IE 353

Engineering Economy
Chapter 5: Evaluation of a Single Project
 Peq = Peq (cash-in) – Peq (cash-out)

 At equivalency Peq (cash-in) =Peq(cash-

out)
 Peq(cashflow ) = zero----- breakeven
 If Peq(cashflow )>0 ----------- profit
 Peq(cashflow )< zero ------loss
 Feasible means more or equal to zero

 i??? MARR = min attractive rate of return

Learning Objectives
 Understand common assumptions in solving
economic analysis problems.
 Understand the concept of Minimum Attractive Rate
of Return (MARR).
 Apply techniques for determining project
profitability:
• Present worth (PW) Equivalent worth methods
• Future worth (FW) (EW)
• Annual worth (AW)
• Internal rate of return (IRR)

• Payback period (generally not appropriate as a

primary decision rule) it measures liquidity not
profitability.
3
Evaluating a single project

Answer the Question whether a proposed capital investment and its

associated expenditures can be recovered by revenue (or savings)
over time in addition to a return (profit) on the capital that is
sufficiently attractive in view of the risks involved and the potential
alternative uses.

Gauge profitability
S
=salvage
value
R

0 1 2 3 4 n

E
I = initial
investment i=MARR
4
Selecting a
Minimum Attractive Rate of Return

To be attractive, a capital investment project

must provide a rate of return that exceeds a
minimum level established by the organization.
This minimum level is the firm’s Minimum
Attractive Rate of Return (MARR).

Minimum Attractive Rate of Return (MARR)

should be larger than the largest of:
 Cost of borrowed money
 Opportunity cost
5
Present Worth (PW) Method

The present worth (PW) is found by

discounting all cash inflows and outflows to
the present time at an interest rate that is
generally the MARR.
A positive PW for an investment project
means that the project is acceptable (it
satisfies the MARR, and it provides more profit
than minimum amount required by investors).
PW Decision Rule: If PW(i=MARR)0, the
project is economically justified (feasible).
6
Example 5-1
Consider a project that has an initial
investment of $50,000 and that returns
$18,000 per year for the next four years. If
the MARR is 12%, is this a good investment?

7
 Example 5-1
Consider a project that has an initial investment of $50,000 and
that returns $18,000 per year for the next four years. If the
MARR is 12%, is this a good investment?
18,000

0 1 2 3 4
MARR=12%/yr
50,000

PW = -50,000 + 18,000 (P/A, 12%, 4)

PW = -50,000 + 18,000 (3.0373)=$4671.4

PW = $4,671.40 >0 → This is a good investment!
8
Example 5-2
Consider a new piece of equipment that has been
proposed to increase the productivity of a certain
operation. The investment cost is $25,000 and the
equipment will have a market value of $5,000 at the
end of a study period of five years. Increased
productivity will amount to $8,000 per year after
operating costs have been subtracted from the
revenue generated by the additional production. If
the firm’s MARR is 20% per year, is this a good
investment?

9
Example 5-2
Consider a new piece of equipment
that has been proposed to increase the 5,000
productivity of a certain operation. The 8,000
investment cost is $25,000 and the
equipment will have a market value of
$5,000 at the end of a study period of 0 1 2 3 4 5
five years. Increased productivity will
amount to $8,000 per year after MARR=20%/yr
operating costs have been subtracted
from the revenue generated by the 25,000
additional production. If the firm’s
MARR is 20% per year, is this a good
investment?

PW = -25,000 + 8,000 (P/A, 20%, 5)+ 5,000 (P/F,20%,5)

PW = -25,000 + 8,000 (2.9906)+ 5,000 (0.4019)=$934.29

PW (20%)= $934.29 >0 → This is a good investment!

(b) Determine whether the project is still economically justified if the
system has zero market value after 5 years (Sensitivity Analysis) 10
Example 5-2 cont.
(b) Determine whether the project is
still economically justified if the system
has zero market value after 5 years
(Sensitivity Analysis) 8,000

0 1 2 3 4 5
i=MARR=20%/yr
25,000

PW = -25,000 + 8,000 (P/A, 20%, 5)

PW = -25,000 + 8,000 (2.9906)=-$1075.2
PW (20%)= -$1075.2 <0 → This investment is not
economically justified if it has no market value at the
end of the study period.
11
Example 5-2
We can solve this example by finding
FW 5,000
8,000

0 1 2 3 4 5
MARR=20%/yr
25,000

FW = -25,000 (F/P,20%,5) + 8,000 (F/A, 20%, 5)+ 5,000

FW = -25,000 (2.4883) + 8,000 (7.4416)+ 5,000=$2325.3

FW (20%)= $2325.3 >0 → This is a good investment!

