Engineering Economy

Outcome-based education
ME2045 Outcome-based education (OBE) is an

1 educational theory that bases each part of an

educational system around goals (outcomes).
Foundation of Engineering Economy By the end of the educational experience, Program learning outcomes
each student should have achieved the
CLOs
Assoc. Prof. Dr. Le Ngoc Quynh Lam learning outcomes.

Learning outcomes describe the measurable

skills, abilities, knowledge or values that
students should be able to demonstrate as a Teaching &
Assessment
Learning
result of a completing a course.

Learning outcomes
Define engineering economy and the time value of money involves formulating, estimating, and evaluating the expected
Identify the steps in an engineering economy study
economic outcomes of alternatives designed to accomplish a defined
Perform calculations for interest rates and rates of return
purpose. Mathematical techniques simplify the economic evaluation
Identify and use engineering economic terminology and symbols.
Describe and graphically represent cash flows. of alternatives.
Describe and calculate economic equivalence. involves the systematic evaluation of the economic merits of
Calculate simple and compound interest amounts for one or more proposed solutions to engineering problems.
time periods.
State the meaning and role of Minimum Attractive Rate of Return Other terms that means the same as EE: engineering economic
(MARR) and opportunity costs.
analysis, capital allocation study, economic analysis

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Solutions to engineering problems must 04 essential elements in EE estimates and decision

promote the well-being and survival of an organization, 1. Cash flows

embody creative and innovative technology and ideas, 2. Times of occurrence of cash flows

permit identification and scrutiny of their estimated outcomes, 3. Interest rates for time value of money
and 4. Measure of worth for selecting an alternative
translate profitability to the through a valid and
acceptable measure of merit.

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Measure of worth Time value of money

The criterion used to select an alternative in engineering It is a well-known fact that money makes money.
economy for a specific set of estimates is called a measure of The time value of money explains the change in the amount of
worth. money over time for funds that are owned (invested) or owed
The measures: (borrowed).

This is the most important concept in engineering economy.

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Applications 07 fundamental principles of EE
EE analysis can play a role in many
types of situations: Textbook page 4 1. Develop the alternatives
Choosing the best design for a high-
efficiency gas furnace. 2. Focus on the differences
Selecting the most suitable robot for a
welding operation on an automotive 3. Use a consistent viewpoint
assembly line.
Making a recommendation about 4. Use a common unit of measure
whether jet airplanes for an overnight
delivery service should be purchased or 5. Consider all relevant criteria
leased.
Determining the optimal staffing plan for 6. Make uncertainty explicit
a computer help desk.
7. Revisit your decisions

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EE procedure (steps in an EE study) Steps in an EE study

1. Problem definition
Identify and understand the problem; identify the objectives of the project

2. Development of alternatives
Collect relevant data and define viable solution alternatives

3. Make realistic cash flow estimates

4. Identify an economic measure of worth criterion for decision making

5. Analysis and comparison of alternatives.

Consider both economic and non economics factors; use sensitivity analysis if needed

6. Selection of the best alternative.

7. Implement the solution; monitoring and post-evaluation of results.

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Example Interest rate
Interest is the manifestation of the time value of money.
Read your textbook. Page 5 and 6 Interest is the difference between an ending amount of money and the beginning amount.
If the difference is zero or negative, there is no interest.

Two perspectives to an amount of interest

interest paid
Interest is paid when a person or organization borrowed money (obtained a loan) and repays a larger
amount over time.
interest earned.
Interest is earned when a person or organization saved, invested, or lent money and obtains a return
of a larger amount over time.

The numerical values and

formulas used are the same
for both perspectives, but the
interpretations are different.

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Interest rate Example

Interest paid on borrowed funds (a loan) is determined using the An employee borrows $10,000 on May 1 and must repay a total of
original amount, also called the principal $10,700 exactly 1 year later.
Determine the interest amount and the interest rate paid.
(Lãi ) Solution
Interest rate (lãi ): Interest paid over a specific time unit is Interest:
expressed as a percentage of the principal
Interest paid = $10,700 10,000 = $700
Interest rate:

The time unit of the rate is called the interest period.

16 17
AIC AIC
S. Inc. plans to borrow $20,000 from a bank for 1 year at 9% S. Inc. plans to borrow $20,000 from a bank for 1 year at 9%
interest for new recording equipment. interest for new recording equipment.

The interest and the total amount due after 1 year: The interest and the total amount due after 1 year:
I Interest = $1180; Total due = $ 21,180 I Interest = $1180; Total due = $ 21,180
II Interest = $1800; Total due = $ 21,800 II Interest = $1800; Total due = $ 21,800
III Interest = $1100; Total due = $ 21,000 III Interest = $1100; Total due = $ 21,000

IV Interest = $1180; Total due = $ 21,100 IV Interest = $1180; Total due = $ 21,100

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Interest earned & ROR & ROI Example

From the perspective of a saver, a lender, or an investor, interest Calculate the amount deposited 1 year ago to have $1000 now at an interest
earned is the final amount minus the initial amount, or principal. rate of 5% per year and the interest earned.
Solution
Rate of return (ROR): Interest earned over a specific period of time The total amount accrued ($1000) is the sum of the original deposit and the
earned interest.
is expressed as a percentage of the original amount.
If X is the original deposit,
Total accrued = deposit + deposit(interest rate)
$1000 = X + X(0.05) = X(1 + 0.05) = 1.05X
Return on Investment (ROI): is used equivalently with ROR in The original deposit is:
different industries and settings, especially where large capital funds
are committed to engineering-oriented programs.
The interest earned: Interest = $1000 952.38 = $47.62

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Inflation Inflation
Inflation represents a decrease in the value of a given currency. Inflation contributes to
$10 now will not purchase the same amount of gasoline for your car (or most A reduction in purchasing power of the currency
other things) as $10 did 10 years ago.
An increase in the CPI (consumer price index)
The changing value of the currency affects market interest rates. An increase in the cost of equipment and its maintenance

In simple terms, interest rates reflect two things: a so-called real rate An increase in the cost of salaried professionals and hourly employees

of return plus the expected inflation rate. A reduction in the real rate of return on personal savings and certain
corporate investments
The real rate of return allows the investor to purchase more than he or she
could have purchased before the investment, In other words, inflation can materially contribute to changes in
while inflation raises the real rate to the market rate that we use on a daily corporate and personal economic analysis.
basis.
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Terminology and Symbols Example

P = value or amount of money at a time designated as the present or time 0. Also P is referred to as
present worth (PW), present value (PV), net present value (NPV), discounted cash flow (DCF), and
capitalized cost (CC); monetary units, such as dollars

F = value or amount of money at some future time. Also F is called future worth (FW) and future
value (FV); dollars

A = series of consecutive, equal, end-of-period amounts of money. Also A is called the annual worth
(AW) and equivalent uniform annual worth (EUAW); dollars per year, euros per month

n = number of interest periods; years, months, days

i = interest rate per time period; percent per year, percent per month

t = time, stated in periods; years, months, days

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Cash Flows: Estimation and Diagramming Cash flow
Cash inflows are all types of receipts, including sales, revenues, Net cash flow for each time period
incomes, money from a loan when received from the lender,
and savings generated by project and business activity.
A plus sign indicates a cash inflow.
Cash outflows are all types of costs, including disbursements,
expenses, deposits into retirement or savings accounts, loan Cash flow diagram
repayments, and taxes caused by projects and business
activity.
A negative or minus sign indicates a cash outflow. When a project t = 0 is the present,
involves only costs, the minus sign may be omitted for some t = 1 is the end of
techniques, such as benefit/cost analysis. time period 1 (end
of interest period)

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Example Example

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Economic Equivalence Simple and compound interest
Economic equivalence is a combination of interest rate and time Simple interest is calculated using the principal only, ignoring any
value of money to determine the different amounts of money at interest accrued in preceding interest periods.
different points in time that are equal in economic value.
The total simple interest over several periods is computed as
It is used in comparison of alternative cash flows.

