth factor.

• The term in brackets is called the Uniform Series Present

Worth Factor (USPWF).
• The factor will give the present worth P of an equivalent
uniform annual series A which begins at the end of year1 to n
at interest rate i.
31
Example: Given an Interest rate of 5% per year, what sum would
be accumulated after 6 years if $200 were invested at the end of
each year for 6 years.

Solution:
i= 5% per year
n= 6 years
F= Accumulated Sum= ??
A= $200

By using Uniform Series Compound Amount Factor (USCAF)

equation;
F= A [(1+i)n -1]/i
F= 200[(1+.05)6 -1]/0.05
F= $1360.38
32
Example: A speculator buys a site near the fringe of an industrial area in a large
city for $10,00,000. Annual outgoings on the site for maintenance, fencing,
watching, etc. amount to $45,000. it is estimated that the site will not be sold
for 8 years, at which time that area is due for development. For what minimum
price must the site be sold at that time so as to break even on the costs if the
original purchase price and the annual outgoing could have been alternatively
invested at 12% per year.
Solution:
P= $10,00,000 A= $45,000 n= 8 years
Minimum Price be sold= ??
i= 12% per year
Future value of Capital by using Single Payment Compound Amount Factor (SPCAF)
F = P (1+i)n = P (F|P, i%, n) F= $24,76,000
Future value of annual cost By using Uniform Series Compound Amount Factor
(USCAF) equation;
F= A [(1+i)n -1]/i ; F= 45000[(1+0.12)8 -1]/0.12 F= $ 5,53,487
Therefore; Minimum Selling Price of site after 8 years will be: Future value of Capital +
Future value of Annual Cost
= $24,76,000 + $ 5,53,487 = 30, 2 9,487
33
Example: A uniform annual investment is to be made into a
Sinking Fund with a view to providing the capital at the end of 7
years for the replacement of a tractor. An interest rate of 6% is
available. What is the annual investment needed to provide for
$50,000.
Solution:
n= 7 years
i= 6% per year
A= ???
F= $50,000
Annual Investment into a fund by using Uniform Series Sinking
Fund Deposit Factor (USSFDF)
A= F [i / (1+i)n -1] = F(A|F, i%, n)
A = 50,000[.06/(1+0.06)7 -1]
A = $5955 per year
34
Example: With an interest rate of 6%, what uniform end-of-
period payment must be made for 10 years to repay an initial debt
of $2000.

Solution:
i= 6% per year
n= 10 years
A= ???
P= $2,000
Uniform end of period payment by using Uniform Series Capital
Recovery Factor (USCRF).

A = P[i(1+i) n/(1+i)n-1]
A = 2,000[0.06(1+0.06)10/(1+0.06)10 -1]
A = $271.80 per year
35
Example: A unit of mechanical equipment has an initial cost of
$1,00,000 and annual maintenance expenditure is exposed to
average $12000 for its 8 years of life. It interest is at 10% and the
equipment has no salvage value, what is its equivalent annual
cost, excluding labor, fuels etc.
Solution:
P= $1,00,000
Annual Maintenance Charges = $12000
n= 08 years
i= 10% per year
Equivalent Annual Cost = ???

First Convert capital sum to an equivalent uniform annual series by Using

Uniform Series Capital Recovery Factor (USCRF).
A = P[i(1+i) n/(1+i)n-1]
A = 1,00,000[0.10(1+0.10)8/ (1+0.10)8 -1]
A = $18,740 per year
Total Equivalent Annual Cost = $18,740 + $12000 = $30,740. 36
What sum of money should be deposited in a bank in order to
provide five equal annual with drawls of $1000, the first of which
will be made one year after the deposit? The fund pays 9 percent.

Solution:
P= ???
A= $1000
n= 05 years
i= 09% per year

By using Uniform Series Present Worth Factor (USPWF)

P = A[(1+i)n-1 / i(1+i) n]
P = 1,000 [(1+0.09)5 -1 / 0.09(1+0.09)5]
P = $3889.70
37
 Equivalence

• Concept of equivalence underlies the methods used to compare

different series of cash flows, one with another.
• For Example: Say $100 today compounded at 10% per year
will become equal to
$100 = $110 end of first year = $121 end of second year=
133.10 end of third year
• Sums of money are described as being equivalent.

38
 Uniform Gradient Series Arithmetic Gradient
Conversion Factor
• It is desirable to formulate to method of finding the uniform series
equivalent of a number of payments that are increasing each year by a
similar amount.
• In most cases, payment or increases may not be constant each year, it is
often possible to convert them to an equivalent approximate uniform
gradient series.
– Uniform increment at the end of each year or period is G.
– Payment or receipt at the end of the second period is G greater than that
at the end of first period.
– Similarly for third period is G greater than at the end of second.
– Thus at the end of the (n-1) years the payment or receipts will be (n-
2)G greater than that at the end of first year.
– At the end of nth year, it will be (n-1)G greater.
– Each increment G that is added at successive year ends is the start of a
new series of installments, A.
– Each of these series can be totaled to establish it final compound
39
amount.
Uniform Gradient Series Arithmetic Gradient
Conversion Factor

• The first increment will have a compound amount = G[ (1+i)n-1-1/i]

