INTRODUCTION
Engineering or business projects require huge capital investments. Economy studies are necessary to be conducted to establish whether a proposed capital investment and its associated expenditures can be recovered over time in addition to a return on the capital that is attractive in view of risks involved and opportunity costs of the limited funds. The concepts of interest and money-time relationships of Chapter 4 are quite useful in arriving at the investment decision.
Since different projects involve different patterns of capital investment, revenue or savings cash flows and expenditure or disbursement cash flows, no single method is perfect for making economy studies of all types of projects. As a result, several methods for making economy studies are commonly used in practice. All methods will produce equally satisfactory results and will lead to the same decision, provided the inherent assumptions of each method are enforced.
This chapter explains the working mechanism of six basic methods for making economy studies and also describes the assumptions and interrelationships of these methods. In making economy studies of the proposed project, the appropriate interest rate to be used for discounting purpose is taken to be equal to the minimum attractive rate of return (M.A.R.R.) expected by the fund provider. The value of M.A.R.R. is established in view of the opportunity cost of capital which reflects the return forgone as it is invested in one particular project.
BASIC METHODS
The following six methods are commonly used for making economy studies:
Equivalent worth:
1. Present worth (P.W.)
2. Future worth (F.W.)
3. Annual worth (A.W.)
Rate of return:
1. Internal rate of return (I.R.R.)
2. External rate of return (E.R.R.)
3. Explicit reinvestment rate of return (E.R.R.R.)
PRESENT WORTH(P.W.) METHOD
In this method, equivalent worth of all cash flows relative to some point in time called present worth i.e. P.W. is computed. All cash inflows and outflows are discounted to the present point in time at an interest rate that is generally M.A.R.R. using appropriate interest factor. The following steps are used to calculate P.W.:
Step 1: Draw the cash flow diagram for the given problem.
Step 2: Determine the P.W. of the given series of cash receipts by discounting these future amounts to the present at an interest rate i equal to M.A.R.R.
Review the options below to login to check your access.
Log in with your Cambridge Aspire website account to check access.
If you believe you should have access to this content, please contact your institutional librarian or consult our FAQ page for further information about accessing our content.