Example:

if the interest rate is 6% per year, $100 today (present time) is

equivalent to $106 one year from today.

Amount accrued = 100 + 100(0.06) = 100(1 + 0.06) = $106

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Example Compound interest

Compound interest:
the interest accrued for each interest period is calculated on the principal plus the
total amount of interest accumulated in all previous periods.
Compound interest means interest on top of interest.
Compound interest reflects the effect of the time value of money on the
interest also.
the interest for one period is calculated as

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Example Minimum Attractive Rate of Return
Example 1.15 page 23 The Minimum Attractive Rate of Return
Example 1.16 page 24-25 (MARR) is a reasonable rate of return
established for the evaluation and selection
of alternatives.

A project is not economically viable unless it

is expected to return at least the MARR.

MARR is also referred to as the hurdle

rate cutoff rate, benchmark rate, and
minimum acceptable rate of return
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Equity financing & Debt financing WACC

Equity financing The corporation uses its own funds from cash Combinations of debt-equity financing mean that a weighted average cost of
on hand, stock sales, or retained earnings. capital (WACC) results.
Individuals can use their own cash, savings, or investments. Example:
Debt financing: The corporation borrows from outside sources If the smart TV is purchased with 40% credit card money at 15% per year
and repays the principal and interest according to some and 60% savings account funds earning 5% per year, the weighted average
cost of capital is 0.4(15%) + 0.6(5%) = 9% per year.
schedule.
Sources of debt capital may be bonds, loans, mortgages, venture For a corporation, the established MARR used as a criterion to accept or
reject an investment alternative will usually be equal to or higher than the
capital pools, and many others.
WACC that the corporation must bear to obtain the necessary capital
Individuals, too, can utilize debt sources, such as the credit card and funds.
bank options.
So the inequality must be correct for an accepted project:

36 37
Opportunity cost End of chapter 1
Opportunity cost: The expected rate of return on the unfunded project. Read all definitions and examples
Do all exercises
The opportunity cost is the rate of return of a forgone opportunity caused
There will be a quiz (Bkel)
by the inability to pursue a project.

Numerically, it is the largest rate of return of all the projects not accepted
(forgone) due to the lack of capital funds or other resources.

When no specific MARR is established, the de facto MARR is the

opportunity cost, that is, the ROR of the first project not undertaken due to
unavailability of capital funds.

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2
Engineering Economy
ME2045

FACTORS: HOW TIME AND INTEREST

AFFECT MONEY
Assoc. Prof. Dr. Le Ngoc Quynh Lam

40
Learning outcomes Introduction
Derive and use the engineering economy factors to account for the time The value of money is a function of time and interest rate.
value of money:
F/P and P/F The general relationship that can be applied to determine the time
P/A and A/P
value of money at various times is in the form:
F/A and A/F
Use linear interpolation in factor tables to determine factor values X = Y.(X/Y, i , n)
Use the present worth (P/G) and uniform annual series (A/G) factors for Where,
arithmetic gradients.
Use the geometric gradient series factor (P/A,g) to find present worth X is the value to be determined
Use the equivalence relations to determine interest rate or rate of return (i) Y is the known or given value
and (n) for a cash flow series. (Find i and n)
(X/Y, i, n) is a function of (i, n), often referred to as (X/Y) factor.
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Single Payment Factors (F/P and P/F) Find F/P and P/F
Single amount factors (F/P and P/F) Single amount factors (F/P and P/F)
F/P: determines the amount of money F accumulated after n years (or periods) from a To find P, given F that occurs n periods in the future:
single present worth P, with interest compounded one time per year (or period).

To find F, given P:

The factor (1 + i)n is called the single-payment compound amount factor (SPCAF), but it (1 + i) is known as the single-payment present worth factor (SPPWF), or the
is usually referred to as the factor. factor.

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Notation & Equation Notation & Equation
Use Factor
tables
(Page 595 623)

Examples:
The value of the
Use Factor tables (Page 595 623) Use formular factor is

Examples:
The value of the factor is column of Table 10 at

Table 10 at period 10 as 0.6139

period 10 as 0.6139

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Find F/P and P/F Example 2.1

Sandy, a manufacturing engineer, just received a year-end bonus of $10,000 that will be
invested immediately. With the expectation of earning at the rate of 8% per year, Sandy
hopes to take the entire amount out in exactly 20 years to pay for a family vacation when
the oldest daughter is due to graduate from college.
Find the amount of funds that will be available in 20 years by using hand solution by
applying the factor formula and tabulated value.

Solution:
The symbols and values are
Cash flow
P = $10,000
F=?
i = 8% per year
n = 20 n = 20 years

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 Example 2.2
Example 2.1 The HBNA plant will require an investment of $200 million to construct. Delays beyond the anticipated
implementation year of 2020 will require additional money to construct the plant. Assuming that the cost of
P = $10,000 F=? i = 8% per year n = 20 years money is 10% per year compound interest, use tabulated factor values to determine the following for the
board of directors of the Italian company that plans to develop the plant.
(a) The equivalent investment needed in 2023 if the plant is delayed for 3 years.
By factor formular:
(b) The equivalent investment needed in 2016 if the plant is constructed sooner than originally
planned.
F = P(1 + i)n = 10,000(1.08)20 = 10,000(4.6610) = $46,610 (a) F3 = ?
Solution
By tabular:
(b) P =?

F = P(F/P, 8%, 20) = 10,000 (4.6610) = $46,610

By Excel: F = FV(0.08,20,,10000) = $ 46,609.57

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Uniform Series Present Worth Factor and

Find P given A (P/A) Find A given P (A/P)

The term in brackets is called the capital recovery factor (CRF), or A/P factor. It

The term in brackets in Equation is the conversion factor referred to as the uniform series present worth calculates the equivalent uniform annual worth A over n years for a given P in year

factor (USPWF). 0, when the interest rate is i.

It is the factor used to calculate the equivalent P value in year 0 for a uniform end-of-period series
of A values beginning at the end of period 1 and extending for n periods

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Find P/A and A/P Example
How much money should you be willing to pay now for a guaranteed
$600 per year for 9 years starting next year, at a rate of return of 16%
per year?
Solution:
The cash flows:
A = $600, i = 16%, and n = 9.
The present worth is
P=?