• The Second increment will have a compound amount = G[ (1+i)n-2-1/i]
• All these compound amounts can now be totaled, giving the sum of the
compound amounts:
F= G[ ((1+i)n-1-1)/i + ((1+i)n-2-1)/i +…….+ ((1+i)2-1)/i +( (1+i) -1)/i+(1-1)/i]
F= G/i[(1+i)n-1 + (1+i)n-2 +…….+ (1+i)2 + (1+i) –(n-1)]
F= G/i[(1+i)n-1 + (1+i)n-2 +…….+ (1+i)2 + (1+i) +1] –nG/i
Substituting the Uniform Series Compound Amount Factor for the
expression in Bracket,

F= G/i[(1+i)n -1]/i –nG/i= G [(1+i)n –(1+n.i)] i2

Substitute the above equation for F in the Sinking Fund factor
equation(A= F [i / ((1+i)n -1)] ),
A= G[1/i – n/((1+i) n -1)]
Above equation is know as Arithmetic Gradient Conversion Factor. 40
Example: if the maintenance cost of a bulldozer amounts to
$2000 by the end of the first year of its service, $2500 by the end
of the second year and $3000, $3500 and $4000 by the end of
third, fourth and fifth year respectively. Find the equivalent
uniform series cost each year over a period of 5 years, i=5%.
Solution:
G= 500
A= ???
n= 5 years
i= 0.5% per year

By using Arithmetic Gradient conversion Factor

A= G[1/i – n/((1+i) n -1)]

A = 500[1/.05) – 5/( (1+0.05)5 _1)]
A= $950 41
Factor Expressions Find Given
A. Single Payment
1. Compound Amount F= P[1+i]n F P
(F|P,i%,n)
2. Present Amount P= F[1/(1+i)n] P F
(P|F,i%,n)
B. Uniform Series
3. Compound F = A [ ((1+i) n -1) / i ] F A
Amount (F|A,i%,n)
4. Sinking Fund A = F [ i /( (1+i) n -1) ] A F
(A|F,i%,n)
5. Present Worth P = A [ ((1+i)n -1) / i (1+i)n ] P A
(P|A,i%,n)
6. Capital Recovery A = P [i (1+i)n / ((1+i)n -1 ) ] A P
(A|P,i%,n)
C. Arithmetic Gradient
7. Uniform Series A = G[1/i – n/ ((1+i)n -1) ) ] A G
Equivalent (A|G,i%,n)

42
Exercise Problems
1) If a woman deposits 600 now, 300 two years from now and
400 five years from now, how much will she have in her
account ten years from now, if i= 5%.
2) How much money would you be willing to spend now in
order to avoid spending 500 seven years from now, if i= 18%.
3) How much money can you borrow now if you promise to pay
600 per year beginning one year from now for 7 years at an
interest rate of 17% per year.
4) How much money would be accumulated in 25 years if 800
were deposited one year from now, 2400 six years from now,
and 3300 eight years from now, all at an interest rate of 18%
per year.
5) MUET plan to buy some property. The payment scheme
offered is 700 every other year through year 8 starting 2 years
from now. What is the present worth of this property if
i=17%. 43
 CHAPTER 2
ECONOMIC COMPARISONS
• The usual goal of engineering economy studies is to minimize
costs or maximize profits or savings
• This chapter deals with the ways in which decisions
concerning economic choices between alternative investments,
methods and materials can be made.
 Investment proposals are evaluated from different
dimensions:
● Economic evaluation
● Social benefit
● Environmental impact
● Consistent with local and nation development plan
● Others….
 Topic focus: Economic evaluation for
investment appraisal 44
 Economy Study Methods
• Economy studies are made to evaluate two aspects of the
decision problems.
1. To decide whether a single investment should be made at all.
The decision alternatives being two in number: either invest or
don’t invest.
2. The second situation occurs where it is necessary to make a
choice between several alternatives that are available for
investment.
• Where one is to be selected from a list of project , all the
projects on the list being mutually exclusive;
• Projects are being selected from a list where the total
finance available for investment.
45
Mutually Exclusive Alternatives

Mutually exclusive projects means that any project of the several

alternative projects will fulfill the same need and that the selection
of one alternative means that the other will be excluded. An
example would be a choice between building a lift station to carry
water over a hill or making deep trench to carry the water through
the hill.
Engineering economy studies usually fall in to either of the
following two problem situations of project classification. There are
different criterions in comparing mutually exclusive projects. To
comparing mutually exclusive projects we classify investment
projects into:
1. Service project
2. Revenue projects
46
 1. Service projects
Service projects are those projects whose revenue does not depend on
the chose of the projects.
”Alternatives of service projects have different costs but the same
revenue.”

Example:
An electric utility considers building of new power plat. To meet
this demand either we implement combustion turbine plant or fuel
cell power Plant.
• The two alternative service projects can satisfy the demand of the
electricity supply. Both alternatives generate same amount of
revenue to the firm’s costumers, but the difference lies in the cost
of implementation and other related costs. Therefore, the
comparison of this type of projects mainly relies on the cost of
projects. Thus, the least the present value, future value or annuity
of the project implies the most economical the project is.
47
Revenue projects

Revenue projects are the type of projects which designed for the
purpose of income generating. And these types of projects
primarily focus on the rate of revenue and then the cost of
expenditure for the obtained revenue. As the more revenue may
resulted from the expense of large costs and low cost of investment
may lead to low revenue recognition, evaluation of revenue or cost
independently probably deviate the reality. Therefore, the
comparison of revenue projects depends on the choices of the
alternatives from the ground of both cost of expenditure and the
expected revenue of the projects.
“Alternatives of revenue projects have different costs and
revenues”

48
Example:

Assume a small construction firm plan to produce pre-cast concrete

for “condominium” construction input. For the implementation the
firm assesses a market for mixer purchase and found two models of
mixers with different specifications and costs. According to the
specifications of the mixers their productivity will also vary, hence
the profitability of the firm depends upon the selection of the
models besides their costs. Therefore, the firm management should
take care of the net value of each model mixers. They should make
net worth analysis of the alternatives and selects the alternative with
the higher value.

