Evaluating a Single Project

PW, FW, AW, IRR/ROR, and BP

The objective of the lesson is to
discuss and critique contemporary
methods for determining project
profitability.
 Ways for Evaluating Capital
Projects
1. Present worth (PW)
2. Future worth (FW)
3. Annual worth (AW)
4. Internal rate of return (IRR)
5. Payback period (generally not
appropriate as a primary decision rule)
To be attractive, a capital project
must provide a return that exceeds a
minimum level established by the
organization. This minimum level is
reflected in a firm’s Minimum
Attractive Rate of Return (MARR).
 Elements contribute to determining
the MARR.
• Amount, source, and cost of money
available
• Number and purpose of good projects
available
• Perceived risk of investment opportunities
• Type of organization
 6

Determination of the MARR Based on the

Opportunity Cost Viewpoint

NE 364 Engineering Economy

1. PRESENT WORTH METHOD.
• The most frequently used method.
• The present worth (PW) is found by discounting all
cash inflows and outflows to the present time at an
interest rate that is generally the MARR.
PW(MARR%)
• A positive PW for an investment project means that
the project is acceptable (it satisfies the MARR).
PW(MARR%) > 0
Present Worth Example
Consider a project that has an initial investment
of $50,000 and that returns $18,000 per year for
the next four years. If the MARR is 12%, is this
a good investment?

PW(12%) = -50,000 + 18,000 (P/A, 12%, 4)

PW(12%) = -50,000 + 18,000 (3.0373)

PW(12%) = $4,671.40 → This is a good investment!

CAPITALIZED WORTH is a special
variation of present worth.
• The capitalized worth of a project with
interest rate i% per year is the annual
equivalent of the project over its useful life
divided by i.
• If only expenses are considered this is
sometimes referred to as capitalized cost.
• The capitalized worth method is especially
useful in problems involving endowments
and public projects with indefinite lives.
The application of CW concepts.
The CW of a series of end-of-period uniform
payments A, with interest at i% per period, is
A(P/A, i%, N). As N becomes very large (if
the A are never-ending payments), the (P/A)
term approaches 1/i.
(P/A,i%,very large N) ≈(1/i)
CW(MARR%) = A(1/MARR).
 13

Example:
Determine the capitalized cost at 15% interest
of a structure with an initial cost of $200,000
and annual operating and maintenance costs
of $40,000.
P = $200,000 + $40,000 (P/A,15%,N = infinity)
= $200,000 + $40,000 (1 / 0.15 )
P = $200,000 + $266,667 = $466,667
 Pause and solve
Betty has decided to donate some funds to her local community
college. Betty would like to fund an endowment that will provide a
scholarship of $25,000 each year in perpetuity (for a very long time),
and also a special award, “Student of the Decade,” each ten years
(again, in perpetuity) in the amount of $50,000.

How much money does Betty need to donate today, in one lump sum,
to fund the endowment? Assume the fund will earn a return of 8% per
year.
2. FUTURE WORTH (FW) method

• FW is an alternative to the PW method.

• Looking at FW is appropriate since the
primary objective is to maximize the future
wealth of owners of the firm.
• FW is based on the equivalent worth of all
cash inflows and outflows at the end of the
study period at an interest rate that is
generally the MARR.
• Decisions made using FW and PW will be the
same.
Future worth example.
A $45,000 investment in a new conveyor system
is projected to improve throughput and increasing
revenue by $14,000 per year for five years. The
conveyor will have an estimated market value of
$4,000 at the end of five years. Using FW and a
MARR of 12%, is this a good investment?

FW(MARR%) = -$45,000(F/P, 12%, 5)+$14,000(F/A, 12%, 5)+$4,000

FW(MARR%) = -$45,000(1.7623)+$14,000(6.3528)+$4,000
FW(MARR%) = $13,635.70 → This is a good investment!
3. ANNUAL WORTH (AW) Method
• Annual worth is an equal periodic series of
dollar amounts that is equivalent to the cash
inflows and outflows, at an interest rate that
is generally the MARR.
• The AW of a project is annual equivalent
revenue or savings minus annual equivalent
expenses, less its annual capital recovery (CR)
amount.
Capital recovery reflects the capital cost of
the asset.
• CR is the annual equivalent cost of the capital
invested.
• The CR covers the following items.
▫ Loss in value of the asset.
▫ Interest on invested capital (at the MARR).
• The CR distributes the initial cost (I) and the
salvage value (S) across the life of the asset.
A project requires an initial investment of $45,000,
has a salvage value of $12,000 after six years, incurs
annual expenses of $6,000, and provides an annual
revenue of $18,000. Using a MARR of 10%,
determine the AW of this project.

Since the AW is positive, it’s a good investment.

