Chapter 5. EVALUATION OF SINGLE PROJECT ©2028017 Batangas State University Introduction All engineering economy studies of capital projects should consider the return that a given project will or should produce. A basic question this book addresses is whether a proposed capital investment and its associated expenditures can be recovered by revenue (or savings) over time in addition to a return on the capital that is sufficiently attractive in view of the risks involved and the potential alternative uses. In this chapter, we concentrate on the correct use of five methods for evaluatingthe economic profitability of a single proposed problem solution. The five methods are Present Worth (PW), Future Worth (FW), Annual Worth (AW), Internal Rate of Return (IRR), Payback Period 209 ©2017 Batangas State University Learning Objectives Discuss methods of evaluation. Critique contemporary methods of evaluation. Evaluate single project in determining project profitability. Make a decision based on the evaluation. 210 ©2017 Batangas State University Rate of Return Rate of return is a measure of the effectiveness of an investment of capital. It is a financial efficiency. When this method is used, it is necessary to decide whether the computed rate of return is sufficient to justify the investment. The advantage of this method is that it is easily understood by management and investors. The applications of the rate of return method is controlled by the following 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 investment required to finance the project, whether equity or borrowed. ROR 211 ©2017 Batangas State University Net Annual Profit Capital Invested Rate of Return Example. An investment of P270,000 can be made in a project that will produce a uniform annual revenue of P185,400 for 5 years and then have a salvage value of 10% of the investment. Out-of-pocket cost for operation and maintenance will be P81,000 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? Use ROR Method Given: Investment = P270,000 Annual Revenue = P185,400 for 5 years Salvage Value = 10% of investment Operation and Maintenance Cost = P81,000 per year Taxes and Insurance Cost = 4% of Investment 212 ©2017 Batangas State University Rate of Return Solution: Step 1: Identify the Given Given: Investment = P270,000 Annual Revenue = P185,400 for 5 years Salvage Value = 10% of investment Operation and Maintenance Cost = P81,000 per year Taxes and Insurance Cost = 4% of Investment Step 2: Analyze what method will be used Net Annual Profit Capital Invested ROR 213 ©2017 Batangas State University Note: Annual Proft = Annual Revenue - Annual Cost Capital Invested = First Cost or Investment Cost Rate of Return Solution: Step 3: Determine the Total Annual Cost and Total Annual Revenue Based from the problem, annual revenue = P185,000, then we need to determine what is the total cost to determine the Net Annual Profit Remember: In ROR Method, Depreciation Cost is included in the Total Cost Operation and Maintenance Cost = = P270,000(0.04) P81,000 = P10,800 Taxes and Insurance Cost = P29,609 (used Sinking Fund Methodwhere i = 25%) Depreciation Cost = P121,409 Total Cost 214 ©2017 Batangas State University Rate of Return Solution: Step 4: Determine the Net Annual Profit Net Annual Profit = Total Annual Revenue - Total Annual Cost = P185,000 - P121,409 = P63,991 Step 5: Use the formula to determine the rate of return Net Annual Profit ROR Capital Invested 215 ©2017 Batangas State University 63,991 ROR 270,000 x100 RoR = 23.70% Rate of Return Solution: Step 6: Make a Decision *Since the computed rate of return is less than the minimum required rate of return of 25%, the investment is not desirable or not accepted. 216 ©2017 Batangas State University Rate of Return Solution using tabulated form: Determine the inflows such as income and outflows such as expenses. Annual revenue An n u a l c o s t s : P185,400 Depre ci at ion O p e r a t i o n a n d m a i nt e na nc e Ta x e s a n d i nsura nc e P29,609 P81000 P10800 To t a l A n n u a l C o s t N e t a n n u a l profi t RoR 217 ©2017 Batangas State University P121,409 P63,991 P63,991 P270,000 X100 23.70% Rate of Return Example. A company estimates that insulation of steam pipes in the factory will reduce the fuel bill by as much as 25%. The cost of the insulation is P100,000 installed and the annual cost of taxes and insurance is 6% of the first cost. Without the insulation, the annual fuel bill is P200,000. If the insulation is worthless after 5 years of use, and a minimum return on