CHAPTER 5

Evaluating a Single project

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Introduction
In this chapter we will answer the
following question :

Whether a proposed capital and its

expenditures can recovered by revenue
over time in addition to a return on the
capital sufficiently attractive in view of
the risks .

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Methods of Evaluating the Economic
Profitability of a Problem Solution
Present Worth ( PW )
Future Worth ( FW )
Annual Worth ( AW )
Internal Rate of Return ( IRR )
External Rate of Return ( ERR )

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Assumptions
1. We know the future with certainty
2. We can borrow and lend with the same i
%.

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The most-used method is the present worth
method.
The present worth (PW) is found by
discounting all cash inflows and
outflows to the present time at an
interest rate that is generally the
MARR.
A positive PW for an investment
project means that the project is
acceptable (it satisfies the MARR).

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Present Worth ( PW )

Eq..
(5-1)
=F0(1+i)0+F1(1+i)-1+F2(1+i)-2+………..
+FN(1+i)- N

i = effective interest rate or MARR

K = index of each compounding period
Fk = future cash flow at the end of period k 6
PW Decision Rule:

If PW (i=MARR) ≥ 0 , the project is

economically justified

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Note
The higher the interest rate and the
further into the future a cash flow occurs ,
the lower its PW is
See figure 5-2
PW of 1,000 10 years from now i =5% is $613.90
PW of 1,000 10years from now i=10% is $385.5

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Figure 5-2

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Example(PW)
Consider a project that has an initial
investment of $50,000 and that returns
$18,000 per year for the next four years.
If the MARR is 12%, is this a good
investment?
PW = -50,000 + 18,000 (P/A, 12%, 4)
PW = -50,000 + 18,000 (3.0373)
PW = $4,671.40  This is a good investment!

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Example 5.1:

A piece of new equipment has been proposed by

engineers to increase the productivity of a certain
manual welding operation. The investment cost
$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. 11
Example. 5-1

 PW = PW(inflows) – PW (outflows)
 PW= $8,000(P/A,20%,5) +$5,000(P/F,20%,5)-$25,000
 PW= $934,29

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Bond Value
The value of the bond at any time is the
PW of future cash receipts
Two types of payments
1.Series of periodic interest payments (rZ)
2.A single payment = C ,When the bond is
sold or retired .

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VN = C(P/F, i%, N) + rZ (P/A, i%,N) Eq.5-2

Z= Face ,or parValue,

C = redemption or disposal price (usually
= Z).
r = bond rate (nominal interest) per
interest period
N= # of periods before redemption
i = bond yield rate per period
VN = PW

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15
Example5-4

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The Capitalized-Worth Method
A special variation of the PW
To find PW for infinite length of time
N ∞
CW = PWN  ∞ = A ( P / A, i%, ∞ )

( 1+i )N - 1
= A lim ------------------ =A ( 1 / i )=A/i
N
∞ i ( 1 + i )N

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Ex. 5-5 page 219

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(a)As we discussed before when N= ∞
(p/A,i%,N)=1/i, then
(p/A,8%,N)=1/0.08 = 12.5
go to App.C then N= 100 this assumed
as (∞ )

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Ex. 5-5 page 219

(b)
30,000  20,000( A / F ,8%,4)
CW ( 100,000( A / P,8%, )) / .08 
0.08

 30,000  20,000( A / F ,8%,4) 

CW  100,000     $530,475
 0.08 

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 Future Worth ( FW )
Equivalent worth of all cash flows (In& Out) at the
end of the planning horizon at MARR

Eq.(5-3)

i = effective interest rate or MARR

K = index of each compounding period
Fk = future cash flow at the end of period k
N = # of compounded periods .

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FW Decision Rule:

If FW (i=MARR) ≥ 0 , the project is

economically justified

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Ex 5-6 page 221

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Example5-7

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The Annual Worth Method
Annual worth is an equal periodic series of dollar
amounts that is equivalent to the cash inflows and
outflows, at an interest rate that is generally the
MARR.
The AW of a project is annual equivalent revenue
or savings minus annual equivalent expenses, less
its annual capital recovery (CR) amount.
AW(i%) = R – E – CR(i%)
R = Annual equivalent Revenue or saving
E = Annual equivalent Expenses
CR = Annual equivalent Capital Recovery
amount
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AW Decision Rule:

If AW (i=MARR) ≥ 0 , the project is

economically justified

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CR (Capital Recovery)
CR is the equivalent uniform annual cost of
the capital invested that covers
1.Loss of value of the asset.
2.Interest on invested capital (at MARR)

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CR
CR (i%) = I(A/P, i%, N) – S(A/F, i%,N) Eq. 5-5
I = initial investment for project
S = salvage (market) value at the end of
the study period
N = project study period

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CR (i%) = (I – S)(A/F, i%, N) +I(i%)
CR (i%) = (I –S)(A/P, i%, N) + S(i%)

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Example 5-8 page 224

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Example 5-9

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Example 5-10

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Example 5-11

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A project requires an initial investment of
$45,000, has a salvage value of $12,000 after
six years, incurs annual expenses of $6,000,
and provides an annual revenue of $18,000.
Using a MARR of 10%, determine the AW of
this project.

Since the AW is positive, it’s a good

investment.
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Internal Rate Of Return Method ( IRR )
IRR solves for the interest rate that equates the
equivalent worth of an alternative’s cash inflows
(receipts or savings) to the equivalent worth of
cash outflows (expenditures)

IRR is positive for a single alternative only if:

both receipts and expenses are present in the cash
flow diagram
the sum of inflows exceeds the sum of outflows

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Internal Rate of Return
It is also called the investor’s method, the
discounted cash flow method, and the
profitability index.
If the IRR for a project is greater than the
MARR, then the project is acceptable.

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INTERNAL RATE OF RETURN METHOD ( IRR )

IRR is i’ %, using the following PW formula:

R k = net revenues or savings for the kth year

E k = net expenditures including investment
costs for the kth year
N = project life ( or study period )

Note: FW or AW can be used instead of PW

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Solving for the IRR is a bit more
complicated than PW, FW, or AW
The method of solving for the i'% that
equates revenues and expenses normally
involves trial-and-error calculations, or
solving numerically using mathematical
software.

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Installment Financing
An application of IRR method
Ex.5-14 will be discussed

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Challenges in Applying the IRR
Method.
It is computationally difficult without
proper tools.

In rare instances multiple rates of return

can be found(take a look to page 255 example 5-A-1).

The IRR method must be carefully applied

and interpreted when comparing two more
mutually exclusive alternatives (e.g., do
not directly compare internal rates of
return). 48
 The External Rate Of Return Method ( ERR )

ERR directly takes into account the

interest rate
(  ) external to a project at which net cash
flows generated over the project life can
be reinvested (or borrowed ).
If the external reinvestment rate, usually
the firm’s MARR, equals the IRR, then
ERR method produces same results as
IRR method
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Calculating External Rate of Return ( ERR )

1. All net cash outflows are discounted to the present (time 0) at ε%

per compounding period.
2. All net cash inflows are discounted to period N at ε %.
3. Solve for the ERR, the interest rate that establishes equivalence
between the two quantities.
The absolute value of the present equivalent worth of the net cash
outflows at ε % is used in step 3.
A project is acceptable when i ‘ % of the ERR method is greater
than or equal to the firm’s MARR

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