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Example Example
How much money should you be willing to pay now for a guaranteed $600 The HBNA plant may generate a revenue base of $50 million per year.
per year for 9 years starting next year, at a rate of return of 16% per year? The president of the Italian parent company Baleez may have reason
to be quite pleased with this projection for the simple reason that over
Solution the 5-year planning horizon, the expected revenue would total $250
million, which is $50 million more than the initial investment.
The cash flows: With money worth 10% per year, address the following question from
A = $600, i = 16%, and n = 9. the president:
Will the initial investment be recovered over the 5-year horizon with
The present worth is the time value of money considered?
If so, by how much extra in present worth funds?
P = 600 16%,9) = 600 (4.6065) = $2763.90
If not, what is the equivalent annual revenue base required for the recovery
plus the 10% return on money?
Excel: PV(16%,9,600) P = ($2763.93).
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Example Find A/F and F/A
Use the factor to determine whether A = $50 million per year for n = 5 years starting 1 year after
the completion (t = 0) at i = 10% per year is equivalently less or greater than $200 M.
The cash flow diagram
Table 15 values: P = 50,000,000 10%,5) = 50,000,000 (3.7908) = $189,540,000
->The present worth value is less than the investment plus a 10% per year return, so the president
should not be satisfied with the projected annual revenue.

To determine the minimum required to realize a 10% per year return, use the factor.
The cash flow diagram
A = 200,000,000 (A/P,10%,5) = 200,000,000 (0.26380) = $52,760,000 per year
The plant needs to generate $52,760,000 per year to realize a 10% per year return over 5 years.

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Example Example
Read example 2.6 page 47

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 Factor Values for Untabulated i or n Values Practice???!!!
Problems chapter 2 (Page 64 66)
Given specific values of i and n, there are several ways to obtain
any factor value:

Use the formula

Use an Excel function

Use linear interpolation in the interest tables.

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An arithmetic gradient series is a cash flow series that either increases or

decreases by a constant amount each period.
The amount of change is called the gradient.

Conventional arithmetic
Base amount gradient series without the
base amount.
Cash flow diagram of an arithmetic gradient series
G = constant arithmetic change in cash flows from one
time period to the next;
G may be positive or negative

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 The total present worth PT for a series that includes a base
The corresponding equivalent annual worth AT is the sum of the
amount A and conventional arithmetic gradient must consider
the present worth of both the uniform series defined by A and base amount series annual worth AA and gradient series annual
the arithmetic gradient series.
worth AG, that is,
The addition of the two results in PT.

where:
PA is the present worth of the uniform series only,
PG is the present worth of the gradient series only,

28 29

Three factors are derived for arithmetic gradients:

the P/G factor for present worth, be expressed in two forms:
the A/G tor for annual series,

To derive them:
Use (

30 31
 Example 2.9
Neighboring parishes in Louisiana have agreed to pool road tax
resources already designated for bridge refurbishment.
At a recent meeting, the engineers estimated that a total of
$500,000 will be deposited at the end of next year into an
account for the repair of old and safety-questionable bridges
throughout the area.
Further, they estimated that the deposits will increase by
$100,000 per year for only 9 years thereafter, then cease.
Determine the equivalent (a) present worth, and (b) annual series
amounts, if public funds earn at a rate of 5% per year.
32 33

Geometric Gradient Series Factors

34 35
Geometric Gradient Series Factors Geometric Gradient Series Factors

36 37

Determining i or n for Known Cash Flow Values Example 2.13 p62

Single Amounts P and F Only
Set up the equivalence relation and (1) solve for the variable using the factor
formula, or (2) find the factor value and interpolate in the tables.

Uniform Series A Series

Set up the equivalence relation using the appropriate factor (P/A, A/P, F/A, or
A/F), and use the second method mentioned above.

Mixed A Series, Gradients, and/or Isolated Values

Set up the equivalence relation and use (1) trial and error or (2) the calculator
functions.

38 39
Example 2.14 p63 End of chapter 2
Review all definitions and examples
Do all exercises (chapter 2)
There will be a quiz (LMS)

40 42

3
Engineering Economy
ME2045

COMBINING FACTORS
Assoc. Prof. Dr. Le Ngoc Quynh Lam

43
Learning outcomes Calculations for Uniform Series That Are Shifted
Using multiple factors to find equivalent amounts for cash flows When a uniform series begins at a time other than at the end of
period 1, it is called a shifted series.
that have nonstandard placement
Determine the P, F, or A values of a series starting at a time other than
period 1.
Example: Find P? or find F?
Determine the P, F, or A values of a shifted series and randomly placed
single cash flows.
Make equivalence calculations for shifted arithmetic or geometric
gradient series that increase or decrease in size of cash flows.

2 3

Calculations for Uniform Series That Are Shifted Calculations for Uniform Series That Are Shifted
Remind: 1. Draw a diagram of the positive and negative cash flows.
2. Locate the present worth or future worth of each series on the
cash flow diagram.
3. Determine n for each series by renumbering the cash flow
diagram.
4. Draw another cash flow diagram representing the desired
equivalent cash flow.
5. Set up and solve the equations.

4 5
Example 3.1 (page 74) Example 3.2 (page 76)
The offshore design group at Bechtel just purchased upgraded CAD software for $5000 now and
Recalibration of sensitive measuring devices costs $8000 per year. If the
annual payments of $500 per year for 6 years starting 3 years from now for annual upgrades. machine will be recalibrated for each of 6 years starting 3 years after
What is the present worth in year 0 of the payments if the interest rate is 8% per year? purchase, calculate the 8-year equivalent uniform series at 16% per year.
SOLUTION
Solution Find PT =?
P'A 6)
PA A 2)
PT = P0 + PA

Note: = 5000 + 500(4.6229)(0.8573)

PA: present worth of a uniform annual series A,
A: present worth at a time other than period 0.
= $6981.60
PT: the total present worth at time 0.

6 7

Example 3.2 (page 76) Example 3.2 (page 76)

Recalibration of sensitive measuring devices costs $8000 per year. If the Recalibration of sensitive measuring devices costs $8000 per year. If the
machine will be recalibrated for each of 6 years starting 3 years after machine will be recalibrated for each of 6 years starting 3 years after
purchase, calculate the 8-year equivalent uniform series at 16% per year. purchase, calculate the 8-year equivalent uniform series at 16% per year.
SOLUTION SOLUTION
-year equivalent uniform series)?
Present worth method
Future worth method
P'A
F = 8000(F/A,16%,6) = $71,820
PT = P'A
A' = F(A/F,16%,8) = $5043.20
= 8000(3.6847)(0.7432) = $21,907.75
The equivalent series A' for 8 years:
A' = PT(A /P,16%,8) = $5043.60

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Calculations Involving Uniform Series and Randomly Placed Calculations Involving Uniform Series and Randomly Placed
Single Amounts Single Amounts
Example 3.3 page 76 Example 3.3 page 76: The engineering company makes a proposal to the mining company that it pay
$20,000 per year for 20 years beginning 1 year from now, plus $10,000 six years from now and
An engineering company in Wyoming that owns 50 hectares of valuable land has decided to
$15,000 sixteen years from now.
lease the mineral rights to a mining company. The primary objective is to obtain long-term
If the mining company wants to pay off its lease immediately, how much should it pay now if the
income to finance ongoing projects 6 and 16 years from the present time.
investment is to make 16% per year?
The engineering company makes a proposal to the mining company that it pay $20,000 per
SOLUTION
year for 20 years beginning 1 year from now, plus $10,000 six years from now and $15,000
Find PT=?
sixteen years from now. PT

If the mining company wants to pay off its lease immediately, how much should it pay now if
the investment is to make 16% per year? = $124,075