 23

Company ABC plans to purchase new equipment to

improve productivity. The equipment cost is $25000
and is expected to have a market value of $5000 at the
end of its 5-year life. If the expected improvement in
productivity will net $8000 per year and Company’s
MARR is 20% per year, should the Company purchase
this equipment?
AW=-25000(A/P,20%,5)+8000+ 5000(A/F,20%,5)
= 312.40
Since AW > 0, then the equipment should be
purchased.
 24

We wish to establish a research fund by

making equal annual deposits, starting now
and for 10 more years, so that $10 million
per year will be available for research. If the
first research grant is to be awarded 11
years from now, how much should we
deposit every year if the fund will generate
income at a rate of 15% per year?
4. INTERNAL RATE OF RETURN (IRR)
• The internal rate of return (IRR) method is the
most widely used rate of return method for
performing engineering economic analysis.
• It is also called the investor’s method, the
discounted cash flow method, and the
profitability index.
• If the IRR for a project is greater than the MARR,
then the project is acceptable.
 How the IRR works
• The IRR is the interest rate that equates the
equivalent worth of an alternative’s cash inflows
(revenue, R) to the equivalent worth of cash
outflows (expenses, E).
• The IRR is sometimes referred to as the breakeven
interest rate.

The IRR is the interest i'% at which

 Solving for the IRR is a bit more
complicated than PW, FW, or AW
• The method of solving for the i'% that
equates revenues and expenses normally
involves trial-and-error calculations, or
solving numerically using mathematical
software.
• The use of spreadsheet software can greatly
assist in solving for the IRR. Excel uses the
IRR(range, guess) or RATE(nper, pmt, pv)
functions.
Challenges in applying the IRR
method.
• It is computationally difficult without proper
tools.
• In rare instances multiple rates of return can be
found. (See Appendix 5-A.)
• The IRR method must be carefully applied and
interpreted when comparing two more mutually
exclusive alternatives (e.g., do not directly
compare internal rates of return).
Use of Linear Interpolation to Find the Approximation of IRR for Example
 32

Summary
• An IRR calculation can include multiple cashflows
at various times, while ROR is (in my mind)
the total net gain or loss relative to the
investment (irrespective of the time of the cash
flows).
• IRR is more effective when comparing
investments that have different time horizons.
Spending $100 to get $120 tomorrow is much
better (from an IRR perspective) than getting
$120 two years from now, since you could take
that $20 gain and invest it for the rest of the two
years.
 33

Rate of Return (or Return on Investment)

• Definition: A relative percentage method
which measures the yield as a percentage of
investment over the life of a project
• ROR is either the interest rate paid
on the unpaid balance of a loan, or
the interest rate earned on the
unrecovered investment balance of
an investment such that the final
payment or receipt brings the
terminal value to equal “0”.
 Unpaid loan Balance

◆Consider the following loan

◆You borrow $1,000 at 10% per year for 4
years
◆You are to make 4 equal end-of-year
payments to pay off this loan
◆Your payments are:
A=$1,000(A/P,10%,4) = $315.47

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 The Loan Schedule

Year BOY Bal Payment Interest Prin. Red. UnPaid

Amount Amount Balance

0 $1,000 0 -- --- $1,000

1 1,000 315.47 100.00 215.47 784.53

2 784.53 315.47 78.45 237.02 547.51

3 547.51 315.47 54.75 260.72 286.79

4 286.79 315.47 28.68 286.79 0

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 Unpaid loan Balance

◆For this loan the unpaid loan balances

at the end of each year are:
0 $1,000

1 784.53

2 547.51
Unpaid loan balance
3 286.79 is now “0” at the end
of the life

4 0

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 37

Rate of Return (ROR)

• Rate of Return (or Return on Investment)
is the total gain or loss of an investment
divided by the initial investment amount.
e.g. if you buy stock for $100 and later
sell it for $120 you have a 20% Rate of
Return. You would have a 20%
ROR regardless of if you sell it tomorrow
or in a year.
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 38

Rate of Return (ROR)

◆ROR is not the interest rate earned on the
original loan amount or investment amount
• Example
• In 1990, when Wakalinga Investment Ltd. went public,
an investment of 100 shares cost $1,650. That
investment would have been worth $12,283,904 on
January 31, 2022.

• What is the rate of return on that investment?

[email protected]
Solution: $12,283,904

0
32
$1,650
Given: P = $1,650
F = $12,283,904
N = 32
Find i:
F = P(1 + i ) N

$12,283,904 = $1,650 (1 + i )32

i = 32.13% Rate of Return
Suppose that you invested that amount
($1,650) in a savings account at 6% per year.
Then, you could have only $10,648 on
January, 2022.

What is the meaning of this 6% interest here?

