Northwestern University College of Engineering, Architecture & Technology

Basic Methods for Making Economy Studies

Prepared by: Click to edit Master subtitle style Engr. Rolly C. Ramos

8/17/12

The Rate of Return (ROR) Method

The rate of return on the capital invested is given by the formula
Rate of Return =
Net annual profit Capital invested

Rate of return is a measure of the effectiveness of an investment of capital. isPrepared by: Rolly C. Ramos a financial efficiency
8/17/12

It

Conditions:

a single investment of capital at the beginning of the first year of the project life and identical revenue and cost data for each year the capital invested is the total amount of capital investment required to finance the project
Prepared by: Rolly C. Ramos 8/17/12

Example: An investment of Php270,000 can be made in a project that will produce a uniform annual revenue of Php85,400 for 5 years and then have a salvage value of 10% of the investment. Costs for operation and maintenance will be Php81,000 per year. Taxes and insurance will be 4% of the first cost per year. The company expects capital to earn not less than 25% before income taxes. Is this a desirable investment?
a single investment of capital at the beginning of the first year of the project life identical revenue and cost data for each year

? ?

Php270,000
Uniform Annual Revenue = Php85,400 Costs of operation = Php81,000/yr

Solution

Prepared by: Rolly C. Ramos

8/17/12

The Annual Worth Method

In this method, interest on the original investment (minimum required profit) is included as a cost. If the excess of annual cash inflows over annual cash outflows is not less than zero, then the proposed investment is justified/valid.
Prepared by: Rolly C. Ramos 8/17/12

Example: An investment of Php270,000 can be made in a project that will produce a uniform annual revenue of Php85,400 for 5 years and then have a salvage value of 10% of the investment. Costs for operation and maintenance will be Php81,000 per year. Taxes and insurance will be 4% of the first cost per year. The company expects capital to earn not less than 25% before income taxes. Is this a desirable investment?
a single investment of capital at the beginning of the first year of the project life identical revenue and cost data for each year

? ?

Php270,000
Uniform Annual Revenue = Php85,400 Costs of operation = Php81,000/yr

Solution

Prepared by: Rolly C. Ramos

8/17/12

The Present Worth Method

This pattern for economy studies is based on the concept of present worth. If the present worth of the net cash flows is equal to, or greater than, zero, the project is justified economically. Advantage:

It Prepared by: Rolly C. Ramos can8/17/12 used for is flexible and be

Example: An investment of Php270,000 can be made in a project that will produce a uniform annual revenue of Php85,400 for 5 years and then have a salvage value of 10% of the investment. Costs for operation and maintenance will be Php81,000 per year. Taxes and insurance will be 4% of the first cost per year. The company expects capital to earn not less than 25% before income taxes. Is this a desirable investment?

No conditions to satisfy.
Solution

Prepared by: Rolly C. Ramos

8/17/12

The Future Worth Method

It is comparable to the present worth method except that all cash inflows and outflows are compounded forward to a future time. If the future worth of the net cash flows is equal to, or greater than, zero, the project is justified economically. Advantage:
Prepared by: Rolly C. Ramos 8/17/12

Example: An investment of Php270,000 can be made in a project that will produce a uniform annual revenue of Php85,400 for 5 years and then have a salvage value of 10% of the investment. Costs for operation and maintenance will be Php81,000 per year. Taxes and insurance will be 4% of the first cost per year. The company expects capital to earn not less than 25% before income taxes. Is this a desirable investment?

No conditions to satisfy.
Solution

Prepared by: Rolly C. Ramos

8/17/12

The Payback (Payout) Period Method

The payback period is the length of time required to recover the first cost of an investment from the net cash flow produced by that investment for an interest rate of zero. Payout Period = investment salvage value net annual cash flow

Prepared by: Rolly C. Ramos

8/17/12

Example: An investment of Php270,000 can be made in a project that will produce a uniform annual revenue of Php85,400 for 5 years and then have a salvage value of 10% of the investment. Costs for operation and maintenance will be Php81,000 per year. Taxes and insurance will be 4% of the first cost per year. The company expects capital to earn not less than 25% before income taxes. Is this a desirable investment?

No conditions to satisfy.
Solution

Prepared by: Rolly C. Ramos

8/17/12

End of Lecture
Prepared by: Rolly C. Ramos 8/17/12

Payback Period: Total annual costs (excluding depreciation)

= 81,000 + 270,000 (0.04) = 91,800

Net annual cash flows = 185,400 91,800 =

93,600

Payout Period

investment salvage value net annual cash flow

Payout Period

270,000 27,000 93,600

Payout Period

= 2.6 years
8/17/12

Prepared by: Rolly C. Ramos

By the Future Worth Method:

185,400 185,400

27,000

185,400

185,400

185,400

Cash flow diagram of cash inflows FW of cash inflows = 27,000 + 185,400 (F/A, 25%, 5) + = 27,000 + 185,400 (8.2070) = Php1,548,580
Annual costs (excluding depreciation) 0 1 = 81,000 + 270,000 2(0.04) 3 = 91,800 4 5

91,800 270,000

91,800

91,800

91,800

91,800

FW of cash outflows

= 270,000 (F/P, 25%, 5) + 91,800 (F/A, 25%, 5) = Php1,577,390

Since the FW of the net cash flows is less than zero (1,548,580 1,577,390) = -Php28,810, the Prepared by: Rolly C. Ramos 8/17/12 investment is not justified.

By the Present Worth Method:

185,400 185,400

27,000

185,400

185,400

185,400

Cash flow diagram of cash inflows PW of cash inflows = 185,400 (P/A, 25%, 5) + 27,000 (P/F, 25%, 5) = 185,400 (2.6893) + 27,000 (0.3277) = Php506,370
Annual costs (excluding depreciation) 0 1 = 81,000 + 270,000 2(0.04) 3 = 91,800 4 5

91,800 270,000

91,800

91,800

91,800

91,800

PW of cash outflows

= =

270,000 + 91,800 (P/A, 25%, 5) Php516,880

Since the PW of the net cash flows is less than zero (506,370 516,880) = -Php10,510, the investment is Prepared 8/17/12 not justified. by: Rolly C. Ramos

By the Annual Worth Method: Annual Revenue Annual 270,000 Costs:

Php185,400
= 29,609

= 81,000 = 10,800 = 67,500 Php188,9 09 Php3,50 9 Since the excess of annual cash inflows over annual cash outflows is less than zero (-3,509), the investment is not justified.
Prepared by: Rolly C. Ramos 8/17/12

Depreciation = 27,000 F/A, 25%, 5

Operation and Maintenance Taxes and Insurance (270,000 * 4%) Interest on capital (270,000 * 25%) Total Annual Cost Excess

By the Rate of Return Method: Annual Revenue Annual 270,000 Costs:

Php185,400
= 29,609

Operation and Maintenance Taxes and Insurance (270,000 * 4%) Total Annual CostAnnual Net Profit Php63,991
Rate of Return = Php270,00 0

Depreciation = 27,000 F/A, 25%, 5

= 81,000 = 10,800 Php121,4 09 Php63,99 1

x 100 = 23.70%

Since the rate of return is less than 25%, the investment is not justified.
Prepared by: Rolly C. Ramos 8/17/12