12
Example 5-2
We can solve this example by finding
AW 5,000
8,000

0 1 2 3 4 5
MARR=20%/yr
25,000

AW = -25,000 (A/P,20%,5) + 8,000+ 5,000 (A/F, 20%, 5)

AW = -25,000 (0.3344) + 8,000 + 5,000 (0.1344)=$312

AW (20%)= $312 >0 → This is a good investment!

13
Future Worth (FW) Method
 Looking at FW seems appropriate since the
primary objective is to maximize the future
wealth of owners of the firm.
 FW is based on the equivalent worth of all
cash inflows and outflows at the end of the
study period (planning horizon) at an interest
rate that is generally the MARR.
 Decisions made using FW and PW will be the
same. FW = PW(F/P,MARR,n)
 FW Decision Rule: If FW(i=MARR)0, the
project is economically justified (feasible)
14
Example 5-8
A $45,000 investment in a new conveyor
system is projected to improve throughput
and increasing revenue by $14,000 per year
for five years. The conveyor will have an
estimated market value of $4,000 at the end
of five years. Using FW and a MARR of
12%, is this a good investment?

15
Example 5-8
A $45,000 investment in a new conveyor system is projected to
improve throughput and increasing revenue by $14,000 per year
for five years. The conveyor will have an estimated market value
of $4,000 at the end of five years. Using FW and a MARR of
12%, is this a good investment?
4,000
14,000

0 1 2 3 4 5
i=MARR=12%/yr
45,000

FW = -$45,000(F/P,12%,5)+$14,000(F/A,12%,5)+$4,000
FW = -$45,000(1.7623)+$14,000(6.3528)+$4,000
FW = $13,635.70 >0 → This is a good investment! 16
CR = I (A/P,MARR,n) – S(A/F,MARR,n)

AW = R-E-CR
AW also called EUAW: equivalent uniform annual worth
S
EUAC= equivalent uniform annual cost
R
EUAC = E +CR
0 1 2 3 4 n
To be feasible R >=EUAC
E
or I
AW=PW (A/P,MARR,n) i=MARR

0 1 2 3 4 n

E
Capital recovery
i=MARR 17
Annual Worth (AW: EUAW*) Method
 Annual worth is an equal periodic (annual) series of dollar
amounts that is equivalent to the cash inflows and outflows,
at an interest rate that is generally the MARR, for a stated
study period.
 Equivalent uniform annual worth (EUAW)=(EUAB-EUAC)
◦ Equivalent uniform annual cost (EUAC) =E+CR
◦ Equivalent uniform annual benefit (EUAB) = R
 The AW of a project is annual equivalent revenues (R) or
savings minus annual equivalent expenses, (E) less its annual
capital recovery (CR) amount.

18
Capital recovery reflects the capital cost of
the asset.

 CR is the equivalent uniform annual cost of the

capital invested.

 The CR distributes the initial cost (I) and the

salvage (market) value (S) at the end of the
study period over the life of the asset.

19
Annual Worth (AW: EUAW*) Method

 The AW of a project is equivalent to its PW and

FW.
 Decisions made using AW, FW and PW will be the
same.
 AW Decision Rule: If AW(i=MARR)0, the project
is economically justified.

 An AW or PW or FW of zero means that an

annual return exactly equal to the MARR has been
earned.

20
 Example 5-9
Annual Cash Flow Calculations: capital recovery
A student bought $1000 worth of furniture. What is the
equivalent annual cost if it is expected to last 10 years and
can be sold for $200? If his MARR = 7%/year.

S=200
0  0 1 2 3 4 5 6 7 8 9 10
10
A A A A A A A A A A
P=1000

EUAC = E + CR = 0 +CR
=1000(A/P,7%,10) −200(A/F,7%,10)
= $127.92/year

21
Example 5-10
A project requires an initial investment of $45,000,
has a salvage value of $12,000 after six years,
incurs annual expenses of $6,000, and provides an
annual revenue of $18,000. Using a MARR of 10%,
determine the CR and AW of this project.

22
Example 5-10
A project requires an initial investment of $45,000, has a salvage
value of $12,000 after six years, incurs annual expenses of $6,000,
12,000
and provides an annual revenue of $18,000. Using a MARR of
10%, determine CR and AW of this project.
18,000

0 1 2 3 4 5 6
45,000 6,000
i=MARR=10%/yr

Since the AW is positive, it’s a good investment.

