P R E S E N T W O RT H , F U T U R E W O RT H ,

A N N U A L W O RT H , I N T E R N A L R AT E
O F R E T U R N , E X T E R N A L R AT E O F
R E T U R N

BASIC ECONOMIC
STUDY METHODS
CONTENTS

The Present Worth Method

The Future Worth Method

The Annual Worth Method

The Internal Rate of Return Method

The External Rate of Return Method

 PRESENT Definition: The Present Worth
WORTH (PW) Method assesses
investment projects by
METHOD -
evaluating the equivalent worth
KEY
of all cash flows at the present
CONCEPTS point in time, typically using the
Minimum Acceptable Rate of
Return (MARR) as the discount
rate.
 PRESENT
WORTH Objective: Determine if an
METHOD - investment project is profitable
KEY by calculating the net present
CONCEPTS value of cash inflows and
outflows. A positive PW signifies
a profit over the required return.
 PRESENT
WORTH Time Value of Money: The PW
METHOD - Method recognizes that a dollar
KEY today is worth more than a dollar
CONCEPTS in the future. Therefore, it
discounts future cash flows to
their present value.
 PRESENT
WORTH
METHOD - Discounting Cash Flows: Cash
flows are adjusted to present
KEY
values by using the MARR as the
CONCEPTS
interest rate over the study period
(e.g., years).
 PRESENT
WORTH
METHOD - Decision Rule: If the PW is
positive, the investment project
KEY
is financially viable. If it's
CONCEPTS
negative, the project may not
meet the desired return.
To find the PW as a function of i% (per interest period) of a series of cash inflows
and outflows, it is necessary to discount future amounts to the present by using the
interest rate over the appropriate study period (years, for example) in the following
manner:

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).
The relationship given in Equation is based on the assumption of a constant
interest rate throughout the life of a particular project.

To apply the PW method of determining a project’s economic worthiness, we

simply compute the present equivalent of all cash flows using the MARR as the
interest rate. If the present worth is greater than or equal to zero, the project is
acceptable.

PW Decision Rule: If PW (i = MARR) ≥ 0, the project is economically

justified.
It is important to observe that the
higher the interest rate and the farther
into the future a cash flow occurs, the
lower its PW is. This is shown
graphically in Figure 5-2. The PW of
$1,000 10 years from now is $613.90
when i = 5% per year. However, if i =
10%, that same $1,000 is only worth
$385.50 now.
EXAMPLE: EVALUATION OF NEW EQUIPMENT PURCHASE USING PW

A piece of new equipment has been proposed by

engineers to increase the productivity of a certain
manual welding operation. The investment cost is
$25,000, and the equipment will have a market value
of $5,000 at the end of a study period of five years.
Increased productivity attributable to the equipment
will amount to $8,000 per year after extra operating
costs have been subtracted from the revenue
generated by the additional production. A cash-flow
diagram for this investment opportunity is given
below. If the firm’s MARR is 20% per year, is this
proposal a sound one? Use the PW method.
SOLUTION:

PW = PW of cash inflows − PW of cash outflows

Because PW(20%) ≥ 0, this equipment is

economically justified.
ASSUMPTIONS OF THE PW METHOD
• Certainty Assumption: The PW method assumes a world of certainty, where future factors like
interest rates are known with precision. This, however, doesn't align with the inherently
uncertain real world.
• Perfect Capital Markets: The method assumes perfect capital markets, where borrowing and
lending occur at the same interest rate, devoid of real-world complexities like taxes and
commissions.
• Cost-Benefit Analysis: Despite these idealized assumptions, the PW method is cost-beneficial.
The value of improved decision-making resulting from PW analysis exceeds the costs.
• Sophisticated Models Exist: While more advanced models exist, they typically confirm
decisions made using the PW model rather than reversing them.
• Maximize Firm's Value: The ultimate goal is to recommend capital investments that enhance a
firm's value, primarily for its stockholders.
 FUTURE
Definition: The Future Worth
WORTH (FW) Method assesses
METHOD - investment projects by
KEY evaluating the equivalent worth
CONCEPTS of all cash flows at the end of a
specified planning horizon, often
employing the Minimum
Acceptable Rate of Return
(MARR) as the interest rate.
 FUTURE
WORTH
METHOD - Objective: Aims to maximize
KEY the future wealth of a firm's
CONCEPTS owners by making well-informed
capital investment decisions.
 FUTURE
WORTH
METHOD - Calculation: The FW is
KEY equivalent to the Present Worth
CONCEPTS (PW) of a project, with FW =
PW(F/P, i%, N).
 FUTURE
WORTH
METHOD - Economic Justification: If the
FW is greater than or equal to
KEY
zero, it indicates that the project
CONCEPTS
is economically justified and a
justifiable investment.
 FUTURE
WORTH Planning Horizon: All cash
METHOD - inflows and outflows are
KEY assessed at the end of a defined
CONCEPTS planning period, which is
essential for long-term
investment decisions.
 FUTURE
WORTH
METHOD - Equivalent to PW: FW is a
practical method for evaluating
KEY
projects and is equivalent to the
CONCEPTS
PW method, simplifying
complex calculations.
 FW Decision Rule: If FW (i = MARR) ≥ 0, the project is economically justified.

