Study Guide in ES 14 – ENGINEERING ECONOMICS Module No.

FM-AA-CIA-15 Rev. 0 10-July-2020

STUDY GUIDE FOR MODULE NO. 3

ECONOMIC STUDY METHODS: PRESENT WORTH ANALYSIS, ANNUAL WORTH ANALYSIS, & THE RATE OF RETURN (ROR) METHOD

MODULE OVERVIEW

Hello Future Engineer!

After finishing module 2, you were able to compare simple interest to compound interest. Also, you were able to analyze situational problems whether ordinary or
deferred annuity. This Study Guide for Module 3 will help you to differentiate the methods for making economic studies namely present worth analysis, annual worth
analysis, & the rate of return (ROR) method.

MODULE LEARNING OBJECTIVES

At the end of this module 3, you should be able to:

1. differentiate the methods for making economy studies namely present worth analysis, annual worth analysis, & the rate of return (ROR) method.

3.1 ECONOMIC STUDY METHODS: PRESENT WORTH ANALYSIS, ANNUAL WORTH ANALYSIS, & THE RATE OF RETURN (ROR) METHOD

ECONOMIC STUDY METHODS

An engineering project or alternative is formulated to make or purchase a product, to develop a process, or to provide a service with specified results. An
engineering economic analysis evaluates cash flow estimates for parameters such as initial cost, annual costs and revenues, nonrecurring costs, and possible salvage
value over an estimated useful life of the product; process, or service. However, most engineering and business projects can be accomplished by more than one
method or alternative. The alternative that requires the minimum investment of capital and will produce satisfactory functional result will always be used unless there are
definite reasons why an alternative requiring a larger investment should be adopted.

There are several methods for comparing alternatives, but only five methods or patterns will be discussed in this chapter: Present Worth Analysis, Annual Worth
Analysis, Rate of Return on Additional Investment Analysis, Benefit/Cost Analysis, Breakeven and Payback Analysis.

1. PRESENT WORTH ANALYSIS

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Study Guide in ES 14 – ENGINEERING ECONOMICS Module No. 3

In comparing alternatives by this method, determine the present worth ofFM-AA-CIA-15

the net cashRev. 0 10-July-2020
outflows for each alternative for the same period of time. The alternative with
the least present worth of cost is selected.

EXAMPLE

1. A company is considering two types of equipment for its manufacturing plant. Pertinent data are as follows:

Type A:
First cost = P200,000
Annual operating cost = P32,000
Annual labor cost = P50,000
Insurance and property taxes = 3%
Payroll taxes = 4%
Estimated life = 10 years

Type B:
First cost = P300,000
Annual operating cost = P24,000
Annual labor cost = P32,000
Insurance and property taxes = 3%
Payroll taxes = 4%
Estimated life = 10 years

If the minimum required rate of return is 15%, which equipment should be selected? Use present worth cost method.

2. ANNUAL WORTH ANALYSIS

To apply this method, the annual cost of the alternatives including interest on investment is determined. The alternative with the least annual cost is chosen. This
pattern, like the rate of return on additional investment pattern, applies only to alternatives which has a uniform cost data for each year and a single investment of capital
at the beginning of the first year of the project life.

EXAMPLE

1. A company is considering two types of equipment for its manufacturing plant. Pertinent data are as follows:

Type A:
First cost = P200,000

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Study Guide in ES 14 – ENGINEERING ECONOMICS Module No. 3

FM-AA-CIA-15 Rev. 0 10-July-2020

Annual operating cost = P32,000
Annual labor cost = P50,000
Insurance and property taxes = 3%
Payroll taxes = 4%
Estimated life = 10 years

Type B:
First cost = P300,000
Annual operating cost = P24,000
Annual labor cost = P32,000
Insurance and property taxes = 3%
Payroll taxes = 4%
Estimated life = 10 years

If the minimum required rate of return is 15%, which equipment should be selected? Use annual cost method.