49
Situation and criterion summery
Situation Criterion

1. Service projects or Alternatives 1. Select alterative with lowest

involve cost only equivalent cost

2. Revenue projects or Alternatives 2. Select alternative which maximizes

involve both cost and benefits the net equivalent benefit (the do-
nothing alternative should always be
considered if available)

50
 The Equivalent Annual Cost Method

• In using equivalent annual cost method for the purposes of

comparison, all the payments and receipts are converted to
their equivalent uniform annual costs.
• It is necessary to make an assumption about the required rate
of return before convert it to uniform series of payments.

51
 Example:1
• At a long-term strip-mining coal site it is proposed to maintain the
main temporary haulage roads serving the excavation by using hand
labor. The annual wage bill is estimated to be $78,000. with other
associated expenses, the total cost of labor to contractor will be
$1,08,000 per year. The production of coal on the site is expected to
last for 6-years, and alternative method of constructing and
maintaining haulage roads need to be investigated.
• The first alternative is to buy a motor grader for $70,000 and, as a
consequence, reduce the labor force. Maintenance of the grader is
estimated to average $3000 per year for the 6-years, after which it
will have a salvage or resale value of $15,000. the labor costs
associated with the use of the grader amount to 60,000 per year.
• The second alternative is to lay more substantial roads in the first
instance, extending these after 2 years and again after 4 years. Initial
cost are then $60,000 with further investments of $30,000 and
$28,000 after 2 and 4 years respectively.
• If the return of at least 10 percent is desirable on the capital
52
investment, which is most economic scheme?
 Solution

• Scheme 1; 0 1 2 3 4 5 6

$1,08,000 per year

$ 15,000
• Scheme 2; 0 1 2 3 4 5 6

$63,000 per year

$ 70,000

• Scheme 3; 0 1 2 3 4 5 6

$48,000 per year

$ 60,000 $ 30,000 $ 28,000 53

 Solution
• Scheme 1:
– Annual cost of labor is $1,08,000
• Scheme 2:
– P= $70,000
– Salvage value= $15000
– A=??
– i= 10%
– n= 6 years
By using the equation for Annual Capital Recovery :
Annual Cost of Motor Grader
A= (P-S) [i (1+i)n / (1+i)n -1 ] + Si
A= (70,000-15000) [0.10 (1+0.10)6/ (1+0.10)6 -1] + 15000 x 0.1
A = 14,128.41
Annual Maintenance Cost = 3,000
Annual labor Cost = 60,000
Total Equivalent Annual Cost = 77,128 54
• Scheme 3:
– P1= $60,000 A1=?? P(A|P,10%,6)
A1 = P1 [i (1+i)n / (1+i)n -1 ]
A1 = 60,000 [0.10 (1+0.10)6/ (1+0.10)6 -1]
A1 = 13,776
==================
– F2= $30,000 F(P|P,10%,2)
– P2= ?? P2= F2/(1+i)n = 30000/1.21 =24793.4
– A2=?? P(A|P,10%,6)
A2 = P2 [i (1+i)n / (1+i)n -1 ]
A2 = 24,793.4 [0.10 (1+0.10)6/ (1+0.10)6 -1]
A2 = 5692.5
==================

55
– F3= $28,000 F(P|P,10%,4)
– P3= ?? P3= F3/(1+i)n = 28000/1.465 =19124.4
– A3=?? P(A|P,10%,6)
A3 = P3 [i (1+i)n / (1+i)n -1 ]
A3= 19124.4 [0.10 (1+0.10)6/ (1+0.10)6 -1]
A3 = 4391
A1 = 13776
A2 = 5693
A3 = 4391
Annual labor costs = 48,000
Total Equivalent Annual Cost = 71,860

56
 Result
• Scheme 3 is therefore the most economic, because its
Equivalent Annual cost is lower than other two schemes.
• In making an Economic choice between alternatives, it is
assumed that the technical merit of each alternative has been
examined and found to be satisfactory.
• Only consideration that may now affect the ultimate decision
are the Irreducible factors.
• In the above example, comparison between the schemes was
made on the basis that each of them represented the annual
cost for 6-years. This may not always be the case, particularly
where the construction of more permanent installations is
under consideration.

