production

economics
ELSEVIER Int. J. Production Economics 42 (1995) 79-96

A compendium and comparison of 25 project

evaluation techniques.
Part 1: Net present value and rate of return methods
Donald S. Remer*, Armando P. Nieto
Haroqv Mudd College ofEngineeringand Science, Claremont, CA 9171 I, USA

Received August 1994; accepted for publication August 1995

Abstract
This two-part paper presents 25 different methods and techniques used to evaluate the economic desirability of
projects. We categorized these 25 methods into 5 types: net present value methods, rate of return methods, ratio methods,
payback methods, and accounting methods. We provide insight into the advantages and limitations of these project
evaluation methods by comparing and contrasting them. Many examples are included to illustrate the use of these
methods.
In Part 1, we examine net present value and rate of return methods. In Part 2, we examine ratio, payback, and
accounting methods. A recap, comparison, and full summary of all 25 methods is included at the end of Part 2.

Ke_ywords: Project evaluation techniques; Net present value methods; Rate of return methods

1. Introduction

Profitable capital investment leads to the growth and prosperity of an economy. If profitability is low,
investment will shrink. The investor needs tools to predict the profitability of proposed investments.
There are many methods and techniques available to help the investor make wise economic decisions.
These evaluation methods and techniques can be applied to independent projects to determine whether or
not to invest in each one, or they can be applied to several mutually exclusive projects for the purpose of
determining which, if any, should be pursued [l]. Such techniques are especially useful for corporate
managers and engineers. Despite the many discussions of these techniques, there does not appear to be one
source which summarizes and compares all the diferent investment yardsticks. It is the primary purpose of this
two-part paper to discuss, summarize, and compare 25 project evaluation methods in one central source. This
paper will help the reader understand the advantages and disadvantages of these methods, as well as which to use
in various applications.

*Corresponding author.

0925-5273/95/$09.50 \<: 1995 Elsevier Science B.V. All rights reserved

SSDI 0925-5273(95)00104-2
80 D.S. Remer. A.P. Nirto/hti. J. Productiotr Economics 42 (1995) 79-96

To understand the use and application of most project evaluation methods, knowledge of basic engineer-
ing economics concepts such as equivalence, time value of money (TVM), cash-flow diagrams, and economic
evaluation factors is required. Although it is not the intent of this paper to explain the derivation or
application of economic evaluation factors, Table 1 presents a summary of these factors, their formulas,
symbols and purpose. For additional information regarding basic engineering terminology, cash-flow
diagrams, TVM, equivalence and economic evaluation factors, see Refs. [2-91 or consult any engineering
economics textbook.
An understanding of various project evaluation methods and techniques provides the investor with
valuable tools for determining which projects, if any, should be accepted or rejected. Table 2 outlines the
typical steps of an economic evaluation [ 1, 6, 10, 111.
For additional information on the establishment of the minimum attractive rate of return (MARR), see
Refs. [4, 121. For additional information regarding sensitivity analysis, see Refs. [13321].
Once an understanding of the many steps involved in making economic project decisions, as well as the
various project evaluation techniques associated with those steps, is obtained, the question of which
evaluation methods to use becomes of great interest. The selection of certain project evaluation methods rests
primarily on items l-7 listed in Table 2. Yet, once these items have been established, the question of how to
determine the best method to use, based on those items, is an economic project in itself. It is not the intent of

Table 1
Summary of economic evaluation factors [4]

Factor name Formula Notation Solves for Given

1
1
Single-payment, present worth P=F ~ (P.F, ix, n) Present worth Future worth
f (1 +i)
Single-payment. compound amount F=P(l +i) (F/P. i%, n) Future worth Present worth

Uniform-series. present worth P=-III1i;r;,l] (PA, i%, n) Present worth Annualized worth

Capital-recovery
A=P[(li(:;t;l] (A/P, i%, II) Annualized worth Present worth

Sinking fund
(A/F. i%, n) Annualized worth Future worth
A=F[(l +L]
Uniform-series, compound amount F=A[il+/i-l]
(F/A, i%. n) Future worth Annualized worth

Table 2
Economic evaluation steps [l, IO]

I. Define a set of investment projects for consideration

2. Establish the planning horizon (or analysis period) for economic study
3. Estimate the cash flow profile for each project
4. Specify the time value of money or minimum attractive rate of return (MARR)
5. Examine the objective and establish criteria to measure effectiveness
6. Apply the project evaluation technique(s)
7. Compare each project proposal for preliminary acceptance or rejection
8. Perform sensitivity analysis
9. Accept or reject a proposal on the basis of the established criteria
 D.S. Remet, A.P. Nietollnt. J. Production Economics 42 (1995) 79-96 81

this paper to develop a set of criteria to do this. However, it is the intent of this paper to develop a clear
description and understanding of the uses, advantages, disadvantages, and limitations of many different
project evaluation techniques. This paper also aims to compare and contrast these methods to provide
insight into the economic results of different project evaluation techniques applied to the same project
proposal. We also provide a list of references that discuss the subtleties of the evaluation techniques in greater
detail than presented here.
In Part 1 of this two-part paper, we briefly introduce 25 project evaluation techniques. Then, we examine
net present value and rate of return methods. Several examples are included.
Part 2 continues with a description of ratio, payback, and accounting methods. Again, several examples
are included. Next, we apply almost every technique to one comparative example. Finally, we summarize,
compare and contrast all 25 different methods.