3. THE RATE OF RETURN (ROR) METHOD

The rate of return on the capital invested is given by the formula,

net annual profit

Rate of Return =
capital invested

Rate of return is a measure of the effectiveness of an investment of capital. It is a financial efficiency. When this method is used, it is necessary to decide
whether the computed ROR is sufficient to justify the investment. The advantage of this method is that it is easily understood by management and investors. The
applications of the ROR method is controlled by the following conditions: a single investment of capital at the beginning of the first year of the project life and identical
revenue and cost data for each year. The capital invested is the total amount of capital investment required to finance the project, whether equity or borrowed.

RATE OF RETURN ON ADDITIONAL INVESTMENT ANALYSIS

The formula for rate of return on additional investment is,

𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑅𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝐴𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

If the rate of return on additional investment is satisfactory, then, the alternative requiring a bigger investment is more economical and should be chosen.

PANGASINAN STATE UNIVERSITY

Study Guide in ES 14 – ENGINEERING ECONOMICS Module No. 3

FM-AA-CIA-15 Rev. 0 10-July-2020

EXAMPLE

1. A company is considering two types of equipment for its manufacturing plant. Pertinent data are as follows:

Type A:
First cost = P200,000
Annual operating cost = P32,000
Annual labor cost = P50,000
Insurance and property taxes = 3%
Payroll taxes = 4%
Estimated life = 10 years

Type B:
First cost = P300,000
Annual operating cost = P24,000
Annual labor cost = P32,000
Insurance and property taxes = 3%
Payroll taxes = 4%
Estimated life = 10 years

If the minimum required rate of return is 15%, which equipment should be selected? Use rate of return on additional investment method.

2. An investment of P270,000 can be made in a project that will produce a uniform annual revenue of P185,400 for 5 years and then have a salvage value of 10% of
the investment. Out-of-pocket costs for operation and maintenance will be P81,000 per year. Taxes and insurance will be 4% of the first cost per year. The
company expects capital to earn not less than 25% before income taxes. Is this a desirable investment? Compute using the present worth, annual worth, and rate
of return.

For the solution of these examples, watch the video using this link:

Engineering Economics: Economic Study Methods (Present Worth, Annual Worth, & Rate of Return Method)
https://youtu.be/6FoEY1F0OWE

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Study Guide in ES 14 – ENGINEERING ECONOMICS Module No. 3

FM-AA-CIA-15 Rev. 0 10-July-2020

LEARNING ACTIVITY 3-1

As you go through this module and after you watched the videos provided, solve the following:

1. A food processing plant consumed 600,000 kW of electric energy annually and pays an average ofP2.00 per kWh. A study is being made to generate its own
power to supply the plant the energy required, and that the power plant installed would cost P2,000,000. Annual operation and maintenance, P800,000. Other
expenses P100,000 per year. Life of power plant is 15 years; salvage value at the end of life is P200,000; annual taxes and insurances, 6% of first cost; and rate of
interest is 15%. Using the sinking fund method for depreciation, determine if the power plant is justifiable. Compute using the present worth, annual worth, and rate
of return.

2. The manager of a canned food processing plant must decide between two different labeling machines. Machine A will have a first cost of P42,000,000, an annual
operating cost of P28,000,000, and a service life of 4 years. Machine B will cost P51,000,000 to buy and will have an annual operating cost of P17,000,000 during
its 4-year life. At an interest rate of 10% per year, which should be selected? Compute using the present worth, annual worth, and rate of return.

(Your answer in this learning activity will be compiled in your Assignment 3 to be submitted on an announced date)

REFERENCE/S

Sta. Maria, Hipolito B.

Engineering economy
c2000 Published by National Book Store, Mandaluyong City

Besavilla, Venancio I. Jr.

Engineering Mathematics Vol. 2
c1998, Philippines

Adopted and Modified By:

ANGELINA A. TIU, MBA

Faculty, Civil Engineering Department

PANGASINAN STATE UNIVERSITY