UNIVERSITY OF SAINT LOUIS

Tuguegarao City

SCHOOL OF ENGINEERING, ARCHITECTURE and

INFORMATION TECHNOLOGY EDUCATION

CORRESPONDENCE LEARNING MODULE

ENGE 1013 – ENGINEERING ECONOMICS

Reviewed by:

ENGR. ARIEL M. LORENZO, ME-ECE

ECE Program Chair

Recommended by:

ENGR. VICTOR C. VILLALUZ, MEE

Academic Dean

Approved by:

DR. EMMANUEL JAMES P. PATTAGUAN

VP for Academics

ENGE 1013 – ENGINEERING ECONOMICS | 1

Finals Week 1

1. Weekly Study and Assessment Guide

CORRESPONDENCE LEARNING MODULE

ENGE 1013 – Engineering Economics
A.Y. 2020-2021

Lesson 4: Basic Economic Study Methods

Topic: Minimum Acceptable Rate of Return

Present Worth Analysis

Future Worth Analysis

Annual Worth Analysis

Rate of Return Analysis

The Internal Rate of Return Method

The External Rate of Return Method

Payback Period

Learning Outcomes: At the end of this module, you are expected to:

1. Solve problems involving minimum attractive rate of return.

2. Carry out basic and other economic study methods.

ENGE 1013 – ENGINEERING ECONOMICS | 2

LEARNING CONTENT

BASIC ECONOMIC STUDY METHODS

All engineering economy studies of capital projects should consider the return that a given project will or should
produce. A basic question we need to address is whether a proposed capital investment and its associated
expenditures can be recovered by revenue (or savings) over time in addition to a return on the capital that is
sufficiently attractive in view of the risks involved and the potential alternative uses.

The interest and money–time relationships discussed in the previous chapter emerge as essential ingredients in
answering this question, and they are applied to many different types of problems. Because patterns of capital
investment, revenue (or savings) cash flows, and expense cash flows can be quite different in various projects,
there is no single method for performing engineering economic analyses that is ideal for all cases. Consequently,
several methods are commonly used.

A project focus will be taken as we introduce ways of gauging profitability. In this chapter, we concentrate on the
correct use of five methods for evaluating the economic profitability of a single proposed problem solution (i.e.,
alternative). The methods described in this chapter are:

1. Present Worth (PW) Analysis

2. Future Worth (FW) Analysis
3. Annual Worth (AW) Analysis
4. Rate of Return Analysis

The first three methods convert cash flows resulting from a proposed problem solution into their equivalent wort
hat some point (or points) in time by using an interest rate known as the Minimum Attractive Rate of Return
(MARR).

MINIMUM ACCEPTABLE RATE OF RETURN

A minimum acceptable rate of return (MARR) is the minimum profit an investor expects to make from an
investment, taking into account the risks of the investment and the opportunity cost of undertaking it instead of
other investments.

ENGE 1013 – ENGINEERING ECONOMICS | 3

If you've done any research and cost analysis before making an investment, you've probably worked out the
minimum acceptable rate of return. Minimum acceptable rates of return are also known as hurdle rates, cut-off
rates or benchmarks.
MARRs are a useful way of weighing up whether an investment is worth the risks associated with it. To calculate
the MARR, you need to look at different aspects of the investment opportunity, including the opportunities for
expanding operation and rate of return on investments.

An investment has been a successful one if the actual rate of return is above the minimum acceptable rate of
return. If it is below, it's seen as an unsuccessful investment and you might, as an investor, pull out of the
investment.

Figure 1: Size of MARR relative to other rate of return values

In general, capital is developed in two ways—equity financing and debt financing. A combination of these two is
very common for most projects.

Equity financing. The corporation uses its own funds from cash on hand, stock sales, or retained earnings.
Individuals can use their own cash, savings, or investments. In the example above, using money from the 5%
savings account is equity financing.

Debt financing. The corporation borrows from outside sources and repays the principal and interest according
to some schedule, much like a plan. Sources of debt capital may be bonds, loans, mortgages, venture capital
pools, and many others. Individuals, too, can utilize debt sources, such as the credit card (15% rate) and bank
options (9% rate) described above.

1. PRESENT WORTH ANALYSIS

A future amount of money converted to its equivalent value now has a present worth (PW) that is always less
than that of the future cash flow, because all P/F factors have a value less than 1.0 for any interest rate greater
than zero. For this reason, present worth values are often referred to as discounted cash flows (DCF), and the
interest rate is referred to as the discount rate. Besides PW, two other terms frequently used are present value
(PV) and net present value (NPV). Up to this point, present worth computations have been made for one project
or alternative.

