ENGINEERING

ECONOMY
BASIC METHODS FOR
MAKING ECONOMY
STUDIES

Engr. Armando C. Emata PME3045

February 23, 2017
TOPIC OBJECTIVES:
Theneed for basic methods in making economy studies
Familiarize with the basic methods or patterns for
making economy studies as follows:
1. Rate of Return Method
2. Annual Worth Method
3. Present Worth Method
4. Future Worth Method; and
5. Payback (Payout) Period Method
Solve sample problems using these methods
Assessment task (AT)
Assignment for next meeting
THE NEED FOR BASIC METHODS
 All economy studies of capital projects should be made
so as to include consideration of the return that a given
project will or should produce.
 However, not all economic decisions are made solely on
the basis of a rate of return.
 There is no single method for making economy studies
that is ideal for all cases because of the following
differences in patterns:
1. revenues or savings flows are quite different
2. cost flows can be quite different in various projects
CONDITIONS AND
VIEWPOINTS
 With respect to investments of capital, and revenue and
cost flows, four conditions may exist:
1) A single, initial capital investment accompanied by
uniform, periodic revenue and cash flows.
2) Two or more capital investments accompanied by
uniform, periodic revenue and cost flows.
3) A single, initial capital investment accompanied by
non-uniform flows of revenues and costs.
4) Two or more capital investments accompanied by
non-uniform flows of revenues and costs.
CONDITIONS AND
VIEWPOINTS
 The first condition is very simple and does occur, but to a
limited extent. The other three conditions are more likely to
occur.
 All of these conditions may be thought of as being made up
of outgoing and incoming cash flows, with a capital
investment being a one-time flow of cash.
 Thus, it should be, and is, possible to solve all long-term
economy problems by a single method or pattern.
 However, in certain cases it is possible to make the analysis
by a simpler procedure.
 Hence, it is not advisable to use a single generalized method
for all cases ; good practice calls for fitting the method to the
situation at hand.
RATE OF RETURN METHOD
 The Rate of Return (ROR) method is a measure of
effectiveness of an investment of capital and is the most
general and widely applicable method for making
economy studies. It is a financial efficiency.
 It commonly is called by several other names, such as
investor’s method, discounted cash flow method, receipts
vs. disbursements method, and profitability index.
 When this method is used, it is necessary to decide
whether the computed rate of return is sufficient to
justify the investment.
Advantage: It is easily understood by management and
investors.
RATE OF RETURN METHOD
 The applications of the ROR method is controlled by the
following conditions:
1) A single investment of capital at the beginning of the
first year of the project life
2) 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 METHOD
 This method is actually subdivided into two namely
1. The Internal Rate of Return (IRR) Method, and
2. The Explicit Reinvestment Rate of Return (ERR)
Method
 For simplicity, the general description and characteristics
of the ROR will be the only one discussed here.

 Equation:

Net annual profit

Rate of Return = ------------------------- (6-1)
Capital invested
RATE OF RETURN METHOD
 PROBLEM 1:
A businessman is considering building a 25-unit apartment in a
place near a progressive commercial centre. He felt that because
of the location of the apartment it will be occupied 90% of the
time. He desires a rate of return of 20%. Other pertinent data as
follows:

Land investment PHP5,000,000

Building investment 7,000,000
Study period 20 years
Cost of land after 20 years 20,000,000
Cost of building after 20 years 2,000,000
RATE OF RETURN METHOD
 PROBLEM 1 cont’d:
Rent per unit per month 6,000
Upkeep per unit 500
Property taxes 1%
Insurance 0.5%

Is this a good investment?

RATE OF RETURN METHOD
 PROBLEM 1 cont’d:
Solution:
Annual income:
Rental = (P6,000) (12) (25) (0.90) = P1,620,000
P20,000,000 – P5,000,000
Land = ----------------------------------
F/A, 20%, 20)

P15,000,000
= ---------------------186.688
= 80,350

Total annual income = P1,700,350

RATE OF RETURN METHOD
 PROBLEM 1 cont’d:
Annual costs:
P7,000,000 – P2,000,000
Depreciation = ----------------------------------- = P26,780
F/A, 20%, 20)

Upkeep = P500 (25) = 12,500

Taxes = P12,000,000 (0.010) = 120,000
Insurance = P7,000,000 (0.005) = 35,000
Total annual cost P 194, 280
Net annual profit = P1,506,070
RATE OF RETURN METHOD
 PROBLEM 1 cont’d:

P1,506,070
Rate of Return = ------------------- x 100
P12,000,000

= 12.55% < 20%

The businessman should not invest.