57
Example 2
• The board of directors of a manufacturing company has under
consideration the erection of a building for the storage of
finished products. They are advised that the two technically
acceptable alternatives are for a reinforced concrete shell roof
structure having an initial cost of $2,000,000 and for a steel-
framed structure with a brick cladding for an initial cost of
1,350,000. the life of the concrete building is estimated to be
60 years and while there will be no maintenance costs for this
building during the first 10 years, there will thereafter be an
annual maintenance cost of $25,000. The life of the other
building is estimated to be 20 years with an equivalent annual
maintenance cost form completion of construction of $30,000.
the salvage value of the concrete building is estimated at
$60,000 and that of the steel-framed building at $20,000. An
acceptable rate of return is assessed at 10%. Which the better
economic proposition? 58
 $ 60,000

0 10 11 20 30 40 50 60

$25,000 per year

$ 2,000,000
• Proposal-1: Reinforced Concrete Building
– P= $2,000,000
– Salvage value= $60,000
– A=??
– i= 10%
– n= 60 years
By using the equation for Annual Capital Recovery : (P-S)(A|P,10%,60)+Si
A= (P-S) [i (1+i)n / (1+i)n -1 ] + Si
A= (2,000,000-60,000) [0.10 (1+0.10)60/ (1+0.10)60 -1] + 60,000 x 0.1
A = 200640 per year
========

59
Annual maintenance charge = 25,000 per year from year 11to 60
Therefore, Present worth of this is equal to= (P|A, 10%,50)
P = A [ (1+i)n -1 / i (1+i)n ] = 25,000 [ (1+0.1) 50 -1/0.1 (1+0.1) 50 ]
P = $2,47,870
The present worth of $2,47,870 at 0 Year will be (P|F, 10%,10)
P= F/(1+i)n = 247,870/(1+0.10)10 = $95579
Therefore, equivalent annual cost over 60 years of $25,000 a yar
from years 11 to 60 is (A|P,10%,60)
A= P [i (1+i)n / (1+i)n -1 ] = (95579) [0.10 (1+0.10)60/ (1+0.10)60 -1]
= $9,578.
Therefore total equivalent annual cost = 200640 + $9,578
= $2,10,169.

60
 $ 20,000
0 10 20

$30,000 per year

$ 1.35m
• Proposal-2 : Steel-framed building
– P= $1,350,000 A = ?? n = 20 years
– Salvage value= $20,000 I = 10%
– By using the equation for Annual Capital Recovery : (P-S)(A|P,10%,60)+Si
A= (P-S) [i (1+i)n / (1+i)n -1 ] + Si
A= (1,350,000-20,000) [0.10 (1+0.10)20/ (1+0.10)20 -1] + 20,000 x 0.1
A = $1,58,275 per year
Maintenance Cost = $ 30,000
= $ 1,88,275
• The steel-framed building is therefore cheaper when the comparison is made on
the basis of annual cost.

61
 Result
• Example 2 raises a number of points.
– A comparison has been made on the basis of annual cost and it is therefore
implicit in the calculation that after 20 years the steel framed building can be
replaced at the same cost as the initial installation and that replacement will
continue at this cost at intervals of 20 years.
– Rising costs are expected in this context.
– In the case of RCC building, the capital investment is being made now, and
therefore no question of increased costs in the replacement situation arises.
– If the replacement cost of steel-framed building in 20 years’ time is increased
by 50% (675,000) over the present-day cost (1,350,000), that becomes,
($2,025,000), then the present worth of the increase in cost under similar
conditions of interest amounts to (P|F,10%,20)= $1,00,305.
– If the second replacement cost is 40 years’ time increases by 50% (1,012,500)
over the first replacement cost ($2,025,000), that is, it becomes ($3,037,500),
the present worth of the increase amounts to (P|F,10%,20)= $22,366.
– These two sums (122671) produce an equivalent uniform annual cost of
$12307 over the total life of 60 years.
– This is small amount in relation to other amounts.
– Though it should be considered when making the selection. 62
• Apart from Financial Aspects of the Economic Appraisal, there
may be considerable advantages within many businesses from
constructing building with a shorter life.
– New developments in products and building materials may
enable to a company to replace the building in 20-years’
time.
– With the long-life building in such a situation it may be
difficult to make good use of it in changed circumstance
unless money is spent on its rehabilitation.
– This aspect becomes an irreducible factor in such a
situation.

63
 Exercise
• In an economic concerned with the alignment of a new road,
one of the alternatives to be evaluated on the basis of
equivalent annual cost consists of a bridge at an estimated cost
of $1,000,000, an embankment costing $1,60,000, and other
earthworks at an estimated cost of $28,000. Maintenance on
the earthworks and the embankment is estimated to reach an
annual cost of $20,000 over the first 4 years of its service and
then to drop to $10,000 for every year thereafter. Maintenance
on the bridge is expected to remain constant throughout its life
at a figure of $50,000 a year. What is the total equivalent
uniform annual cost of this alternative if the life of the bridge
is estimated at 60 years, the life of the earthwork and the
embankments is in perpetuity and the interest rate to used is
15%.?
64
 Solution
• Capital Recovery for the Bridge
= 1,000,000(A|P,15%,60) = $1,50,000
• Interest for embankment and earthworks
= 1,88,000(15%) = $ 28,000
• Annual maintenance of the bridge
= 50,000 per year = $ 50,000
• Basic Annual Maintenance Cost =$ 10,000
on the Embankment and Earthwork
• Equivalent Annual Cost of excess maintenance over
first 4-Years
= 10,000(P|A,15%,4)(15%) =$ 4,283
=$2,42,483
• NOTE: The treatment of the more extensive maintenance over the first 4 years
should be noted.
– This can be dealt with most readily by assuming a basic maintenance of $10,000
a year in perpetuity and then converting the uniform series of $10,000 a year for
the first 4-years to a Present Worth Lump Sum. The interest can then be applied
65
as in the case of the capital recovery for the bridge.
 The Present worth Method

• The second method of appraising alternative capital

investment project is Present Worth Method and well tried
method.
• This method is known as the Net Present Worth or Present
value or net present value (NPV).
• The basis of the this method is that all future receipts or
payments concerned with an investment project are converted
to present worth using an interest rate or acceptable rate of
return.

