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
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. Prepared by: Rolly C. Ramos
8/17/12
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: by: Rolly C. Ramos It Prepared is flexible and can8/17/12 be used for
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
Payout Period
Payout Period
=
=
investment – salvage value net annual cash flow 270,000 – 27,000 93,600
= 2.6 years
Prepared by: Rolly C. Ramos
8/17/12
By the Future Worth Method: 0
27,000
185,400
185,400
185,400
185,400
185,400
1
2
3
4
5
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
= 81,000 + 270,000 (0.04)
= 91,800
1
2
3
4
91,800
91,800
91,800
91,800
5
91,800
270,000
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: 0
27,000
185,400
185,400
185,400
185,400
185,400
1
2
3
4
5
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
= 81,000 + 270,000 (0.04)
= 91,800
1
2
3
4
91,800
91,800
91,800
91,800
5
91,800
270,000
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 by: Rolly C. Ramos 8/17/12 not justified.
By the Annual Worth Method: Annual Revenue Annual Costs:
Php185,400
270,000 – Depreciation = 27,000 F/A, 25%, 5
Operation and Maintenance Taxes and Insurance
= 29,609
= 81,000 =
(270,000on * 4%) 10,800 = Interest capital (270,000 67,500 * 25%) Php188,9 Total Annual 09 Cost Excess Php3,50 9 inflows Since the excess of annual cash
over annual cash outflows is less than zero (-3,509), the investment is not justified. Prepared by: Rolly C. Ramos
8/17/12
By the Rate of Return Method: Annual Revenue Annual Costs:
Php185,400
270,000 – Depreciation = 27,000 F/A, 25%, 5
Operation and Maintenance Taxes and Insurance
= 29,609
= 81,000 =
(270,000 * 4%)
10,800 Php121,4 Total Annual 09 Cost Php63,99 Net Annual 1 Profit Php63,991
Rate of Return =
x 100 = 23.70%
Php270,00 0
Since the rate of return is less than 25%, the investment is not justified. Prepared by: Rolly C. Ramos
8/17/12