RATE OF RETURN METHOD
 PROBLEM 1 cont’d:
Another solution...
Investment = P5,000,000 + P7,000,000 = P12,000,000
Amount of investment after 20 years = P20,000,000
+ 2,000,000
= P22,000,000
Annual income = (P6,000)(12) (25) (0.90) = P1,620,000
RATE OF RETURN METHOD
 PROBLEM 1 cont’d:
Another solution cont’d...
Annual costs:
P12,000,000 – P22,000,000
Depreciation = ---------------------------------- = P–53,570
F/A, 20%, 20

Upkeep = P500 (25) = 12,500

Taxes = P12,000,000 (0.10) = 120,000
Insurance = P7,000,000 (0.005) = 35,000
Total annual profit = P113,390
Net annual profit P1,506,070
RATE OF RETURN METHOD
 PROBLEM 1 cont’d:
Another solution cont’d...

P1,506,070
Rate of Return = ------------------ x 100
P12,000,000

= 12.55% < 20%

The businessman should not invest.

Note:
The negative sign for depreciation means that the value
of the investment has increased after 20 years.
RATE OF RETURN METHOD
 PROBLEM 2:
A firm is considering purchasing equipment that will
reduce costs by P40,000. The equipment costs P300,000
and has a salvage value of P50,000 and a life of 7 years.
The annual maintenance cost is P6,000. While not in use
by the firm, the equipment can be rented to others to
generate an income of P10,000 per year.
If money can be invested for an 8% return, is the firm
justified in buying the equipment?
RATE OF RETURN METHOD
 PROBLEM 2 cont’d:
Solution cont’d:
Annual savings:
Reduction in annual cost = P40,000
Rental = 10,000
Total annual savings P50,000
RATE OF RETURN METHOD
 PROBLEM 2 cont’d:
Solution cont’d:
Annual costs:

P300,000 – P50,000
Depreciation = --------------------------
F/A, 8%, 7
P250,000
= ---------------- = P28,018
8.9228
Maintenance = 6,000
Total annual cost P34,018
Annual net savings P15,982
RATE OF RETURN METHOD
 PROBLEM 2 cont’d:
Solution cont’d:

annual net savings

Rate of Return = -------------------------
capital
P15,982
= ---------------- x 100
P300,000

= 5.33% < 8%

The equipment should not be purchased.

RATE OF RETURN METHOD
 PROBLEM #3:
The MGC company has a contract with a hauler to
transport its naphtha requirements of 3,600,000 litres per
year from a refinery in Batangas to its site in Paco at
cost of P1.05 per litre. It is proposed that the company
buys a tanker with a capacity of 18,000 litres to service
its requirements at a first cost of P8,000,000, life is 6
years and a salvage value of P800,000. Other expenses
are as follows:
a) Diesel fuel at P7.95 per litre and the tanker consumes
120 litres per round trip from Paco to Batangas and
back.
RATE OF RETURN METHOD
 PROBLEM #3 cont’d:
b) Lubricating oil and servicing is P3,200 per month
c) Labour including overtime and fringe benefits for one
driver and one helper is P21,000 per month.
d) Annual taxes and insurance, 5% of first cost
e) General maintenance per year is P40,000
f) Tires cost P32,000 per set and will be renewed every
150 round trips

What should the MGC company do if a 15% interest rate

on investment is included in the analysis?
RATE OF RETURN METHOD
 PROBLEM #3 cont’d:
Solution:
Hauling
Annual cost = (P1.05) (3,600,000) = P3,780,000
Buying tanker
Annual cost: P8,000,000 – P800,000
Depreciation = --------------------------------
F/A, 15%, 6