This is your opportunity cost if putting

money in savings account was the best you
can do at that time!
So, in 1990, as long as you earn more than 6% interest
in another investment, you will take that investment.

Therefore, that 6% is viewed as a minimum attractive

rate of return (or required rate of return).

So, you can apply the following decision rule, to see if

the proposed investment is a good one.

ROR (32.13%) > MARR(6%)

 Why ROR measure is so popular?

• This project will bring in a 15% rate of return on

investment.

• This project will result in a net surplus of $10,000

in NPW.

Which statement is easier to understand?

 Return on Investment
• Definition 1: Rate of return (ROR) is defined as
the interest rate earned on the unpaid balance of
an installment loan.
Example: A bank lends $10,000 and receives annual
payment of $4,021 over 3 years. The bank is said to
earn a return of 10% on its loan of $10,000.
•Definition 2: Rate of return (ROR) is the break-
even interest rate, i*, which equates the present
worth of a project’s cash outflows to the present
worth of its cash inflows. Mathematically
PWi*(+ cash flows) – PWi*( - cash flows) = 0
 Loan Balance Calculation:
A = $10,000 (A/P, 10%, 3)
= $4,021
Unpaid Return on Unpaid
balance unpaid balance
at beg. balance Payment at the end
Year of year (10%) received of year

0 -$10,000 -$10,000
1 -$10,000 -$1,000 +$4,021 -$6,979
2 -$6,979 -$698 +$4,021 -$3,656
3 -$3,656 -$366 +$4,021 0

A return of 10% on the amount still outstanding at the

beginning of each year
 Computational Methods
Direct Direct Trial & Computer
Solution Solution Error Solution
Method Method
Log Quadratic

n Project A Project B Project C Project D

0 -$1,000 -$2,000 -$75,000 -$10,000

1 0 1,300 24,400 20,000

2 0 1,500 27,340 20,000

3 0 55,760 25,000

4 1,500
 Direct Solution Methods
• Project A • Project B
$1,300 $1,500
$1,000 = $1,500( P / F , i ,4) PW (i ) = −$2,000 + + =0
(1 + i ) (1 + i ) 2

$1,000 = $1,500(1 + i ) −4 1
Let x = , then
0.6667 = (1 + i ) −4 1+ i
PW (i ) = −2,000 + 1,300 x + 1,500 x 2
ln 0.6667
= ln(1 + i ) Solve for x:
−4
x = 0.8 or -1.667
0101365
. = ln(1 + i )
Solving for i yields
e 0.101365
= 1+ i
1 1
0.8 = → i = 25%, − 1667
. = → i = −160%
i = e 0.101365 − 1 1+ i 1+ i
= 10.67% Since − 100%  i  , the project's i * = 25%.
 ROR using Present Worth
•PW definition of ROR
•PW(-CF’s) = PW(+CF’s)
•PW(-CF’s) - PW(+CF’s) = 0
•AW definition of ROR
•AW(-CF’s) = AW(+CF’s)
•AW(-CF’s) - AW(+CF’s) = 0
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 ROR Criteria

• Determine the i* rate

• If i*>= MARR, accept the project
• If i* < MARR, reject the project

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 ROR using Present Worth
+$1,500

•See Figure 7.2 +$500

0 1 2 3 4 5

-$1,000
•Assume you invest $1,000 at t = 0: Receive $500 @ t=3 and $1,500
at t = 5. What is the ROR of this project?

[email protected]
 Basic Decision Rule:
• Determine the i* rate
• If i*>= MARR, accept the project
• If i* < MARR, reject the project
This rule does not work for a situation where
an investment has multiple rates of return
PAYBACK PERIOD

Determine the payback

period for an investment.
The Payback Method
The payback period is the length of time that it
takes for a project to recover its initial cost out
of the cash receipts that it generates.

When the annual net cash inflow is the same

each year, this formula can be used to compute
the payback period:
Investment required
Payback period =
Annual net cash inflow
The Payback Method
Management Tanganyika Beach Resort at Katavi
wants to install an espresso bar in its restaurant
that
1. Costs $140,000 and has a 10-year life.
2. Will generate annual net cash inflows of
$35,000.

Management requires a payback period of 5 years

or less on all investments.

What is the payback period for the espresso bar?

The Payback Method
Investment required
Payback period =
Annual net cash inflow

$140,000
Payback period = $35,000

Payback period = 4.0 years

According to the company’s criterion,

management would invest in the espresso bar
because its payback period is less than 5 years.
Quick Check ✓
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
Quick Check ✓
Consider the following two investments:
Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
• Project X has a payback period of 2 years.
• Project Y has a payback period of slightly more than 2 years.
• Which project do you think is better?
Evaluation of the Payback Method
Ignores the
time value
of money.