investment of 10% is desired, would it be worthwhile to invest in the insulation? Solve using the ROR method. Given: Investment = P100,000 Annual fuel bill = P200,000 Salvage Value = 0 Taxes and Insurance Cost = 6% of Investment Return on investment = 10% 212 ©2017 Batangas State University Rate of Return Solution: Net Annual Profit = Revenue – Total Cost Computing Annual Savings: Annual Savings: P200,000(0.25) = P50,000 Computing Annual Cost: Depreciation: (P100,000-0)(0.10)/1.10^5-1 = P16,379.75 T&I = 0.06(P100,000) = P6,000 TAC = P22,379.75 ROR: ROR=Net Annual Profit/Capital Invested ROR=(Savings-Cost)/Capital Invested ROR=(P50,000-P22,379.75)/P100,000 x 100% = 27.62%, recommend to invest 212 ©2017 Batangas State University Annual Worth Method In this method, interest on the original investment (sometimes called minimum required profit) is included as a cost. If the excess of the annual cash inflows over annual cash outflows is not less than zero the proposed investment is justified-is valid. This method is covered by the same limitations as the rate of return pattern a single initial investment of capital and uniform revenue and cost throughout the life of the investment. Excess Annual Cash Inflows - Annual Cash Outflows 218 ©2017 Batangas State University Annual Worth Method Example. An investment of P270,000 can be made in a project that will produce a uniform annual revenue of P185,400 for 5 years and then have a salvage value of 10% of the investment. Out-of-pocket cost for operation and maintenance will be P81,000 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? Use Annual Worth Method Given: Investment = P270,000 Annual Revenue = P185,400 for 5 years Salvage Value = 10% of investment Operation and Maintenance Cost = P81,000 per year Taxes and Insurance Cost = 4% of Investment 219 ©2017 Batangas State University Annual Worth Method Solution: Step 1: Identify the Given Given: Investment = P270,000 Annual Revenue = P185,400 for 5 years Salvage Value = 10% of investment Operation and Maintenance Cost = P81,000 per year Taxes and Insurance Cost = 4% of Investment Step 2: Analyze what method will be used Excess Annual Cash Inflows - Annual Cash Outflows 220 ©2017 Batangas State University Note: Annual Cash Inflows includes Annual Revenue Annual Worth Method Solution: Step 3: Determine the Annual Cash Inflow and Annual Cash Outflow Based from the problem, annual revenue = P185,000 which is the cash inflow, we need to determine the total annual cash outflows Operation and Maintenance Cost = P81,000 = P270,000(0.04) = P10,800 Taxes and Insurance Cost = P29,609 (used Sinking Fund Method where i = 25%) Depreciation Cost Interest on Capital = P270,000(0.25) = P67,500 Total Annual Cash Outflows = P188,909 221 ©2017 Batangas State University Annual Worth Method Solution: Step 4: Determine the Excess using Annual Worth Method Excess Annual Cash Inflows - Annual Cash Outflows = P185,400 - P188,909 Excess = (P3,509) Step 5: Make a Decision *Since the excess of annual cash inflows over annual cash outflows is less than zero (-P3,509) the investment is not desirable or not ideal. Note: If excess is positive value, then the investment is advisable, otherwise, do not invest. 222 ©2017 Batangas State University Annual Worth Method Solution using tabulated form: Annual revenue Annual costs: P185,400 Depreciation P29,609 Operation and maintenance P81000 Taxes and insurance P10800 Interest on capital P67,500 Total Annual Cost Excess 223 ©2017 Batangas State University P188,909 -P3,509 Annual Worth Method Example. An investment of P3M can be made in a business that will produce a uniform annual revenue of P1.2M for five years and then have a salvage value of 10% of the investment. Operations and maintenance will be P100,000 per year. Taxes and insurance will be 5% of the first cost per year. The investor expects to earn not less than 20% before income taxes. Is this a good investment? Use the annual cost method. Given: Investment = P3M Annual Revenue = P1.2M for 5 years Salvage Value = 10% of investment = P300,000 Operation and Maintenance Cost = P100,000 per year Taxes and Insurance Cost = 5% of Investment = P150,000 Interest on Capital = 20% = P600,000 219 ©2017 Batangas State University Annual Worth Method Example. An investment of P3M can be made in a business that will produce a uniform annual revenue of P1.2M for five years and then have a salvage value of 10% of the investment. Operations and maintenance will be P100,000 per year. Taxes and insurance will be 5% of the first cost per year. The