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PRESENT WORTH ANALYSIS OF EQUAL-LIFE ALTERNATIVES

The PW comparison of alternatives with equal lives is straightforward. The present worth P is renamed PW of
the alternative. The present worth method is quite popular in industry because all future costs and revenues are
transformed to equivalent monetary units NOW; that is, all future cash flows are converted (discounted) to
present amounts (e.g., pesos) at a specific rate of return, which is the MARR. This makes it very simple to
determine which alternative has the best economic advantage.

EXAMPLE 1:

Metropolitan Tuguegarao Water District (MTWD) is trying to decide between two different sizes of pipe for a new
water main. A 250-mm line will have an initial cost of P 8,370,000, whereas a 300- mm line will cost P 11,340,000.
Since there is more head loss through the 250-mm pipe, the pumping cost is expected to be P 162,000 more

per year than for the 300-mm line. If the lines are expected to last for 30 years, which size should be selected on
the basis of a present worth analysis using an interest rate of 10% per year?

EXAMPLE 2:

GAMA-H Construction, Inc., plans to purchase new cut-and-finish equipment. Two manufacturers offered the
estimates below.

1. Determine which vendor should be selected on the basis of a present worth comparison, if the MARR is
15% per year.
2. GAMA-H Construction, Inc has a standard practice of evaluating all options over a 5-year period. If a
study period of 5 years is used and the salvage values are not expected to change, which vendor should
be selected?

ENGE 1013 – ENGINEERING ECONOMICS | 5

 2. FUTURE WORTH ANALYSIS

The future worth (FW) of an alternative may be determined directly from the cash flows, or by multiplying the PW
value by the F/P factor, at the established MARR. The n value in the F/P factor is either the LCM value or a
specified study period. Analysis of alternatives using FW values is especially applicable to large capital
investment decisions when a prime goal is to maximize the future wealth of a corporation’s stockholders.

Future worth analysis over a specified study period is often utilized if the asset (equipment, a building, etc.) might
be sold or traded at some time before the expected life is reached.

EXAMPLE 1:

An industrial engineer is considering two robots for purchase by a fiber-optic manufacturing company. Robot X
will have a first cost of P 4,320,000, an annual maintenance and operation (M&O) cost of P 1,620,000, and a P
ENGE 1013 – ENGINEERING ECONOMICS | 6
2,160,000 salvage value. Robot Y will have a first cost of 5,238,000, an annual M&O cost of P 11,458,000, and
a P 2,700,000 salvage value. Which should be selected on the basis of a future worth comparison at an interest
rate of 15% per year? Use a 3-year study period.

EXAMPLE 2:

Two processes can be used for producing a polymer that reduces friction loss in engines. Process T will have a
first cost of P 40,500,000, an operating cost of P 3,240,000 per year, and a salvage value of P 4,320,000 after
its 2-year life. Process W will have a first cost of P 72,900,000, an operating cost of P 1,350,000 per year, and a
P 6,480,000 salvage value after its 4-year life. Process W will also require updating at the end of year 2 at a cost
of P 4,860,000. Which process should be selected on the basis of a future worth analysis at an interest rate of
12% per year?

ENGE 1013 – ENGINEERING ECONOMICS | 7

 3. ANNUAL WORTH ANALYSIS

Here we will learn the equivalent annual worth, or AW, method. AW analysis is commonly considered the more
desirable than PW and FW because the AW value is easy to calculate; the measure of worth—AW in monetary
units per year—is understood by most individuals; and its assumptions are essentially identical to those of the
PW method.

Annual worth is also known by other titles. Some are equivalent annual worth (EAW), equivalent annual cost
(EAC), annual equivalent (AE), and equivalent uniform annual cost (EUAC). The alternative selected by the
AW method will always be the same as that selected by the PW and FW method, and all other alternative
evaluation methods, provided they are performed correctly.

The annual worth method offers a prime computational and interpretation advantage because the AW value
needs to be calculated for only one life cycle. The AW value determined over one life cycle is the AW for all
future life cycles. Therefore, it is not necessary to use the LCM of lives to satisfy the equal-service requirement.

EXAMPLE:

University of Saint Louis (USL) is considering the purchase of a piece of new GPS equipment. Data concerning
the alternative under consideration are presented below.

