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Sullivan • Wicks
United States version.

Koelling
Engineering Economy
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Engineering
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Economy
ISBN-13: 978-0-273-75153-3
Fifteenth Edition
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Sullivan • Wicks • Koelling

9 780273 751533
 The final test of any system is, does it pay?
—Frederick W. Taylor (1912)

5.1 Introduction
All engineering economy studies of capital projects should consider the return
that a given project will or should produce. A basic question this book addresses
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 Chapter 4 emerge
as essential ingredients in answering this question, and they are applied to many
different types of problems in this chapter.
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).∗
Later, in Chapter 6, multiple alternatives are evaluated. The five methods described
in Chapter 5 are Present Worth (PW), Future Worth (FW), Annual Worth (AW),
Internal Rate of Return (IRR), and External Rate of Return (ERR). The first three
methods convert cash flows resulting from a proposed problem solution into their
equivalent worth at some point (or points) in time by using an interest rate known
as the Minimum Attractive Rate of Return (MARR). The concept of a MARR, as well
as the determination of its value, is discussed in the next section. The IRR and ERR
methods compute annual rates of profit, or returns, resulting from an investment
and are then compared to the MARR.
The payback period is also discussed briefly in this chapter. The payback
period is a measure of the speed with which an investment is recovered by the
cash inflows it produces. This measure, in its most common form, ignores time
value of money principles. For this reason, the payback method is often used to
supplement information produced by the five primary methods featured in this
chapter.

Unless otherwise specified, the end-of-period cash-flow convention and discrete

compounding of interest are used throughout this and subsequent chapters.
A planning horizon, or study (analysis) period, of N compounding periods
(usually years) is used to evaluate prospective investments throughout the
remainder of the book.

∗ The analysis of engineering projects using the benefit–cost ratio method is discussed in Chapter 10.

201
202 CHAPTER 5 / EVALUATING A SINGLE PROJECT

5.2 Determining the Minimum Attractive Rate

of Return (MARR)
The Minimum Attractive Rate of Return (MARR) is usually a policy issue resolved
by the top management of an organization in view of numerous considerations.
Among these considerations are the following:

1. The amount of money available for investment, and the source and cost of these
funds (i.e., equity funds or borrowed funds)
2. The number of good projects available for investment and their purpose (i.e.,
whether they sustain present operations and are essential, or whether they
expand on present operations and are elective)
3. The amount of perceived risk associated with investment opportunities
available to the firm and the estimated cost of administering projects over short
planning horizons versus long planning horizons
4. The type of organization involved (i.e., government, public utility, or private
industry)

In theory, the MARR, which is sometimes called the hurdle rate, should be chosen
to maximize the economic well-being of an organization, subject to the types of
considerations just listed. How an individual firm accomplishes this in practice
is far from clear-cut and is frequently the subject of discussion. One popular
approach to establishing a MARR involves the opportunity cost viewpoint described
in Chapter 2, and it results from the phenomenon of capital rationing. This situation
may arise when the amount of available capital is insufficient to sponsor all worthy
investment opportunities. The subject of capital rationing is covered in Chapter 13.
A simple example of capital rationing is given in Figure 5-1, where the
cumulative investment requirements of seven acceptable projects are plotted
against the prospective annual rate of profit of each. Figure 5-1 shows a limit of
$600 million on available capital. In view of this limitation, the last funded project
would be E, with a prospective rate of profit of 19% per year, and the best rejected
project is F. In this case, the MARR by the opportunity cost principle would be 16%
per year. By not being able to invest in project F, the firm would presumably be
forfeiting the chance to realize a 16% annual return. As the amount of investment
capital and opportunities available change over time, the firm’s MARR will also
change.∗
Superimposed on Figure 5-1 is the approximate cost of obtaining the
$600 million, illustrating that project E is acceptable only as long as its annual
rate of profit exceeds the cost of raising the last $100 million. As shown in Figure
5-1, the cost of capital will tend to increase gradually as larger sums of money are
acquired through increased borrowing (debt) or new issuances of common stock
(equity). Determining the MARR is discussed further in Chapter 13.