investor expects to earn not less than 20% before income taxes. Is this a good investment? Use the annual cost method. Given: Investment = P3M Annual Revenue = P1.2M for 5 years Salvage Value = 10% of investment Operation and Maintenance Cost = P100,000 per year Taxes and Insurance Cost = 5% of Investment Interest on Capital = 20% 219 ©2017 Batangas State University Annual Worth Method Solution using tabulated form: conclusion: not desirable Annual revenue Annual costs: P1.2M Depreciation P362,825.20 Operation and maintenance P100,000 Taxes and insurance(5%) P150,000 Interest on capital (20%) P600,000 Total Annual Cost Excess 223 ©2017 Batangas State University P1,212,825.2 -P12,825.20 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. The present worth method is flexible and can be used for any type of economy study. It is extensively in making economy studies in the public works field, where long-lived structures are involved. Present worth Method = PW inflows – PW outflows Here, we will just get the present value of money using the formula in money-time relationship. 224 ©2017 Batangas State University Present Worth Method Example. An investment of P270,000 can be made in a project that will produce a uniform annual revenue of P185,400 for 5 years and then have a salvage value of 10% of the investment. Out-of-pocket cost for operation and maintenance will be P81,000 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? Use Present Worth Method 225 ©2017 Batangas State University Present Worth Method Solution: Step 1: Identify the Given Given: Investment = P270,000 Annual Revenue = P185,400 for 5 years Salvage Value = 10% of investment Operation and Maintenance Cost = P81,000 per year Taxes and Insurance Cost = 4% of Investment Step 2: Analyze what method will be used ©2017 Batangas State University Present worth Method = PW inflows 226 Present Worth Method Solution: PW of cash inflows = P185,400 ((1-1.25^-5)/0.25) + P27,000 (1.25^-5) = P185,400 (2.6893) + P27,000 (0.3277) = P507,439.87 Annual Cost (excluding depreciation )= OM + T&I = 91,800 PW of cash outflows = P270,000+ P91,800 ((1-1.25^-5)/0.25) = P516,875.90 PW=PW of cash inflows – PW of cash outflows =P507,439.87 - P516,875.90 PW=-P9436.03 Decision. *Since the PW of the net cash flows is less than zero (-P9436.03) the investment is not ©2017 Batangas State University 227 justified or not ideal. Future Worth Method The future worth method for economy studies is exactly comparable to the present worth method except that all cash inflows and outflows are compounded forward to a reference point in time called the future. If the future worth of the net cash flow is equal to, or greater then zero, the project is justified economically. Future worth Method = FW inflows – FW outflows Here, we will forward the value of money-time relationships. 228 ©2017 Batangas State University money in future time using also the formula in Future Worth Method Example. An investment of P270,000 can be made in a project that will produce a uniform annual revenue of P185,400 for 5 years and then have a salvage value of 10% of the investment. Out-of-pocket cost for operation and maintenance will be P81,000 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? Use Future Worth Method 229 ©2017 Batangas State University Future Worth Method Solution. Step 1: Identify the Given Given: Investment = P270,000 Annual Revenue = P185,400 for 5 years Salvage Value = 10% of investment Operation and Maintenance Cost = P81,000 per year Taxes and Insurance Cost = 4% of Investment Step 2: Analyze what method will be used 230 ©2017 Batangas State University Future Worth Method Solution. FW of cash inflows = P27,000 + P185,400 ((1.25^5-1)/0.25) = P27,000 + P185,400 (8.2070) = P1,548,583.59 Annual Cost (excluding depreciation )= 91,800 FW of cash outflows = P91,800 ((1.25^5-1)/0.25) + P270,000 (1.25^5) = P1,577,380.08 FW=FW of cash inflows – FW of cash outflows =P1,548,583.59 – P1,577,380.08 FW=-P28,796.49 Decision *Since the FW of the net cash flows is less than zero (-P28,796.49)the investment is not justified or not ideal. 231 ©2017 Batangas State University Payback Period The payback period is commonly defined as 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. •Payback period (years) = investment – salvage net annual cash flow 232 ©2017 Batangas State University Payback Period Example. An investment of P270,000 can be made in a project that will produce a uniform annual revenue of P185,400 for 5 years and then have a salvage value of 10% of the investment. Out-of-pocket cost for operation and maintenance will be P81,000 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? What is the payback period? 