BASIC METHODS FOR MAKING ECONOMY STUDIES
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Rate of Return (ROR) Method
Annual Worth (AW) Method
Present Worth (PW) Method
Future Worth (FW) Method
Payback (Payout) Period Method
Rate of Return (ROR) Method
Rate of return is a measure of the effectiveness of an investment of capital.
A rate of return equivalent from 20% to 25% of the investment is adequate to justify the
investment.
𝒏𝒆𝒕 𝒂𝒏𝒏𝒖𝒂𝒍 𝒑𝒓𝒐𝒇𝒊𝒕
𝑹𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 =
𝒄𝒂𝒑𝒊𝒕𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒆𝒅
Annual Worth (AW) 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, the
proposed investment is justified (valid).
Present Worth (PW) Method
If the present worth of the net cash flows is equal to or greater than zero, the project is justified
economically.
Future Worth (FW) Method
All cash inflows and outflows are compounded forward to a reference point in time called
future.
If the future worth of the net cash flows is equal to or greater than zero, the project is justified
economically.
Payback (Payout) Period Method
The payback period is 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.
𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
𝑃𝑎𝑦𝑜𝑢𝑡 𝑝𝑒𝑟𝑖𝑜𝑑(𝑦𝑒𝑎𝑟𝑠) =
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤
EXAMPLES:
1. 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
costs 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 of the investment?
2. A project is estimated to cost P100,000, lasts 8 years, and have a P10,000 salvage value. The
annual gross income is expected to average P24,000 and annual expenses, excluding
depreciation, will total P6,000. If capital is earning 10% before income taxes, determine if this is
a desirable investment using (a) ROR, (b)AWM, (c) PWM, and (d) FWM.
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COMPARISON OF ALTERNATIVES
Fundamental Principle:
The alternative that requires the minimum investment of capital and will produce satisfactory
functional result will always be used unless there are definite reasons why an alternative requiring a
larger investment should be adopted.
Methods or Patterns in Comparing Alternatives
 Rate of Return on Additional Investment Method
 Annual Cost (AC) Method
 Equivalent Uniform Annual Cost (EUAC) Method
 Present Worth Cost (PWC) Method
 Capitalized Method
 Payback (Payout) Period Method
Rate of Return on Additional Investment Method
If the rate of return on the additional investment exceeds the current rate of return on the
capital, the more expensive alternative should be chosen.
𝑹𝒂𝒕𝒆 𝒐𝒇 𝒓𝒆𝒕𝒖𝒓𝒏 𝒐𝒏 𝒂𝒅𝒅𝒊𝒕𝒊𝒐𝒏𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
𝒂𝒏𝒏𝒖𝒂𝒍 𝒏𝒆𝒕 𝒔𝒂𝒗𝒊𝒏𝒈𝒔
=
𝒂𝒅𝒅𝒊𝒕𝒊𝒐𝒏𝒂𝒍 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕
Annual Cost (AC) Method
The annual cost of the alternatives including interest on investment is determined.
The alternative with the least annual cost is chosen.
Equivalent Uniform Annual Cost (EUAC) Method
All cash flows (irregular and uniform) must be converted to an equivalent uniform annual cost,
that is, a year end amount which is the same each year.
The alternative with the least equivalent uniform annual cost is preferred.
Present Worth Cost (PWC) Method
Determine the present worth of the net cash outflows for each alternative for the same period
of time.
The alternative with the least present worth of cost is selected.
Capitalized Method
Determine the capitalized cost of all the alternatives and choose that one with the least
capitalized cost.
Payback (Payout) Period Method
The alternative with the shortest payback period is adopted.
EXAMPLES:
1. A highway contractor needs some heavy duty trucks for his construction jobs. Suppliers of two
trucks, T and Z, have furnished the following data:
If the contractor requires a minimum rate of return of 18% on his investment, which truck
should he buy?
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Truck T
Truck Z
First cost
P1,200,000
P2,000,000
Life
4 years
8 years
Salvage value at end of life
P100,000
P180,000
Annual out of pocket costs
P180,000
P120,000
2. A company is considering two types of equipment for its manufacturing plant. Pertinent data are
as follows:
Type A
Type B
First cost
P200,000
P300,000
Annual Operating Cost
P32,000
P24,000
Annual Labor Cost
P50,000
P32,000
Insurance and Property Taxes
3%
3%
Payroll Taxes
4%
4%
Estimated Life
10
10
If the minimum required rate of return is 15%, which equipment should be selected?
3. A gasoline driven pump and an electric power pump are being considered for use in a mine for a
period of 10 years. The data available are: If the minimum required rate of return is 15%, what
would you recommend?
Gasoline
Electric
First cost
P12,000
P25,000
Life in years
5 years
10 years
Salvage value
P1,000
P2,000
Annual operating cost
P3,200
P1,800
Annual repairs
P600
P400
Annual taxes (% of first cost)
3%
3%
4. Based on estimates the data for two types of bridges with different lives are as follows. If the
minimum attractive rate of return is 9%, determine which project is more desirable.
Timber Bridge
Steel Bridge
First cost
P50,000
P140,000
Salvage value
P2,000
P10,000
Life in years
12 years
36 years
Annual maintenance
P6,000
P2,5000
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COMPARISON OF ALTERNATIVES (ADDITIONAL PROBLEMS)
5. A company is going to buy a new machine for manufacturing its product. Four different
machines are available. Money is worth 17% before taxes to the company. Which machine
should be chosen?
A
B
C
D
First cost
P24,000
P30,000
P49,600
P52,000
Life in years
5
5
5
5
Power per year
P1,300
P1,360
P2,400
P2,020
Labor per year
P11,600
P9,320
P4,200
P2,000
Maintenance per year
P2,800
P1,900
P1,300
P700
Taxes and insurance
3%
3%
3%
3%
6. A plant to provide the company’s present needs can be constructed for P2,800,000 with annual
operating disbursements of P600,000. It is expected that at the end of 5 years the production
requirements could be doubled, which will necessitate the addition of an extension costing
P2,400,000. The disbursements after 5 years will likewise double. A plant to provide the entire
expected capacity can be constructed for P4,000,000 and its operating disbursements will be
P640,000 when operating on half capacity (for the first 5 years) and P900,000 on full capacity.
The plants are predicted to have indeterminately long life. The required rate of return is 20%.
What would you recommend?
7. To remedy the traffic situation at a busy intersection in Quezon City, two plans are being
considered. Plan A is to build a complete cloverleaf costing P9,200,000 which would provide for
all needs during the next 30 years. Maintenance costs are estimated to be P2,000 a month for
the first 15 years and P3,500 a month for the second 15 years. Plan B is to build a partial
cloverleaf at a cost of P6,500,000 which would be sufficient for the next 15 years. At the end of
15 years, the cloverleaf will be completed at an estimated cost of P7,500,000. Maintenance
would cost P1,400 a month during the first 15 years and P3,500 a month for the second 15
years. If money is worth 8%, which of the two plans would you recommend?
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