If the equipment has a life of eight years and USL’s minimum attractive rate of return (MARR) is 5%, what is the
annual worth of the equipment and would you recommend buying the new GPS equipment?

ENGE 1013 – ENGINEERING ECONOMICS | 8

ENGE 1013 – ENGINEERING ECONOMICS | 9
 4. RATE OF RETURN ANALYSIS

A. THE INTERNAL RATE OF RETURN METHOD

The IRR method is the most widely used rate-of-return method for performing engineering economic analyses.
It is sometimes called by several other names, such as the investor’s method, the discounted cash-flow method,
and the profitability index.

This method solves for the interest rate that equates the equivalent worth of an alternative’s cash inflows (receipts
or savings) to the equivalent worth of cash outflows (expenditures, including investment costs). Equivalent worth
may be computed using any of the three methods discussed earlier. The resultant interest rate is termed the
Internal Rate of Return (IRR). The IRR is sometimes referred to as the breakeven interest rate.

The most commonly quoted measure of economic worth for a project or alternative is its rate of return (ROR).
Whether it is an engineering project with cash flow estimates or an investment in a stock or bond, the rate of
return is a well-accepted way of determining if the project or investment is economically acceptable.

For a single alternative, from the lender’s viewpoint, the IRR is not positive unless:

1. both receipts and expenses are present in the cash-flow pattern, and 2.
the sum of receipts exceeds the sum of all cash outflows.

Using a PW formulation, we see that the IRR is the i% at which:

where:

Rk = net revenues or savings for the kth year;

Ek = net expenditures, including any investment costs for the kth year;

N = project life (or study period).

IRR Decision Rule: If IRR ≥ MARR, the project is economically justified. Plot

of PW versus Interest Rate

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EXAMPLE:

Applications of green, lean manufacturing techniques coupled with value stream mapping can make large
financial differences over future years while placing greater emphasis on environmental factors. Engineers in
Boysen Paints have recommended to management an investment of P 10,200,000 now in novel methods that
will reduce the amount of wastewater, packaging materials, and other solid waste in their consumer paint
manufacturing facility. Estimated savings are P 765,000 per year for each of the next 10 years and an additional
savings of P 15,300,000 at the end of 10 years in facility and equipment upgrade costs. Determine the rate of
return.

B. THE EXTERNAL RATE OF RETURN METHOD

The reinvestment assumption of the IRR method may not be valid in an engineering economy study. For instance,
if a firm’s MARR is 20% per year and the IRR for a project is 42.4%, it may not be possible for the firm to reinvest
net cash proceeds from the project at much more than 20%.This situation, coupled with the computational
demands and possible multiple interest rates associated with the IRR method, has given rise to other rate of
return methods that can remedy some of these weaknesses.

One such method is the ERR method. It directly takes into account the interest rate ( ) external to a project at
which net cash flows generated (or required) by the project over its life can be reinvested (or borrowed). If this
external reinvestment rate, which is usually the firm’s MARR, happens to equal the project’s IRR, then the ERR
method produces results identical to those of the IRR method.

In general, three steps are used in the calculating procedure. First, all net cash outflows are discounted to time
zero (the present) at % per compounding period. Second, all net cash inflows are compounded to period N at
%. Third, the ERR, which is the interest rate that establishes equivalence between the two quantities, is
determined. The absolute value of the present equivalent worth of the net cash outflows at % (first step) is used
in this last step. In equation form, the ERR is the i% at which

where:

Rk = excess of receipts over expenses in period k;

Ek = excess of expenditures over receipts in period k;

N = project life or number of periods for the study;

ENGE 1013 – ENGINEERING ECONOMICS | 11
 = external reinvestment rate per period.

Graphically, we have the following (the numbers relate to the three steps):

A project is acceptable when i% of the ERR method is greater than or equal to the firm’s MARR.

IRR Decision Rule: If IRR ≥ MARR, the project is economically justified.

EXAMPLE:

A piece of new equipment has been proposed by engineers to increase the productivity of a certain manual
welding operation. The investment cost is P 1,275000, and the equipment will have a market (salvage) value of
P 255,000 at the end of its expected life of five years. Increased productivity attributable to the equipment will
amount to P 408,000 per year after extra operating costs have been subtracted from the value of the additional
production. Is the investment a good one? MARR is 20% per year. IRR Decision Rule: If IRR≥MARR, the project
is economically justified.

