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BASIC METHODS FOR

ENGINEERING

ECONOMIC STUDY

Module5.1

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BASIC METHODS FOR

ENGINEERING ECONOMIC STUDYto determine the feasibility of investing

capital in a proposed venture.

Basic Question:

Are the future benefits large enoughto justify the costs of the project?

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is a measure of the effectiveness of aninvestment of capital.

is easily understood.

Condition: A single investment of capital at the beginning of the first year of the project life and identicalrevenue and cost data for each year.

1. THE RATE OF RETURN METHOD (ROR)

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1. THE ROR cont.

INVESTEDCAPITALPROFIT ANNUAL NET

ROR

ROR i (investment is feasible and justified)

%)100(FC P

ROR bb

where Pb = net profit before income taxes, thus

)( D AC AI Pb

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Where : FC = required investment AI = gross annual income / annual revenue AC = annual expenses or costs

= includes materials, direct labor, overhead, property taxes

O operationM maintenanceT taxes

T M O AC

D = depreciation

ii

SV FC D

N 1)1(

1. THE ROR cont.

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the minimum required profit is included as acost.

if the excess of annual cash inflows over annualcash outflows is not less than zero, then theproposed investment is justified or valid.

Condition: A single investment of capital at the beginning of the first year of the project life and identicalrevenue and cost data for each year.

2. THE ANNUAL WORTH METHOD

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Inflow Outflow (investment is feasible and justified)

where: Fci = interest on capital

2. THE ANNUAL WORTH METHOD cont.

)( FCi D AC AI Pb

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3. THE PRESENT WORTH METHOD

if the present worth of the net cash flows isequal to, or greater than zero, then the project

is justified economically.flexible, can be used in any type of economystudy.depreciation is excluded in the cash outflow.

Inflow Outflow (investment is feasible and justified)

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3. THE PRESENT WORTH METHOD cont.

INFLOWS:

AI AI AI AI

SV

N1 2 30 . . . . . . .

(going to present)

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3. THE PRESENT WORTH METHOD cont.

OUTFLOWS:

AC AC AC AC

FC

N1 2 3

0. . . . . . .

(going to present)

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4. THE FUTURE WORTH METHOD

if the future worth of the net cash flows is equalto, or greater than zero, then the project is

justified economically.depreciation is excluded in the cash outflow

Inflow Outflow (investment is feasible and justified)

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4. THE FUTURE WORTH METHOD cont.

INFLOWS:

AI AI AI AI

SV

N1 2 30 . . . . . . .

(going to future)

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4. THE FUTURE WORTH METHOD cont.

OUTFLOWS:

AC AC AC AC

FC

N1 2 3

0. . . . . . .

(going to future)

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5. THE PAYBACK PERIOD METHOD

the payback period is defined as the length of timerequired to recover the first cost of an investment

from the net cash flow produced by that investmentfor an interest rate of zero.

FLOW CASH ANNUAL NET VALUE SALVAGE INVESTMENT

Period Payback years

AC AI SV FC

Period Payback years

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SAMPLE PROBLEM 1

An investment of P 270,000.00 can be made in a projectthat will produce uniform annual revenue of P 185,400.00for 5 years and then have a salvage value of 10% of the

investment. Out-of pocket costs for operation andmaintenance will be P 81,000.00 per year. Taxes andinsurance will be 4% of the first cost per year. Thecompany expects capital to earn not less than 25% beforeincome taxes. Is this a desirable investment? What is thepayback period of the investment?(Ans. ROR = 23.70%; Inflow = P 185,400.00, Outflow = P 188,908.76;

P income = P 507,439.87, P costs = P 516,875.90; F income = P 1,548,583.59,

F costs = P 1,577,380.08; PP = 2.6 years)

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SAMPLE PROBLEM 2

A project capitalized for P 50,000.00 invested in depreciableassets will earn a uniform, annual income of P 19,849.00 in10 years. The salvage value is P 2000.00. The cost for

operation and maintenance total P 9,000.00 a year, andtaxes and insurance will cost 4% of the first cost each year.If the company expects its capital to earn 12% beforeincome taxes, is the investment worthwhile?