Methods for evaluating the economic profitability

of an alternative:
1. Present Worth Method
2. Annual Worth Method
3. Future Worth Method
4. Internal Rate of Return
5. Benefit/Cost Ratio
Payback Period
Minimum Attractive Rate of Return (MARR)
An interest rate used to convert cash flows
into equivalent worth at some point(s) in time
Considerations:
1. Amount of money available for investment, and
source and cost of these funds.
2. The number of good projects available for
investment and their purpose (i.e., elective or
essential).
3. The amount of perceived risk that is associated
with the investment opportunities.
4. The type of organization involved.

MARR is sometimes referred to as hurdle rate

CAPITAL RATIONING
MARR approach involving opportunity cost
viewpoint
Exists when management decides to restrict
the total amount of capital invested, by desire
or limit of available capital
Select only those projects which provide
annual rate of return in excess of MARR
As amount of investment capital and
opportunities available change over time, a
firms MARR will also change

Present Worth Method (PW)

Based on the concept of equivalent worth of all
cash flows relative to the present (base point)
All cash inflows and outflows discounted to present
at interest -- generally MARR
PW is a measure of how much money can be
afforded for investment in excess of cost
PW is positive if dollar amount received for
investment exceeds minimum required by investors
PW(i %) = F0(1 + i)0 + F1(1 + i)-1 + F2(1 + i)-2 +
+ Fk(1 + i)-k + + FN(1 + i)-N
PW(i %) = Fk(1 + i)-k
Where:
i = effective interest rate (MARR) per compounding period
k = index for each compounding period (0 k N)
Fk = future cash flow at the end of period k
N = number of compounding periods in the planning horizon

PW(i %) > 0

interest rate is assumed constant through project

the higher the interest rate and further into future
a cash flow occurs, the lower its PW

Future Worth Method (FW)

FW is based on the equivalent worth of all cash
inflows and outflows at the end of the planning
horizon at an interest rate that is generally MARR
FW(i %) = F0(1 + i)N + F1(1 + i)N-1 + F2(1 + i)N-2 +
+ Fk(1 + i)N-k + + FN(1 + i)0
FW(i %) = Fk(1 + i)N-k

i = effective interest rate

k = index for each compounding period
Fk = future cash flow at the end of period k
N = number of compounding periods in study
period

The FW of a project is also equivalent to:

FW = PW ( F / P, i%, N )

FW(i %) > 0
If FW > 0, it is economically justified

Annual Worth Method (AW)

Based on the concept of equal annual series of all
cash flows, or is an equal annual series of dollar
amounts, over a stated period ( N ), equivalent to
the cash inflows and outflows at interest rate that is
generally MARR
AW is annual equivalent revenues ( R ) minus
annual equivalent expenses ( E ), less the annual
equivalent capital recovery (CR)

AW(i %) = R E CR(i %)
where:
R = annual equivalent revenues or savings
E = annual equivalent expenses
CR = annual equivalent capital recovery cost

Also:
AW = PW ( A / P, i %, N )
AW = FW ( A / F, i %, N )
If AW > 0, project is economically attractive
AW = 0 : annual return = MARR earned

CAPITAL RECOVERY ( CR )
the equivalent uniform annual cost of the capital
invested
CR(i %) = I(A/P, i%, N) S(A/F, i%, N)
Where:
I = initial investment for the project
S = salvage or market (residual) value at the end of study
period
N = project study period

Capital Recovery cost covers:

(a) Loss in value of the asset
(b) Interest on invested capital

Internal Rate of Return Method (IRR)

- also called investors method, discounted cash
flow method, and profitability index
- solves for the interest rate that equates the
equivalent worth of an alternatives cash inflows to
the equivalent worth of its cash outflows.
- May be computed/estimated using any of PW, AW
and FW resultant interest rate is IRR

Rk (P/F, i'%, k) - Ek (P/F, i'%, k) = 0

where:
Rk = net revenues or savings for year k
Ek = net expenses including investments for kth year
N = project life
i' = internal rate of return
- IRR is compared with MARR
- If IRR MARR, then acceptable!
- For single alternatives, the IRR is not positive
unless both receipts and expenses are present in
the cash flow pattern and the sum of inflows
exceeds the sum of outflows

Problems with IRR:

1) IRR assumes that recovered funds are reinvested
at i'% rather than at the MARR
2) Computational intractability (multiple IRRs)
3) Must be carefully applied and interpreted in cases
when there are two or more alternatives

+
PW(i%)

i'%

i%
Plot of PW(i%) versus interest rate

Benefit/Cost Ratio Method (B/C Ratio)

Two commonly used formulations of B/C Ratio:
1. Conventional B/C Ratio:
AW (benefits of proposed project)

B/C =

AW (total costs of proposed projects)

B/C =

B
CR + (O&M)

where:
B = annual equivalent worth of benefits
CR = capital recovery cost
O&M = equivalent annual operations
maintenance expenses

and

2. Modified B/C Ratio:

B/C =

B (O&M)
CR

- A project is acceptable if B/C 1.0

- Both B/C methods give consistent answers to the
question of whether the ratio is 1.0
- Both yield the same recommended choice when
comparing alternatives

Payback (Payout) Period Method

- Indicates a projects liquidity rather than profitability
- May be used as a measure of the projects riskiness
- Liquidity deals with how fast an investment can be
recovered.
- Calculates the number of years required for positive
cash flows to just equal the total investment

(Rk - Ek ) - I 0

k=i

- The simple payback method ignores the time value

of money and all cash flows that occur after (e.g.,
salvage value considered only if = N)
- Discounted payback period:

(Rk - Ek )(P/F, i%, k) - I 0

k=1

- Does not take into consideration the economic life

- Misleading if one alternative has longer (less
desirable) payout period but higher rate of return (or
Net PW) on the invested capital

Multiple Rate of Return Problem

- May occur when IRR method is used and cash
flows reverse sign more than once over the study
period
- Two ways to overcome multiple values:
Manipulate cash flows as little as necessary to
minimize sign reversals
External Rate of Return (ERR)

- Manipulation
Use MARR or an external reinvestment rate to
manipulate funds, then proceed using IRR

- External Rate of Return (ERR) Method

Uses external interest rate () at which net cash
flows generated by a project can be reinvested
outside the firm
If external reinvestment rate equals IRR, then
ERR method produces results identical to those
of the IRR method.

Ek (P/F, %, k)(F/P, i'%, N) =

k=0

Rk (F/P, %, N-k)

k=0

Rk = excess of receipts over expenditures in period k

Ek = excess of expenditures over receipts in period k
N = project life or number of periods for the study
= external reinvestment rate per period
- project is acceptable when the i'% of the ERR
method is greater than or equal to the firms MARR
- Graphical representation:
Rk (F/P, %, N-k)
i'% = ?
0

Periods

Ek (P/F, %, k)