This Equation summarizes the general calculations necessary to determine a

project’s FW:
EXAMPLE: THE RELATIONSHIP BETWEEN FW AND PW

Evaluate the FW of the potential improvement project

described in
“Example: Evaluation of New Equipment Purchase Usin
g PW”
. Show the relationship between FW and PW for this
example.
EXAMPLE: EVALUATION OF NEW EQUIPMENT PURCHASE USING PW

A piece of new equipment has been proposed by

engineers to increase the productivity of a certain
manual welding operation. The investment cost is
$25,000, and the equipment will have a market value
of $5,000 at the end of a study period of five years.
Increased productivity attributable to the equipment
will amount to $8,000 per year after extra operating
costs have been subtracted from the revenue
generated by the additional production. A cash-flow
diagram for this investment opportunity is given
below. If the firm’s MARR is 20% per year, is this
proposal a sound one? Use the PW method.
SOLUTION:

Again, the project is shown to be a good investment (FW ≥ 0). The PW is a multiple
of the equivalent FW value:
To this point, the PW and FW methods have used a known and constant MARR
over the study period. Each method produces a measure of merit expressed in
dollars and is equivalent to the other. The difference in economic information
provided is relative to the point in time used (i.e., the present for the PW versus the
future, or end of the study period, for the FW).
 ANNUAL
WORTH Definition: The Annual Worth
METHOD - (AW) Method simplifies
investment project evaluation by
KEY
converting all cash flows into a
CONCEPTS
uniform, equivalent annual
amount for a specified study
period.
 ANNUAL
WORTH
METHOD - Objective: Determine the
financial viability of an
KEY
investment project by calculating
CONCEPTS
the equivalent annual worth of
cash inflows and outflows.
 ANNUAL
WORTH Calculation: The AW is
METHOD - computed by transforming all
cash flows into an equivalent
KEY
annual payment over the study
CONCEPTS
period, using the Minimum
Acceptable Rate of Return
(MARR) as the interest rate.
 Components of AW: AW
represents the difference between
ANNUAL annual equivalent revenues or
WORTH savings (R) and annual
METHOD - equivalent expenses (E), less the
KEY annual equivalent capital
CONCEPTS recovery (CR) amount, computed
over the study period.
AW Formula: The AW, as a
function of interest rate (i%), is
calculated as follows:
AW(i%) = R - E - CR(i%)
 ANNUAL
WORTH Equivalent to PW and FW: The
METHOD - AW of a project is equivalent to
its Present Worth (PW) and
KEY
Future Worth (FW). Therefore,
CONCEPTS
AW = PW(A/P, i%, N) and AW =
FW(A/F, i%, N), allowing for
easy computation.
 ANNUAL
WORTH Economic Attractiveness: If the
METHOD - AW, evaluated at the MARR, is
greater than or equal to zero, the
KEY
project is deemed economically
CONCEPTS
attractive; otherwise, it is not. An
AW of zero signifies an annual
return matching the MARR.
 ANNUAL
WORTH Preference for Decision-
METHOD - Makers: The AW method is
often favored by decision-makers
KEY
familiar with annual income
CONCEPTS
statements and cash-flow
summaries due to its ease of
interpretation.
 AW Decision Rule: If AW (i = MARR) ≥ 0, the project is economically justified.

