BASIC METHODS FOR MAKING ECONOMY STUDIES

1.) THE RATE OF RETURN (ROR) PATTERN

Rate of return measures the effectiveness of an investment of capital. It is a financial efficiency. When
this method is used, it is necessary to decide whether the computed rate of return is sufficient to justify the
investment.
This method has the considerations advantage of being easily understood by management and
investors. In the rate of return pattern, it is assumed that there is a single investment life and that the revenue
and cost for each year are the same.

OR

EXPLICIT REINVESTMENT RATE OF RETURN (E.R.R.) METHOD

It is easy to calculate the rate of return by this method when there is a single lump sum investment and
uniform savings or returns at the end of each period during the life of the project. The pattern for this method is
as follows:

Required capital investment = C

Annual income = G
Annual expenses:
Operation and maintenance = O + M (this includes expenses for direct labor, direct materials,
and overhead, including property taxes, but excluding depreciation)
Depreciation = (Co - Cn)(A/F, i%, n) = D
Net profit before income taxes (Pb)
Pb = G – ( O + M +D )
Annual rate of return on required investment before income taxes = (Pb/C) x 100

If this rate of return is greater than or equal to the minimum acceptable rate of return (M.A.R.R.), then
investment of capital in the project is, in most cases, justified.

2.) THE ANNUAL WORTH (A.W.) PATTERN

In this method a minimum required profit on the invested capital is included as a cost. If the excess of
revenue over disbursements is not less than zero, the proposed investment is justified – is valid. This method is
covered by the same limitations as the rate of return pattern a single initial investment and uniform revenue
and costs throughout the life of the investment.
If disbursements only are considered, the criterion is usually expressed as annual worth-cost (A.W.C.) or
annual cost (A.C.)

OR

ANNUAL COST (A.C.) METHOD

This method is similar to the E.R.R. method with the exception that a minimum required profit (M.R.P.)
on the invested capital is included as a cost. The pattern for this method is as follows:

Required capital investment = C

Annual income = G
Annual expenses:
Operation and maintenance = O + M (this includes expenses for direct labor, direct materials,
and overhead, including property taxes, but excluding depreciation)
Depreciation = (Co - Cn)(A/F, i%, n) = D
Minimum required profit = C x i
Excess of annual income over annual expenses: G – ( O + M + D + C x i )

If this excess is zero or positive, then the investment of capital in the project is justified. In applying this
method, it must be remembered that profit is included as an element of cost.
3.) THE PRESENT WORTH (P.W.) PATTERN

This pattern for economy studies is based on the concept of present worth. If the present worth of the
net cash flows is equal, or greater than, zero, the project is justified economically. The present worth method is
flexible and can be used for any type of economy study. It is used extensively in making economy studies in
public works field, where long-lived structures are involved.
PW cash inflow ≥ PW cash outflow

4.) INTERNAL RATE OF RETURN (I.R.R.) METHOD

The internal rate of return is a rate which relates the positive and negative cash flows of a project.
Receipts are considered positive and disbursements negative.

For example, an initial investment Do is made at the beginning of the first year. The net receipts, R,
reduce the net amount of the investment, while the disbursements, D, tend to increase the capital investment.
There is a certain rate of return which will exactly reduce the worth of the investment to zero at the end of time
period. The computed rate of interest or profit rate, i, is the internal rate of return. This gives the relationship
among the positive and negative cash flows as of the end of the nth year.

Considering the future worth of all cash flows as of beginning of first year
-D0(F/P, i%,n) + R1(F/P, i%,n -1) + R2(F/P, i%,n-2) – D3(F/P, i%,n-3) + R4(F/P, i%,n-4) + Rn-1(F/P, i%,1) + Rn = 0

Considering the present worth of all cash flows as of beginning of first year
-D0 + R1(P/F, i%, 1) + R2(P/F, i%, 2) – D3(P/F, i%, 3) + R4(P/F, i%,4) + Rn-1(P/F, i%, n-1) + Rn (P/F, i%, n) = 0

In general, the internal rate of return, i , cannot be computed directly, hence, it becomes necessary to apply trial
and error and interpolation methods.

Sample Problems:

1.) On a land worth $800,000 an investor constructs a building worth $3,000,000 containing a theater, a
bank, stores and offices. The owner estimates that that the annual receipts from rentals will be $720,000 and
annual expenses to cover taxes, insurance and maintenance of the building will be $80,000. He also estimates
that the land can be sold for $1,200,000, the building for $2,000,000 at the end of 20 years. If his money is now
earning 15% before taxes, will this property earn enough for the investment to be justified? Use E.R.R. method.

2.) The first cost of an office building is $1,000,000. The operating costs are estimated to be as follows:
for depreciation $25,000 per year; for taxes and insurance, 3% of the first cost per year; and for variable
maintenance cost operation cost per year assuming 100% occupancy of the building, $50,000. What should be
the yearly income if the building is 90% occupied, on the average, during any year of its life and the owner
expects a rate of return of 8%.

3.) An existing machine in a factory has an annual maintenance cost of $40,000. A new and more
efficient machine will require an investment of $90,000 and is estimated to have a salvage value of $30,000 at
the end of a service life of 8 years. Its annual expenses for maintenance, upkeep etc. total $27,000. If the
company expects to earn 12% on investment, will it be worth-while to purchase the new machine using (a) P.W.
method and (b) rate-of-return.

4.) A company spends $180,000 annually for electrical energy to run its plant. It is contemplated to build
a power plant that will supply the same energy to the plant under the following assumptions: first cost,
$1,000,000; annual operation and maintenance, $60,000; life of the power plant, 15 years; salvage value at the
end of life, $100,000; annual taxes and insurance, 3.5%of the first cost. The company is earning at least12% on
its capital. Should the power plant be built? Use A.W. method.
 5.) A contractor can purchase a dump truck for $85,000. It is estimated that if sold at the end of 7 years
it will have a value of $10,000. Its estimated annual maintenance cost is $2,400, and daily operating expenses
are estimated to be $42 including the wage of the driver. It is also possible to hire a similar unit for $140 a day
including fuel cost. If money is worth 10%, how many days a year must the dump truck be used to justify the
purchase of the truck? Use A.W. method.

6.) A lot purchased for $6,000 fifteen years ago can now be sold for $90,000. Real property taxes of $200
were paid at the end of 15 years. If the agent selling the property receives $4,500 as commission, determine the
before-tax rate of return on the investment.

7.) A project capitalized for $50,000 invested in depreciable assets will earn a uniform, annual income of
$19,849 in 10 years. The costs for operation and maintenance total $9,000 a year, and taxes and insurance will
cost 4% of the first cost each year. If the company expects its capital to earn 12%, before taxes, is the
investment worthwhile? Use (a) rate of return (b) annual cost method (c) present worth method with and
(d) internal rate of return

8.) To compensate for loss against floods, a factory is insured for $3,000,000 with annual premium of
$20,000. For further protection, dikes can be built around the factory at a cost of $100,000 with 50% salvage
value. If the dikes are built the insurance company agrees to lower the premium to $7,500. Annual maintenance
of the dikes will cost $1,000. If the total loss in case of floods is double the insured value, and the company
wants to make 15% on its invested capital, should the dikes be installed?

Solve the following copy the problems in a long bond paper. One problem per page due March 17, 2025.
Staple your paper on the upper left and write page number on the lower right.