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Calculations Involving Uniform Series and Randomly Placed Calculations Involving Uniform Series and Randomly Placed
Single Amounts Single Amounts
Example 3.4 page 77:
Example 3.4 page 77:
A design-build-operate engineering company in Texas that owns a sizable amount of land plans to
lease the drilling rights (oil and gas only) to a mining and exploration company. SOLUTION:
The contract calls for the mining company to pay $20,000 per year for 20 years beginning 3 years
1. Total present worth PT in year 0
from now (i.e., beginning at the end of year 3 and continuing through year 22) plus $10,000 six years
from now and $15,000 sixteen years from now. P'A = 20,000 16%,20)
Utilize engineering economy relations to determine the five equivalent values listed below at 16% per
PT = P' 16%,2) + 10,000 16%,6) + 15,000 16%,16)
year.
1. Total present worth PT in year 0 = 20,000 16%,20 16%,2) + 10,000 16%,6)
2. Future worth F in year 22
+ 15,000 16%,16)
3. Annual series over all 22 years
4. Annual series over the first 10 years = $93,625
5. Annual series over the last 12 years
2. Future worth F in year 22
SOLUTION
F = 20,000 16%,20) + 10,000 16%,16) + 15,000 16%,6) = $2,451,626

14 15
Calculations Involving Uniform Series and Randomly Placed
Single Amounts Calculations for Shifted Gradients
3. Annual series over all 22 years REMIND:
The present worth of an arithmetic gradient will always be located
A1 22 = PT(A/P,16%,22) = 93,625(0.16635) = $15,575
two periods before the gradient starts.
OR: A1 22 = F(A/F,16%,22) = $15,575.
4. Annual series over the first 10 years
A1 10 = PT (A/P,16%,10) = 93,625(0.20690) = $19,371
5. Annual series over the last 12 years
A11 22 = F(A/F,16%,12) = 2,451,626(0.03241) = $79,457

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Example 3.5 page 80 Example 3.6 page 82

Fujitsu, Inc. has tracked the average inspection cost
on a robotics manufacturing line for 8 years. Cost
averages were steady at $100 per completed unit
for the first 4years butt have increased consistently
by $50 per unit for each of the last 4 years.
Analyze the gradient increase, using the factor.
Where is the present worth located for the gradient?
Find AT
What is the general relation used to calculate total
present worth in year 0?
SOLUTION
Cash flows:
Find PT?

PT = PA + PG = 100(P/A,i,8) + 50(P/G,i,5)(P/F,i,3)

18 19
Example 3.6 page 82 Example 3.7

20 21

Example 3.7 Example 3.8

22 23
Example 3.8 End of chapter 3
Read all definitions and examples
Do all exercises
There will be a quiz (LMS)

Investment and withdrawal series

24 25

4
Engineering Economy
ME2045

NOMINAL AND EFFECTIVE INTEREST RATES

Assoc. Prof. Dr. Le Ngoc Quynh Lam

26
Learning outcomes
Simple interest (lãi )
Make computations for interest rates and cash flows that are on a time
Simple interest is calculated using the principal only, ignoring any interest accrued in
basis other than a year. preceding interest periods.
Explain interest rate statements that include nominal and effective rates.
Derive and use the formula for an effective annual interest rate.
Determine the effective interest rate for any stated time period
Determine the payment period (PP) and compounding period (CP) for equivalence
computations. Compound interest (lãi kép)
the interest accrued for each interest period is calculated on the principal plus the
Perform equivalence calculations for single amount cash flows and PP CP total amount of interest accumulated in all previous periods.
Perform equivalence calculations for series and gradient cash flows and PP CP. compound interest includes interest on the interest earned in the previous period
Perform equivalence calculations for cash flows with PP < CP.
Derive and use the effective interest rate formula for interest rates that are
compounded continuously.

2 3

Nominal and Effective Interest Rate Statements Nominal and Effective Interest Rate Statements
Nominal interest rate (lãi danh )- r Effective interest rate (lãi ) i

Ex: the interest rate of 1.5% per month is the same as each of
the following nominal rates. Note:
Compounding period
(CP) An effective rate may not always include the compounding period in the statement.

If the CP is not mentioned, it is understood to be the same as the time period mentioned
Compounded monthly
with the interest rate.
Eg. With CP = 1 month,
Nominal rate is 4.5% per quarter Eg. 1.5% per month equivalent effective rate: 1.5% per month, compounded monthly
compounded monthly.

4 5
 Effective Interest Rate Statements Other terms
Annual Percentage Rate (APR)
is often stated as the annual interest rate for credit cards, loans, and
house mortgages.
This is the same as the nominal rate.
An APR of 15% is the same as a nominal 15% per year
Or a nominal 1.25% on a monthly basis.
Annual Percentage Yield (APY)
is a commonly stated annual rate of return for investments, certificates
of deposit, and saving accounts.
This is the same as an effective rate.
Note:
the effective rate is always greater than or equal to the nominal
rate, and similarly APY APR.

6 7

Three time-based units associated with an interest rate statement

Nominal and Effective Interest Rate Statements
Interest period (t): Example 1:
The (nominal) rate of 8% per
The period of time over which the interest is expressed. An effective rate can be determined from a nominal rate by using the relation:
year, compounded monthly:
This is the t in the statement of r% per time period t, t = 1 year
Eg. 1% per month. CP = 1 month
m = 12 times/year
Compounding period (CP):
The shortest time unit over which interest is charged or earned. Example 2:
This is defined by the compounding term in the interest rate statement, A rate of 6% per year,
compounded weekly:
Eg.:, 8% per year, compounded monthly.
t=
Example:
If CP is not stated, it is assumed to be the same as the interest period. CP =
m= r = 9% per year, compounded monthly
Compounding frequency (m):
The number of times that compounding occurs within the interest period t. m = 12
If the compounding period CP and the time period t are the same, the compounding frequency is 1.
the effective rate:
Eg.: 1% per month, compounded monthly
9%/12 = 0.75% per month, compounded monthly

8 9
Example 4.1
Nominal and Effective Interest Rate Statements

Solution

10 11

Example 4.2 Example 4.2

Solution

12 13
4.2 Effective Annual Interest Rates Effective Annual Interest Rates
The future worth F at the end of 1 year:
F = P + Pia = 1(1 + ia)
In which, ia = effective annual interest rate
F = 1(1 + i)m
i is the rate for one compounding period
The effective annual interest rate:

14 15

16 17
 Example 4.3 page 104
Example 4.3 page 104

18 19

Jigsaw activity (4.3 4.7) 4.3 Effective Interest Rates for Any Time Period

20 24
Example 4.5 page 107 Example 4.5 page 107

25 26

Example 4.5 page 107

Example 4.6 page 108

27 28
4.4Equivalence Relations: Payment Period and Compounding Period

Ex: If a company deposits money each month

into an account that earns at the nominal rate of
8%per year, compounded semiannually, the
cash flow deposits define a payment period of 1
month and the nominal interest rate defines a
compounding period of 6 months.
These time periods are shown in Figure

29 30

Ex: Ex:

31 32
 EX 4.8

33 34

EX 4.8 EX 4.8

35 36
Ex 4.9 4.7 Equivalence Relations: Single Amounts and Series with PP < CP

37 38

EX 4.11 EX 4.11

39 40
EX 4.11 4.8 Effective Interest Rate for Continuous Compounding

41 42

EX. 4.13

43 44
End of chapter 4
Read all definitions and examples
Do all exercises
There will be a quiz (Bkel)

45 47

Learning outcomes
5
Engineering Economy
ME2045
Utilize different present worth (PW) techniques to evaluate and
select alternatives.
Identify mutually exclusive and independent projects; define revenue and
PRESENT WORTH ANALYSIS cost alternatives.
Select the best of equal-life alternatives using present worth analysis.
Assoc. Prof. Dr. Le Ngoc Quynh Lam Select the best of different-life alternatives using present worth analysis
Select the best alternative using future worth (FW) analysis
Select the best alternative using capitalized cost (CC) analysis

2
 Case study: Water for Semiconductor Manufacturing Case study: Water for Semiconductor Manufacturing
A fab costs upward of $2.5 billion to construct, with approximately 1% of this total, or $25 million, required to
The worldwide contribution of semiconductor sales is about $250 billion per year, or about
provide the UPW needed, including the necessary wastewater and recycling equipment.
10% of the GDP (gross domestic product). This industry produces the microchips
A newcomer to the industry, Angular Enterprises, has estimated the cost profiles for two options to supply its
used in many of the communication, entertainment, transportation, and computing devices
anticipated fab with water. It is fortunate to have the option of desalinated seawater or purified
we use every day. Depending upon the type and size of fabrication plant (fab), the need for
groundwater sources in the location chosen for its new fab. The initial cost estimates for the UPW system
ultrapure water (UPW) to manufacture these tiny integrated circuits is high, ranging from
are given below
500 to 2000 gpm (gallons per minute). Ultrapure water is obtained by special processes that
commonly include reverse osmosis deionizing resin bed technologies. Potable water
obtained from purifying seawater or brackish groundwater may cost from $2 to $3 per 1000
gallons, but to obtain UPW on-site for semiconductor manufacturing may cost an additional
$1 to $3 per 1000 gallons.

3 4

5.1 Formulating alternatives 5.1 Formulating alternatives

The nature of the economic proposals is Parameters:
Figure 5-1: First cost: P
always one of two types: Progression Expected life: n
Mutually exclusive (ME) alternatives: from
Effective interest rate: i
Only one of the proposals can be selected. proposals to
economic Salvage value (trade-in value): SV
For terminology purposes, each viable Rework/upgrade cost
evaluation to
proposal is called an alternative. selection Annual operating costs AOC
Independent projects: More than one Maintenance and operating cost: M&O
proposal can be selected. Each viable
proposal is called a project. Revenue: Each alternative generates cost (cash outflow) and revenue (cash inflow)
Revenue-or estimates, and possibly savings, also considered cash inflows. Revenues can vary for
The DN (Do nothing) alternative or project means cost-based
each alternative.
that the current approach is maintained; nothing new Cost: Each alternative has only cost cash flow estimates. Revenues or savings are
is initiated. No new costs, revenues, or savings are alternatives assumed equal for all alternatives; thus, alternative selection is not dependent upon
generated. their estimation. These may also be referred to as service alternatives.

5 6
 Decision making 5.2 PW Analysis of Equal-Life Alternatives
Equal-life 5.2 Ideas:
alternatives
Present worth all future costs and revenues are transformed to equivalent
(PW) analysis
Different-life 5.3 monetary units NOW
alternatives
Select the best all future cash flows are converted to present amounts at a
FW analysis
alternative 5.4
specific rate of return, which is the MARR

Capitalized very simple to determine which alternative has the best

cost analysis 5.5
economic advantage.
7 8

5.2 PW Analysis of Equal-Life Alternatives 5.2 PW Analysis of Equal-Life Alternatives

Required condition and alternative evaluation procedure:
- Equal service requirement: All alternatives have the same capacities for the same time Example 5.1 (page134)
period (life) A university lab is a research contractor to NASA for in-space fuel cell
If the required condition is met calculate PW at the stated MARR for each alternative systems that are hydrogen- and methanol-based.
. During lab research, three equal-service machines need to be evaluated
- Mutually exclusive selection: economically.
- One alternative: If PW 0, the requested MARR is met or exceeded, and the Perform the present worth analysis with the costs shown below. The MARR
alternative is economically justified. is 10% per year.
- Two or more alternatives: Select the alternative with the PW that is numerically
largest, that is, less negative or more positive. This indicates a lower PW of cost for
cost alternatives or a larger PW of net cash flows for revenue alternatives.
- Independent project selection:
- One or more independent projects: Select all projects with PW 0 at the MARR.

9 10
5.2 PW Analysis of Equal-Life Alternatives 5.3 PW Analysis of Different-Life Alternatives
When the PW method is used to compare mutually exclusive alternatives
that have different lives, using either of two approaches:
Solution:
- Type: Cost alternatives LCM: Compare the PW of alternatives over a period of time equal to the
- Check the required condition: Yes. (equal- life)
least common multiple (LCM) of their estimated lives.
- Present worth at MARR = 10%:
Study period: Compare the PW of alternatives using a specified study
period of n years. This approach does not necessarily consider the useful
life of an alternative. The study period is also called the planning horizon.

The solar-powered machine is selected since the PW of its costs is the lowest; it has the
numerically largest PW value.
11 12

5.3 PW Analysis of Different-Life Alternatives 5.3 PW Analysis of Different-Life Alternatives

Example 5.3 (page 136):
The assumptions when using the LCM approach are that: National Homebuilders, Inc. plans to purchase new cut-and-finish equipment. Two
manufacturers offered the following estimates.
1. The service provided will be needed over the entire LCM years or more.

2. The selected alternative can be repeated over each life cycle of the LCM
in exactly the same manner.
a) Determine which vendor should be selected on the basis of a PW comparison, if the
3. Cash flow estimates are the same for each life cycle
MARR is 15% per year.
b) National Homebuilders has a standard practice of evaluating all options over a 5-year
period. If a study period of 5 years is used and the salvage values are not expected to
change, which vendor should be selected?

13 14
5.3 PW Analysis of Different-Life Alternatives 5.3 PW Analysis of Different-Life Alternatives
Example 5.3 (page 136): Solution Example 5.3 (page 136): Solution
b. For a 5-year study period, no cycle repeats are necessary.
a. Since nA = 6 and nB = 9 LCM = 18
The PW analysis is

Vendor A is now selected based on its smaller PW value.

This means that the shortened study period of 5 years has caused a switch in the economic
Vendor B is selected, since it costs decision.
less in PW terms; that is, the PWB In situations such as this, the standard practice of using a fixed study period should be
value is numerically larger than carefully examined to ensure that the appropriate approach, that is, LCM or fixed study period,
PWA. is used to satisfy the equal-service requirement.

15 16

5.4 Future Worth Analysis

5.4 Future Worth Analysis Example 5.5 (page 139)

A British food distribution conglomerate purchased a Canadian food store chain for £75 million 3
The selection guidelines for FW analysis are the same as for
years ago. There was a net loss of £10 million at the end of year 1 of ownership. Net cash flow is
PW analysis; FW 0 means the MARR is met or exceeded. increasing with an arithmetic gradient of £+5 million per year starting the second year, and this
pattern is expected to continue for the foreseeable future. Because of the heavy debt financing
For two or more mutually exclusive alternatives, select the one used to purchase the Canadian chain, the international board of directors expects a MARR of 25%
per year from any sale.
with the numerically largest FW value.
a) The British conglomerate has just been offered £159.5 million by a French company wishing
to get a foothold in Canada. Use FW analysis to determine if the MARR will be realized at this
selling price.

b) If the British conglomerate continues to own the chain, what selling price must be obtained at
the end of 5 years of ownership to just make the MARR?