2. Project evaluation techniques

There are many different project evaluation techniques; some are more widely used than others. We have
categorized many various methods of project evaluation into five basic types: net present value methods, rate
of return methods, ratio methods, payback methods and accounting methods. Each of these methods is
shown in Table 3 under the appropriate category.
The most popular techniques are the net present value criterion methods, the internal rate of return
method, external rate of return method, return on investment method, benefit/cost ratio method and
payback period method. In 1978 and 1991, surveys of project evaluation techniques used by some of the
largest Fortune 500 companies, such as DuPont, Kodak, Ford, IBM and Westinghouse, were taken [22].
According to these surveys, there has been a shift from the use of the internal rate of return method to the net
present value criterion methods, and a decrease in the use of the payback period method. For more

Table 3
Project evaluation techniques

Net present vulue methods Ratio methods

Net present value criterion Premium worth percentage (S/S)
Present worth Return on original investment ($/$)
Future worth Return on average investment (S/S)
Annual worth Conventional benefit/cost (S/S)
Capitalized worth Modified benefit/cost (S/$)
Life cycle costing Lorie-savage benefit/cost ($/S)
Maximum prospective value criterion Profit-to-investment (S/S)
Savings-to-investment (S/$)
Cost effectiveness (S/unit of effectiveness)

Rate qf return methods Payback methods

Internal rate of return Conventional payback period
External rate of return Discounted payback period
Growth rate of return Project balance

Accountiny methods
Original book method
Average book method
Year-by-year method
Hoskolds method
82 D.S. Remer. A.P. Nietojlnt. J. Production? Economics 42 (1995) 79-96

information about which techniques are most widely used by todays businesses and corporations, see Refs.
[22-251.
Other less common methods include the life cycle costing method, maximum prospective value criterion
method, growth rate of return method, premium worth percentage method, profit-to-investment ratio
method, savings-to-investment ratio method, cost effectiveness method, project balance method, and ac-
counting methods. Results from the same two project evaluation technique surveys mentioned earlier
showed that there was an increase in the use of these less common methods from 7% to 21%. Of those
companies surveyed in 1991, no project evaluation was ever done without using either the internal rate of
return method or the net present value criterion methods [22, 231.
A description of the net present value methods will be presented first, followed by the rate of return
methods. The ratio methods, the payback methods, and the accounting methods will be discussed in Part 2 of
this two-part paper.

I. Net present value methods

A. Net present value criterion

The net present value criterion method (NPV) is also referred to as the net present worth criterion [l, 26,
271. Usually, when reference is made to this method, it encompasses several other similar methods that use
the same economic factors (Table l), but resolved for different times. For this reason, equivalent value or
equivalent worth is a better term to characterize all the different analysis periods. Equivalent worth methods
are also referred to as discounted cash-flow or equivalence methods [4, 10, 111.
In the most general terms, the net present value criterion method can be divided into four subtopics or time
analysis periods: present worth method, future worth method, annual worth method, and capitalized worth
method. The present worth method examines the cash flows of a project over a given time period and resolves
them to one equivalent present date cash how through the use of the economic factors listed in Table 1.
Similarly, the future worth method resolves them to one equivalent cash flow at a future date. The annual
worth method also examines the cash flows of a project, but does not resolve them to any one cash flow at
any one date. Instead, the annual worth method resolves all cash flows to an equivalent series of equal,
usually annual cash flows over a specified number of years in any analysis period. Similarly, the capitalized
worth method resolves all project cash flows to a series of equal annual cash flows, but, over an infinite time
period from any given starting date.
One assumption that must be made whenever using any of the equivalence methods is that all cash flows
received from a project are reinvested at the same fixed rate used to calculate the equivalent worths [4, 181.
This is a subtle but very important assumption which will be examined later. The rate referred to is the
interest rate, or rate of return, used in the economic factors presented in Table 1. Usually, this rate is called
the minimum attractive rate of return (MARR). Since all four methods use the same economic factors, they
yield the same results when used to evaluate a project. Therefore, only one of the four methods is needed to
judge the profitability of a project. Thus, the use of the term net present value encompasses all of the
equivalence methods.

