Basic Methods for making

Economy Studies

Charlie A. Marquez, PIE

1. Rate of Return Method
Rate of Return on Capital Invested or
ROR = Net Annual Profit / Capital Invested
ROR is a measure of the effectiveness of an investment of capital.
When this method is used, it is necessary to decide whether the
computed ROR is sufficient to justify the investment.
2. Annual Worth Method
In this method, interest on the original investment or minimum
required profit is included as a cost. If the excess of annual cash
inflows over annual cash outflows is not less than zero the
proposed investment is justified (meaning valid).
3. Present Worth Method
In this method, if the net cash flows is equal to or greater than
zero, the project is justified economically. The present worth method
is flexible and can be used for any type of economy study. It is used
extensively in making economy studies in the public works field, where
long-lived structures are involved.

4. Future Worth Method

This method is the same as the Present Worth Method except
that all cash inflows and outflows are computed in the future. If the
Future Worth of the net cash flows is equal to or greater than zero,
the project is justified economically.
5. Payback Period Method
Payback period is defined as the length of time required to recover
the first cost of an investment from the net cash flow produced by that
investment for no interest rate.

Payback period (yrs) = Investment–salvage value / net annual cash flow

Sample Problems
1. An investment of P2.7M can be made in a business that is expected
to provide a uniform annual revenue of P1.854M for 5 years and
then have a salvage value of 10% of the investment. Out of pocket
costs for operation and maintenance will be P810K per year. Taxes
and insurance will be 4% of the first cost per year. The business
expects capital to earn not less than 25% before income taxes. Is
this a desirable investment? What is the expected payback period
of the investment? Solve by a) ROR Method; b) Annual Worth
Method; c) Present Worth method; d) Future Worth Method; d)
Payback Period
Sample Problems
2. You are considering building a 25-unit dormitory near UST. You felt that
because of the location of the dorm, it will be occupied 90% of the time. You
want a rate of return of 20%. Other data related are as follows:
Land P5M
Building P7M
Study period 20 years
Cost of land after 20 years P20M
Cost of Building after 20 yrs P2M
Rent per unit per month P8K
Upkeep per unit per year P1K
Taxes and Insurance 1.5%
Is this a good investment? Solve using the ROR Method.
Sample Problems
3. A newly built business property contains a space for a store and two
offices. The owner offered this to you for P1.2M. In your estimate, you
will be able to have this rented for at least P458,460.00 annually for the
next 10 years. You also estimated that annual disbursements will not
exceed P60,000. In your estimate, you can sell the property for P700K
at the end of 10 years. Annual T&I will be 2.5% of the first cost.
a) If you have cash money to purchase the property and you want a
return of 20%, will you buy the property?
b) If you will borrow 25% of the required capital and will amortize it
for 10 years at an interest rate of 18%, will you still invest in this
business?
c) If you can borrow the entire capital by floating bonds at 15% that
will mature in 10 years, will you still invest? Interest in the sinking
fund is also 15%.
Sample Problems
4. A young Industrial Engineer is considering establishing his own small
company. An investment of P400K will be required, and he plans to
recover his investment in 15 years. It is estimated that sales will be
P800K per year and that operating expenses will be as follows:
Materials P160K per year
Labor P280K per year
Overhead P40K + 10% of sales per year
Selling Expense P60,000 per year
He will give up his regular paying job paying P216K per year and devote
full time to the operation of his business. This will result in decreasing
labor cost P40K per year, material cost by P28K per year, and overhead
cost by P32K per year. If this young Industrial Engineer expects to earn
at least 20% of his capital, should he invest?
Sample Problems
5. A man formerly employed as a chief mechanic has saved P1M which are
now invested in certain stocks giving him an annual dividend of 15%. He
plans to invest this amount in his own repair shop. In his present job, he is
earning P25K per month but he has to resign to run his own business. He
will need the services of the following: 2 mechanics each earning P400 a day
and 8 helpers earning P200 a day. These men will work on the average 300
days a year. His other expenses are the following:
Rent P30K a month
Misc. P25K a month
Sales Tax 3% of Gross Income
Insurance 2%
The length of his lease is 5 years. If the average charge for each car repaired
is P1K. Determine the number of cars he must service in one year so that he
will obtain a profit of at least 20% on his investment.
Sample Problems
6. A company is considering constructing a plant to manufacture a
proposed product. The land costs P15M, the building costs P30M, the
equipment costs P12.5M, and P5M working capital is required. At the
end of 12 years, then land can be sold for P25M, the building for P12M,
the equipment for 250K, and all of the working capital recovered. The
annual disbursements for labor, materials, and all other expenses are
estimated to cost P23.75M. If the company requires a minimum return
of 25%, what should be the minimum annual sales for 12 years to
justify the investment?
Sample Problems
7. A food processing plant consumed 600,000 kwh of electric energy
annually and pays an average of P2.00 per kwh. A study is being made
to generate its own power to supply the plant energy required, and
that the power installed would cost P2M. Annual operation and
maintenance is P800K. Other expenses will be P100K per year. Life of
the power plant is 15 years, salvage value is P200K, annual taxes and
insurance is 6%, and the rate of interest is 15%. Using the sinking fund
method for depreciation, determine if the power plant is justifiable.
Sample Problems
8. A company is charged P150 per ton for hauling its raw materials by a
trucking company. Forty tons per day are hauled for 300 days a year. It
is desired to install a railway system which will bring down the cost of
hauling to only P6.60 per ton. Maintenance cost of this system is P12K
per month. Tax is 1% and average earning is 20%.
a) If the company has the cash necessary for the installation, would
you recommend the change?
b) If the company has to float P5M worth of non callable bonds at 15%
that will mature in 10 years to have the capital for the project,
would you recommend the change?