23
Example 5-11
A corporate jet costs $1,350,000 and will incur
$200,000 per year in fixed costs (maintenance,
licenses, insurance, and hangar rental) and $277
per hour in variable costs (fuel, pilot expenses, etc.).
The jet will be operated for 1,200 hours per year for
five years and then sold for $650,000. if it provides
an annual revenue of $900,000. Using a MARR of
15%, determine the CR, EUAC and EUAW of this
project. Is this a good investment?

FC = 200,000/year
cv=277/hour---------X=1200hr /year
CV = 277x1200

E = 277x1200 + 200,000 24
 $650,000
Example 5-11 R=$900,000

0 1 2 3 4 5
$1,350,000 E
i=MARR=15%/yr

The total annual expense for the jet is the sum of the fixed costs and the
variable costs;
E = $200,000 +(1,200 hours)($277/hour)=$532,400
R = $900,000

CR = $1,350,000(A/P,15%,5)-$650,000(A/F,15%,5) = $306,310

EUAC = CR + E
EUAC = 306,310 +$532,400 = $838,710

EUAW = R – EUAC
EUAW= $900,000-$838,710 = $61,290 >0
25
Since the EUAW is positive, it’s a good investment.
Example 5-12
A project for installing a new heating system requires
an initial investment of $110,000 and has a salvage
value of $8,000 after six years, what is the minimum
annual electrical power savings required to make
this project economically acceptable? The MARR
=15% per year. electricity costs $0.1 per kWhr
power.

PW = 0 or AW=0 or FW =0

AW=R-E-CR=0---------------here E=0
R=CR
26
Example 5-12
A project for installing a new heating system requires an initial
investment of $110,000 and has a salvage value of $8,000 after
8,000
six years, what is the minimum annual electrical power savings
required to make this project economically acceptable? The
MARR =15% per year. electricity costs $0.1 per kWhr power
R?
0 1 2 3 4 5 6
110,000 i=MARR=15%/yr

To make this project acceptable, the annual power savings

must be at least as large as the annual capital recovery (CR).
AW = R – E-CR
R=110,000(A/P,15%,6)-8000(A/F,15%,6)
R = $28,148.40; minimum annual dollar savings needed to
justify the system.
If electricity costs $0.1 per kWhr power, then the system can
save 281,480 kWhr per year. 27
Example 5-13
Determine the monthly lease payment for a car that
has an agreed-upon sales price of $34,995; an APR
of 9%, compounded monthly; and an estimated
residual value of $20,000 at the end of a 36-month
lease. An up-front payment of $3,000 is due when
the lease agreement (contract) is signed.

“Note, the residual value is what the dealership expects the

car’s value will be when the vehicle is returned at the end of the
lease period.
The monthly cost of the lease is the capital recovery amount
determined by using its negotiated sales price, residual value,
and interest rate.”
“if the customer returns the car with an actual residual value of
less than the agreed upon, he will have to pay the difference in
cash when the car is returned.”
28
Example 5-13
20,000
3,000
4 36
0 1 2 3
34,995 APR=9% compounded monthly

𝑟 9%
𝑖𝑚𝑜 = = = 0.75%/month
12 12

AW = R-E-CR = zero
E= 0
R=CR= monthly lease

𝐶𝑅(0.75%) = $31,995(𝐴/𝑃, 0.75%, 36) − $20,000(𝐴/𝐹, 0.75%, 36)

= $531.44 /month

29
 Internal Rate of Return (IRR)
 Rate of return analysis is the most frequently
used exact analysis technique in industry.
 It is also called the investor’s method, the
discounted cash flow method, and the profitability
index.
 Major advantages
▪ Rate of return is a single figure of merit that is readily
understood.
▪ Calculation of rate of return is independent from the
minimum attractive rate of return (MARR).
• IRR Decision Rule: If IRR  MARR, the project is
economically justified (feasible).

30
 Internal Rate of Return (IRR)
 The IRR is the interest rate that equates the equivalent
worth of an alternative’s cash inflows (revenues, savings,
Salvage) to the equivalent worth of cash outflows
(expenses, including investment costs).
◦ The interest rate, i%, at which the equivalent benefits
(Revenues, savings, R, S) are equal to the equivalent costs
(expenditures including investment costs, E)

◦ The interest rate at which the present worth, future worth,

and equivalent uniform annual worth are equal to 0.
 The IRR is sometimes referred to as the breakeven interest
rate.
31
 Plot of NPW versus Interest Rate
Investment Cases
For an alternative with a single investment cost at the
present time followed by a series of positive cash
inflows over n, a graph of PW versus interest rate
typically has the general convex form shown below.
The point at which PW=0 defines i%, which is the
project’s IRR
A A A A A
P =-I +sigma(Aj/(1+i)^j)
Year Cash Flow 0 1 2 3 n-1 n
0 -I
I
+
1 +A
2 +A
3 +A
PW