∗ As we shall see in Chapter 11, the selection of a project may be relatively insensitive to the choice of a value for the
MARR. Revenue estimates, for example, are much more important to the selection of the most profitable investment.
 SECTION 5.3 / THE PRESENT WORTH METHOD 203

Independent Projects (Demand)—Any Subset (or All)

35 Can Be Selected
35
A
30
30
B

Annual Rate of Profit (%)

26
25 MARR ⫽ 16%/year
C 23
D Approximate Cost
20 19
of Capital Obtained
E 16 (Supply)
15 14
F
G Reject F
10 Reject G

100 200 300 400 500 600 700 800

Cumulative Investment Amount (Millions of Dollars)

Figure 5-1 Determination of the MARR Based on the Opportunity Cost Viewpoint
(A popular measure of annual rate of profit is “Internal Rate of Return,” discussed
later in this chapter.)

5.3 The Present Worth Method

The PW method is based on the concept of equivalent worth of all cash flows
relative to some base or beginning point in time called the present. That is, all cash
inflows and outflows are discounted to the present point in time at an interest rate
that is generally the MARR. A positive PW for an investment project is a dollar
amount of profit over the minimum amount required by investors. It is assumed
that cash generated by the alternative is available for other uses that earn interest
at a rate equal to the MARR.
To find the PW as a function of i% (per interest period) of a series of cash inflows
and outflows, it is necessary to discount future amounts to the present by using the
interest rate over the appropriate study period (years, for example) in the following
manner:
PW(i%) = F0 (1 + i)0 + F1 (1 + i)−1 + F2 (1 + i)−2
+ · · · + Fk (1 + i)−k + · · · + FN (1 + i)−N

N
= Fk (1 + i)−k . (5-1)
k=0

Here, i = effective interest rate, or MARR, per compounding period;

k = index for each compounding period (0 ≤ k ≤ N);
Fk = future cash flow at the end of period k;
N = number of compounding periods in the planning horizon (i.e., study
period).
204 CHAPTER 5 / EVALUATING A SINGLE PROJECT

The relationship given in Equation (5-1) is based on the assumption of a constant

interest rate throughout the life of a particular project. If the interest rate is assumed
to change, the PW must be computed in two or more steps, as was illustrated in
Chapter 4.
To apply the PW method of determining a project’s economic worthiness, we
simply compute the present equivalent of all cash flows using the MARR as the
interest rate. If the present worth is greater than or equal to zero, the project is
acceptable.

PW Decision Rule: If PW (i = MARR) ≥ 0, the project is economically justified.

It is important to observe that the higher the interest rate and the farther into
the future a cash flow occurs, the lower its PW is. This is shown graphically in
Figure 5-2. The PW of $1,000 10 years from now is $613.90 when i = 5% per year.
However, if i = 10%, that same $1,000 is only worth $385.50 now.

Figure 5-2 PW of $1,000 i = 0%

1,000 $1,000
Received at the End of Year
k at an Interest Rate of i%
per Year
900

800
i ⫽ 5% as i , PW

700

i ⫽ 10%
Present Worth (PW) in $

600 $613.90

PW of $1,000 Received
500 i ⫽ 20% at End of Year 10

400
$385.50
i ⫽ 30%
300

200
$161.50
100
$72.50

0
0 1 2 3 4 5 6 7 8 9 10
End of Year k
 SECTION 5.3 / THE PRESENT WORTH METHOD 205

EXAMPLE 5-1 Evaluation of New Equipment Purchase Using PW

A piece of new equipment has been proposed by engineers to increase the
productivity of a certain manual welding 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 attributable to the
equipment will amount to $8,000 per year after extra operating costs have
been subtracted from the revenue generated by the additional production.
A cash-flow diagram for this investment opportunity is given below. If the
firm’s MARR is 20% per year, is this proposal a sound one? Use the PW
method.

$5,000

$8,000 $8,000 $8,000 $8,000 $8,000

1 2 3 4 5
End of Year

i ⫽ 20%/yr

$25,000

Solution
PW = PW of cash inflows − PW of cash outflows,
or
PW(20%) = $8,000(P/A, 20%, 5) + $5,000(P/F, 20%, 5) − $25,000
= $934.29.
Because PW(20%) ≥ 0, this equipment is economically justified.

The MARR in Example 5-1 (and in other examples throughout this chapter)
is to be interpreted as an effective interest rate (i). Here, i = 20% per year. Cash
flows are discrete, end-of-year (EOY) amounts. If continuous compounding had been