Present worth method. Net present value criterion method can either be used to generalize any of the
equivalence methods or specifically refer to the present worth method [6, 271. Table 4 shows the different
terms used to describe all four equivalence methods [l, 446, 9, 12, 13, 18, 25-331.
The present worth method provides an easy way to evaluate projects by moving all cash flows to the
present. Table 5 shows the different criteria for determining the efficiency of a project when applying the
present worth method [6]. Using the present worth method is sometimes referred to as discounting.
Similarly, the interest rate used is sometimes referred to as the discount rate [S].
 D.S. Remer, A.P. Nietollnt. J. Production Economics 42 (1995) 79-96 83

Table 4
Terms used to describe net present value or equivalence methods

Equivalence method Also known as

Present worth method Net present worth, net present value criterion, net present worth criterion, present worth analysis, net
present value profit, venture worth, present worth amounts, general present value model, general, dis-
counted cash flow model, discounted cash flow measures
Future worth method Future worth analysis, future worth-cost, future cost, terminal worth, net future value, net future worth
Annual worth method Net equivalent uniform annual value criterion, annual equivalent criterion, equivalent uniform annual
worth evaluation, annual worth analysis, equivalent uniform annual cost, equivalent uniform annual
benefit, annualized cash flow method, levelized annual cash flow method
Capitalized worth method Capitalized equivalence worth analysis, capitalized cost method, capitalized equivalence method

Table 5
Present worth criteria for determining project efficiency [6]

Resources Constraints and limitations Criterion

Fixed input Amount of resources is fixed Maximize present wortha of benefits or other outputs
Fixed output There is a fixed task, benefit or other output Minimize present worth of costs of other inputs
to be accomplished
Neither input nor Neither resources, nor amount of benefits Maximize present worth of benefits minus costs (i.e.,
output is fixed or other outputs is fixed maximize the net present worth)

The criterion holds for the future worth as well as the annual equivalence worth methods

As shown in Table 5, depending upon the situation, maximizing or minimizing the net present worth of
a project will provide the most efficiency, and therefore, the most profitability, under the application of the
present worth method.
When using any project evaluation method, there are three different analysis-period situations to be
considered.
1. The useful life of each alternative equals the analysis period.
2. The alternatives have useful lives different from the analysis period, and usually different from each
other.
3. There is an infinite analysis period.
The useful life of any project is simply the estimated amount of time that the project will be in use (i.e.,
generate a cash flow, negative or positive). Example 1 demonstrates the use of the present worth method for
items 1 and 2 above. An example for item 3 will be presented later when discussing the capitalized worth
method, which, by definition, describes a project with an infinite analysis period.
To apply the present worth method, the following procedure listed in Table 6 must be followed [27].
In general, a project is accepted if the net present value is positive and rejected if the net present value is
negative. If the net present value is equal to zero, then the investor is indifferent to the project. Also, if two or
more projects are considered, the project which has the greater present value is generally selected. However,
depending on the project situation as described in Table 5, the project with a lower present worth may be
better [26, 341.
Example la demonstrates the use of the present worth method. For simplicity, most examples in this paper
consider the initial investment of the project to be the only negative net cash flow.
84 D.S. Remer, A.P. Nieto/Int. J. Production Economics 42 (1995) 79-96

Table 6
Steps for applying the present worth method [27]

1. Determine the interest rate for which all future cash flows can be reinvested. This is known as the required rate of return or minimum
attractive rate of return (MARR)
2. Estimate the economic useful life of the project
3. Estimate the positive and negative cash flows for each period over the analysis period
4. Calculate the net cash flows of each period
5. Calculate the present worth of each of the net cash flows determined above in 4

Example la. Present worth analysis of two projects with equal lioes.
The cash flows for two proposed Projects A and B are shown below. (Note: These cash flows will be
frequently referred to throughout this paper.)

Year Investment Income Operating and Misc. Salvage Net cash

($) ($) maintenance costs ($) value ($) flow 6)
costs ($)

Project A
0 1000 0 0 0 0 - 1000
1 0 375 40 35 0 300
2 0 375 40 35 0 300
3 0 375 40 35 0 300
4 0 375 40 35 0 300
5 0 325 40 35 50 300

Project B
0 1000 0 0 0 0 - 1000
1 0 475 30 45 0 400
2 0 475 30 45 0 400
3 0 375 30 45 0 300
4 0 325 30 45 0 250
5 0 125 30 45 50 100

Each of these projects has been proposed to accomplish the same purpose. The MARR for both projects is
10%. Using the notation described in Table 1, the present worth of Projects A and B can be expressed as
follows:

Present worth of Project A:

PWA = - 1000 + 300 (P/A, lo%, 5) = $137

Present worth of Project B:

PWB = - 1000 + 400(P/F, lO%, 1) + 400(P/F, lO%, 2) + 300(P/F, lo%, 3) + 250(P/F, lO%, 4)

+ lOO(P/F, lo%, 5) = $152.

Both projects are favorable because they present worth values greater than zero. However, since
PWB > PWA, Project B should be chosen.
 D.S. Remer, A.P. Nietollnt. J. Production Economics 42 (1995) 79-96 85

An important point to remember is that when using any of the equivalence methods, the same interest rate
must be used for comparing both projects. Another important point is that all projects must be compared
over equal time periods. However, sometimes the projects to be compared do not always have equal lives.
Example lb illustrates this situation.

Example lb. Present worth analysis of two projects with unequal lives
The cash flows for two Projects C and D are show below.