17 18
5.4 Future Worth Analysis 5.4 Future Worth Analysis
Example 5.5 (page 139) Example 5.5 (page 139)
Solution Solution
Set up the FW relation in year 3 (FW3) at i = 25% Determine the future worth 5 years from now at
per year and an offer price of £159.5 million 25% per year
FW3 FW5
5(F/P,25%,1) + 159.5
The offer must be for at least £246.81 million to
Conclusion: make the MARR.

No, the MARR of 25% will not be realized if the This is approximately 3.3 times the purchase price
£159.5 million offer is accepted. only 5 years earlier, in large part based on the
required MARR of 25%.

19 20

5.5 Capitalized Cost Analysis 5.5 Capitalized Cost Analysis

Many public sector projects such as bridges, dams, highways
and toll roads, railroads, and hydroelectric and other power
generation facilities have very long expected useful lives.
A perpetual or infinite life is the effective planning horizon.
Permanent endowments for charitable organizations and
universities also have perpetual lives.
The economic worth of these types of projects or endowments
is evaluated using the present worth of the cash flows.

21 22
5.5 Capitalized Cost Analysis 5.5 Capitalized Cost Analysis

23 24

5.5 Capitalized Cost Analysis

25 26
CHAPTER SUMMARY End of chapter 5
The PW method of comparing alternatives involves converting all cash flows to
Read all definitions and examples
present dollars at the MARR.
The alternative with the numerically larger (or largest) PW value is selected. Do all exercises
When the alternatives have different lives, the comparison must be made for equal- There will be a quiz (Bkel)
service periods.
This is done by performing the comparison over either the LCM of lives or a specific study
period. Both approaches compare alternatives in accordance with the equal-service
requirement.
When a study period is used, any remaining value in an alternative is recognized through the
estimated future market value.
If the life of the alternatives is considered to be very long or infinite, capitalized cost is
the comparison method.
The CC value is calculated as A/i, because the factor reduces to 1 in the limit of n = .

27 28

6
Engineering Economy
ME2045

ANNUAL WORTH ANALYSIS

Assoc. Prof. Dr. Le Ngoc Quynh Lam

29
Learning outcomes 6.1 Advantages and Uses of AW analysis
Utilize different annual worth (AW) techniques to evaluate and
select alternatives.
Demonstrate that the AW value is the same for each life cycle.
When alternatives being compared have different lives, the AW method makes the
Calculate and interpret the capital recovery (CR) and AW amounts. assumptions that
Select the best alternative using AW analysis.
Evaluate alternatives with very long lives using AW analysis
Perform a life-cycle Cost (LCC) analysis using AW method

2 3

6.1 Advantages and Uses of AW analysis

4 5
6.2 Calculation of Capital Recovery and AW Values 6.2 Calculation of Capital Recovery and AW Values

6 7

6.2 Calculation of Capital Recovery and AW Values 6.2 Calculation of Capital Recovery and AW Values

8 9
6.2 Calculation of Capital Recovery and AW Values 6.3 Evaluating Alternatives by AW Analysis

10 11

6.3 Evaluating Alternatives by AW Analysis Solution

12 13
Solution Solution

14 15

16 17
6.4 AW of a Permanent Investment Example 6.5
Cash flows recurring at regular or irregular intervals are handled
exactly as in conventional AW computations; convert them to
equivalent uniform annual amounts A for one cycle.

This automatically annualizes them for each succeeding life

cycle.

Add all the A values to the CR amount to find total AW, as in

Equation [6.2]

18 19

Solution Example 6.5

20 21
6.5 Life-Cycle Cost Analysis 6.5 Life-Cycle Cost Analysis

22 23

6.5 Life-Cycle Cost Analysis 6.5 Life-Cycle Cost Analysis

24 25
6.5 Life-Cycle Cost Analysis 6.5 Life-Cycle Cost Analysis

26 27

6.5 Life-Cycle Cost Analysis End of chapter 6

Read all definitions and examples
Do all exercises
There will be a quiz (Bkel)
Read chapter 7

28 29
 7
Engineering Economy
ME2045

Rate of Return Analysis: One Project

Assoc. Prof. Dr. Le Ngoc Quynh Lam

33

Learning outcomes
State and understand the meaning of rate of return.
Use a PW or AW relation to determine the ROR of a series of cash flows.
State the difficulties of using the ROR method, relative to the PW and
AW methods.
Determine the maximum number of possible ROR values and their
values for a specific cash flow series.
Determine the external rate of return using the techniques of modified
ROR and return on invested capital.
Calculate the nominal and effective rate of return for a bond investment.

2 3
 7.1 Interpretation of a Rate of Return Value
Rate of return (ROR) is commonly used to evaluate the desirability of
investments or projects.
Internal rate of return (IROR; IRR)
Return on Investment (ROI)

IRR can be used to rank multiple prospective projects.

Because the internal rate of return is a rate quantity, it is an indicator of
the efficiency, quality, or yield of an investment.
To decide how to proceed, IRR will be compared to preselected
minimum attractive rate of return (Chapter 8)

4 Engineering Economics 5

7.1 Interpretation of a Rate of Return Value 7.1 Interpretation of a Rate of Return Value
Borrower of money, the interest rate is applied to the unpaid balance so that the
Rate of return analysis is the most frequently used exact analysis
total loan amount and interest are paid in full exactly with the last loan payment.
technique in industry.
Lender of money, there is an unrecovered balance of the principal of the loan at
Major advantages each time period. The interest rate is the return on this unrecovered balance so
Rate of return is a single figure of merit that is readily understood. that the total amount lent, and the interest are recovered exactly with the last
Calculation of rate of return is independent from the minimum receipt.
attractive rate of return (MARR).

6 7
 7.1 Interpretation of a Rate of Return Value 7.1 Interpretation of a Rate of Return Value
Example 7.1
Explanation: To get started in a new telecommuting position with AB Hammond Engineers, Jane took out a $1000 loan
at i = 10% per year for 4 years to buy home office equipment.
The rate of return is expressed as a percent per period. From the perspective, the investment in this young engineer is expected to produce an equivalent
net cash flow (NCF) of $315.47 for each of 4 years.
i = 10% per year, it is stated as a positive percentage;
A = $1000(A/P,10%,4) = $315.47
the fact that interest paid on a loan is actually a negative rate of return from
This represents a 10% per year rate of return on the unrecovered balance.
the perspective is not considered. Compute the amount of the unrecovered investment for each of the 4 years using:
(a) the rate of return on the unrecovered balance (the correct basis) and
The numerical value of i can range from 100% to infinity, that is, 100% i
(b) the return on the initial $1000 investment.
< . In terms of an investment, a return of i = 100% means the entire (c) Explain why all of the initial $1000 amount is not recovered by the final payment in part (b).
(d) Determine the unrecovered balance after 3 years in Table 7 1 using factors rather than detailing the
amount is lost. amounts for each year.

