APPLICATION OF MONEY-TIME

RELATIONSHIP IN ENGINEERING
ECONOMY STUDIES

By
Engr. Hiba Arshad
 Lecture 8

APPLICATION OF MONEY TIME

RELATIONSHIP
METHODS FOR ECONOMIC
ANALYSIS
1. Present Worth Method
2. Future Worth Method
3. Annual Worth Method
4. Internal Rate of Return
Method
5. External Rate of Return
Method
6. Payback Period Method
METHODS FOR ECONOMIC
ANALYSIS
•The first three methods convert cash flows
resulting from a proposed solution into their
equivalent worth at some point (or points) in time by
using an internal rate known as the Minimum
Attractive Rate of Return (MARR).
•The IRR and ERR methods produce annual rates
of profit, or returns, resulting from an investment,
and then compared against the MARR.
•A sixth method, 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 common form, ignores time value of
money principles. For this reason, the payback
method is often used to supplement information
4. ANALYZING PROJECTS WITH INTERNAL RATE
OF RETURN METHOD (IRR METHOD)
The Internal Rate of Return (IRR) method is the most widely
used rate of return method for performing engineering
economic analyses. It is sometimes called by several other
names, such as investor’s method, discounted cash flow
method, and profitability index.
This method solves for the interest rate that equates the
equivalent worth of an alternative’s cash inflows (receipts or
savings) to the equivalent worth outflows (expenditures,
including investment costs). Equivalent worth may be computed
with any of the three methods discussed earlier. The resultant
interest rate is termed the Internal Rate of Return (IRR)
For Single alternative, 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. Be
sure to check both of these conditions in order to avoid the
unnecessary work involved with finding that the IRR is negative.
(Visual inspection of the total net cash flow will determine
whether the IRR is zero or less) By using a PW formulation, the
IRR is the i%* at which
4. ANALYZING PROJECTS WITH INTERNAL RATE
OF RETURN METHOD (IRR METHOD)
Where
Rk = net revenues or savings for the kth year
Ek = net expenditure including any investment cost for the kth
year
N = project life (or study period)

Once i’ has been calculated, it is compared with the MARR to assess

whether the alternative in question is acceptable. If i’ ≥ MARR, the
alternative is acceptable; otherwise, it is not.
A popular variation of Equation below firms computing the IRR for an
alternative is to determine the i’ at which its net PW is zero. In
equation form, the IRR is the value of i’ at which

The IRR is the value of i’ that causes the unrecovered investment

balance to exactly equal 0 at the end of the study period (Year N) and
thus represents the internal earning rate of a project. It is important to
notice that i’% is calculated on the beginning of year unrecovered
investment through the life of a project rather than on the total initial
investment.
Example-5
A capital investment of $10,000 can be made in a project that
will produce a uniform annual revenue of $5,310 for five years
and then have a salvage (i.e. market) value of $2,000. Annual
expenses will be $3,000. The company is willing to accept any
project that will earn at least 10% per year, before income
taxes, on all invested capital. Determine whether it is
acceptable by using the IRR method.
Solution:
In this example we immediately see that the sum of positive
cash flow ($13,550) exceeds the sum of negative cash flows
($10,000). Thus, it is likely that positive valued i’% can be
determined. By writing an equation for the PW of the project’s
total net cash flow and setting it equal to zero, we can compute
the IRR.
PW = 0 = -$10,000 + ($5,310-$3,000)(P/A,i%5)
+ $2,000(P/F,i%,5); i% = ?
If we did not already know the answer from Example 4-2(I =
10%), we would probably try a relatively low i, such 5%, and a
relatively high I, such as 15% Linear interpolation will be used
Example-5
At i% = 5%: PW = - $10,000 + $2,310 (4.3295)
+ $2,000(0.7835) = -$1,568
At i% = 5%: PW = - $10,000 + $2,310 (3.3522)
+ $2,000(0.0.4972) = -$1,262
Because we have both a positive and negative PW, the answer is
bracketed. The dashed curve in Figure is what we are linearly
approximating. The answer, i%, can be determined by using similar
triangle dashed in figure
line BA/line BC = line dA/line de

Where BA, for example, is this line segment: B – A = 15% -5%, Thus,
15%-5%/$1,568 - (-$1,262) = i% - 5% / $1,568 - $ 0
Or
i% = 5% + 1,568 (15% - 5%) / 1.568 – ( - $1,262)
= 5% - 5% = 10%
This approximate solution illustrates the trial-and-error process,
together with linear interpolation. The error this answer is due to
nonlinearity of the PW function and would be less if the range of
interest rates used in the interpolation has been smaller.
We already know that the project is minimally acceptable and that i =
MARR = 10% per year. We can confirm this by substituting i =10% in
5. ANALYZING PROJECTS WITH EXTERNAL RATE
OF RETURN METHOD (ERR METHOD)
The reinvestment assumption of the IRR method noted
previously may not be valid in an engineering economy
study. For instance, if a firm’s MARR is 20% per year and
the IRR for a project is 42.4%, it may not be possible for
the firm to reinvest net cash proceeds from the project
at much more than 20%. This situation, coupled with the
computational demands and possible multiple interest
rates associated with the IRR method, has given rise to
other rate of return methods that can remedy some of
these weaknesses.
One such method is the External Rate of Return (ERR)
method. It directly takes into account the interest rate
(∊) external to a project at which net cash flows
generated (or required) by the project over its life can
be reinvested (or borrowed). If this external
reinvestment rate, which is usually the firm’s …cont...
MARR,
5. ANALYZING PROJECTS WITH EXTERNAL RATE
OF RETURN METHOD (ERR METHOD)
In general, three steps are used in the calculating
procedure. First, all net cash outflows are discounted to
time 0 (the present) at ∊% per compounding period.
Second, all net cash inflows are compounded to period
N at ∊%. Third, the external rate of return, which is the
interest rate that establishes equivalence between the
two quantities, is determined. The absolute value of the
present equivalent worth of the net cash outflows at ∊%
(first step) is used in this last step. In equation form, the
ERR is the i% at which