233 ©2017 Batangas State University Payback Period Total annual cost = P81,000 +P270,000(0.04) = P91,800 Net annual cash flows = P185,400 – P91,800 = P93,600 Payback period:= investment-salvage value Net annual cash flows = P270,000-P27,000 P93,600 = 2.6 years or 2 years and 7 months and 6 days 234 ©2017 Batangas State University Months = (Payback periodyears)*12 Days = (Computed Monthsmonths)*30 Chapter Test Direction. Read and understand the given situation. Solve the problem using the given methods of evaluation. A man is considering P500,000 to open a semi-automatic auto washing business in a city of 400,000 population. The equipment can wash on the average of 12 cars per hour., using two men to operate it and to do small amount of hand work. The man plans to hire two men, in addition to himself and operate the station on an 8 hour basis, 6 days/week, 50weeks/year. He will pay his employees P25 per hour. He expects to charge P25.00 for a car wah out of pocket miscellaneous cost would be P8500/month. He would pay his employees for 2 weeks for vacation each year. Because of the length of his lease, he must write off his investment with 5 years. His capital now is earning 15% and he is employed at a steady job that pays P25,000/month. he desires a rate of return of at least 20% on his investment. Would you recommend the investment? Use the following method (ROR, Annual worth, Present, Future and Payback Period) Cost = Labor, Vacation Leave, Miscellaneous Fee, Depreciation and Owners Salary Interest = 0.15% 235 ©2017 Batangas State University Chapter Test ROR: Given: Revenue = 12 car/hr(8hr/day)(6days/wk)(50wks/yr)(P25/car) = P720,000/yr Cost: Labor = 2employee(8hr/day)(6days/wk)(50wks/yr)(P25/employee) = P120,000 Vacay Leave = 2employee(8hr/day)(12)(P25/employee) = P4,800 Misc Fee = P8500(12) = P102,000 Owner’s Salary = P25,000(12) = P300,000 Dep. = (P500,000-0)(0.15)/1.15^5-1 = P74,157.78 TAC= P600,957.78 ROR = (Revenue – Cost)/Investment ROR = (P720,000 – P600,957.78)/P500,000 X 100% = 23.81%, therefore since greater than 20%, should invest 235 ©2017 Batangas State University Chapter Test Annual Worth: Given: Revenue = 12 car/hr(8hr/day)(6days/wk)(50wks/yr)(P25/car) = P720,000/yr Cost: Labor = 2employee(8hr/day)(6days/wk)(50wks/yr)(P25/employee) = P120,000 Vacay Leave = 2employee(8hr/day)(12)(P25/employee) = P4,800 Misc Fee = P8500(12) = P102,000 Owner’s Salary = P25,000(12) = P300,000 Dep. = (P500,000-0)(0.15)/1.15^5-1 = P74,157.78 Interest on Capital = P500,000(0.20) = P100,000 TAC= P600,957.78 + P100,000 = P700,957.78 AW = P720,000 – P700,957.78 = 19,042.22, since greater than zero, therefore should invest 235 ©2017 Batangas State University Chapter Test Present Worth: Given: Investment = P500,000 Revenue = 12 car/hr(8hr/day)(6days/wk)(50wks/yr)(P25/car) = P720,000 Cost: Labor = 2employee(8hr/day)(6days/wk)(50wks/yr)(P25/employee) = P120,000 Vacay Leave = 2employee(8hr/day)(12)(P25/employee) = P4,800 Misc Fee = P8500(12) = P102,000 Owner’s Salary = P25,000(12) = P300,000 TAC= P526,800 Inflows = P720,000((1-1.15^-5/0.15)) = P2,413,551.67 Outflows = P500,000 + P526,800 ((1-1.15^-5/0.15)) = P2,265,915.31 PW = P2,413,551.67 - P2,265,915.31 = P147,636.36, since greater than zero, therefore we should invest 235 ©2017 Batangas State University Chapter Test Future Worth: Given: Investment = P500,000 Revenue = 12 car/hr(8hr/day)(6days/wk)(50wks/yr)(P25/car) = P720,000 Cost: Labor = 2employee(8hr/day)(6days/wk)(50wks/yr)(P25/employee) = P120,000 Vacay Leave = 2employee(8hr/day)(12)(P25/employee) = P4,800 Misc Fee = P8500(12) = P102,000 Owner’s Salary = P25,000(12) = P300,000 TAC= P526,800 Inflows = P720,000((1.15^5-1/0.15)) = P4,854,514.50 Outflows = P500,000(1.15^5) + P526,800 ((1.15^5-1/0.15)) = P4,557,565.04 FW = P4,854,514.50 - P4,557,565.04 = P296,949.46, since greater than zero, therefore we should invest 235 ©2017 Batangas State University Chapter Test Payback Period: Given: Investment = P500,000 Revenue = 12 car/hr(8hr/day)(6days/wk)(50wks/yr)(P25/car) = P720,000 Cost: Labor = 2employee(8hr/day)(6days/wk)(50wks/yr)(P25/employee) = P120,000 Vacay Leave = 2employee(8hr/day)(12)(P25/employee) = P4,800 Misc Fee = P8500(12) = P102,000 Owner’s Salary = P25,000(12) = P300,000 TAC= P526,800 Payback Period = (inv-sv)/(revenue-cost) = (P500,000-0)/(P720,000-P526,800) = 2.59 years = 2 years and 7 months and 2 days 235 ©2017 Batangas State University