Evaluating a Single

Project
The Internal Rate of Return (IRR) Method

The IRR method is the most widely used rate or return

method for performing engineering economic analyses. It is
sometimes called by several other names, such as investor’s
method, discounted cash flow method, and profitability index.
This method solves for the interest rate that equates the
equivalent worth of an alternative cash inflows (receipts or
savings) to the equivalent worth of cash outflows (expenditures,
including investment costs). Equivalent worth may be
computed with any of the three methods discussed (PW, FW, or
AW). The resultant rate is termed the internal rate of return
(IRR).
Internal Rate of Return (IRR)

n n

 R ( P / F , i '%, k ) =  E ( P / F , i '%, k )
k =0
k
k =0
k

n n
PW =  Rk ( P / F , i '%, k ) −  Ek ( P / F , i '%, k ) = 0
k =0 k =0

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)
IRR DECISION RULE
If IRR ≥ MARR, the project is economically justifiable.
Sample Problem

 A piece of new equipment has been proposed by an

engineer to increase the productivity of a certain manual
welding operation. The investment cost is Php250,000
and the equipment will have a market value of Php50,000
at the end of the study period of 5 years. Increased
productivity attributable to the equipment will amount to
Php80,000 per year after operating costs have been
subtracted from the revenue generated by the additional
production. If the firm’s MARR is 20% per year, is this
proposal a sound one? Use IRR method to evaluate the
economic soundness of the investment.
The External Rate of Return (ERR) Method

The reinvestment assumption of the IRR method may not be

valid in an engineering economy study. To remedy the weakness
and disadvantages of IRR, some other rate of return method can
be used. One such method is the external rate of return (ERR).
It directly takes into account the interest rate external to a
project at which net cash flows generated by the project over its
life can be reinvested (or borrowed). If this external
reinvestment rate, which is usually the firm’s MARR, happens to
equal the project’s IRR, then ERR method produces identical to
those of the IRR method.
External Rate of Return
In general, three steps are used in calculating ERR.
 All net cash outflows are discounted to time 0 (the
present) at ε% per compounding period.
 All net cash inflows are compounded to period n at ε%.
 The external rate of return, which is the interest rate that
establishes equivalence between the two quantities, is
determined.
 In equation form, the ERR is the at which
n n

 E ( P / F , %, k )( F / P, i '%, n ) =  R ( F / P, %, n − k )
k =0
k
k =0
k
ERR DECISION RULE
If ERR ≥ MARR, the project is economically justifiable.
Sample Problem

 A piece of new equipment has been proposed by an

engineer to increase the productivity of a certain manual
welding operation. The investment cost is Php250,000
and the equipment will have a market value of Php50,000
at the end of the study period of 5 years. Increased
productivity attributable to the equipment will amount to
Php80,000 per year after operating costs have been
subtracted from the revenue generated by the additional
production. If the firm’s MARR is 20% per year, is this
proposal a sound one? Use ERR method to evaluate the
economic soundness of the investment.
Assignment

 An initial capital of Php1,000,000 was put up for a new

business that will produce an annual income of
Php600,000 for 5 years and will have a salvage value of
Php20,000 at the time. Annual expenses for its operation
(salaries and wages, insurance, taxes) and maintenance
amounts to Php300,000. If MARR is 10% compounded
annually, is this investment profitable or not?