MODULE 5

BASIC METHODS FOR MAKING ECONOMIC STUDIES

 to determine the feasibility of investing capital in a proposed venture.

1. THE RATE OF RETURN METHOD (ROR)

 is a measure of the effectiveness of an investment of capital.
 is easily understood.
Conditions: A single investment of capital at the beginning of the first year of
the project life and identical revenue and cost data for each year.

NET ANNUAL PROFIT

ROR 
CAPITAL INVESTED

ROR ≥ i (investment is feasible and justified)

where: FC – required investment

AI – gross annual income / annual revenue
AC – annual expenses or costs
– includes materials, direct labor, overhead, property taxes
AC  O  M  T
O – operation
M – maintenance
T – taxes
D – depreciation
FC  SV
D
 (1  i ) N 1
 
 i 
Pb – net profit before income taxes
Pb  AI  ( AC  D)
ROR – rate of return
Pb
RORb  (100%)
FC
2. THE ANNUAL WORTH METHOD
 the minimum required profit is included as a cost.
 if the excess of annual cash inflows over annual cash outflows is not less
than zero, then the proposed investment is justified or valid.
Conditions: A single investment of capital at the beginning of the first year of
the project life and identical revenue and cost data for each year.
Inflow ≥ Outflow (investment is feasible and justified)
where: Fci = interest on capital
Pb  AI  ( AC  D  FCi )
3. THE PRESENT WORTH METHOD
 if the present worth of the net cash flows is equal to, or greater than zero,
then the project is justified economically.
 flexible, can be used in any type of economy study.
 depreciation is excluded in the cash outflow.

Inflow ≥ Outflow (investment is feasible and justified)

Inflows:
SV

AI AI AI AI

0 1 2 3 ………… N

(going to present)

Outflows:

0 1 2 3 ………… N

AC AC AC AC
FC

(going to present)

4. THE FUTURE WORTH METHOD

 if the future worth of the net cash flows is equal to, or greater than zero,
then the project is justified economically.
 depreciation is excluded in the cash outflow.

Inflow ≥ Outflow (investment is feasible and justified)

Inflows:
SV

AI AI AI AI

0 1 2 3 ………… N

(going to future)
 Outflows:

0 1 2 3 ………… N

AC AC AC AC
FC

(going to future)

5. THE PAYBACK (PAYOUT) PERIOD METHOD

 the payback period is defined as the length of time required to recover the
first cost of an investment from the net cash flow produced by that
investment for an interest rate of zero.

INVESTMENT  SALVAGE VALUE

Payout Period years 
NET ANNUAL CASH FLOW
FC  SV
Payout Period years 
AI  AC
Sample Problems:
1. A project capitalized for P 50,000.00 invested in depreciable assets will earn
a uniform, annual income of P 19,849.00 in 10 years. The salvage value is P
2000.00. The cost for operation and maintenance total P 9,000.00 a year,
and taxes and insurance will cost 4% of the first cost each year. If the
company expects its capital to earn 12% before income taxes, is the
investment worthwhile?
2. An investment of P 270,000.00 can be made in a project that will produce
uniform annual revenue of P 185,400.00 for 5 years and then have a salvage
value of 10% of the investment. Out-of pocket costs for operation and
maintenance will be P 81,000.00 per year. Taxes and insurance will be 4% of
the first cost per year. The company expects capital to earn not less than
25% before income taxes. Is this a desirable investment? What is the
payback period of the investment?
(Ans. ROR = 23.70%; Inflow = P 185,400.00, Outflow = P 188,908.76;
Pincome = P 507,439.87, Pcosts = P 516,875.90; Fincome = P 1,548,583.59,
Fcosts = P 1,577,380.08; PP = 2.6 years)
COMPARING ALTERNATIVES
 the alternative that requires the minimum investment and will produce
satisfactory functional result will always be used unless there are definite
reasons why an alternative requiring a larger investment should be used.

1. THE RATE OF RETURN on the ADDITIONAL INVESTMENT METHOD

(ROR)
 if the ROR is satisfactory, then the alternative requiring a bigger
investment is more economical and should be chosen.