Year Investment ($) Net cash flow ($)

Project C
0 1000 1000
1 0 300
2 0 300
3 0 300
4 0 300
5 0 300

Project D
0 1000 - 1000
1 0 400
2 0 400
3 0 300
4 0 250
5 0 100
6 0 250
7 0 250
8 0 250
9 0 250
10 0 250

As before, the MARR is assumed to be 10%. The problem of two projects with unequal lives can be
overcome by assuming that one project can simply be repeated to provide a longer time period equal to the
other project or projects. This is referred to as the repeated projects assumption. Therefore, the best
analysis period to consider is equal to the lowest common denominator of the two lives of the project or
projects involved. In this example, the lowest common denominator of the two projects is 10 years.
In choosing 10 years as the analysis period, Project C must be repeated twice.

PWc = - 1000 + 300(P/A, lO%, 5) - lOOO(P/F, lO%, 5) + 300(P/A, lO%, 5)(P/F, lO%, 5)

= $222,

PWn = - 1000 + 1152 + 250(P/A, lo%, 5)(P/F, lo%, 5) = $741.

Again, both projects are favorable because their present worths are greater than zero. However, since
PW, > PWc, Project D should be chosen

One disadvantage of the present worth method is the repeated projects assumption. This assumes that the
cost of the project, if repeated, remains constant throughout the analysis period. Depending upon the project,
this assumption may be incorrect. As was assumed in Example lb, the initial investment of Project C was
unchanged at the end of five years. However, if the project proposal was to purchase a new computer system,
the probability of the costs remaining unchanged over the span of five years is unlikely. In addition,
86 D.S. Renter. A.P. NietoJlnt. J Production Economics 42 (1995) 79-96

a company will probably not want to buy the same computer system after five years. One way to compensate
for this drawback is to use cost indexes and cost-capacity equations. A cost index is a ratio of the cost of
something today to its cost at some time in the past. The equations of cost capacity relate the size of the
project to its cost. Both of these tools can be used to generate a more realistic value for the cost of a project
than simply making the repeated projects assumption [30]. For more information on cost indexes and
cost-capacity equations, see Refs. [30, 35-411.

Future worth method. The present worth method can be thought of as a way to determine the present
consequences of an investment. Similarly, the future worth method determines the future consequences of an
investment [6]. This method is also known as future worth analysis [6], the future value method [S] and
future worth-cost [ll]. See Table 4.
The process for calculating the future worth of a project is similar to Table 6, except that all cash flows are
compounded or resolved to a future date, usually the end of the projects life [31]. The factors used when
making these calculations are listed in Table 1. Just as with the present worth method, the amount measured
as the future worth must be evaluated on the basis of Table 5. In general a project is accepted if the future
worth is positive, rejected if the future worth is negative. As before, if the future worth is zero, the investor is
indifferent to the project [31]. Example 2 shows the use of the future worth method. Since the future worth
method is very similar to the present worth method, only one example will be presented.

Example 2. Future worth analysis of two projects with equal lives

Using the same cash flows as given in Example 1, the future worth of Projects A and B can be expressed as:

Future worth of Project A:

FWA = - lOOO(F/P, lo%, 5) + 300(F/A, lo%, 5) = $221

Future worth of Project B:

FW, = - lOOO(F/P, lo%, 5) + 400(F/P, lo%, 4) + 400(F/P, lo!!, 3) + 300(F/P, IO%, 2)

+ 250(F/P, lo%, 1) + 100 = $246

Both projects are favorable as their future worths are greater than zero. However, since FWB is greater
than FWA, Project B should be chosen.

As with the present worth method, the future worth method does not distinguish between the sizes of the
projects. Also, the problem of the repeated projects assumption is still encountered, although it can be
resolved in the same manner described earlier.

Annual worth method. The annual worth method is a variation of the two previous discussed methods.
Instead of resolving or compounding all cash flows to one present or future date, respectively, this method
converts all cash flows to a series of equal, usually annual, cash flows over a specified time, generally the
projects life. The factors used to determine the annual worth (shown in Table 1) were derived based on the
reasoning that the present worth of the calculated equal annual cash flows must equal the present worth of
the original cash flows. The criteria for accepting or rejecting a project are the same as for the present and
future worth methods 17311.The criteria for analyzing (i.e., maximizing or minimizing) the annual equivalent
amount is the same as that listed in Table 5. Example 3 illustrates the use of the annual worth method Cl].

Example 3. Annual worth analysis of two projects with equal lives

Using the same cash flows represented in Example 1, the annual worth can be expressed as:

Annual worth of Project A: AWA = - lOOO(A/P, lo%, 5) + 300 = $36

 D.S. Remer, A.P. NietoJInt. J. Production Economics 42 (1995) 79-96 87

To calculate the annual worth of Project B, the problem can be written as in Example 2. However, it can
also be incorporated with the present worth method by using the present worth value to calculate the
equivalent annual worth.
Annual worth of Project B: AW, = 152(A/P, lo%, 5) = $40
Both projects are favorable, however, since AW, > AWA, Project B should be chosen.
Although this method usually requires that the present (or future) worth first be calculated, one advantage
of the annual worth method is that there is no need to choose an appropriate number of years (usually the
least common multiple of years between projects, see Example lb). It does not matter if the analysis period
stretches over one life cycle or two life cycles of the project because the cash flows will be the same each year
[4]. Although the repeated projects assumption described earlier still exists, it can be handled in the same
way as explained under present worth method. Another advantage of this method is the simplicity of its
results. It is sometimes easier to understand the prospects of a project by examining its yearly costs (or
benefits) per dollar, than it is to understand the meaning of just one cash flow resolved to the present or
a future date. This is especially true for people who are unfamiliar with the meanings of the present and/or
future worth of a project. Therefore, the annual worth method can be very useful when explaining the results
to people with little or no knowledge of engineering economics.
The annual worth method is sometimes referred to as the annual equivalence worth method, net
equivalent uniform annual value criterion [12], annual equivalent criterion [31], and equivalent uniform
annual worth evaluation [4], (see Table 4). Frequently, in engineering economy literature, it is also referred to
as either the equivalent uniform annual cost method or the equivalent annual benefit method. The only
difference between these two terms is that the first refers to minimizing the annual worth of costs, while the
second refers to maximizing the annual worth of benefits [12].

Capitalized worth method. The capitalized worth method is simply the annual worth method evaluated over
an infinite time period. Once the present worth of a project has been established, the annual equivalent cash
flow can be calculated (and vice versa), provided the interest rate used remains constant over time. The
equation or factor needed to make this calculation is derived from Table 1. It can be expressed in the
following way:
A = Pi,
where A is the capitalized equivalent, P is the present worth and i is the interest rate [l, 4,121. An example of
a capitalized cost is shown in Example 4.

Example 4. Capitalized worth analysis of two projects with equal lives

Using the same cash flows from Example 1, the annual worth of Project A was found to be $36 (Example
3). If the repeated projects assumption is made, then $36 equals the capitalized annual equivalent.
Capitalized annual worth of Project A:
CWA = PWA. i = $36
The present worth of Project A can then be expressed as:
PWA = (CW,/i) = (36/0.10) = $360.

Similarly, if the repeated projects assumption is made, the capitalized annual worth of Project B is equal to
$40 (Example 3). The present worth of Project B can then be expressed as
PWB = (CW,/i) = (40/0.10) = $400.
Since PWB > PWA, Project B should be chosen.
88 D.S. Rernev, A.P. Nietollnt. J. Production Economics 42 (1995) 79-96

If no repeated projects assumption is made and an infinite life of the project is assumed instead, then the
capitalized annual equivalent worth of the project can be found based upon the original present worth of the
project.
From Example 1, the present worth of Project A was found to be $137, while the present worth of
Project B was found to be $152. The capitalized equivalents of each project can then be expressed as

cw* = PW*. i = (137)(0.10) = $13.70,

cw, = PWn. i = (152)(0.10) = $15.20.

Since PWs > PWA, Project B should be chosen.

In this example, both the assumptions of repeated projects and infinite lives may be unrealistic. These
assumptions were made only to illustrate the uses of this method. However, there is no need to use this
method when any of the other equivalent methods will suffice. The capitalized worth method is usually used
on projects which really do have very long lives, such as parks, football stadiums or other public works
projects.

Under this method, the present worth of the project is commonly referred to as the capitalized cost, while
the annual equivalent cash flow is referred to as the perpetuity or equivalent uniform annual cost (or benefit).
Other names for this method include the capitalized cost method and capitalized equivalence worth method
WI.
As stated earlier, the net present value criterion methods (NPV) have become more popular over the last 16
years. Out of 27 companies surveyed in 1978, only 52% reported using NPV, whereas out of 33 companies
surveyed in 1991, 97% reported using NPV [22, 231.
Each of the equivalence methods selected the same project from Examples l-4. Therefore, for the purposes
of selecting a project, only one of these methods is required. Depending on the situation, however, one
equivalence method may provide more insight than another. Table 7 compares the different uses, advantages
and disadvantages among each of the equivalence methods.
The net present value may be calculated in four ways using discrete cash flows or continuous cash flows
with discrete interest or continuous interest. For simplicity, in this paper, we are only considering discrete
cash flows and discrete compounding. For information about finding the net present value using the other

Table I
Uses. advantages and disadvantages among equivalence methods

Equivalence method Uses Advantages Disadvantages

Present worth Discounts all cash flows to present Uses TVM. Shows present Ignores size of project. Repeated
date consequence of a project projects assumption. Usually, not
understood by people unfamiliar
with engineering economics
Future worth Compounds all cash flows to a Uses TVM. Shows future Same as above
future date consequence of a project
Annual worth Converts all cash flows to a series Uses TVM. Shows yearly Ignores size of project. Repeated
of equal, usually annual cash consequence of a project. Easier projects assumption
Rows understood by people unfamiliar
with engineering economics.
Capitalized worth Determines equal. usually annual. Uses TVM. Shows yearly Ignores size of project
cash flows equivalent of an consequence of an infinite
infinite lived project project life

* TVM = Time value of money

 D.S. Remer, A.P. Nietollnt. J. Production Economics 42 (1995) 79-96 89

Table 8
Life cycle costing checklist [ 1S]

Purchase or manufacturing cost Service reliability

Transportation cost Benefits and penalties for quality
Installation costs Salvage value
Direct costs Distribution expense
Indirect costs General and administrative expense
Maintenance costs Conformity with trends
Inventory for materials Safety and ecological considerations
Inventory for parts Government rules and regulations
Periodic overhauls Uncertainty and risk
Supervision

three ways, see Ref. [7]. When evaluating a project, the cash flows can be analyzed using probability methods
[l, 4, 12, 34, 27, 28, 373 or fuzzy logic [21, 421. Although inflationary effects should usually be considered,
they are ignored in this paper. For information about how to handle inflation, see references [43, 441.

