186 Engineering Economics with Applications

Rate of return:
1. Internal rate of return (I.R.R.)
2. External rate of return (E.R.R.)
3. Explicit reinvestment rate of return (E.R.R.R.)

5.3 Present Worth (P.W.) Method

In this method, equivalent worth of all cash flows relative to some point in time called present
worth i.e. P.W. is computed. All cash inflows and outflows are discounted to the present point
in time at an interest rate that is generally M.A.R.R. using appropriate interest factor. The
following steps are used to calculate P.W.:
Step 1: D
 raw the cash flow diagram for the given problem.
Step 2: D
 etermine the P.W. of the given series of cash receipts by discounting these future
amounts to the present at an interest rate i equal to M.A.R.R. in the following
manner:
P.W. = F0(1+i)0 + F1(1+i)-1 + F2(1+i)–2 +. . . + Fk(1+i)–k +. . . + Fn(1+i)–n (5.1)

Step 3: Determine the P.W. of the given series of cash disbursement by discounting
these future amounts to the present at an interest rate i equal to M.A.R.R. using
Equation (5.1).
Step 4: Determine the net present worth, (N.P.W.) as:
N.P.W. = P.W. at Step 2 – P.W. at Step 3
(i) If N.P.W. > 0, the investment in the project is economically justified.
(ii) If N.P.W. < 0, the investment in the project is economically not justified.
(iii) If N.P.W. = 0, the investment in the project is barely economically justified.
Examples 5.1 and 5.2 illustrate the P.W. method.

Example 5.1

Production engineers of a manufacturing firm have proposed a new equipment to increase

productivity of a manual gas-cutting operation. The initial investment (first cost) is ` 5,00,000 and
the equipment will have a salvage value of ` 1,00,000 at the end of its expected life of 5 years.
Increased productivity will yield an annual revenue of ` 2,00,000 per year. If the firm’s minimum
attractive rate of return is 15%, is the procurement of the new equipment economically justified?
Use P.W. method.

Solution
Step 1: The cash flow diagram for this problem is shown in Fig. 5.1.
 Methods for Making Economy Studies 187

Figure 5.1 Cash flow diagram, Example 5.1

Step 2: The P.W. of the series of cash receipts is computed as:

P.W. = ` 2,00,000(P/A, 15%, 5) + ` 1,00,000(P/F, 15%, 5)
= ` 2,00,000(3.3522) + ` 1,00,000(0.4972)
P.W. = ` 7,20,160

Step 3: The P.W. of the series of cash disbursements is computed as:

P.W. = ` 5,00,000

Step 4: N.P.W. = ` 7,20,160 – ` 5,00,000

     N.P.W. = ` 2,20,160

Since N.P.W. > 0, the purchase of this equipment is economically justified.

Example 5.2

An investment of ` 1,05,815.4 can be made in a project that will produce a uniform annual revenue
of ` 53,000 for 5 years and then have a salvage value of ` 30,000. Annual disbursements will be
` 30,000 each year for operation and maintenance costs. The company’s minimum attractive rate of
return is 10%. Show whether this is a desirable investment by using the present worth method.

Solution
Step 1: The cash flow diagram for this problem is shown in Fig. 5.2.
188 Engineering Economics with Applications

Figure 5.2 Cash flow diagram, Example 5.2

Step 2: The P.W. of the series of cash receipts is computed as:

P.W. = ` 53,000(P/A, 10%, 5) + ` 30,000(P/F, 10%, 5)
= ` 53,000(3.7908) + ` 30,000(0.6209)
P.W. = ` 2,19,539.4
Step 3: The P.W. of the series of cash disbursements is computed as:
P.W. = ` 1,05,815.4 + ` 30,000(P/A, 10%, 5)
= ` 1,05,815.4 + ` 30,000(3.7908)
P.W. = ` 2,19,539.4
Step 4: N.P.W. = ` 2,19,539.4 – ` 2,19,539.4
    N.P.W. = 0
Since, N.P.W. = 0, the project is shown to be barely justified.