0 i
4 +A
: : −
n +A IRR
Difficulties in Solving for an Interest Rate
 There will be a negative rate of return whenever
loan repayments are less than the loan or an
investment fails to return benefits at least equal to
the investment
 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.
❖ Check these conditions to assure a positive IRR

42
Difficulties in Solving for an Interest Rate

 The method of solving for the i% that equates

revenues and expenses is computationally difficult, it
normally involves trial-and-error calculations until the
i% is converged upon or can be interpolated, or
solving numerically using mathematical software.
 A good starting point is the MARR, if PW(MARR)>0,
we know that i% >MARR

 The use of spreadsheet software can greatly assist in

solving for the IRR. Excel uses the IRR(range, guess)
or RATE(nper, pmt, pv,fv) functions.

34
Difficulties in Solving for an Interest Rate
 In cash flows with more than one sign change; we find that
solving the cash flow equation can result in more than one
positive interest rate none of which is a suitable measure
of the project’s economic desirability. Another method of
evaluation (e.g., PW) should be utilized.
o Multiple solutions (roots) can occur; they can be identified by
graphing the NPW versus the interest rate
o Modified Internal Rate of Return (MIRR) is a methodology used
to solve problems with multiple-roots
$10.00
60
$8.00
$6.00
19 20
10 $4.00
PW

$2.00
0 1 2 3 4 5 $0.00
($2.00) 0% 10% 20% 30% 40% 50%

50 ($4.00)
50
i 35
Internal Rate of Return Calculation - one
alternative: Example 5-14
An engineer invests $5000 at the end of every year for 40 year
career. If the engineer wants $1 million in savings at retirement,
what interest must the investment earn (IRR)?

A=5000/year
F = 1000,000
N=40
i? IRR
F=A(F/A,IRR,n)
1000000=5000 (F/A,IRR,40)
200 = (F/A,IRR,40)
 Example 5-14
Internal Rate of Return Calculation

F=1M

0 1 2 3 40

A=5000
𝐹𝑊 = 0 = −$5000(F/A, i%,40) + $1,000,000

(F/A, i%,40) = $1,000,000/$5000 = 200

From the compound interest tables (may need
interpolation)
(F/A, 7%, 40) = 199.636
thus the required rate of return for the investment is 7%.
 Internal Rate of Return Calculation - one
alternative: Example 5-15

An investment results in the following cash

flows. Compute the internal rate of return.

Year Cash Flow

0 -$700
1 +100
2 +175
3 +250
4 +325
Example 5-15
Internal Rate of Return Calculation
Year Cash Flow 325
250
0 -$700 175
100
1 +100
2 +175 0 1 2 3 4
3 +250
700
4 +325

𝐴𝑊 = 0 trial and error

100 + 75(A/G, i%, 4)−700(A/P, i%, 4) = 0

Try i = 5% 100 + 75 A/G, 5%, 4 −700 A/P, 5%, 4 =

100 + 75*1.4391 – 700 * 0.2820 = +11 +
Try i = 8% 100 + 75(A/G, 8%, 4)−700(A/P, 8%, 4) = −6
Try i = 7% 100 + 75(A/G, 7%, 4)−700(A/P, 7%, 4) = 0 0 i
−

The IRR is 7%
 Internal Rate of Return Calculation - one
alternative: Example 5-16
Maria borrowed a student loan of $9000 each year
at the start of each year for 4 years. No interest is
charged until graduation, then the interest rate is
5%.
If Maria makes 5 equal annual payments to repay the
loan starting one year after graduation, what is each
payment?
What is the internal rate of return for Maria’s loan
(from the day she started borrowing till the day she
paid it all back)?
 Example 5-16
Internal Rate of Return Calculation
36000

-4 -3 -2 -1 0 1 2 3 4 5
A A A A A
Loan Payment = A = (9000)(4)(A/P, 5%, 5) = $8316
9000 9000 9000 9000

0 1 2 3 4 5 6 7 8 9
8316 8316 8316 8316 8316

NPWi = 0 = 9000 + 9000( P A, i %, 3) − 8316(P/A, i%, 5)(P/F, i%, 4)