B. Life cycle costing

General Administration Bulletin No. FPMR E-153 requests that all federal agencies adopt life cycle
costing (LCC) as a basis for procuring supplies and services. Used principally by the government, or by large
contractors to the government, such as the defense industry [4, 181, life cycle costing is almost the same as the
present worth method. All computational methods are the same as those for the present worth method,
except that life cycle costing considers all costs in its calculations [4, 181. Table 8 shows a list of some of the
specific costs considered when performing life cycle costing [ 181. The project which has the lowest life cycle
cost is chosen. The learning curve is also often used with life cycle costing. For information on the uses of
learning curves and life cycle costing, see Refs. [45, 473.
The similarity of life cycle costing to the present worth method eliminates the need for a separate example.
If the costs listed as miscellaneous in Example 1 include the remaining costs listed in Table 8, then the life
cycle costing calculation would be identical to the present worth calculation. For more information on the
procedure for life cycle costing, see Ref. [47].

C. Maximum prospective value criterion

The maximum prospective value criterion method (MPVC) is also very similar to the present worth
method. The only difference is that this method examines the reinvestment assumption of the present worth
method in greater detail. In addition to assuming that all future cash flows are reinvested at the same interest
rate used in the calculations, the maximum prospective value criterion method assumes that there is an
investment period available between the actual cash flow reinvestments made for each time period. In other
words, the present worth method assumes that there is a cash flow available for reinvestment at equally
spaced time intervals, usually years. For discrete compounding and discrete cash flows, the maximum
prospective value criterion method assumes that there are short-term investments that can be made, within
the equally spaced time intervals, such that a greater cash flow is available at the end of the time interval than
would have been otherwise. Therefore, when calculating the maximum prospective value of a project, two
interest rates are used. The first interest rate used represents the short-term investment rate [9]. The second
interest rate usually represents the MARR, as long as the following three conditions apply:
(1) Many short-term investment proposals are being simultaneously considered.
(2) Only a small amount of the cash available for short-term investment is allocated to each proposal.
(3) The investment return from each proposal is available on a regular periodic basis.
90 D.S. Remer, A.P. Nietojht. J. Production Economics 42 (1995) 79-96

By offering the advantage of investing now in light of future anticipated opportunities, this method is
better at maximizing the capital growth rate. Also, the use of two rates reflects relationships frequently
encountered in practice [9].
An example of this method will not be given because of the complexity involved in determining the
additional cash flows resulting from the short term investments. However, once these new cash flows are
calculated, the application of this method is the same as that explained in Examples l-4. See Ref. [9] for an
example of this method.
Now that we have discussed net present value methods, we will now consider rate of return methods.

II. Rate of return methods

A. Internal rate of return

The internal rate of return method (IRR) is a measure of investment worth which calculates the interest
rate for which the present worth of a project equals zero [4, 28, 31, 38,48,49]. The term internal implies
that the interest rate does not represent any external factors, such as the MARR, but only internal
confines of the cash flow [l]. Other names for this method include the rate of return method, discounted cash
flow rate of return, interest rate of return, return on investment, investors method, break-even rate of return
and profitability index [l, 41. Table 9 shows the different terms used to describe the internal rate of return
method and other rate of return methods.
In the same 1978 survey discussed earlier in this paper, use of the internal rate of return method was
reported by all 27 companies. The 1991 survey showed a decrease in the use of the IRR method from 100% to
90% [22, 231.
Although this method does not incorporate the MARR in the calculations, the criteria for accepting or
rejecting a project does depend on the available MARR, as shown in Table 10. If the calculated internal rate
of return, or the discount rate, i*, is greater than the MARR, i, the project is acceptable. If the calculated
discount rate equals the MARR, then the investor remains indifferent to the project. Otherwise, the project is

Table 9
Terms used to describe rate of return methods

Rate of return method Also known as

Internal rate of return Rate of return method, discounted cash flow rate of return, interest rate of return, return on
investment, investors method, break-even rate of return, profitability index, yield to maturity (for
bonds)
External rate of return Composite rate of return, modified rate of return, Solomons average rate of return, overall rate of
return
Growth rate of return No other names found

Table 10
Criteria for the internal rate of return method (i* = discount rate)

Condition Decision

i* > MARR, i Accept project

i* = MARR, i Remain indifferent
i* < MARR, i Reject project
 D.S. Remer, A.P. Nietollnt. J. Production Economics 42 (1995) 79-96 91

rejected [31]. Since the calculations are based on the net present value criterion method, those same
assumptions of immediately reinvesting all future cash flows at the same interest rate must still hold.
The procedure for calculating the internal rate of return is demonstrated in Example 5.

