Chapter 3part-1

Decision making
Evaluating a Single Project
The objective of Chapter 3 is to discuss
contemporary methods for determining project
profitability.

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 Proposed capital projects can be evaluated
in several ways.
• Present worth (PW)
• Future worth (FW)
• Annual worth (AW)
• Internal rate of return (IRR)
• External rate of return (ERR)
• Payback period

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To be attractive, a capital project must provide a
return that exceeds a minimum level established
by the organization.
This minimum level is reflected in a firm’s
Minimum Attractive Rate of Return (MARR).

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 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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Example:
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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 Assumptions of the PW method

1. It is assumed we know the future with certainty.

2. It is assumed we can borrow or lend money at the
same interest rate.

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Bond value is a good example of present worth.
Two type of payments:
1. A series of periodic interest payments will be received until the
bond is retired.
2. A single payment when the bond is retired or sold. (Bond’s
maturity date is reached )

Face, Par, or value = Bond value (received after N periods )

Redemption or disposal price = bond value
Bond rate = nominal interest per interest period
N = number of periods before redemption
i = bond yield rate per period
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Bond value = 10,000$
Bond rate = 8% / 4 = 2% per 3 months (quarter)
i = 10% / 4 = 2.5% per 3 months (quarter)
N = 8×4 = 32 quarters.
Uniform received payments = Bond value × Bond rate
= 0.02 ×10,000 = 200$ per quarter

P01/16/21
= 10,000 (P/F, 2.5%, 32) + 200 (P/A,Alfraihat
Dr.Ahmad 2.5%, 32) = 8907.6$ 23
(a) Bond value = 5,000$. Bond rate = 8% per year. i = 10% per year.
N = 20 quarters.
Uniform received payments = Bond value × Bond rate
= 0.08 ×5,000 = 400$ per year
P = 5,000 (P/F, 10%, 20) + 400 (P/A, 10%, 20) = 4148.4$
(b) P = 4600$ find i?
4600 = 5,000 (P/F, i%, 20) + 400 (P/A, i%, 20)
By trial and error, i = 8.9%
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 Capitalized worth CW

• Capitalized worth is the present worth of all revenues or

expenses over an infinite length of time.
• If only expenses are considered this is sometimes referred
to as capitalized cost.
• The capitalized worth method is especially useful in
problems involving endowments and public projects with
indefinite lives.

As N becomes very large, (P/A) = 1/i. So, CW = A(1/i).

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 A = 30,000 + 20,000 (A/F, 8%, 4) = 34,438$
CW = -100,000 – 34,438 (P/A, 8%, infinity )
= -100,000 – 34,438/.08 = -530,475$

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 Future Worth (FW)

• FW is based on the equivalent worth of all cash

inflows and outflows at the end of the study period at
an interest rate that is generally the MARR.

• Decisions made using FW and PW will be the same.

A positive FW for an investment project means that the project
is acceptable (it satisfies the MARR).

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 Annual Worth (AW)

• 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 (R) minus annual equivalent expenses (E),
minus annual capital recovery (CR) amount.

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• Capital Recovery CR is the annual equivalent cost of the
capital invested.
• The CR covers the following items.
– Loss in value of the asset.
– Interest on invested capital (at the MARR).
• The CR distributes the initial cost (I) and the salvage value (S)
across the life of the asset.

Equivalent Uniform Annual Cost (EUAC) = CR + E

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Example:
A corporate jet costs 1,350,000$ and will incur 200,000$ per year in
fixed cost (maintenance,… ) and 277$ per hour variable cost (fuel,
…). The jet will be operated 1200 hours per year for five years
and then sold for 650,000$. The jet revenues 1000$ per hour. The
MARR is 15% per year.
1. Revenue, R = 1000$ × 1200 = 1,200,000$ per year
2. Expense, E = 200,000$ + 277$ ×1200 = 532,400$ per year
3. Capital Recovery,
CR = 1,350,000(A/P, 15%, 5) – 650,000(A/F, 15%, 5)
= 306,310$ per year
4. Annual Worth, AW = R – E – CR = 361,290$ per year
5. Equivalent Uniform Annual Cost,
01/16/21 EUAC = E + CR = 838,710$
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1. Revenue, R = 300,000 × 0.1 = 30,000$ per year
2. Expense, E = 0 $
3. Capital Recovery,
CR = 110,000(A/P, 15%, 6) – 8,000(A/F, 15%, 5)
= 28,148.4$ per year
4. Annual Worth, AW = R – E – CR = 1,851.6$ per year
5. Equivalent Uniform Annual Cost,
01/16/21 EUAC = E + CRDr.Ahmad
= 28,148.4$
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 Internal Rate of Return

• The internal rate of return (IRR) method is the most widely used
rate of return method for performing engineering economic
analysis.
• 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.
• The IRR is the interest rate that equates the equivalent worth
of an alternative’s cash inflows (revenue, R) to the equivalent
worth of cash outflows (expenses, E).
• The IRR is sometimes referred to as the breakeven interest
rate.

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The IRR is the interest i'% at which

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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 -345,000 + 115,000(P/F, i, 6) + 98,000(P/A, i, 6) = 0
OR -345,000(F/P, i, 6) + 115,000 + 98,000(F/A, i, 6) = 0
OR -345,000(A/P, i, 6) + 115,000(A/F, i, 6) + 98,000 = 0

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 -345,000 + 115,000(P/F, i, 6) + 98,000(P/A, i, 6) = 0
Try i = MARR = 20%
-345,000 + 115,000×0.3349 + 98,000×3.3255 = 19,412.5
Try i = 25%
-345,000 + 115,000×0.2621 + 98,000×2.9514 = -25,621

20% 19,412.5
i  25 20  25
i% 0 
0  25621 19412.5  25621
25% -25,621

i = IRR = 22.1% per year

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 -25,000 + 5,000(P/F, i, 5) + 8,000(P/A, i, 5) = 0
Try i = 20% -25,000 + 5,000×0.4019 + 8,000×2.9906 = 934.3$
Try i = 25% -25,000 + 5,000×0.3277 + 8,000×2.6893 = -1847.1
20% 934.3
i  25 20  25
i% 0 
0  1847.1 934.3  1847.1
25% -1847.1

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i = IRR = 21.68% per year
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A = 0.07 × 7000 = 490$
7000 - 490(P/A, i, 50) = 0 (P/A, i, 50) = 14.2857
i = 6% (P/A, 6%, 50) = 15.7619 i7 67

i = 7% (P/A, 7%, 50) = 13.8007 14.2857  13.8007 15.7619  13.8007

i = IRR = 6.75% per three months

M 4
 r   .0675  4 
i  IRR  1    1  1    1  29.86% per year
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 -7500 + 350(P/A, i, 24) = 0 (P/A, i, 50) = 21.4286
i = 1% (P/A, 1%, 24) = 21.2434
i = 0.75% (P/A, 0.75%, 24) = 21.8891

i = IRR = 0.93% per month

12
 .0093  12 
i  IRR  1    1  11.75% per year
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