8 9

7.1 Interpretation of a Rate of Return Value 7.1 Interpretation of a Rate of Return Value
(a) Table 7 1 shows the unrecovered balance of the principal at the end of each year in column 6 using the 10%
rate on the unrecovered balance at the beginning of the year. After 4 years the total $1000 is recovered, and
Guides the balance in column 6 is exactly zero.
(b) Table 7 2 shows the unrecovered balance if the 10% return is always figured on the initial $1000. Column 6
in year 4 shows a remaining unrecovered amount of $138.12 because only $861.88 is recovered in the 4
years (column 5).
(c) As shown in column 3, a total of $400 in interest must be earned if the 10% return each year is based on the
initial amount of $1000. However, only $261.88 in interest must be earned if a 10% return on the unrecovered
balance is used. There is more of the annual cash flow available to reduce the remaining loan when the rate
is applied to the unrecovered balance as in part (a)and Table 7 1. Figure 7 1 illustrates the correct
interpretation of rate of return in Table 7 1. Each year the $315.47 receipt represents 10% interest on the
unrecovered balance in column 2 plus the recovered amount in column 5.
(d) To determine the unrecovered balance after any year in the repayment schedule, simply find the future worth
of the loan principal at the end of the year in question using the F P factor and remove the equivalent future
value of all payments made thus far, 3 years in this case.

For this $1000, 4-year, 10% per year loan, Unrecovered balance, year 3 = -1000(F P,10%,3) +
315.47(F A,10%,3) = -1331.00 + 1044.21 = $-286.79

10 11
 7.1 Interpretation of a Rate of Return Value 7.1 INTERPRETATION OF A RATE OF
RETURN VALUE
Given a cash flow stream, IRR is the interest rate i which yields a zero NPW (i.e., the
benefits are equivalent to the costs), or a zero worth at any point in time. This can be
In rate of return problems, you seek an unknown interest rate (i*)
expressed in 5 different ways as follows.
that satisfies the following:
NPW = 0
PWi*(+ cash flows) PWi*( - cash flows) = 0
PW of benefits PW of costs = 0
PW of benefits = PW of costs This means that the interest rate i*, is an unknown parameter and
must be solved or approximated.
PW of benefits/PW of costs = 1
EUAB EUAC = 0
EUAC = Equivalent Uniform Annual Cost
EUAB = Equivalent Uniform Annual Benefit

Engineering Economics 12 9/24/2024 13

7.2 Rate of Return Calculation Using a PW

7.2 Rate of Return Calculation Using a PW or AW Relation
or AW Relation To determine the rate of return, develop the ROR equation using either a PW
What is the internal rate of return (IRR)? or AW relation, set it equal to 0, and solve for the interest rate.
IRR is the interest rate at which present worth or equivalent uniform annual worth is equal
Alternatively, the present worth of cash outflows (costs and disbursements)
to 0.
PWO may be equated to the present worth of cash inflows (revenues and
In other words, the internal rate of return is the interest rate at which the benefits are
savings) PWI.
equivalent to the costs.
That is, solve for i using either of the relations:

Engineering Economics 14 15
7.2 Rate of Return Calculation Using a PW 7.2 Rate of Return Calculation Using a PW
or AW Relation or AW Relation
The annual worth approach utilizes the AW values in the same The i value that makes these equations numerically correct is
fashion to solve for i
called i*.

It is the root of the ROR relation.

To determine if the investment cash flow series is

viable, compare i* with the established MARR.

16 17

7.2 Rate of Return Calculation Using a PW 7.2 Rate of Return Calculation Using a PW
or AW Relation or AW Relation
i* Using Trial and Error

The general procedure of using a PW-based equation is as follows:

1. Draw a cash flow diagram.

2. Set up the rate of return equation in the form of Equation [7.1].

3. Select values of i by trial and error until the equation is balanced.

18 19
 7.2 Rate of Return Calculation Using a PW
or AW Relation
Example: Find the IRR of this machine

Machine A
Initial cost $20,000
Life 5 years
Salvage value $4,000
Annual receipts $10,000
Annual disbursements $4,400

20

7.2 Rate of Return Calculation Using a PW 7.3 Special Considerations When Using
or AW Relation the ROR Method
PW(i%) = -$20,000 + ($10,000 - $4,400)(P/A, i%, 5) + $4,000(P/F, i%, 5) = 0
Try i = 10%:
PW(i%) = -$20,000 + ($10,000 - $4,400)(P/A, 10%, 5) + $4,000(P/F, 10%, 5) Some assumptions and special considerations with ROR
= $3,374.63 > 0 analysis:
Try i = 15%: Multiple i* values.
PW(i%) = -$20,000 + ($10,000 - $4,400)(P/A, 15%, 5) + $4,000(P/F, 15%, 5)
= $661.54 > 0 Reinvestment at i*.
Try i = 18%: Different procedure for multiple alternative evaluations.
PW(i%) = -$20,000 + ($10,000 - $4,400)(P/A, 18%, 5) + $4,000(P/F, 18%, 5)
= - $626.61 < 0

I*=ROR= 16.4763%
Verify with Excel function

23
7.4 Multiple Rate of Return Values 7.4 Multiple Rate of Return Values
There is more than
one sign change in Two tests to perform in sequence on the nonconventional series to
the net cash flows, it determine if there is one unique value or possibly multiple i* values
conventional nonconventional
is possible that there
that are real numbers.
will be multiple i*
values in the -100% to Test 1: rule of signs states that the total number of real-number
plus infinity range. roots is always less than or equal to the number of sign changes in the series.
Test 2: Cumulative cash flow sign test, also known as criterion,
states that only one sign change in a series of cumulative cash flows which
starts negatively indicates that there is one positive root to the polynomial
relation.

READ - EXAMPLE 7.3

24 25

7.5 Techniques to Remove Multiple Rates 7.5 Techniques to Remove Multiple Rates of Return
of Return

Modified ROR (MIRR) Approach

Return on Invested Capital (ROIC) Approach

26 27
7.6 Rate of Return of a Bond Investment 7.6 Rate of Return of a Bond Investment
Bond a long term note issued by a corporation or a government entity (the borrower)
to finance major projects.
The borrower receives money now in return for a promise to pay the face value V of the
bond on a stated maturity date.
Bonds are usually issued in face value amounts of $1000, $5000, or $10,000.
Bond dividend I, also called bond interest, is paid periodically between the time the
money is borrowed and the time the face value is repaid. The bond dividend is paid c
times per year. Expected payment periods are usually semiannually or quarterly.
The amount of interest is determined using the stated dividend or interest rate, called the
bond coupon rate b.

28 29

8
Engineering Economy
ME2045

Rate of Return Analysis: Multiple Alternatives

Assoc. Prof. Dr. Le Ngoc Quynh Lam

30
 8.1 Why Incremental Analysis Is
Learning outcomes Necessary
State why the ROR method of comparing alternatives requires an incremental cash
flow analysis. Assume we have two or more mutually exclusive alternatives
Calculate the incremental cash flow series for two alternatives.
Objective: Which, if any of the alternatives is preferred?
Interpret the meaning of the incremental ROR ( *) determined from the incremental
cash flow series. Prior Chapters: Use the PW or AW approach
Based on a PW relation, select the better of two alternatives using incremental ROR
analysis or a breakeven ROR value. Last chapter: We apply the ROR approach
Select the better of two alternatives using incremental ROR analysis based on an AW Present Worth: Equal service lives must apply
relation.
Select the best from several alternatives using incremental ROR analysis.
Use a single spreadsheet to perform PW, AW, ROR, and incremental ROR analyses
for mutually exclusive and independent alternatives.