Example 5. Internal rate of return analysis for two projects with equal lives
Again, using the same Projects A and B, as well as the same 10% MARR given in Example 1, the present
worth of a project can be expressed as follows:

PWA = - 1000 + 300(P/A, iz, 5).

To find the internal rate of return, i*, of any project, the present worth must be set equal to zero. This
implies

1000 = 300(P/A, ii, 5) or (P/A, ix, 5) = 3.333.

In general, the value for i* of any project can be found either by using the exact formula given in Table 1
and solving directly for i*, or by using tables of interest factors for various interests rates (which, prior to
programmable calculators and computers, usually required a trial-and-error method). For more information
on how to perform either of these two techniques for solving for i*, see Ref. [4] or any other engineering
economics textbook.
After performing a trial-and-error solution, ix is found to be 15.5%.
Similarly, the present worth of Project B can be expressed as follows:

PW, = - 1000 + 400(P/F, iB*, 1) + 400(P/F, iB*, 2) + 300(P/F, i& 3) + 250(P/F, i& 4) + lOO(P/F, i& 5).

Solving for ig is more difficult than solving for ix because of the additional terms involved. However, it can
still be done either by solving directly for i$ or using tables of interest factors and a trial-and-error method.
Setting PW, equal to zero and solving, ig is found to be 17%.
Both of these projects are favorable because their internal rates of return are greater than the MARR.
However, since ig > ii, Project B should be chosen.

When evaluating among mutually exclusive projects, an incremental analysis of the internal rate of return
method may be used [4]. This examines the incremental rate of return of a second project as compared with
the first project. Normally, incremental analysis is performed when there are differences in the initial
investments of two or more projects. In the previous example, there was really no need to perform this type of
analysis because the initial investments of Projects A and B are equal. However, consider the following two
sets of cash flows for two mutually exclusive projects:

Year Project X Project Y

0 - $2000 - $10000
1 $4000 $14000
IRR 100% 40%
PW $818 $1364

Using a MARR of lo%, the internal rate of return and present worth for Projects X and Y are calculated.
Project X has a higher rate of return, yet Project Y has a higher present worth. This inconsistency can be
explained by the need for incremental analysis when comparing mutually exclusive projects with different
initial investments.
Incremental analysis begins by first examining the project with the lowest initial investment. Then, the
project with the second lowest initial investment is examined to determine if the extra incremental
92 D.S. Remer, A.P. Nieto/Int. J. Production Economics 42 (1995) 79-96

investment is favorable. The incremental cash flows are found to be:

Year Project Y - Project X

0 - $8000
1 $10000
IRR 25%

The internal rate of return for the incremental cash flows was calculated to be 25%, which is greater than
the 10% MARR. This implies that the incremental investment for Project Y is favorable because the extra
$8000 of investment yields a 25% rate of return. Therefore, Project Y should be selected. Of course, the
present worth method already established that Project Y was better; however, this illustrates the fact that any
rate of return is only a relative percentage measure which ignores the scale of investment. For additional
information about incremental analysis and the internal rate of return method, see Refs. [4, 11, 12, 27, 501.
Many times, the internal rate of return method offers solutions with multiple roots. Therefore, choosing the
correct root is extremely important. For more information concerning this problem, see Refs. [l, 51,24, 121.
Also, the assumption of reinvesting all project funds at the determined internal rate of return may not always
be realistic, especially when the internal rate of return is very high. For example, a small company may not
have other projects which can yield a high internal rate of return. The higher the internal rate of return and
the smaller the company, the more likely that this assumption is not realistic. The external rate of return
method compensates for these situations [25].

B. External rate of return

A variation of the internal rate of return method is the modified or external rate of return method (ERR)
[31]. This is almost identical to the internal rate of return method except that the external rate of return
method does not assume that all cash flows are immediately reinvested at the calculated internal rate of
return. Instead, it assumes that all cash flows are reinvested at another rate (i.e., an external rate of return).
This external rate of return is set equal to the MARR providing the investor with q m re realis,:c return on
the investment [ll].
The external rate of return method calculates the interest rate for which the future worth of the initial
project investment equals the future worth of all other cash flows invested at the MARR [31]. The criteria for
accepting or rejecting a project are identical to that described in Table 10. Other names for this method
include the composite rate of return, Solomons average rate of return [4, 3 11, and the overall rate of return
Cl]; see Table 9. Example 6 demonstrates how to apply the external rate of return method.

Example 6. External rate of return analysis of two projects with equal lives
Using the same cash flows from Example 1, the future worth of all cash flows after the initial investment for
Project A can be expressed as
FW Alncome= 300(F/A, i, 5), where i represents the MARR = 10%.
Solving, FWAlncome = $1832.
The future worth of the initial investment can be expressed as
FW Ahvestment = - lOOO(F/P, ii 5), where ia represents the external rate of return.
The calculations involved are now similar to those performed in Example 2. Adding FWAIncome and
FW~,nvestment and setting equal to zero:
1832 - lOOO(F/P, ia, 5) = 0 or lOOO(F/P, ix, 5) = 1832.
 D.S. Remer, A.P. Nietollnt. J. Production Economics 42 (1995) 79696 93

Solving, ia, the external rate of return, is found to be equal to 12%, which is less than the internal rate of
return, ix of 15.5%.
Similarly, the future worth of all cash flows after the initial investment for Project B can be expressed as

FW aincome = 400(F/P, i, 4) + 400(F/P, i, 3) + 300(F/P, i, 2) + 250(F/P, i, 1) + 100.

