Engineering Economics - Comparison
Methods Detailed Explanation
1. Present Worth Method of Comparison
Definition: The Present Worth (PW) method evaluates and compares different investment
alternatives by converting all cash flows (inflows and outflows) to their equivalent value at the
present time using a specific interest rate (discount rate).
Concept: Money has time value — ₹1 today is worth more than ₹1 in the future. The option that
gives the highest PW is selected in revenue-based projects, and lowest PW in cost-based
projects.
Formula (Uniform Series):
PW = -P + A × [(1 + i)^n - 1] / [i(1 + i)^n]
Formula (Uneven Cash Flows):
PW = Σ[CF_t / (1 + i)^t]
Example: Two machines:
Machine A: Initial Cost = ₹50,000, Annual Return = ₹15,000, Life = 5 yrs
Machine B: Initial Cost = ₹60,000, Annual Return = ₹18,000, Life = 5 yrs
Interest rate = 10%
PW Factor for 5 years = 3.7908
PW of A = ₹15,000 × 3.7908 – ₹50,000 = ₹6,862
PW of B = ₹18,000 × 3.7908 – ₹60,000 = ₹8,234
Conclusion: Machine B has a higher PW. Hence, it is preferred.
2. Future Worth Method of Comparison
Definition: The Future Worth (FW) method compares alternatives by converting all cash flows to
their value at the end of the project life using compound interest.
Concept: FW finds what today’s investments and returns will be worth in the future.
Formula:
FW = -P(1 + i)^n + A × [(1 + i)^n - 1] / i
Example: Using the same data as above.
Future Worth factor (F/A) = 6.1051
Compound factor = (1.10)^5 = 1.6105
FW of A = ₹15,000 × 6.1051 – ₹50,000 × 1.6105 = ₹11,052
FW of B = ₹18,000 × 6.1051 – ₹60,000 × 1.6105 = ₹13,262
Conclusion: Machine B has a higher FW. Hence, it is preferred.
3. Annual Equivalent Method of Comparison
Definition: The Annual Equivalent Worth (AEW) method converts all cash flows into equal yearly
amounts over the life of the investment.
Concept: Useful when alternatives have different lives or when comparing annual performance.
Formula:
AEW = PW × [i(1+i)^n] / [(1+i)^n - 1]
Example: PW of A = ₹6,862, PW of B = ₹8,234
CRF = 0.2638
AEW of A = ₹6,862 × 0.2638 = ₹1,811.48
AEW of B = ₹8,234 × 0.2638 = ₹2,172.47
Conclusion: Machine B has a higher AEW. Hence, it is preferred.
4. Rate of Return Method of Comparison
Definition: The Rate of Return (RoR) method, also known as Internal Rate of Return (IRR), finds
the interest rate at which the net present value (NPV) of cash flows becomes zero.
Concept: It answers, “What return (%) am I getting from this investment?” Compare it with the
Minimum Attractive Rate of Return (MARR).
Formula:
0 = -P + A × [(1 + i)^n - 1] / [i(1 + i)^n]
Interpolation:
IRR = i1 + [NPV1 / (NPV1 - NPV2)] × (i2 - i1)
Example: Machine A: P = ₹50,000, A = ₹15,000, n = 5
Try i = 15%: NPV ≈ ₹283
Try i = 16%: NPV ≈ –₹886
IRR ≈ 15.24%
Since 15.24% > 10% MARR, the project is acceptable.
Conclusion: Select the project with the highest IRR above MARR.
Summary Table
Method | Converts To | Best When | Choose Based On
-------|-------------|-----------|----------------
Present Worth | Present-day value | Evaluate today's worth | Highest PW or lowest cost
Future Worth | Value at project end | Estimate total future value | Highest FW
Annual Equivalent | Equal yearly value | Compare yearly performance | Highest AEW
Rate of Return | Interest % earned | Know return rate | Highest IRR > MARR