= P822,575
3,600,000
(18,000)(150)
Fuel = ------------------- (120)(P7.95) = 190,000
RATE OF RETURN METHOD
 PROBLEM #3 cont’d:
Solution cont’d:
Oil = (P3,200)(12) = P 38,400
Labour = (P21,000)(12) = 252,000
Taxes & insurance = (P8M)(0.05) = 400,000
Maintenance = 40,000

3,600,000
Tires = ------------------- (P32,000) = 42,667
(18,000)(150)

Total annual cost = P1,786,442

RATE OF RETURN METHOD
 PROBLEM #3 cont’d:
Solution:

Annual savings = P3,780,000 – P1,786,442

= P1,993,558
P1,993,558
Rate of Return = ------------------
P8,000,000 x 100

= 24.92% > 15%

The company should buy the tanker.

ANNUAL WORTH (AW) METHOD
 The annual worth (AW) method is similar to the ERR
method, with one important exception:
◦ The minimum required profit (MRP) or interest in the
original investment, is included as a cost.
 The criterion for this method is that as long as the excess
of revenue (annual cash inflows) over costs (annual cash
outflows) is zero or positive, then a project is
economically justified.
 The AW method is covered by the same limitations as the
rate of return pattern i.e., a single initial investment of
capital and uniform revenue and cost throughout the life
of investment.
ANNUAL WORTH (AW) METHOD
Advantages:
1) Appears to be somewhat easier to use and interpret as
compared to ROR since if the costs are equal to or less
than the revenue, the investment is supposedly justified.
2) Very convenient to use in comparing several alternatives
that produce the same revenue.
Disadvantages:
3) Not easy to use when the revenues of the several
alternatives are not the same.
4) It does not make obvious the significance of excess
revenue over costs when such an excess exists, and this is
often the case.
ANNUAL WORTH (AW) METHOD
 This method also suffers a certain disadvantage in that it
includes the item of profit as a cost, although it will not
be included as such for either accounting or tax purposes.
 In the AW method, interest on the original investment
(sometimes called minimum required profit) is included
as cost.
 If the excess of the annual cash inflows aver annual cash
outflows is not less than zero the proposed investment is
justified – is valid.
 This method is covered by the same limitations as the
rate of return pattern.
ANNUAL WORTH (AW) METHOD
 PROBLEM #4:
A man is considering investing P500,000 to open a semi-
automatic auto-washing business in a city of 400,000
population. The equipment can wash, on the average; 12
cars per hour using two men to operate it and to do small
amount of hand work. The man plans to hire two men, in
addition to himself, 50 weeks per year. He will pay his
employees P25.00 per hour. He expects to charge P25.00
for a car wash. Out-of-pocket miscellaneous cost would
be P8,500 per month. He would pay his employees for 2
weeks for vacation each year.
ANNUAL WORTH (AW) METHOD
 PROBLEM #4 cont’d:
Because of the length of his lease, he must write off his
investment within 5 years. His capital now is earning
15%, and he is employed at a steady job that pays
P25,000 per month. He desires a rate of return of at least
20% on his investment.
Would you recommend the investment?
ANNUAL WORTH (AW) METHOD
 PROBLEM #4 cont’d:
Solution:
By the rate of return method
Annual revenue = (12)(25)(8)(6)(50) =
P720,000
P500,000 P500,000
F/A, 15%, 5 = --------------
Depreciation = --------------- 6.7424

= P 74,160
Labour = (2)(48)(50)(P25.00) = 120,000
ANNUAL WORTH (AW) METHOD
 PROBLEM #4 cont’d:
Solution cont’d:
Vacation pay = (2)(2)(48)(P25.00) = 4,800
Miscellaneous = (P8,500)(12) = 102,000
Owner’s salary = P25,000 (12) = 300,000
Total annual cost = P600,960
Net annual profit P119,040
P119,040
Rate of Return = -------------
P500,000 X 100 = 23.81 % > 20%

The man should invest.