Example 5-16
Internal Rate of Return Calculation
NPWi = 0 = 9000 + 9000( P A, i %, 3) − 8316(P/A, i%, 5)(P/F, i%, 4)
If i=10%
PW(10%)=9000 + 9000 (2.4869) – 8316 (3.7908)(0.6830)
=9000 + 22382.1 - 21531.1 = 9,851

i=12%
PW(12%)= 9000 + 9000 (2.4018) – 8316 (3.6048)(0.6355)
= 9000 + 21616.2 - 19050.7 = 11,565.5 wrong direction

i=4% PW (4%)= 9000 +9000 (2.7751) -8316 (4.4518)(0.8548)

= 9000 + 24975.9 - 31645.7 = 2330.2

i=3%
PW(3%) = 9000 + 9000 (2.8286) – 8316 (4.5797)(0.8885)
= 9000 +25457.4 - 33838.3 = 619

i=2%
PW (2%) = 9000 + 9000 * 2.8839 – 8316 * 4.7135
= -1255.5

By interpolation IRR = 2.66%

 Internal Rate of Return Calculation - one
alternative: Example 5-18
Albert borrowed $7,000 from a large bank on the condition
that he would repay 7% of the loan every three months,
until a total of 50 payments had been made. At the time of
the 50th payment, the $7,000 loan would be completely
repaid. Albert computed his annual interest rate to be:
[0.07($7,000)x4]/$7,000 = 0.28 (28%) (4 quarters/year)
What true effective annual interest rate did he pay?

P = 7000
N=50 quarter
A= 0.07*7000 = 490/quarter
P = A (P/A,i?,50) or A=P (A/P,i?,50)
i/quarter ----IRR
 Example 5-18
Internal Rate of Return Calculation
What true effective annual interest rate did he pay?

490 = 7000( A P, i %, 50) 0.07x7000 = 490

0.07 = ( A P, i %, 50) 0 1 2 3 4 49 50

i% (A/P, i%,50) 7000

6% 0.0634
i’% 0.07
7% 0.0725

By interpolation, i % = 6.73% per quarter

effective annual interest rate=[(1 +0.0673)4 -1] 100% =30% per
year.
 Bond value
Bond: an interest bearing certificate; is an instrument of
obligation of the bond issuer to the holders. The
indebted entity (issuer) issues a bond that states the
bond rate (coupon) that will be paid and when the
loaned funds (bond principal) are to be returned
(maturity date) C
1000
rZ
50
0 1 2 n
0 1 2 n
Vn i%/ interest period
1000 i%/ interest period

Vn=C (P/F, i%, n) + rZ (P/A, i%, n)

The commercial value of a bond is the PW of all future net cash
flows expected to be received--the period dividends [face, or par,
value (Z) times the bond rate (r)], and the redemption or disposal
price (C), all discounted to the present at the bond’s yield rate, i%. 45
 Bond value
Z= par value or face value ‫ = قيمه اسميه‬1000
r= bond rate = 5%/period
N= life of the bond
C= redemption or disposal price or value
Vn = bond value, real price of the bond
i= bond yield, it is the IRR of the investment
C

900 rxZ

50 0 1 2 n
0 1 2 n Vn i%/ interest period

800 i%/ interest period

Vn=C (P/F, i%, n) + rZ (P/A, i%, n)

46
 Bond special case - important
If Vn=Z=C
i=r
C
Example Z=C=Vn = 1000
r=5% rxZ
1000 x.05 =50 0 1 2 n
Here i=r=5% Vn i%/ interest period

1000

50
0 1 2 n
1000 i%/ interest period

Vn=C (P/F, i%, n) + rZ (P/A, i%, n)

47
 Example 5-3
What is the value of a 6%, compounded
semiannually, 10-year bond with a par (and
redemption) value of $20,000 that pays
dividends semi-annually, if the purchaser
wishes to earn an 8%, compounded
semiannually return?

Vn?
r= 3%/half year
N=20 half years
Z=C=20000
i=4%/half year

48
 Example 5-3

Vn=C (P/F, i%, n) + rZ (P/A, i%, n)

20,000

0.03x20,000
0 1 2 20
Vn

Vn = $20,000 (P/F, 4%, 20) + (0.03)$20,000 (P/A, 4%, 20)

Vn = $20,000 (0.4564) + (0.03)$20,000 (13.5903)

Vn = $17,282.18
49
Example 5-4
Stan has the opportunity to purchase a certain Treasury bond
that matures in 8 years and has a face value of $10,000. The
bond stipulates a fixed nominal interest rate of 8% per year, but
interest payments are made to the bondholder every three
months.
Stan would like to earn 10% nominal interest (compounded
quarterly) per year on his investment, because interest rates in
the economy have risen since the bond was issued. How much
should Stan be willing to pay for the bond?
N=8years x4 = 32 quarter
Z=10000
r=8%, compounded quarterly r=2%/Quarter
i=10/4=2.5%/quarter
Vn?
50
 Example 5-4