2 3

8.1 Ranking Inconsistency Problem

8.1 Ranking Inconsistency
Two Investments A and B
For some problems, PW and ROR may rank the same problems
differently. Why? Discount rate = 10%
PW assumes reinvestment at the MARR or discount rate. Each investment requires $100 at t = 0
ROR assumes reinvestment at the i* or rate A is a 1-year investment
Two different reinvestment rate assumptions apply B is a 5- year investment

4 5
8.1 Two Projects; A and B 8.1 Example Problem
A $120 i*A = 0.20 = 20% Using ROR, A is superior to B
0 1 2 3 4 5 i*B = 0.15 = 15% Using PW, B is superior to A

$100 PWA(10%) = +$9.09 Inconsistent Rankings!

$201.14

B
PWB(10%) = +24.89

0 1 2 3 4 5

$100

6 7

8.1 Another example Problem 8.1 Another example Problem

assume that a company uses a MARR of 16% per year, These calculations show that even though the i* for alternative A
that the company has $90,000 available for investment, and is higher, alternative B presents the better overall ROR for the
that two alternatives (A and B) are being evaluated. $90,000.
Alternative A requires an investment of $50,000 and has an
internal rate of return iA* of 35% per year.
Alternative B requires $85,000 and has an i*B of 29% per year.

Intuitively we may conclude that the better alternative is the one

that has the larger return, A in this case.

8 9
 8.2 Calculation of Incremental Cash Flows
8.1 Why Incremental Analysis Is Necessary
for ROR Analysis
Given two or more alternatives
Under some circumstances, project ROR values do not provide
the same ranking of alternatives as do PW and AW analyses. Rank the investments based upon their initial time t = 0
This situation does not occur if we conduct an incremental ROR investment requirements
analysis
Summarize the investments in a tabular format

10 11

8.2 Calculation of Incremental Cash Flows 8.2 Calculation of Incremental Cash Flows for ROR Analysis
for ROR Analysis
Given two or more alternatives
Rank the investments based upon their initial time t = 0
investment requirements
Summarize the investments in a tabular format

Revenue alternative, where there are both negative and positive cash flows
Cost alternative, where all cash flow estimates are negative

12 13
EXAMPLE 8.1 EXAMPLE 8.1

14 15

EXAMPLE 8.2 EXAMPLE 8.2

16 17
8.3 Interpretation of Rate of Return on the 8.3 Interpretation of Rate of Return on the
Extra Investment Extra Investment
consider the ROR on the incremental cash flow series between two
alternatives B and A. The incremental ROR value, identified as i*B A, and
discussed further below, has a predictable relation to individual alternative
The i*incremental is the ROR of the additional or incremental investment ROR values in weighted average calculations like those presented in
required to move from one project to the next most- costly project. Section 8.1.
If the i*incremental value is < MARR, the increment is not worth it. Go with to Alternative B has a larger initial investment than A:
RORB <ROR A, then i*B A < RORB.
lower investment cash flow.
RORB > RORA, then i*B A > RORB

18 19

8.3 Interpretation of Rate of Return on the

8.3 Interpretation of Rate of Return on the Extra
Extra Investment Investment
Given two mutually exclusive alternatives, A and B. If Cost-
The i* (B-A) value also represents the interest rate at which
the two alternatives are economically equivalent. Discard those alternatives whose i* values are less than the MARR they
would lose anyway!
No need to compute incremental investments among the candidate projects
Rule: Accept all projects whose ROR > MARR and stay within any budget
limitations

20 21
8.4 Rate of Return Evaluation Using PW: 8.4 Rate of Return Evaluation Using PW:
Incremental and Breakeven (Two Alternatives) Incremental and Breakeven (Two Alternatives)

Given multiple alternatives

If unequal lives either establish a common project life, or
Apply the LCM of life approach found in Chapter 5

22 23

EXAMPLE 8.3 EXAMPLE 8.3

Step 1
Alternatives A and B are correctly ordered with the higher first-cost alternative in
column 2 of Table 8 4
Step 2
The cash flows for the LCM of 10 years are tabulated

24 25
EXAMPLE 8.3 EXAMPLE 8.3
Step 3 Step 4, 5, 6

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8.4 Rate of Return Evaluation Using PW:

Incremental and Breakeven (Two Alternatives) Recall example 8.3
Breakeven rate of return Recall: MARR = 18%
Recall, the incremental i*(B-A) is the interest rate at which the For MARR < 12.65% extra
two alternatives are economically equivalent. investment is justified. Go
This special interest rate is called: with B
Breakeven Interest Rate
For MARR > 12.65%, the
Fisherian Intersection Rate extra investment is not
justified: Go with A
If MARR = 12.65%, both
options are economically
equivalent.

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8.5 Rate of Return Evaluation Using AW 8.5 Rate of Return Evaluation Using AW
ROR approach requires comparison over an equal-service life
When the lives are equal or unequal set up the AW relationship
for the cash flows of each alternative
Then solve 0 = AWB AWA for the i* value

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8.6 Incremental ROR Analysis of Multiple 8.6 Incremental ROR Analysis of Multiple
(More than Two) Alternatives (More than Two) Alternatives
Select the one alternative that:
A given alternative should not be compared with one alternative
Requires the largest investment for which the incremental investment is not justified
And indicates that the extra investment over another If a given alternative loses out in a comparison, that alternative
acceptable alternative is justified is dropped from further consideration.

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8.6 Incremental ROR Analysis of Multiple 8.6 Incremental ROR Analysis of Multiple
(More than Two) Alternatives (More than Two) Alternatives

1. Order the alternatives from smallest to largest initial 4. Compute the i* value for all alternatives in the considered
investment.
set.
2. Compute the cash flows for each alternative (assume or
create equal lives). If any alternative has an i* < MARR, drop it from further consideration
3. If the alternatives are revenue-cost alternatives do the The candidate set will be those alternatives with computed i* values >
following
MARR.
Call this the FEASIBLE set

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8.6 Incremental ROR Analysis of Multiple 8.6 Incremental ROR Analysis of Multiple
(More than Two) Alternatives (More than Two) Alternatives
Calculate i* for the first alternative
4. Compute i*Challenger Defender

The first alternative is called the DEFENDER If i*Challenger Defender > MARR, drop the defender and the challenger
wins the current round.
The second (next higher investment cost) alternative is
5. If i* Challenger Defender < MARR, drop the challenger and the defender
called the CHALLENGER moves on to the next comparison round
At each round, a winner is determined
Compute the incremental cash flow as
Either be the current Defender or the current challenger
(Challenger Defender) The winner of a given round moves to the next round and becomes
the current DEFENDER and is compared to the next challenger

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8.6 Incremental ROR Analysis of Multiple
(More than Two) Alternatives
Example 8.7

6. This process continues until there are no more challengers

remaining.
The alternative that remains after all alternatives have been
evaluated is the final winner.

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