The CR amount for a project is the equivalent uniform annual cost of the
capital invested. It is an annual amount that covers the following two items:
1. Loss in value of the asset
2. Interest on invested capital (i.e., at the MARR)
As an example, consider a device that will cost $10,000, last five years, and have a salvage (market) value of $2,000.
Thus, the loss in value of this asset over five years is $8,000. Additionally, the MARR is 10% per year.
It can be shown that, no matter which method of calculating an asset’s loss in value over time is used, the equivalent
annual CR amount is the same. For example, if a uniform loss in value is assumed ($8,000/5 years = $1,600 per year),
the equivalent annual CR amount is calculated to be $2,310, as shown in the Table below:

Calculation of Equivalent Annual CR Amount

Year Value of Uniform Interest on CR Amount PW of CR Amount at i= 10%
Investment Loss in Beginning- for Year
at Beginning Value of-Year
of Yeara Investment
at I = 10%
1 $10,000 $1,600 $1,000 $2,600 $2,600(P/F, 10%, 1) = $2,364
2 $8,400 $1,600 $840 $2,440 $2,440(P/F, 10%, 2) = $2,016
3 $6,800 $1,600 $680 $2,280 $2,280(P/F, 10%, 3) = $1,713
4 $5,200 $1,600 $520 $2,120 $2,120(P/F, 10%, 4) = $1,448
5 $3,600 $1,600 $360 $1,960 $1,960(P/F, 10%, 5) = $1,217
Total: $8,758
CR(10%) = $8,758(A/P, 10%, 5) = $2,310.
This is also referred to later as the beginning-of-year unrecovered investment.
There are several convenient formulas by which the CR amount (cost) may be calculated to obtain the result in Table “
Calculation of Equivalent Annual CR Amount”. Probably the easiest formula to understand involves finding the annual
equivalent of the initial capital investment and then subtracting the annual equivalent of the salvage value. ∗ Thus,

∗ The following two equations are alternative ways of calculating the CR amount:

Where:
I = initial investment for the project;∗
S = salvage (market) value at the end of the study period;
N = project study period.
 Thus, by substituting the CR(i%) expression of Equation into the AW expression, Equation
becomes

When Equation is applied to the example in Table “Calculation of Equivalent Annual CR Amount”.
, the CR cost is
INTERNAL The IRR method is one of the
R AT E O F most commonly utilized rate-of-
RETURN return techniques for conducting
(IRR) engineering economic analyses.
METHOD - Known by various names,
KEY including the investor's method,
CONCEPTS discounted cash-flow method,
and profitability index.
INTERNAL Equating Cash Flows: This
R AT E O F method calculates the interest
RETURN rate at which the equivalent
(IRR) worth of cash inflows (receipts
METHOD - or savings) equals the equivalent
KEY worth of cash outflows
CONCEPTS (expenditures, including
investment costs).
INTERNAL
R AT E O F Equivalent Worth
RETURN Computation: The equivalent
(IRR) worth can be determined using
METHOD - any of the three methods
KEY mentioned earlier in the
CONCEPTS presentation.
INTERNAL
R AT E O F
RETURN Internal Rate of Return (IRR):
The result of this calculation is
(IRR)
termed the Internal Rate of
METHOD - Return (IRR). It is also referred
KEY to as the breakeven interest rate.
CONCEPTS
 Conditions for Positivity: For a
INTERNAL single alternative from the
R AT E O F lender's perspective, the IRR is
RETURN not positive unless (1) both
receipts and expenses are present
(IRR)
in the cash-flow pattern, and (2)
METHOD - the sum of receipts exceeds the
KEY sum of all cash outflows.
CONCEPTS Checking these conditions is
crucial to avoid unnecessary
calculations.
INTERNAL Comparison with MARR:
R AT E O F Once i' (the IRR) is calculated, it
RETURN is compared with the Minimum
Acceptable Rate of Return
(IRR)
(MARR) to determine the
METHOD - acceptability of the alternative. If
KEY i' ≥ MARR, the alternative is
CONCEPTS deemed acceptable; otherwise, it
is not.
 Using a present worth (PW) formulation, the IRR is determined as the interest rate at
which the following equation holds:

where
Rk = net revenues or savings for the kth year;
Ek = net expenditures, including any investment costs for the kth year;
N = project life (or study period).