66
 Example:1
• At a long-term strip-mining coal site it is proposed to maintain the main
temporary haulage roads serving the excavation by using hand labor. The
annual wage bill is estimated to be $78,000. with other associated
expenses, the total cost of labor to contractor will be $1,08,000 per year.
The production of coal on the site is expected to last for 6-years, and
alternative method of constructing and maintaining haulage roads need to
be investigated.
• The first alternative is to buy a motor grader for $70,000 and, as a
consequence, reduce the labor force. Maintenance of the grader is estimated
to average $3000 per year for the 6-years, after which it will have a salvage
or resale value of $15,000. the labor costs associated with the use of the
grader amount to 60,000 per year.
• The second alternative is to lay more substantial roads in the first instance,
extending these after 2 years and again after 4 years. Initial cost are then
$60,000 with further investments of $30,000 and $28,000 after 2 and 4
years respectively.
• If the return of at least 10 percent is desirable on the capital investment,
which is most economic scheme?
67
 Solution

• Scheme 1:
– Present worth of annual labor cost over 6 years
=1,08, 000 (P|A,10%,6) = $4,70,362
• Scheme 2:
– Initial cost of motor grader = $ 70,000
– Present worth of maintenance and labor costs
= 63,000 (P|A,10%,6) = $2,61,312
= $3,31,312
– Less: Present worth of salvage value
= 15,000(P|F,10%,6) = $ 8,467
– Present worth of Total Costs = $3,22,845

68
 Solution

• Scheme 3:
– Initial cost of first section of road = $ 60,000
– Present worth of second investment
= 30,000 (P|F,10%,2) = $ 24,794
– Present worth of third investment
= 28,000 (P|F,10%,4) = $ 19,125
– Present worth of Annual labor costs
= 48,000(P|F,10%,6) = $2,09,050
– Present worth of Total Costs = $3,12,969
• Therefore on the basis of the above present worth evaluation the economic
appraisal comes out in favor of Scheme-3 since, with the given interest rate,
the whole scheme can be financed with a smaller lum sum than the other
two.
69
 Example 2
• The board of directors of a manufacturing company has under
consideration the erection of a building for the storage of
finished products. They are advised that the two technically
acceptable alternatives are for a reinforced concrete shell roof
structure having an initial cost of $2,000,000 and for a steel-
framed structure with a brick cladding for an initial cost of
1,350,000. the life of the concrete building is estimated to be
60 years and while there will be no maintenance costs for this
building during the first 10 years, there will thereafter be an
annual maintenance cost of $25,000. The life of the other
building is estimated to be 20 years with an equivalent annual
maintenance cost form completion of construction of $30,000.
the salvage value of the concrete building is estimated at
$60,000 and that of the steel-framed building at $20,000. An
acceptable rate of return is assessed at 10%. Which the better
economic proposition? 70
 Solution

• Reinforced Concrete Building

– Initial cost of building = $2,000,000
– Less: Present worth of salvage value
=60,000 (P|F,10%,60) =$ 198
S1,999,802
– Equivalent capital value at the end of year 10 of annual
maintenance of $25,000 from year 11 to year 60
= 25,000(P|A,10%,50) = $2,47,870
– Present worth of $2,47,870 at the end of year 10
= 2,47,870 (P|F,10%,10) =$ 95,579
– Present worth of total payments over 60 years =$2,095,381

71
 Solution
• Steel-framed Building
– Initial cost of building = $1,350,000
– Present worth of maintenance costs
=30,000 (P|A,10%,60) = $ 299,013
– Present worth of renewal cost less salvage values at the end of
20 years = (1350000-20,000) (P|F,10%,20) = $ 197,705
– Present worth of renewal cost less salvage values at the end of
40 years = (1350000-20,000) (P|F,10%,40) = $ 29,393
=$1,876,111
– Less: Present worth of salvage value
=20,000 (P|F,10%,40) =$ 66
S1,876,045
• This confirms the result of the analysis made by the equivalent uniform annual cost
method.

72
 Capitalized Costs
• The term Capitalized Cost is commonly used by engineers in cases where
comparisons of cost are made over periods of time in perpetuity and annual
costs are assumed to be incurred on a perpetual basis.
• Capitalized cost is the present sum which will finance the initial
construction costs plus an annual cost at a fixed rate of interest in
perpetuity.
• Capitalized costs can be used as a basis for making economy studies and
are considered to be a particular case of the present worth study method.
Capitalized Cost= P+(A/i)
• The capitalized cost method was used extensively in construction works
because many of the projects that were undertaken, such as railways dams,
sewers, etc were considered to have perpetual life.
• Capitalized costs are still favored, however, present worth methods in view
of the more accurate and realistic estimation of structural lives that is now
possible.

73
 Step by Step for Capitalized-Cost Calculations

1. Draw a Cash-flow diagram showing all nonrecurring (One-time)

expenditures or receipts and at least two cycles of all recurring
(Periodic) expenditures or receipts.
2. Find the present worth of all nonrecurring expenditures (receipts).
3. Find the equivalent uniform annual cost (EUAC) through one
cycle of all recurring expenditures and uniform annual cost series.
4. Divide the EUAC obtained in step 3 by the interest rate to get the
capitalized cost of the EUAC.
Capitalized Cost = EUAC/i
5. Add the value obtained in step 2 to the value obtained in step 4.