Short-comings
of the payback Ignores cash
period. flows after
the payback
period.
Evaluation of the Payback Method
Serves as
screening
tool.
Identifies
Strengths investments that
of the payback recoup cash
period. investments
quickly.
Identifies
products that
recoup initial
investment
quickly.
Payback and Uneven Cash Flows
When the cash flows associated with an
investment project change from year to year,
the payback formula introduced earlier cannot
be used.
Instead, the un-recovered investment must be
tracked year by year.

$1,000 $0 $2,000 $1,000 $500

1 2 3 4 5
Payback and Uneven Cash Flows

For example, if a project requires an initial

investment of $4,000 and provides uneven net
cash inflows in years 1-5 as shown, the
investment would be fully recovered in year 4.

$1,000 $0 $2,000 $1,000 $500

1 2 3 4 5
 The Profitability Index (PI)
Total PV of Future Cash Flows
PI =
Initial Investent
• Minimum Acceptance Criteria:
▫ Accept if PI > 1

• Ranking Criteria:
▫ Select alternative with highest PI
 The Profitability Index
• Disadvantages:
▫ Problems with mutually exclusive
investments
• Advantages:
▫ May be useful when available investment
funds are limited
▫ Easy to understand and communicate
▫ Correct decision when evaluating
independent projects
The Practice of Capital Budgeting
• Varies by industry:
▫ Some firms use payback, others use
accounting rate of return.
• The most frequently used technique
for large corporations is IRR or NPV.
Example of Investment Rules
Compute the IRR, NPV, PI, and payback period for
the following two projects. Assume the required
return is 10%.
Year Project A Project B
0 -$200 -$150
1 $200 $50
2 $800 $100
3 -$800 $150
Example of Investment Rules
Project A Project B
CF0 -$200.00 -$150.00
PV0 of CF1-3 $241.92 $240.80

NPV = $41.92 $90.80

IRR = 0%, 100% 36.19%
PI = 1.2096 1.6053
Example of Investment Rules
Payback Period:
Project A Project B
Time CF Cum. CF CF Cum. CF
0 -200 -200 -150 -150
1 200 0 50 -100
2 800 800 100 0
3 -800 0 150 150

Payback period for project B = 2 years.

Payback period for project A = 1 or 3 years?
NPV and IRR Relationship
Discount rate NPV for A NPV for B
-10% -87.52 234.77
0% 0.00 150.00
20% 59.26 47.92
40% 59.48 -8.60
60% 42.19 -43.07
80% 20.85 -65.64
100% 0.00 -81.25
120% -18.93 -92.52
NPV Profiles
$400
NPV

$300
IRR 1(A) IRR (B) IRR 2(A)
$200

$100

$0
-15% 0% 15% 30% 45% 70% 100% 130% 160% 190%
($100)

($200)
Project A
Discount rates
Cross-over Rate Project B
 Summary – Discounted Cash Flow
• Net present value
▫ Difference between market value and cost
▫ Accept the project if the NPV is positive
▫ Has no serious problems
▫ Preferred decision criterion
• Internal rate of return
▫ Discount rate that makes NPV = 0
▫ Take the project if the IRR is greater than the required
return
▫ Same decision as NPV with conventional cash flows
▫ IRR is unreliable with non-conventional cash flows or
mutually exclusive projects
• Profitability Index
▫ Benefit-cost ratio
▫ Take investment if PI > 1
▫ Cannot be used to rank mutually exclusive projects
▫ May be used to rank projects in the presence of capital
rationing
Summary – Payback Criteria
• Payback period
▫ Length of time until initial investment is recovered
▫ Take the project if it pays back in some specified
period
▫ Doesn’t account for time value of money, and there is
an arbitrary cutoff period
• Discounted payback period
▫ Length of time until initial investment is recovered on
a discounted basis
▫ Take the project if it pays back in some specified
period
▫ There is an arbitrary cutoff period
Summary – Accounting Criterion
• Average Accounting Return
▫ Measure of accounting profit relative to book
value
▫ Similar to return on assets measure
▫ Take the investment if the AAR exceeds some
specified return level
▫ Serious problems and should not be used
 Quick Review
• Consider an investment that costs $100,000 and
has a cash inflow of $25,000 every year for 5
years. The required return is 9%, and payback
cutoff is 4 years.
▫ What is the payback period?
▫ What is the discounted payback period?
▫ What is the NPV?
▫ What is the IRR?
▫ Should we accept the project?
• What method should be the primary decision
rule?
• When is the IRR rule unreliable?
 73

Answer to Review
• Payback period = 4 years
• The project does not pay back on a discounted
basis.
• NPV = -2758.72
• IRR = 7.93%