5.4 Future Worth (F.W.) Method

This method involves computation of equivalent worth of all cash flows relative to some point
in time called future worth i.e. F.W. All cash inflows and outflows are discounted to the future
point in time at an interest rate that is generally M.A.R.R. using appropriate interest factor.
Use the following steps are used to calculate F.W.
Step 1: Draw the cash flow diagram for the given problem.
196 Engineering Economics with Applications

Step 3: From the cash flow diagram shown in Fig. 5.2, it is clear that the equivalent annual
expenses E = ` 30,000.
Step 4: From the cash flow diagram shown in Fig. 5.2, it is clear that the initial investment
P = ` 1,05,815.4 and salvage value S = ` 30,000.
Step 5: The equivalent annual capital recovery amount (C.R.) is calculated by using the
following formula:
C.R. = P(A/P, i%, n) – S(A/F, i%, n)
C.R. = ` 1,05,815.4(A/P, 10%, 5) – ` 30,000(A/F, 10%, 5)
= ` 1,05,815.4(0.2638) – ` 30,000(0.1638)
= ` 27,914.10 – ` 4,914
C.R. = ` 23,000.1
Step 6: A.W. is calculated as:
A.W. = R – E – C.R.
A.W. = ` 53,000 – ` 30,000 – ` 23,000.1
A.W. = –` 0.1 which is almost equal to 0.
Since A.W. = 0, this equipment is economically barely justified.

5.6 Internal Rate of Return (I.R.R.) Method

Out of all the rate of return methods, this method is widely used for making economy studies.
This method is also known by several other names such as investor’s method, discounted cash
flow method, receipts versus disbursements method and profitability index. In this method
an interest rate i¢ called I.R.R. is computed and it is compared with M.A.R.R. to take decision
on the economic viability of the project. This method can be used only when both positive
and negative cash flows are present in the problem. I.R.R. is also defined as an interest rate at
which net present worth (N.P.W.) is 0. The following steps are used to compute I.R.R.:
Step 1: Draw the cash flow diagram for the given problem.
Step 2: Determine the P.W. of the net receipts at an interest rate of i¢ in the following
manner:
n
 Rk (P/F, i ¢ %, k)  (5.6)
k=0
where Rk = net receipts or savings for the kth year.
n = project life
 Methods for Making Economy Studies 197

Step 3: Determine the P.W. of the net expenditures at an interest rate i¢ in the following
manner:
n
 Ek (P/F, i ¢ %, k)  (5.7)
k=0

where, Rk = net expenditures including investments for the kth year

Step 4: Determine the net present worth (N.P.W.). as:
n n
N.P.W. = Â Rk (P/F, i ¢ %, k) – Â Ek ( P/F, i ¢ %, k)  (5.8)
k=0 k=0
Step 5: Set N.P.W. = 0 and determine the value of i¢%
Step 6: Compare the value of i¢% with M.A.R.R.
(i) If i¢% > M.A.R.R., the investment in the project is economically justified
(ii) If i¢% < M.A.R.R., the investment in the project is economically not justified
(iii) If i¢% = M.A.R.R., the investment in the project is economically barely justified
Note: The value of i¢% can also be determined as the interest rate at which net F.W. = 0 or
at which net A.W. = 0.
Examples 5.7 and 5.8 illustrates the I.R.R. method.

Example 5.7

Solve the problem given in Example 5.1 by I.R.R. method.

Solution

Step 1: The cash flow diagram for the given problem is shown in Fig. 5.1.
Step 2: The P.W. of the net receipts at an interest rate of i¢ is calculated as:
P.W. = ` 2,00,000(P/A, i¢%, 5) + ` 1,00,000(P/F, i¢%, 5)

Step 3: The P.W. of the net expenditures at an interest rate of i¢ is calculated as:
P.W. = ` 5,00,000

Step 4: The net present worth, N.P.W. is obtained as:

N.P.W. = ` 2,00,000(P/A, i¢%, 5) + ` 1,00,000(P/F, i¢%, 5) – ` 5,00,000

Step 5: 0 = ` 2,00,000(P/A, i¢%, 5) + ` 1,00,000(P/F, i¢%, 5) – ` 5,00,000

The equation given at Step 5 normally involves trial-and-error calculations until the i¢% is
found. However, since we do not know the exact value of i¢%, we will probably try a relatively
low i¢%, such as 5%, and also a relatively high i¢%, such as 40%.
198 Engineering Economics with Applications

At i¢% = 5%:
` 2,00,000(P/A, 5%, 5) + ` 1,00,000(P/F, 5%, 5) – ` 5,00,000
` 2,00,000(4.3295) + ` 1,00,000(0.7835) – ` 5,00,000 = + ` 4,44,250

At i¢% = 40%:
` 2,00,000(P/A, 40%, 5) + ` 1,00,000(P/F, 40%, 5) – ` 5,00,000
` 2,00,000(2.035) + ` 1,00,000(0.1859) – ` 5,00,000 = – ` 74,410
Since we have both a positive and a negative P.W. of net cash flows, linear interpolation can be
used as given below to find an approximate value of i¢%
40% - 5% i ¢% - 5%
=
` 4, 44,250 - ( - `74, 410) ` 4, 44,250 - `0

` 4, 44,250
i ¢% = 5% + (40% - 5%)
` 4,44,250 - ( - `74,410)

Hence, i¢% = 34.98%

Step 6: Since the value of i¢ % = 34.98% > M.A.R.R. = 15%, the investment in the project
is economically justified.