74
Example
Calculate the capitalized cost of a project that has an initial cost of
$150,000 and an additional investment cost of $50,000 after 10 years. The
annual operating cost will be 5000 for the first 4 years and $8000 thereafter.
In addition there is expected to be a recurring major rework cost of $15,000
every 13 years. Assume that i=5%.
Solution:
P= $1,50,000/-
P= $50,000/- after 10-years
Find the present worth of the nonrecurring costs
P1= 150,000+ 50,000 (P/F, 5%,10)
P1= 180,000/-
Convert the recurring cost of 15,000 every 13 years to (Equivalent
Uniform Annual Cost (EUAC) A1) for the first 13 years.
A1 = 15,000(A/F, 5%,13) = $847.
The capitalized cost for the annual cost can be computed in two ways
1. Consider a series of $5000 from now to infinity and find the
present worth of 8000-5000=3000 or
2. Find the present worth of 5000 for 4 years and the present
worth of 8000 from year 5 to infinity. 75
• Using the first method, we find the annual cost (A2) is 5000
and the present worth (P2) of 3000 from year 5 to infinity;
P2 = 3000/0.05(P/F,5%,4) = 49,362.
• The two annual costs are converted to a capitalized cost (P3)
P3 = A1 + A2 / i = 847+5000 / 0.05 = 116940
• The total capitalized cost (PT) can now be obtained by addition
PT = P1 + P2 + P3 = 346997.

76
 Exercise
• Two sites are currently under consideration for a bridge to cross River Indus. The
south site would connect a major state highway with an interstate loop around the
city and would alleviate much of the local traffic congestion during rush hours,
and the bridge would have to stretch from one hill to another to span the widest of
the river, railroad tracks and local highways below. This bridge would therefore be
a suspension bridge. The north site would require a much shorter span allowing
for construction of a truss bridge, but would require new road construction.
The suspension bridge would have a first cost of $30million with annual
inspection and maintenance costs of $15,000. In addition, the concrete deck would
have to be resurfaced every 10 years at a cost of $50,000. the truss bridge and
approach roads are expected to cost $12 million and would have annual
maintenance costs of $8000. the bridge would have to painted every 3 years at a
cost of 10,000. In addition, the bridge would have to be sandblasted and painted
every 10 years at a cost of $45000. the cost of purchasing right of ways is
expected to be $800,000 for the suspension bridge and $10.3 million for the truss
bridge. Compare the alternatives on the basis of their capitalized cost if the interest
rate is 6%.

77
• Solution:
– Capitalized Cost of Suspension Bridge
• P1 = Present worth of initial cost= 30.0+0.8= 30.8 Million.
– The recurring operating cost is A1 = $15000, while the annual equivalent of the
resurface cost is
• A2 = 50,000(A/F, 6%,10)= $3794.
• P2 = Capitalized cost of recurring costs = A1 + A2 / i = 15,000+3794/.06
P2 = $313,233.
– Finally the total capitalized cost (Ps )= P1 + P2 = $31.1Million.
– Capitalized Cost of Truss Bridge
• P1 = Present worth of initial cost= 12.0+10.3= 22.3 Million.
• A1 = $8000
• A2 = annual cost of Painting= $10,000(A/F,6%,3)= $3141
• A3 = annual cost of sandblasting = $45,000(A/F,6%,10)= $3414
• P2 = A1 + A2 +A3 / i = $242,583
– The total capitalized cost (PT )= P1 + P2 = $22.5Million
78
 Exercise
• A city planning commission is considering two proposals for a
new civic center. Proposal ‘F’ requires an initial investment of
$10 million now and an expansion cost of $4 million 10 years
from now. The annual operating cost is expected to be
$250000 per year. Income form conventions, shows, etc is
expected to be $190000 the first year and to increase by 20000
per year for four more years and then remain constant until
year 10. In year 11 and thereafter income is expected to be
$350000 per year. Proposal ‘G’ requires an initial investment
of $18 million now and an annual operating cost of $300,000
per year. However, income is expected to be $260000 for the
first year and increase by $30000 per year upto year7.
Thereafter income will remain at $400000 per year. Determine
which proposal should be selected on the basis of capitalized
cost, if the interest rate is 6% per year.
79
 The choice between Annual Cost and Present
worth methods
Equivalent Uniform Annual Cost Method

1. Comparison is more readily understood and interpreted than present worth method.
2. This method lends itself to the comparison or assessment of schemes involving more or
less regular annual costs.

Present Worth Method

1. Comparison is not more readily understood and interpreted than Equivalent Uniform
Annual Cost Method.
2. Present worth methods make for ease of computations where cash flows are very
irregular.
3. This method involve the calculation of a large sum of money, especially if the studies are
concerned with a long period of time.
Annual Cost Methods are often more commonly used in very large, public-oriented
industries, where future budgeted cash flows tend to be reasonably uniform, and to a
lesser extent, in the analysis of property investments.
However, the correct use of either one or the other method will lead to the same
80
conclusions
 Example
• A civil engineering contractor operates a fleet of dumpers, and
from past experience has found that a dumper normally has a
useful working life of 5 years. Such a machine has an initial
capital cost of $10,000 and at the end of the 5-year period has
a salvage values of $800. the cost of maintenance of each
dumper amounts to $3000 for the first year, and increases by
$500 for each succeeding year. If the current interest rate is
12%, what is the equivalent annual cost of owning and
maintaining each dumper? If the contractor can sell the
dumpers for $1200 each at the end of the fourth year, should
he be advised to do so?