Where Rk = excess of receipts over expenses in period k

Ek = excess of expenditures over receipts in
period k
N = project life or number of periods for the …cont...
study
A project is acceptable when i% of the ERR method is
greater than or equal to the firm’s MARR.
The external rate of return method has two basic advantages
over the IRR methods:
1.It can usually be solved for directly rather than by trial error.
2.It is not subject to the Possibility of multiple rates of return
(Note: The multiple rate of return problem with the IRR)

Example-6
Referring to Example 1, suppose that ∊ = MARR = 20% per year.
What is the alternative’s external rate of return, and is the
alternative acceptable?

Solution
By utilizing Equation ….., we have this relationship to solve for i:
$25,000(F/P,i'%,5) = $8,000(F/A,20%,5) + $5,000
(F/P, i’%,5) = $64,532.80/$25,000 = 2.5813
i’= 20.88%
Because i’ > MARR, the alternative is barely justified.
6. ANALYZING PROJECTS WITH PAY BACK PERIOD METHOD

All methods presented thus for reflect the profitability of

a proposed alternative for a study period of N. The
payback method, which is often called the simple
payout method, mainly indicates a project’s liquidity
rather than its profitability. Historically, the payback
method has been used as measure of a recovered. A
riskiness, since liquidity deals with how fast an
investment can recovered. A low-valued payback period
is considered desirable. Quite simply, the payback
method calculates the number of years required for
cash inflows to just equal cash outflows. Hence the
simply payback period is the smallest value of Ѳ (Ѳ ≥ N)
for which this relationship is satisfied under our normal
end-of-year cash flow convention. For a project where
all capital investment occurs at time 0, we have:
6. ANALYZING PROJECTS WITH PAY BACK PERIOD METHOD

If this method is applied to the investment project in Example, the

number of years required for the undiscounted sum of cash
inflows to exceed the initial investment is four years. This
calculation is shown in column 3. Only when Ѳ = N (the last time
period in the planning horizon), the salvage value included in the
determination of a payback period. As can seen from Equation
above mentioned, the payback period does not indicate anything
about project desirability except the speed with which the
investment
Col. 1 willCol.
be2 recovered.
Col.The
3 paybackCol. 4 Col. 5
End of Year Net Cash Flow Cumulative PW at i Present Worth of Cumulative PW at
K = 0%/yr. Through Cash Flow at i = MARR = 20%/yr.
Year 20%/yr through Year K
0 -25,000 -25,000 -25,000 -$25,000
1 8,000 -17,000 6,667 -18,333
2 8,000 -9,000 5,556 -12,777
3 8,000 -1,000 4,630 -8,147
4 8,000 +7,000 3,858 -4,289
5 13,000 +20,000 5,223 +934
Ѳ = 4 years because Ѳ = 5 years because
the cumulative the cumulative
balance turns positive discounted balance
at EOY 4 …cont...
turns positive at EOY
6. ANALYZING PROJECTS WITH PAY BACK PERIOD METHOD

Period can produce misleading results, and it is

recommended as supplemental information only in
conjunction with one or more of the five methods
previously discussed.
Sometimes the discounted payback period, Ѳ’(Ѳ’ ≤ N), is
calculated so that the time value of money is
considered:

Where i% is the minimum attractive rate of return, I is

the capital investment usually made at the present time
(K=0), and Ѳ’ is the smallest value that satisfies above
mentioned equation. Above table (column 4 and 5) also
illustrates the determination of 0 cash inflows exceed
the $25,000 capital investment. Payback period of three
years or less are often desired in U.S. industry, …cont...
so the
6. ANALYZING PROJECTS WITH PAY BACK PERIOD METHOD

This variation Ѳ’ of the simple payback period produces

the breakeven life of a project in view of the time value
of money. However, neither payback period calculation
includes cash flows occurring after Ѳ (or Ѳ’). This means
that Ѳ (or Ѳ’). may not take into consideration the
entire useful life of physical assets. Thus, these methods
will be misleading if one alternative that has a longer
(less desirable) payback period than another produces a
higher rate of return (or PW) on the invested capital.
Using the payback period to make investment decisions
should generally be avoided except as a measure of
how quickly invested capital will be recovered, which is
an indicator of project risk. The simple payback and
discounted payback period methods tell us how long it
takes cash inflows from a project to accumulate to equal
(or exceed) the project’s cash outflows. The longer it
takes to recover invested monies, the greater is the
Thank you