Example 5.8

Solve the problem given in Example 5.2 by the I.R.R. method.

Solution

Step 1: The cash flow diagram for the given problem is shown in Fig. 5.2.
Step 2: The P.W. of the net receipts at an interest rate of i¢ is calculated as:
P.W. = ` 53,000(P/A, i¢%, 5) + ` 30,000(P/F, i¢%, 5)

Step 3: The P.W. of the net expenditures at an interest rate of i¢ is calculated as:
P.W. = ` 1,05,815.4 + ` 30,000(P/A, i¢%, 5)

Step 4: The net present worth N.P.W. is obtained as:

     N.P.W. = ` 53,000(P/A, i¢%, 5) +
 ` 30,000(P/F, i¢%, 5)
– ` 1,05,815.4 – ` 30,000(P/A, i¢%, 5)

Step 5: 0 = ` 53,000(P/A, i¢%, 5) + ` 30,000(P/F, i¢%, 5) – ` 1,05,815.4 – ` 30,000(P/A, i¢%, 5)

The equation given at Step 5 normally involves trial-and-error calculations until the i¢% is
found. However, since we do not know the exact value of i¢%, we will probably try a relatively
low i¢%, such as 5%, and a relatively high i¢%, such as 12%.
 Methods for Making Economy Studies 199

At i¢% = 5%:
` 53,000(P/A, 5%, 5) + ` 30,000(P/F, 5%, 5) – ` 1,05,815.4 – ` 30,000(P/A, 5%, 5)
` 53,000(4.3295) + ` 30,000(0.7835) – ` 1,05,815.4 – ` 30,000(4.3295) = + ` 17,268.1
At i¢% = 12%:
` 53,000(P/A, 25%, 5) + ` 30,000(P/F, 25%, 5) – ` 1,05,815.4 – ` 30,000(P/A, 25%, 5)
` 53,000(3.6048) + ` 30,000(0.5674) – ` 1,05,815.4 – ` 30,000(3.6048) = – ` 5,883
Since we have both a positive and a negative P.W. of net cash flows, linear interpolation can
be used as given below to find an approximate value of i¢%:
12% - 5% i ¢% - 5%
=
`17,268.1 - ( - `5,883) `17,268.1 - `0

`17,268.1
i ¢% = 5% + (12% - 5%)
`17,268.1 - ( - `5,883)

i¢% = 10.22%, which is approximately equal to 10%.

Step 6: Since the value of i¢ % = M.A.R.R., the investment in the project is economically
barely justified.
Note: Let us check whether the value of N.P.W. at i¢ = 10% is 0.
N.P.W. = ` 53,000(P/A, i¢%, 5) + ` 30,000(P/F, i¢%, 5) – ` 1,05,815.4 – ` 30,000(P/A, i¢%, 5)
At i¢% = 10%:
N.P.W. = ` 53,000(P/A, 10%, 5) + ` 30,000(P/F, 10%, 5) – ` 1,05,815.4 – ` 30,000(P/A, 10%, 5)
    = ` 53,000(3.7908) + ` 30,000(0.6209) – ` 1,05,815.4 – ` 30,000(3.7908)
N.P.W. = 0
Thus i¢ = 10% which is equal to the given M.A.R.R. and therefore, the investment in the
project is economically barely justified.

5.7 External Rate of Return (E.R.R.) Method

The following steps are involved in the E.R.R. method:
Step 1: Draw the cash flow diagram for the given problem.
Step 2: Consider an external interest rate e, equal to given M.A.R.R. However, if a specific
value of e is given then take e equal to that value. e is, indeed, an external interest
 SECTION 5.6 / THE INTERNAL RATE OF RETURN METHOD 237

Figure 5-5 Use of

A d
Linear Interpolation to $19,413 B
Find the Approximation
of IRR for Example 5-12

i9%

Present Worth
0
20% e 25%

2$25,621 C

Figure 5-6 Spreadsheet Solution, Example 5-12

Spreadsheet Solution
Figure 5-6 displays the spreadsheet solution for this example. The Excel function
IRR(range, guess) requires the net cash flows for the study period and an
initial guess for the IRR value (using the MARR is a good idea). Unlike the