81
 Solution

• Equivalent Annual Cost for 5-year life:

Capital Recovery = (10,000-800)(A|P,12%,5)+800(i) = $2,648 per year
• Equivalent Annual maintenance Cost
= (3000+500(A|G,12%,5) = $3,887 per year
Therefore Total Equivalent Annual Cost = $6,535 per year
• Considering 4-year life:
Capital Recovery = (10,000-1200)(A|P,12%,4)+1200(i) = $3,014 per year
• Equivalent Annual maintenance Cost
= (3000+500(A|G,12%,4) = $3,679 per year
Therefore Total Equivalent Annual Cost = $6,720 per year

Result:
It will therefore be to the contractor’s benefit to keep his machines for 5
years.
82
 Internal Rate of Return (IRR) Method
• We have learned in Equivalent Annual Cost and the Present Worth
method of using the time value of money to make comparisons, on
the basis of assumed rate of return.
• We will learn to calculate the actual rate of return for a proposal,
rather than commencing from the premise of an acceptable
minimum required rate of return to be used as a basis for the
calculations.
• One well-established method is Internal Rate of Return Method
(IRR),
• This method employs discounted cash flow techniques.
• There are number of alternative names in common use, but all share
the same underlying fundamental principle.
• These names are: Investors’ Method, the Profitability Index, The
Interest Rate of Return, the marginal efficiency of Capital, the
yield method and the discounted cash flow method.
83
Con…

• IRR can be defined as a method of investment appraisal is a

means of arriving at a rate of interest that will discount all the
future cash flows associated with an investment, both positive
and negative, into equality with the initial capital investment.
• The basic principle of the method is that the future positive
cash flows are regarded as being payments that reduce the
outstanding capital outlay together with paying the interest that
is accruing on the outstanding capital.

84
 Con…
• For Example:
– If sum of $1000 is invested today and it receives back a payment of $500 at the
end of the first year, followed by a final payment of $500 at the end of the
second year, then the initial investment is recovered but at a zero rate of return.
Capital has earned no return during the 2 years in which it has been locked up in
the investment.
– If the same money is invested and at the end of the first year receives a positive
cash flow of $553, together with a similar sum $553 at the end of the second
year. It can be said that the investment has made a return or paid interest.
• Let us assume rate of return for investment is equal to 7%. By the end of
first year, payable interest on total amount is equal to $70. We have received
a sum of $553 at the end of first year , so net sum of $483 received and
leaving outstanding debit of $517. At 7%, for the second year on $517,
interest rate amount will be $36. After deducting this amount from the
second annual payment of $553, there is balance of $517, which just clears
the outstanding capital debits.
– This example shows that Rate of Return of 7% is calculated only on the
outstanding balance of the capital remaining invested. This is a reasonable basis
for calculation. 85
 The Calculation of IRR
• The principles of the calculations in the IRR method for a Single
Investment;
• Example: A company purchases a small computer for the sum of $15,000.
For 5-years the computer is hired out to clients and the gross receipts are
those appearing in columns 2 of Table (Receipts, or positive cash flows, are
listed without a sign; negative cash flows are listed in brackets.) After 5-
years, the company decides to reconditions the computer at a cost of $500
and to sell it for $2000. the resale value is shown in Column 2 of the table,
and for clarity it is kept separate from the annual cash flows. It is required
to establish IRR on this investment by the hire company.
Year Receipts Payments Net cash flows
0 --- ($15,000) ($15,000)
1 $6,000 ($2,000) $4,000
2 $7,500 ($3,500) $4,000
3 $6,500 ($2,500) $4,000
4 $8,000 ($3,000) $5,000
5 $5,000 ($2,000) $2,500
6 $2,000 ($5,00) $1,500
Total $35,000 ($29,000) $6,000
86
The Calculation of IRR
• In order to find IRR, it is necessary to establish the value of the interest rate
that will just equate the present worth of all the future cash flows, both positive
and negative, considered over the full period of 5 years to the initial capital
investment.
• IRR can only be determined by using Trial and error method.
• The present worth of the future net cash flows is calculated using this value.
• If the resulting calculation gives a positive answer, that is, if the discounted
future cash flows sum to a larger amount than the negative initial investment,
then a second higher interest rate is chosen.
• Calculation repeated until two interest rates are reached that give one positive
net summation and one negative net summation.
• Table shows the result of present worth calculated with interest rate of
5,11,13,and 15 percentage.
• Last row of table shows the initial totals whether the chosen interest rates are
appropriate.
• In this case, 11% (Total is 15443) and 13% (Total is 14682) have been
chosen. 87
 The Calculation of IRR

Year Net (P|F, PV of (P|F, PV of (P|F, PV of (P|F, PV of

cash 5%,n) net cash 11%,) net 13%,n) net 15%,n) net
flow flow cash cash cash
flow flow flow
0 (15000) 1.00 -15000 1.00 -15000 1.00 -15000 1.00 -15000
1 4000 0.95 3809.52 0.90 3603.60 0.88 3539.82 0.87 3478.26
2 4000 0.91 3628.12 0.81 3246.49 0.78 3132.59 0.76 3024.57
3 4000 0.86 3455.35 0.73 2924.77 0.69 2772.20 0.66 2630.06
4 5000 0.82 4113.51 0.66 3293.65 0.61 3066.59 0.57 2858.77
5 4000 0.78 3134.10 0.59 2373.81 0.54 2171.04 0.50 1988.71

3140.609 442.32 -317.76 -1019.63

88
 The Calculation of IRR

• To have the appropriate IRR, make a linear interpolation

between the two values.