10,000
rb=8%
0.02x10,000
0 1 2 8x4=32
quarter
Vn
i=10% compounded
Vn=C (P/F, i%, n) + rZ (P/A, i%, n) quarterly

Vn = $10,000 (P/F, 2.5%, 32) + (0.02)$10,000 (P/A, 2.5%, 32)

Vn = $4,537.71+ 4,369.84

Vn = $8,907.55
51
 Example 5-4

10,000
rb=8%
0.02x10,000
0 1 2 8x4=32
quarter
Vn
i=10% compounded
Vn=C (P/F, i%, n) + rZ (P/A, i%, n) quarterly

Vn = $8,907.55

If he pays 8,907 he will get a yield of 2.5%/quarter

If he pays 10,000 ----- the yield will be 2%/Quarter

52
 Example 5-5
A bond with a face value of $5,000 pays interest of
8% per year. This bond will be redeemed at par value
at the end of its 20-year life, and the first interest
payment is due one year from now.
(a) How much should be paid for this bond in order
to receive a yield of 10% per year on the
investment?
(b) If this bond is purchased now for $4,600, what
annual yield would the buyer receive?

Z=5000=C
N=20 r=8%/year i =10% 53
 Example 5-5

5,000
rb=8%
0.08x5,000
0 1 2 20
Vn
i=10%

(a) Vn = $5,000 (P/F, 10%, 20) + (0.08)$5,000 (P/A, 10%, 20)

Vn = $4,148.44

54
 Example 5-5 If this bond is purchased now for $4,600,
what annual yield would the buyer receive?

4600= $5,000 (P/F, i%, 20) + (0.08)$5,000 (P/A, i%, 20)

I Vn
10% $4,148.44
i? 4600
8% (i=r) Vn=Z=C= 5000

By interpolation
i%=8.9% per year

55
 Internal Rate of Return Calculation - one
alternative: Example 5-17
A new corporate bond was initially sold to an investor
for $1000. The issuing corporation promised to pay
the bondholder $40 interest every 6 months, and to
repay the $1000 face value at the end of 10 years.
After 1 year, the bond was sold by the original buyer
for $950.
a) What rate of return did the original buyer receive on
this investment?
b) What rate of return can the new buyer expect if
he/she keeps the bond for its remaining 9-year life?
c) If the issuing corporation paid a 1% fee to sell the
bond, what is the effective interest rate that the firm
is paying on the bond?
 Example 5-17
Internal Rate of Return Calculation
(a) What rate of return did the original buyer receive on this
investment?

PW of costs = PW of benefits
950
1000 = 40( P A, i %, 2) + 950(P/F, i%, 2) 40
40
Try i = 1.5% PW of benefits = 1000.41 0 1 2
i is interest rate per period which is 6 months.
1000
i=1.5%/half year
= 3%, compounded semiannual
 Example 5-17
Internal Rate of Return Calculation
(b) What rate of return can the new buyer expect if he/she
keeps the bond for its remaining 9-year life?
1000
40
0 1 2 3 4 17 18
PW of costs = PW of benefits
950

950 = 40( P A, i %, 18) + 1000(P/F, i%, 18)

Try i = 4% 𝑃W of benefits = 999.96

Try i = 5% 𝑃W of benefits = 883.10

By interpolation IRR = 4.43%

IRR = 4.43% / half year = 8.86%, compounded semiannual
 Example 5-17
Internal Rate of Return Calculation
c) If the issuing corporation paid a 1% fee to sell the bond,
what is the effective interest rate that the firm is paying on
the bond?

990

0 1 2 19 20
40
NPW = PW of benefits - PW of costs = 0 1000

NPWi = 990 − 40( P A, i %, 20) − 1000(P/F, i%, 20)

Try i = 4.0% NPW4.0% = −10
Try i = 4.5% NPW4.5% = 55.08
By interpolation IRR = 4.077%
Effective interest rate = (1 + 0.04077) 2 − 1 = 8.32%
 Capitalized Worth
The Capitalized worth (CW)* of a series of end-of-
period uniform payments A, with interest at i% per
period, is A(P/A, i%, n). As n becomes very large the
(P/A) term approaches 1/i.
A
0 1 2 ∞
CW i%

