Engineering Economics

Chapter 4
Comparison Methods Part I

II

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Determining MARR
MARR, is the minimum rate of return on a project a
manager or company is willing to accept before
starting a project, given its risk and the opportunity
cost of forgoing other projects.

For example, suppose we know that investing in a

conservative project (e.g. government bond with
very low risk) yields a known rate of return. When
considering a new project, we may use the
conservative project's rate of return as the MARR.
We will only invest in the new project if its
anticipated return exceeds the MARR,
accompanying by a certain risk.
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Determining MARR

The MARR is usually determined by evaluating

existing opportunities in operations expansion, rate
of return for investments, and other factors deemed
relevant by management. A risk premium can also
be attached to the MARR if management feels that
specific opportunities inherently contain more risk
than others that could be pursued with the same
resources.

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Determining MARR
A common approach for evaluating a MARR is to apply the
discounted cash flow method to the project, which is used in
present value models (PW). The MARR rate determines how
rapidly the value of the dollar decreases out in time, which,
parenthetically, is a significant factor in determining the
payback period for the capital project when discounting
forecast savings and spending back to present-day terms.

Most companies use a 12% MARR rate, which is based on the

fact that the S&P 500 typically yields returns somewhere
between 8% and 11% (annualized). Companies operating in
industries with more volatile markets might use a slightly
higher rate in order to offset risk and attract investors.

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MARR Example: Dealing with Multiple Independent Projects

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MARR Example: Arrange Projects Based on Rate of Return

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MARR Example: Find Cumulative Cost and Total Budget

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 Example:

Copyright © 2009 by Pearson Education Canada 4-8

4.4 Present Worth (PW) and
Annual Worth (AW) Comparisons
• For these two methods (PW) and (AW): we try to find a
comparable basis to evaluate projects in monetary units
• Present Worth (PW) method: compare projects by
computing their present worth at MARR. The preferred
project is the one with the greater present worth. Companies
by choosing projects with the greatest present worth will
maximize the value of the company
• Annual Worth (AW) method: compare projects by
computing their annual worth (uniform series) at MARR. The
preferred project is the one with the greater annual worth.
• Rather than using Present Worth and Annual Worth, we
could, depending on cases, use Present Cost and Annual
Cost.
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 An Extreme View of MARR:
Suppose your firm invests in a project with the first cost (initial
cost) of $100,000. This project will bring in $50,000 a year
later and another $50,000. two years from now. Under what
kind of circumstance will you consider this project to be
acceptable.
The answer will be when the interest rate is 0%. If the current
market interest rate is 0%, then the project described above
maybe acceptable as its rate of return is also 0%.

Now suppose that the firm’s MARR is set at the current market
interest rate, say 5%. By inserting the interest rate of 5%, what
will the Present Worth of the cash flows of this project?
50,000 50,000
𝑷𝑾 = −100,000 + + 2
= −𝟕, 𝟎𝟐𝟗
1 + 0.05 (1 + 0.05)

http://www.tradingeconomics.com/japan/interest-rate 4 - 10
CLOSE-UP 4.1 Present Cost and Annual Cost
Sometimes mutually exclusive projects are compared in
terms of present cost or annual cost. That is, the best
project is the one with minimum present worth of cost
as opposed to the maximum present worth.

Two conditions should hold for this to be valid:

1. all projects have the same major benefit, and
2. the estimated value of the major benefit clearly
outweighs the projects' costs, even if that estimate
is imprecise. Therefore, the "do nothing" option is
rejected.

The value of the major benefit is ignored in further calculations since it

is the same for all projects. We choose the project with the lowest cost,
considering secondary benefits as offsets to costs.
Comment: Present Worth (Benefits) vs. Present Cost
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CEI Building, Herb Grey Parkway
4.4.1 Present Worth Comparisons for
Independent Projects
• Assume n > 1 independent projects – same benefit
• We may invest in 1, 2,…n of the projects…or “do
nothing” by investing elsewhere at MARR

The alternative to investing money in an independent project is to

"do nothing." Doing nothing doesn't mean that the money is not used
productively. In fact, it would be used for some other project, earning
interest at a rate at least equal to the MARR.
If an independent project has a present worth greater than zero (at
MARR), it is acceptable. If an independent project has a present
worth less than zero (at MARR), it is unacceptable.
If an independent project has a present worth of exactly zero, it is
considered marginally acceptable.

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EXAMPLE 4.2 (p. 92 textbook)
Steve Chen, a third-year electrical engineering student, has noticed that
the networked personal computers provided by his university for its
students are frequently fully utilized, so that students often have to wait to
get on a machine. The university has a building plan that will create more
space for network computers, but the new facilities won't be available for
five years. In the meantime, Steve sees the opportunity to create an
alternative network in a mall near the campus. The first cost for equipment,
furniture, and software is expected to be $70,000. Students would be able
to rent time on computers by the hour and to use the printers at a charge
per page. Annual net cash flow from computer rentals and other charges,
after paying for labour, supplies, and other costs, is expected to be
$30,000 a year for five years. When the university opens new facilities at
the end of five years, business at Steve's network would fall off and net
cash flow would turn negative. Therefore, the plan is to dismantle the
network after five years. The five-year-old equipment and furniture are
expected to have zero value. If investors in this type of service enterprise
demand a return of 20% per year, is this a good investment?

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EXAMPLE 4.2 SOLUTION (p.92)
The present worth of the project is
PW = - 70,000 + 30,000(P/A, 20%,5)
= - 70,000 + 30,000(2.9906) = 19,718 ≈ 20,000
The project is acceptable since the present worth of about $20,000 is
greater than zero.

Another way to look at the project is to suppose that, once Steve has set
up the network off campus, he tries to sell it. If he can convince potential
investors, who demand a return of 20% a year, that the expectation of a
$30,000 per year cash flow for five years is accurate, how much would
they be willing to pay for the network? Investors would calculate the
present worth of a 20% interest rate and an annuity paying $30,000 for
five years. This is given by
PW = 30,000(P/A, 20%,5) = 30,000(2.9906) = 89,718 ≈ 90,000
Investors would be willing to pay approximately $90,000. Steve will have
taken $70,000, the first cost, and used it to create an asset worth almost
$90,000. As illustrated in Figure 4.2, the $20,000 difference may be
viewed as profit.
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