Rate of return(%) = 11 + [(15443-15000)/(15443-14682)] (2)

= 11 + 1.17
= 12.17%

89
 Graphical process for IRR
• Figure illustrates graphically the process by which the IRR is established.
• The curve is drawn for a series of
incremental interest rates; 7000

• Net present worth of the net cash flows 6000

values in Table is calculated for a range 5000
of interest rates. 4000

• For interest rates less that the IRR, the 3000

net present worth are positive; 2000

• Where the interest rates are greater, the 1000

net present worth are negative. 0
0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20%
• Where the curve intersects the zero net -1000
present worth line, IRR can be read off -2000
Series1
on the x-axis.
• Minimum required rates of return is
12.17 percent. 90
 Yield on Bonds by IRR
• A company can raise money to finance future capital investment is by
issuing a Bond or debenture.
• In issuing a bond the borrower agrees to make to the lender a number
of fixed-size interest payments (bond rate) at a stated interval.
• Borrower also contracts in the bond to repay its face value at a stated
future date.
• Bond rate is calculated for the payment of interest on the face value
of the bond.
• If bond is sold at other than its face value, either when issued
initially or at some time before redemption, the purchaser’s actual
yield on the investment in the bond will not be the same as the bond
rate.
• The actual yield on the bond can be calculated by using the IRR
method. 91
 Example
• A small company wishes to raise the sum of $1,00,000 by issuing 25-year
debentures at 5%. To make the issue more attractive to the public, each $100
debenture is to be offered for sale at a price of $95. interest on the debentures
will be payable at the end of each 6-months, until the contract terminates with
the repayment to the purchaser of the face value of the debenture. A purchaser
of some of the debentures requires to know the yields that will be purchased in
terms of a nominal interest rate.
Solution
Debentures are not due for repayment until the expiry of 25-years, the number
of 6-monthly period over which interest will be payable amounts to 50.
For each bond of $100, $2.5 will be payable to the lender at the end of each 6-
month period.
Cash flow diagram is simple:
Initially investment (negative cash flow) of $95 for purchase of the bond, with
$2.5 positive cash flow for 50 periods
Final figure will be $100 at the end of 25 years.
Present worth facilitated if it is completed separately for the series of payments
of $2.5 and final payment of $100.
92
• Present worth for $95=$2.5,
2.5(P|A, i%,50)
• Present worth for $100,
100(P|F, i%,50)
• Try 2.5 percent
Present worth = 2.5(P|A, i%,50) + 100(P|F, i%,50)
Present worth = $100
• Try 3 percent
Present worth = 2.5(P|A, i%,50) + 100(P|F, i%,50)
Present worth = $87.13
• By Interpolation:
Interest rate = 2.5+(100-95)/(100-87.13)(0.5)
= 2.69 percent per 6 months
The nominal interest will be 2(2.69) = 5.38 percent and
Effective annual rate will be Ieff = (1+0.0269)2-1 = 0.545 or 5.45 percent.

93
Selection from Multiple Alternatives
• Multiple-alternative may be classified as being either mutually
exclusive or independent.
• Mutually exclusive alternatives are those from which one only
is to be selected and remaining alternatives are automatically
rejected.
• An independent alternative is selected in its own right and on
its own merit, as a result of its meeting the minimum
requirements that are set for selection.
• From a set of independent alternatives, each one that meets the
minimum requirements will be implemented so long as capital
is available.

94
 Exercise
• Consider the case for the reorganization of a Precast concrete production
factory. As the factory is currently operating, the total cost of labor,
including overheads, insurances, holidays with pay, etc, amounts to
$2,00,000 a year. The manager of factory produces two alternative schemes
for mechanizing the handling and placing of the concrete into the moulds.
The scheme involves an initial investment in equipment of $1,00,000. this
will reduce the labor cost for producing the same quantity of units to
$1,70,170 a year. The revised labor cost takes into account the additional
insurance and power that will be required for running the new scheme.
• The second alternative is to invest rather more capital, $2,00,000, in new
equipment, reducing the inclusive labor figure to $1,44,520 a year. The
three schemes are to be compared over a period of 5-years, since this is the
estimated life of the mechanical equipment. The factor manager has
decided that an interest rate of 11 % represents a necessary minimum rate
of return for any investment which is made at the particular time. The cash
flows for the three schemes are listed in Table below. In evaluating
mutually exclusive multiple alternative, the proposal are set out in order of
increasing capital investment from left to right. Note that all cash flows in
Table are negative, that is they are payments. 95
Year Existing Alternative (B) Alternative (C)
Arrangement (A)
0 ----- 1,00,000 2,00,000
1 2,00,000 1,70,170 1,44,520
2 2,00,000 1,70,170 1,44,520
3 2,00,000 1,70,170 1,44,520
4 2,00,000 1,70,170 1,44,520
5 2,00,000 1,70,170 1,44,520

96