 (1 + i) n − 1  1
( P / A, i %, ) = lim n →  n 
=
 i (1 + i )  i
𝐴
C𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑊𝑜𝑟𝑡ℎ P= ,
𝑖
A= iP
*if only expenses are considered it is referred to as Capitalized cost 60
 Example 5-6
A firm wishes to donate an advanced laboratory at a
university. The donation principal will earn interest
that averages 8% per year, which will be sufficient to
cover all expenditures incurred and maintenance of
the laboratory for an indefinitely long period of time.
Cash requirements are estimated to be $100,000
now (to establish it), $30,000 per year indefinitely,
and $20,000 at the end of every fourth year (forever)
for equipment replacement.
What amount of principal is required to establish the
laboratory and then earn enough interest to support
the remaining cash requirements of this laboratory
forever?
61
Example 5-6 (Solution #1)
0 1 2 3 4 5 6 7 8 ∞

30,000
20,000 20,000
i=8%
100,000

We have 2 uniform series, $30,000 occurring each year

and $20,000 at the end of every fourth year
𝐴𝑦𝑒𝑎𝑟 = 20,000(𝐴/𝐹, 8%, 4)

𝐴
30,000 20,000 (𝐹 , 8%, 4)
𝐶𝐶(8%) = 100,000 + + = $530,475
0.08 0.08

62
 Example 5-6 (solution #2)
0 1 2 3 4 5 6 7 8 ∞

30,000
20,000 20,000
100,000 i=8%
Find an equivalent uniform series:
0 1 2 3 4 5 6 7 8 ∞
CC
A i=8%

A (8%) = 100,000( A / P,8%, ) + 30,000 + 20,000( A / F ,8%,4)

𝐴∞ 8% = 100,000𝑖 + 30,000 + 4,438 = $42,438,
42,438
CC (8%) = = $530,475
0.08 63
Example 5-7 Capitalized Cost

 A city plans a pipeline to transport water

from a distant watershed area to the city.
The pipeline will cost $8 million and will
have an expected life of 70 years. The city
expects to keep the water line in service
indefinitely. Compute the capitalized cost,
assuming 7% interest rate.
 Example 5-7 Capitalized Cost (soln 1)

0  0 70 140 ∞

$8 million $8 million $8 million $8 million

P

n=70
0 70 =

A
$8 million

A = 8 million (A F, 7%, 70) = $4960

A 4960
Capitalized Cost P = 8 million + = = $8,071,000
i 0.07
 Example 5-7 Capitalized Cost
(Alternate Solution I1)
0 70 140 ∞

$8 million $8 million $8 million $8 million

n=70
0 70 =
A
$8 million

A = 8 million (A P, 7%, 70) = $565,000

A 565000
Capitalized Cost P= = = $8,071,000
i 0.07
The Payback Period Method
 The simple payback period is the number of years
required for cash inflows to just equal cash outflows
(breakeven point).
 It is a measure of liquidity rather than a measure of
profitability.
 It is a measure of the speed with which an
investment is recovered by the cash inflows it
produces; speed to reaching breakeven point, not
overall profitability.
 A low-valued payback period is desirable
 In its most common form, this measure (simple
payback period) ignores the time value of money
principles. The discounted payback period take
time value of money into consideration.

67
The Payback Period Method
The simple payback period is the smallest value of N
(N ≤ n) for which the relationship below is satisfied.
N
 ( Rt − Et ) − I  0
t =1

For the discounted payback period, future cash flows

are discounted back to the present, so that the
discounted payback period is the smallest value of N′
(N′≤ n) that satisfies the relationship:
N'
 ( Rt − Et )(P F , i%,t ) − I  0
t =1
where I is the capital investment usually made at the
present time, i% is the MARR.
68
Problems with the payback period method.

 It doesn’t reflect any cash flows occurring after

N, or N'.
 It doesn’t indicate anything about project
desirability except the speed with which the
initial investment is recovered.
 It can produce misleading results. May not be
consistent with equivalent worth and rate of
return methods (exact methods)
 It should never be used as a method equivalent
to PW, EUAW, or rate of return to select
between alternatives, but merely as supplemental
information about an alternative
69
Simple Payback Period Analysis

 To conduct a simple payback period analysis without

considering the time value of money (i.e., assuming i
= 0%):
1. Start with initial cost
2. Add the cash flow in each subsequent year until balance
reaches zero or a positive amount 𝑁

0 = −𝐼 + ෍ 𝐶𝐹1
𝑡=1

3. If necessary, interpolate to find the “exact” length of the

payback period. (Assumes cash flows are distributed
evenly throughout the year)
Simple Payback Period Analysis

 If there is only an initial cost and uniform

annual benefits (R )for i = 0%:
1. Start with initial cost
2. Divide by uniform annual benefits R

𝐼
𝑁=
𝑅
 Discounted Payback Period Analysis
A More Realistic Method
 Payback analysis may be performed using a required
return on investment or MARR (i%).
 To find the payback period N at a stated rate of
return, determine the N value in years using:
𝑁

0 = −𝐼 + ෍ 𝐶𝐹𝑡 (𝑃/𝐹, 𝑖%, 𝑡)

𝑡=1

where CFt is the net cash flow at the end of year t.