Once i ′ has been calculated, it is compared with the MARR to assess whether the
alternative in question is acceptable. If i ′ ≥ MARR, the alternative is acceptable;
otherwise, it is not.
IRR Decision Rule: If IRR ≥ MARR, the project is economically justified.
A popular variation of Equation for computing the IRR for an alternative is to determine the i ′ at which h its net PW
is zero. In equation form, the IRR is the value of i′ at which

∗ i′ is often used in place of i to mean the interest rate that is to be determined.

For an alternative with a single investment cost at the present time followed by a series of positive cash inflows over
N, a graph of PW versus the interest rate typically has the general convex form shown in Figure below. The point at
which PW = 0 in Figure 5-3 defines i ′ %, which is the project’s IRR. The value of i ′ % can also be determined as
the interest rate at which FW = 0 or AW = 0.

Plot of PW versus
Interest Rate
 Reinvestment Assumption
Challenges: The IRR method's
reinvestment assumption may not
EXTERNAL
always hold in engineering economy
R AT E O F studies. For example, when a firm's
RETURN Minimum Acceptable Rate of Return
(MARR) is 20% per year and the IRR
(ERR)
for a project is 42.4%, it may not be
METHOD - feasible to reinvest cash proceeds from
KEY the project at a rate significantly higher
than 20%. These challenges, coupled
CONCEPTS
with computational demands and
potential multiple interest rates, have
led to the development of alternative
rate of return methods.
 ERR Method Introduction: The ERR
(External Rate of Return) method is one
EXTERNAL
such alternative. It directly considers
R AT E O F the interest rate (∈) external to a
RETURN project at which net cash flows
generated or required by the project
(ERR)
over its life can be reinvested or
METHOD - borrowed. Typically, this external
KEY reinvestment rate aligns with the firm's
MARR. When the firm's MARR
CONCEPTS
matches the project's IRR, the ERR
method produces results identical to
those of the IRR method.
 Calculation Procedure: The ERR
method involves three key steps:
EXTERNAL 1. Discounting all net cash outflows
R AT E O F to time zero (the present) at a rate
RETURN of ∈ per compounding period.

(ERR) 2. Compounding all net cash inflows

to period N at a rate of ∈.
METHOD -
3. Determining the ERR, which is the
KEY interest rate that equates the present
CONCEPTS equivalent worth of net cash
outflows at ∈ to the future
equivalent worth of net cash
inflows at ∈.
The absolute value of the present equivalent worth of the net cash outflows at ∈% (first step)
is used in this last step. In equation form, the ERR is the i ′ % at which

where
Rk = excess of receipts over expenses in period k;
Ek = excess of expenditures over receipts in period k;
N = project life or number of periods for the study;
∈ = external reinvestment rate per period.
Graphically, we have the following (the numbers relate to the three steps):

A project is acceptable when i ′ % of the ERR method is greater than or equal to the firm’s MARR.
ERR Decision Rule: If ERR ≥ MARR, the project is economically justified.

The ERR method has two basic advantages over the IRR method:
1. It can usually be solved for directly, without needing to resort to trial and error.
2. It is not subject to the possibility of multiple rates of return.
EXAMPLE: DETERMINING THE ACCEPTABILITY OF A PROJECT, USING ERR

When ∈ = 15% and MARR = 20% per year, determine whether the project (whose net cash-flow
diagram appears next) is acceptable. Notice in this example that the use of an ∈% different from the
MARR is illustrated. This might occur if, for some reason, part or all of the funds related to a project
are “handled” outside the firm’s normal capital structure.
SOLUTION:

E0 = $10,000 (k = 0),
E1 = $5,000 (k = 1),
Rk = $5,000 for k = 2, 3, ... , 6,
[$10,000 + $5,000(P/F, 15%, 1)](F/P, I’%, 6) = $5,000(F/A, 15%, 5);
i′% = 15.3%.
The i ′ % is less than the MARR = 20%; therefore, this project would be unacceptable according to
the ERR method.