NET ANNUAL SAVINGS

ROR 
ADDITIONAL INVESTMENT

2. THE ANNUAL COST METHOD

 the annual cost of the alternatives including interest on investment is
determined
 the alternative with the least annual cost is chosen.
Conditions: Alternatives with a uniform cost data for each year and a single
investment of capital at the beginning of the first year of the project life.

3. THE PRESENT WORTH COST METHOD

 determine the present worth of the net cash outflows for each alternative
for the same period of time.
 the alternative with the least present worth of cost is chosen.

4. THE PAYBACK (PAYOUT) PERIOD METHOD

 the payback period of each alternative is computed.
 the alternative with the shortest payback period is adopted.

INVESTMENT  SALVAGE VALUE

Payout Period years 
NET ANNUAL CASH FLOW

FC  SV
Payout Period years 
AI  AC
Sample Problems:
1. A gasoline driven pump and an electric power pump are being considered for
use in a mine for a period of 10 years. If money is worth 12%, which would
you recommend? The data available are:

GASOLINE ELECTRIC
First Cost P 12,000.00 P 25,000.00
Salvage Value 1,000.00 2,000.00
Annual Operating Cost 3,200.00 1,800.00
Annual Repairs 600.00 400.00
Annual Taxes (% of FC) 3% 3%
Estimated Life 5 10

(Ans. ROR = 12.55%; ACMgasoline = P 7,331.51, ACMelectric = P 7,260.64;

PWCMgasoline = P 41,746.63, PWCMelectric = P 4,1668.10; PPgasoline = -2.64
years, PPelectric = -8 years)

2. A company is considering 2 types of equipment for its manufacturing plant. If

the minimum required ROR is 15%, which equipment should be selected?
Pertinent data are as follows:

TYPE A TYPE B
First Cost P 200,000.00 P 300,000.00
Annual Operating Cost 32,000.00 24,000.00
Annual Labor Cost 50,000.00 32,000.00
Insurance and Property Taxes 3% 3%
Payroll Taxes 4% 4%
Estimated Life 10 10

(Ans. ROR = 18.79%; ACMTYPE A = P 129,850.41, ACMTYPE B = P 126,055.62;

PWCMTYPE A = P 651,689.18, PWCMTYPE B = P 632,643.98; PPTYPE A = -2.22
years, PPTYPE B = -4.53 years)
REPLACEMENT STUDIES

Reasons for Replacement:

1. Decrease in physical efficiency
2. Obsolescence

Sample Problems:
1. A contractor has a concrete mixer whose original cost was P 6,000.00. It is
now 4 years old, having 3 more years to go before being scrapped at an
estimated salvage value of P 1,2000. It could now be sold for P 2,000.00. It
can produce 800 m3 of concrete per year at an annual cost for operation of P
1,000.00 and for maintenance P 400.00. It is proposed to replace it with a
new machine whose first cost will be P 8,000.00 having a life of 9 years and
salvage value of P 1,600.00. It will produce 10,000 m3 of concrete per year at
an operating cost of P 800.00 per year and for maintenance P 320.00 per
year. Assume that cost for direct materials and labor is P 24 per m3 in each
case. Yield on investment is to be 6%. Should the machine be replaced?
(Ans. ACMold concrete mixer = P 1,771.29, ACMnew concrete mixer = P 1,932.94)
2. An ice plant bought a Freon compressor. The estimated life of the
compressor is 15 years. An investigation reveals that the new compressors
are very much improved during that time. However, this compressor is still in
good condition. It can be sold for an estimated price of P 1,200.00. It can be
kept and operated for 2 more years. A new compressor of the same capacity
may be purchased to replace it at a cost completely installed for P 18,000.00.
If the old machine operates at P 1,200.00 per year and the new machine at P
600.00 per year and salvage value is 10% of the first cost, would you
recommend replacement? Money is worth 8% to the company.
(Ans. ROR = 3.5%; ACMold compressor = P 1,872.92, ACMnew compressor = P
2,636.64; PWCMold compressor = P 22,837.74, PWCMnew compressor = P 23,135.69)