C. PAYBACK PERIOD

The payback period refers to the amount of time it takes to recover the cost of an investment. Simply put, the
payback period is the length of time an investment reaches a break-even point.

Investors and money managers can use the payback period to make quick judgments about their investments.

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The payback period is the cost of the investment divided by the annual cash flow. The shorter the payback, the
more desirable the investment. Conversely, the longer the payback, the less desirable it is.

EXAMPLE:

Two equivalent pieces of quality inspection equipment are being considered for purchase by Square D Electric.
Machine 2 is expected to be versatile and technologically advanced enough to provide net income longer than
machine 1. The quality manager used a return of 15% per year.

*** END of LESSON 4***

SEATWORK

PROBLEM-SOLVING. Solve each of the problems below and show your complete, systematic, and neat solution
on a clean sheet of paper. Show the CFD (Cash Flow Diagram) in your solution.
1. Louis Partridge is considering buying a tuxedo. It would cost P500 but would save him P160 per year in rental
charges over its five-year life. What is the IRR for this investment?

ENGE 1013 – ENGINEERING ECONOMICS | 13

2. San Miguel Corporation is considering a new canner. The canner costs P120 000 and will have a scrap value
of P5000 after its 10-year life. Given the expected increases in sales, the total savings due to the new canner,
compared with continuing with the current operation, will be P15 000 the first year, increasing by P5000 each
year thereafter. Total extra costs due to the more complex equipment will be P10 000 per year. The MARR
is 12 percent. Compute the IRR. Should it invest in the new canner?
3. Monterey can buy a new meat slicer system for P50 000. The company estimates it will save P11 000 per
year in labor and operating costs. The same system with an automatic loader is P68 000, and will save
approximately P14 000 per year. The life of either system is thought to be eight years. Monterey uses a
MARR of 12 percent for this type of project. Which alternative is better based on the IRR?
4. An El Nido resort is considering adding either a parasailing operation or kayak rentals to their other activities.
Available space limits them to one of these two choices. The initial costs for parasailing will be P100 000,
with net returns of P15 000 annually for the 15-year life of the project. Initial costs for kayaking will be P10
000, with net returns of P2000 per year for its 15-year life. Assume that both projects have a 0-salvage value
after 15 years, and the MARR is 10 percent.
a. Using present worth analysis, which alternative is better?
b. Using IRR, which alternative is better?
5. Everlyse runs a second-hand book business out of her home where she advertises and sells the books over
the internet. Her small business is becoming quite successful and she is considering purchasing an upgrade
to her computer system that will give her more reliable uptime. The cost is P5000. She expects that the
investment will bring about an annual savings of P2000, due to the fact that her system will no longer suffer
long failures and thus she will be able to sell more books. What is the payback period on her investment,
assuming that the savings accrue over the whole year?
6. The Last Great American Dynasty is going to upgrade its paper-shredding facility. The company has a choice
between two models. Model 007, with a first cost of P500 000 and a service life of seven years, would save
P100 000 per year. Model MX, with a first cost of P100 000 and an expected service life of 20 years, would
save P15 000 per year. If the company’s MARR is 8 percent, which model is the better buy based on a.
payback period
b. annual worth
7. Chris Evans, an engineer at Rose River Vineyards, has a $100 000 budget for winery improvements. He has
identified four mutually exclusive investments, all of five years’ duration, which have the cash flows shown in
the table. For each alternative, he wants to determine (a) the payback period and (b) the present worth. For
his recommendation report, he will order the alternatives from most preferred to least preferred in each case.
Rose River uses an 8 percent MARR for such decisions.

