ENGINEERING ECONOMICS

BASIC ECONOMY STUDY

METHODS
FORMULATING ALTERNATIVES

An alternative or project is composed of estimates for

the first cost, expected life, salvage value, and annual
costs.
Salvage value is the best estimate of an asset’s worth
at the end of its useful life. Annual costs are
commonly termed annual operating costs (AOC) or
maintenance and operating (M&O) costs/
FORMULATING ALTERNATIVES

Two types of Alternatives:

The “Do-nothing (DN)” option:

Selection of the DN alternative means that the current approach
is maintained; no new costs, revenues, or savings are generated.
FORMULATING ALTERNATIVES

Type of Cash Flow:

MINIMUM ATTRACTIVE RATE OF RETURN
(MARR)
Minimum attractive rate of return (MARR) is the lowest interest rate that will induce
companies or individuals to invest their money.
The MARR must be higher than the cost of money used to finance the alternative, as well
as higher than the rate that would be expected from a bank investment.
Some considerations for MARR:
MINIMUM ATTRACTIVE RATE OF RETURN
(MARR) MARR is also referred as the hurdle rate; that is, a
financially viable project’s expected ROR must meet or
exceed the hurdle rate.

For a corporation, the MARR is always set above its cost

of capital.
ECONOMIC ANALYSIS METHODS
1. Present Worth (PW)
2. Future Worth (FW)
3. Annual Worth (AW)
4. Internal Rate of Return (IRR)
5. External Rate Return (ERR)
THE PRESENT WORTH METHOD
The Present Worth method is based on the concept of equivalent worth of all cash
flows relative to some base or beginning point in time called the present.
A future amount of money converted to its equivalent value now has a present worth
(PW) value.
This present value is always less than that of the actual future cash flow, for any
interest rate greater than zero, all P/F factors have a value less than 1.0. For this
reason, present worth values are often referred to as discounted cash flows (DCF).
All cash inflows and outflows are discounted to the present point in time at an
interest rate that is generally the MARR.
PRESENT WORTH ANALYSIS OF ALTERNATIVES

• Convert all cash flows to PW using MARR

• Precede costs by minus sign; receipts by plus sign
EVALUATION:
For mutually exclusive (ME) alternatives, the following guidelines are applied to
justify a single project or to select one from several alternatives:
One alternative: If PW ≥ 0, the requested MARR is met or exceeded and the
alternative is economically justified.
Two or more alternatives: Select the alternative with the PW that is numerically
largest. This indicates a lower PW of cost for cost alternatives or a larger PW of net
cash flows for revenue alternatives.
EVALUATION OF A BOND PURCHASE
A bond is a type of security under which the issuer owes the holder a debt, and is
obliged – depending on the terms – to repay the principal of the bond at the maturity
date as well as interest over a specified amount of time.
Each bond has a face value V of
$100, $1000, or more that is fully
returned to the purchaser when the
bond maturity is reached. Additionally,
bonds provide the purchaser with
periodic interest payments I using the
bond coupon rate b, and c, the
number of payment periods per year.
THE PRESENT WORTH OF DIFFERENT LIFE
ALTERNATIVES
Present worth analysis requires an equal service comparison of alternatives, that is, the
number of years considered must be the same for all alternatives.
The PW of the alternatives must be compared over the same number of years and must end at
the same time to satisfy the equal-service requirement.
If equal service is not present, short-lived alternatives will be favored based on lower PW of
total costs, even though they may not be economically favorable.
Two ways to use PW analysis to compare alternatives with unequal life estimates:
1. LCM: Compare the PW of alternatives over a period of time equal to the least common
multiple (LCM) of their estimated lives.
2. Study period: Compare the PW of alternatives using a specified study period of n years.
For either approach, calculate the PW at the MARR and use the same selection guideline as
that for equal-life alternatives.
THE PRESENT WORTH OF DIFFERENT LIFE
ALTERNATIVES
PW Evaluation using a Study Period
• Once a study period is specified, all cash flows after this time are ignored
• Salvage value is the estimated market value at the end of study period
• Short study periods are often defined by management when business goals are
short-term
• Study periods are commonly used in equipment replacement analysis
FUTURE WORTH ANALYSIS
• The Future Worth analysis 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.
• The economic information provided by the FW method is very useful in capital
investment decision situations.
• Selection guidelines are the same as those for PW analysis.
• If FW is greater than or equal to zero, the project is economically justified.
CAPITALIZED COST (CC) ANALYSIS
• Capitalized cost (CC) is the present worth of an alternative that will last “forever”
• Public sector projects such as bridges, dams, irrigation systems, and railroads fall
into this category, since they have useful lives of 30, 40, and more years.
• CC refers to the present worth of a project with a very long life, that is, PW as n
becomes infinite

“A” essentially represents the interest on a perpetual investment

* For finite life alternatives, convert all cash flows into an A value over one life cycle
and then divide by i
ANNUAL WORTH ANALYSIS
• All cash flows are converted to an equivalent uniform annual amount over one
life cycle of the alternative.
• The major advantage over all other methods is that the equal service requirement is
met without using the least common multiple (LCM) of alternative lives.
• The AW value is calculated over one life cycle and is assumed to be exactly the same
for any succeeding cycles, provided all cash flows change with the rate of inflation
or deflation.
• The selection guidelines for the AW method are the same as for the PW method.
One alternative: AW > 0, the alternative is financially viable
Two or more alternatives: Choose the numerically largest AW value (lowest cost or
highest income)
ANNUAL WORTH ANALYSIS

ASSUMPTIONS:
• Services needed for at the LCM of lives of alternatives
• Selected alternative will be repeated in succeeding life cycles in same manner as for
the first life cycle
• All cash flows will be same in every life cycle (i.e., will change by only inflation or
deflation rate)
RATE OF RETURN
RATE OF RETURN
INTERNAL RATE OF RETURN METHOD

Definition:
• The annual rate of growth that an investment is expected to generate
• The rate of return that sets the net present value of all cash flows (both
positive and negative) from the investment equal to zero.
• The internal rate of return measures the investment yield
• Assumes cash inflows are reinvested into the project (or another
investment with identical return)
EXTERNAL RATE OF RETURN METHOD

Definition:
• The external rate of return method is used when revenue cannot be
reinvested back into the project – is invested elsewhere
• The ERR Method allows for an external reinvestment rate i i to be
considered.
• ii is the rate that cash flows generated by the project can be reinvested.
(it is where you put the cash that is generated)
EXTERNAL RATE OF RETURN METHOD

Method:
1. Net cash outflows are discounted to time zero at i i (i.e. find the PV of
outflows)
2. Net cash inflows are compounded to N (end of the cash flow diagram
timeline) at ii (i.e., find the FV of inflows)
3. ERR is the interest rate i’% that established equivalence between
these two quantities
- Use the absolute value of the PW