If the cash flows are the same each year (A1 = A2 =

A), the P/A factor may be used:
0=-I+A(P/A, i%, N)
 Discounted Payback Period Analysis
A More Realistic Method

 If necessary, interpolate to find N

 After N years (not necessarily an integer), the cash

flows will recover the investment and yield a
return of the MARR.
 If the expected retention period (n) is known to be
less than N (PBP) years, there is not enough time
to recover the investment and the required return
(the project is not feasible).
 Discounted Payback Period Analysis
A More Realistic Method
 As long as there is a net annual benefit in each of the
subsequent years, if the asset or project is active for more
than N years, a larger return will result.

 This method is much more useful that simple payback

period analysis (i = 0%) for making decisions about
investment.

 However, any cash flows occurring after N years are

ignored in the payback period computation.

 Thus, this method can still result in a less than optimal

investment decision.
Example 5-21: finding the
simple and discounted 8,000 5,000
payback period for Ex. 5-2.
0 1 2 3 4 5
i=MARR=20%/yr
25,000

Cumulative PW Cumulative
EOYk Net Cash Flow at i=0%/yr PW for CF at i=20% PW at i=20%/yr
through year k through year k

0 -$25,000 -$25,000 -$25,000 -$25,000

1 $8,000 -$17,000 8000/1.2=6,667 -$18,333

2 $8,000 -$9,000 8000/1.2^2=5,556 -$12,777

3 $8,000 -$1,000 8000/1.2^3= 4,630 -$8,147

4 $8,000 +$7,000 8000/1.2^4 = 3,858 -$4,289

5 $13,000 13000/1.2^5 = 5,225 +$934

75
Example 5-21: finding the
simple and discounted payback
period for Ex. 5-2.
$10,000

$5,000

$0
0 1 2 3 4 5

($5,000)

($10,000)

($15,000)

($20,000)
Cumulative PW at i=0%/yr through
year k
Cumulative PW at i=20%/yr
($25,000)
through year k

($30,000)
 Example 5-22
 A semiautomatic machine purchased for
$18,000 is to be used for up to 10 years.
The machine is expected to generate annual
revenues of $3000.
 Compute the payback period at 0% (simple
PBP) and 15% (discounted PBP).
 Example 5-22
 If the unrealistic assumption were made that
the company owner required no return on
investments (i.e., that i = 0), the following
NPW equation would result:

0 = -18,000 + N(3000)

 The payback period, N, is 6 years – that is,

assuming i = 0%, in 6 years we make $18,000
in annual benefits, which equals the $18,000
initial cost
 Example 5-22
 The cash flow each year is $3000. The NPW
equation is:
0=-I+A(P/A,15%,N)
=-18,000+3000(P/A,15%,N)

The resulting payback period is N = 16.5 years.

Using the planning horizon (analysis period, project

life) of 10 years, the machine will not return the
required 15% per year. It will never breakeven
during its life.
 Payback period Calculation
Year Cash Flow 325
250
0 -$700 100
175
1 +100
2 +175 0 1 2 3 4
3 +250
700
4 +325

Simple PBP between 3 and 4

Year Cash Discounted CF at Cumulative DCF
MARR 5%
0 -700 -700 -700
1 100 100/1.05 = 95.2 -604.8
2 175 175/1.05^2 = 158.7 -446.1
3 250 250/ 1.05^3 = 216 -230.1
4 325 325 / 1.05^4 = 267.4 37.3

Discounted PBP also between 3 and 4

 Payback period Calculations if MARR = 10%
Year Cash Flow 325
250
0 -$700 100
175
1 +100
2 +175 0 1 2 3 4
3 +250
700
4 +325

Year Cash Discounted CF at Cumulative DCF

MARR 10%
0 -700 -700 -700
1 100 100/1.1 = 90.9 -609.1
2 175 175/1.1^2 = 144.6 -464.5
3 250 250/ 1.1^3 = 188 -276.5
4 325 325 / 1.1^4 = 222 -54.5

You will never find a Discounted PBP. And the project is not feasible