QUIZ

PROBLEM-SOLVING. Solve each of the problems below and show your complete, systematic, and neat solution
on a clean sheet of paper. Show the CFD (Cash Flow Diagram) in your solution.
ENGE 1013 – ENGINEERING ECONOMICS | 14
1. company that manufactures magnetic membrane switches is investigating two production options that have
the estimated cash flows shown. Which one should be selected on the basis of a. a present worth analysis
at 13% per year?
b. a future worth analysis at 5% per year?
c. an annual worth analysis at 23% per year?
In-house Contract
First cost P 30,000,000 -
Annual cost P 5,000,000 P 3,000,000
Annual income P 14,000,000 P 4,100,000
Salvage value P 2,000,000 -
Life, years 5 5
2. A pipeline engineer working in Kuwait for the oil giant BP wants to perform a present worth analysis on
alternative pipeline routings—the first predominately by land and the second primarily undersea. The
undersea route is more expensive initially due to extra corrosion protection and installation costs, but cheaper
security and maintenance reduces annual costs.
a. Perform the present worth analysis for the engineer at 15% per year as basis of choosing which route is
to be selected.
b. Perform the annual worth analysis for the engineer at 12% per year as basis of choosing which route is
to be selected.
c. Perform the future worth analysis for the engineer at 23% per year as basis of choosing which route is to
be selected.
Land Undersea
Installation cost P 215,000,000 P 350,000,000
Pumping, operating, security per year P 22,000,000 P 2,000,000
Replacement of valves and appurtenances
P 30,000,000 P 70,000,000
in year 25
Life, years 50 50
3. Bently OpenTower is a new structural design software package is available for analyzing and designing
three-sided guyed towers and three- and four-sided self-supporting towers. A single-user license will cost P
318,000 per year. A site license has a one-time cost of P 1,166,000. GAMMA-H Inc, a structural engineering
consulting company, is trying to decide between two alternatives: buy a single-user license now and one
each year for the next 3 years (which will provide 4 years of service), or buy a site license now. Determine
which strategy should be adopted at an interest rate of 10% per year for a 4-year planning period using the
annual worth method of evaluation.

4. An engineer is considering two different liners for an evaporation pond that will receive salty concentrate from
a brackish water desalting plant. A plastic liner will cost P 47.7 per square foot initially and will require
replacement in 15 years when precipitated solids will have to be removed from the pond using heavy
equipment. This removal will cost P 26,500,000. A rubberized elastomeric liner is tougher and, therefore, is
expected to last 30 years, but it will cost P 65 per square foot. If the size of the pond is 110 acres (1 acre =
43,560 square feet), which liner is more cost effective on the basis of a present worth comparison at an
interest rate of 8% per year?

5. Two manufacturers supply MRI systems for medical imaging. St. Jude’s Hospital wishes to replace its current
MRI equipment that was purchased 8 years ago with the newer technology and clarity of a stateof-the-art
system. System K will have a first cost of P 81,600,000, an operating cost of P 3,570,000 per year, and a
salvage value of P 20,400,000 after its 4-year life. System L will have a first cost of P 107,100,000, an
operating cost of P 2,550,000 the first year with an expected increase of P 153,000 per year thereafter, and
no salvage value after its 8-year life. Which system should be selected on the basis of a future worth analysis
at an interest rate of 12% per year?
ENGE 1013 – ENGINEERING ECONOMICS | 15
6. PGM Consulting is under contract to Montgomery County for evaluating alternatives that use a robotic,
liquidpropelled “pig” to periodically inspect the interior of buried potable water pipes for leakage, corrosion,
weld strength, movement over time, and a variety of other parameters. Two equivalent robot instruments are
available. Robot Joeboy will have a first cost of P 4,590,000, annual M&O costs of P 1,620,000, and a P
2,160,000 salvage value after 3 years. Robot Watcheye will have a first cost of P 6,570,000, annual M&O
costs of P 1,458,000, and a P 1,782,000 salvage value after its 5-year life.
a. Assume an interest rate of 8% per year, which robot should be used if present worth analysis will be
used?
b. Assume an interest rate of 14% per year, which robot should be used if future worth analysis will be
used?
c. Assume an interest rate of 17% per year, which robot should be used if annual worth analysis will be
used?

7. Potable water is in short supply in many countries. To address this need, two mutually exclusive water
purification systems are being considered for implementation in the Philippines. Determine which system
should be selected when MARR=8% semi-annually using
a. PW method
b. FW method
c. AW method
System A System B
Capital investment P 5,300,000 P 7,950,000
Annual revenues P 2,650,000 P 3,710,000
Annual expenses P 1,166,000 P 2,120,000
Market value of useful life P 1,060,000 0
Useful life 5 years 10 years

REFERENCES

Textbooks

Chan Park. (2018). Fundamentals of Engineering Economy. Pearson Prentice Hall.

Niall M. Fraser and and Elizabeth Jewkes. (2016). Engineering Economics Financial Decision Making for
Engineers. Pearson Canada.

R. Paneerselvam. (2014). Engineering Economics. PHI Learning Private Limited, New Delhi.

Leland Blank and Anthony Tarquin. (2013). Basics of Engineering Economy. McGraw-Hill Higher Education.

Hipolito Sta. Maria. (). Engineering Economy. National Bookstore.

Online Reference

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