ANNUAL WORTH (AW) METHOD
 PROBLEM #4 cont’d:
Solution cont’d:
By the annual worth method:
Annual revenue = (12)(P25)(8)(6)(50) = P720,000

P500,000
Depreciation = --------------- = 74,160
F/A, 15%, 5

Labour = (2)(48)(50)(P25) = 120,000

Vacation pay = (2)(2)(48)(P25.00) = 4,800
Miscellaneous = P25,000(12) = 300,000
ANNUAL WORTH (AW) METHOD
 PROBLEM #4 cont’d:
Solution cont’d:
By the annual worth method cont’d:
Interest on capital = P500,000(0.20) = 100,000
Total annual cost = P700,960

Excess = P 19,040
Note:
Since the excess of annual revenue over annual cost is
greater than zero, the investment is justified.
The man should invest.
PRESENT WORTH (PW) METHOD
 The present worth (PW) method for economy studies is
based on the concept of equivalent worth of all cash
flows as of some base or beginning time called the
present.
 The criterion for this method is that as long as the
present worth of the net cash flows is equal to or greater
than zero, the project is economically justified.
 Because the annual revenues and costs do not have to be
the same, or even occur at regular intervals, the PW
method is flexible and theoretically can be used for any
type of economy study.
PRESENT WORTH (PW) METHOD
 Itis used quite extensively in making economy studies in
the public works field where long-lived structures are
involved.
Disadvantages of this method:
1. It appears to assume that the present worth of all future
expenses is to be paid at one time.
2. The present worth usually is an amount of considerable
magnitude that may mislead the economy analyst.
Despite the difficulties that have been discussed, the
present worth method, is quite useful for situations in
which there are non-uniform cash flows.
FUTURE WORTH (FW) METHOD
 The future worth (FW) method for economy studies is
exactly comparable to the present worth method except
that all cash inflows and outflows are compounded
forward to a reference point in time called the future.
 If the future worth of the net cash flows is equal to, or
greater than zero, the project is justified economically.
PAYBACK (PAYOUT) PERIOD
METHOD
 The payback period is commonly 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 an interest rate of zero.

Investment – salvage value

Payout period = ----------------------------------- (6-2)
(years) Net annual cash flow
SAMPLE – ALL BASIC METHODS
 PROBLEM #5:
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?
What is the payback period of the investment?
SAMPLE – ALL BASIC METHODS
 PROBLEM #5 cont’d:
Solution:
By the rate of return method:
Annual revenue = P185,400
Annual costs: P270,000 – P27,000 P243,000
Depreciation = -------------------------
F/A, 25%, 5 = --------------
8.2070

= P 29,609
Operation and maintenance = 81,000
Taxes & insurance = P270,000(0.04) = 10,800
Total annual cost P121,409
Net annual profit P 63,991
SAMPLE – ALL BASIC METHODS
 PROBLEM 5 cont’d:
Solution cont’d:
By the rate of return method cont’d:

P63,991
Rate of return = -------------- x 100 = 23.70%
P270,000

Since the ROR is less than 25%, the investment is not

justified.
SAMPLE – ALL BASIC METHODS
 PROBLEM 5 cont’d:
Solution cont’d:
By the annual worth method:
Annual revenue = P185,400
Annual costs: P270,000 – P27,000
Depreciation = -------------------------- = P29,609
F/A, 25%, 5

Operation & maintenance = 81,000

Taxes & insurance = P270,000(0.04) = 10,800
Interest on capital = P270,000(0.25) = 67,500
Total annual cost = P188,909
Excess – P 3,509
SAMPLE – ALL BASIC METHODS
 PROBLEM 5 cont’d:
Solution cont’d:
By the annual worth method cont’d:

Since the excess annual cash inflows over annual cash

outflows is less than zero (– P3,509), the investment is
not justified.
SAMPLE – ALL BASIC METHODS
 PROBLEM 5 cont’d:
Solution cont’d:
By the present worth method:

P27,000

P185,400 P185,400 P185,400 P185,400 P185,400

0 1 2 3 4 5

Cash flow diagram of cash inflows

SAMPLE – ALL BASIC METHODS
 PROBLEM 5 cont’d:
Solution cont’d:
By the present worth method cont’d:

PW of cash inflows = P185,400(P/A, 25%, 5) +

P27,000(P/F, 25%, 5)
= P185,400(2.6893) +
P27,000(0.3277)
= PHP506,370
SAMPLE – ALL BASIC METHODS
 PROBLEM 5 cont’d:
Solution cont’d:
By the present worth method cont’d:

Annual costs =P81,000 + P270,000(0.04)

(excluding depreciation) = P91,800

0 1 2 3 4 5

P91,800 P91,800 P91,800 P91,800 P91,800

P270,000
Cash flow diagram of cash outflows
SAMPLE – ALL BASIC METHODS
 PROBLEM 5 cont’d:
Solution cont’d:
By the present worth method cont’d:

PW of cash = P270,000 + P91,800(P/A, 25%, 5)

outflows = PHP516,880

Since the PW of the net cash flows is less than zero (–

P10,510), the investment is not justified.
SAMPLE – ALL BASIC METHODS
 PROBLEM 5 cont’d:
Solution cont’d:
By the future worth method:

Referring to the cash flow diagrams in the solution by

the PW method;
FW of cash inflows = P27,000 + P185,400(F/A, 25%, 5)
= P27,000 + P185,400(8.2070)
= P1,548,580
SAMPLE – ALL BASIC METHODS
 PROBLEM 5 cont’d:
Solution cont’d:
By the future worth method cont’d:

FW of cash = P91,800(P/A, 25%,5) + P270,000(F/P, 25%,5)

outflows = P91,800(8.2070) + P270,000(3.0518)
= P1,577,390

Since the FW of the net cash flows is less than zero (–

P28,810), the investment is not justified.
SAMPLE – ALL BASIC METHODS
 PROBLEM 5 cont’d:
Solution cont’d:
By the payback period method:

Total annual cost = P81,000 + P270,000(0.40) =

P91,800
Net annual cash flows = P185,400 – P91,800 = P93,600
investment – salvage value
net annual cash flows
Payback period = ----------------------------------
P270,000 – P27,000
P93,600
= ------------------------- = 2.6 years
SAMPLE – ALL BASIC METHODS
 PROBLEM 5 cont’d:
Solution cont’d:

Note:
In computing the total annual cost, depreciation was not
included because the method does not consider the time
value of money or interest. The use of the payback
period for making investment decisions should be
avoided as it may produce misleading results.
Assignment – February 28, 2017
 For next meeting, submit in one sheet of bond paper. Write your name,
subject/section, date and write the problem statement. Please write legibly.
Non-compliance will mean non-acceptance of your assignment.
 The corporate president of an automotive distributor in Nueva Ecija
availed of an early retirement package from her company and decided
to partner with a Japanese colleague to put up a mushroom growing
facility. There were two sites being considered:
One alternative is to build in her hometown of Cabanatuan City
where the plant would cost P10,000,000. Labour would cost
P720,000 yearly and an annual overhead cost of P240,000 is
anticipated. Power and water bills are estimated at about P150,000
per month based on the proposed equipment and lighting load. Taxes
and insurance would total 5% of the first cost of the plant. She lives
about 30 minutes away from the proposed site.
Continued next page >>>
Assignment – February 28, 2017
The other alternative is an industrial zone in Angeles City,
Pampanga where the plant would cost P8,000,000. Labour would
cost about 15% less than at Cabanatuan and overhead cost would be
slightly lower at P204,000 annually. Taxes and insurance are
anticipated to be around 2% of the first cost as the plant would
eventually be an economic zone in a year’s time. If this site is
chosen, she would need to rent a place to be there so she could stay
5 days a week. Rental and utility costs will be P12,000 per month
and gasoline and toll fees would amount to P10,000 per month.
Power and water will be slightly lower at P120,000 monthly as the
supply comes from a cooperative.
If capital must be recovered in 10 years and money is worth 14%,
which site should the enterprising retiree choose?
Data next page >>>
Assignment – February 28, 2017
DETAILS CABANATUAN PAMPANGA
1. Cost of plant P10,000,000 P8,000,000
15% less than
2. Labour cost/year P720,000
Cabanatuan
3. Overhead cost/year P240,000 P204,000
4. Taxes & insurance per
5% of first cost 2% of first cost
year
5. Power & water per
P1,800,000 P1,440,000
costs per year
6. House rental and
- P12,000
utilities cost per month
7. Gas and toll expenses
- P10,000
per month
8. Life, years 10 10
9. Cost of money 14% 14%