Solving, FWBlncome = $1856.

The future worth of the initial investment can be expressed as

FW BInvestment = - lOOO(F/P, ii, 5), where i; represent the external rate of return.

Summing FWBlncome and FWBlnvestment and setting equal to zero:

lOOO(F/P, ib, 5) = 1856.

Solving, iB is found to be equal to 13%, which is less than the internal rate, ig of 17%.
Again, both of these projects are favorable as their external rates of return are greater than the MARR.
However, since ik > ia, Project B should be chosen.
The lower and more conservative rates given by external rate of return analysis represent the minimum
amount of return each of the projects will yield. Usually, when comparing two or more projects, an
incremental analysis may be performed. However, for the same reasons given previously, there was really no
need to do so here. For information on how to perform incremental analysis, see Refs. [4, 11, 12, 27, 501, or
any other engineering economics text book.

By assuming that all project funds are reinvested at the MARR, the external rate of return provides more
certainty than the internal rate of return because it determines the minimum guaranteed return of the project.

C. Growth rate of return

The growth rate of return method (GRR) determines a projects rate of return at any instance during the
projects life. This method answers the question, How fast must this investment grow in order to equal
a desired cash Row at a specific date ? To apply this method, a point in time during the projects life (usually
a specified year) must be selected for analysis. We shall refer to this point in time as the year of analysis.
Two cash flows are then calculated. One cash flow represents the present worth of all negative only cash flows
before the year of analysis. The second cash Row represents the value of all other cashjows discounted back
(or compounded forward) to the year of analysis. (It should be noted that only the positive cash flows before
the year of analysis will be compounded forward.) Both cash flows should be calculated using the MARR.
The growth rate of return can then be calculated in manner similar to that described for the internal and
external rate of return methods. The criteria for this method are similar to those for the internal rate of return
method shown in Table 10 [34]. The results given by the growth rate of return method are identical to those
given by the net present value criterion method. Example 7 outlines the procedure for using the growth rate
of return method and graphically illustrates its concept.

Example 7. Growth rate of return analysis for two projects with equal lives
As before, the same set of cash flows given in Example 1 will be used. Since the growth rate of return
method can only be applied to one given year at a time, a decision has to be made according to the goals of
the company for which Projects A and B are being considered. For this example, the third year has been
arbitrarily chosen as the year of analysis. Only the results for Project B will be shown graphically (see
Figs. 1 and 2).
The first cash flow represents the present worth of all negative cash flows before the year of analysis. In
this example, the initial investment is the only negative cash flow before the year of analysis for both
Projects A and B. Therefore, no calculation is necessary to find the first cash flow because the initial
94 D.S. Remer, A.P. Nietollnt. J. Production Economics 42 (1995) 79-96

-1
0 1 2 3 4 5
Years

Fig. 1. Original cash flow of project B. Fig. 2. GRR analysis for year 3.

investment is already at the present. The first cash flow for Projects A and B can then be represented as

PW of negative cash flows before year 3 = PW3ANeg = PW3BNeg = - $1000

Next, the second cash flow must be calculated. This cash flow represents the value of all other cash flows
discounted back (or compounded forward) to year 3 or year of analysis. For Project A, all remaining cash
flows must be compounded or discounted (at the MARR = 10%) to year 3. This can be expressed as follows:

Cash flow at year 3 = CF,, = 300(F/A, i, 3) + 300(P/A, i, 2), where i = MARR = 10%.

Solving, CF,* is found to be $1514.

Having found the first and second cash flows, the procedure to calculate the growth rate of return is similar
to that described for the internal and external rate of return methods (see Examples 5 and 6). The first cash
flow represents a present worth. The second cash flow represents some future worth (year 3 for our example).
The growth rate of return is simply the rate at which the first cash flow must grow in order to equal the
second cash flow. This can be expressed as follows:

lOOO(F/P, iGA, 3) = 1514, where ioA equals the growth rate of return for Project A.

Solving, iGA is found to be 14%.

For Project B, the first cash flow, representing the present worth of all negative cash flows before the year
of analysis, was shown to be equal to the initial investment of $1000. To find the second cash flow, the
remaining cash flows must be compounded or discounted to year 3. This can be expressed as

Cash flow of at year 3 = CFAB = 400(F/P, i, 2) + 400(F/P, i, 1) + 300 + 250(P/F, i, 1) + lOO(P/F, i, 2),

where i = MARR = 10%

Solving, CF,, is found to be $1534.
Having determined the first and second cash flows, we can calculate the rate at which the first cash flow
must grow in order to equal the second cash flow (i.e., the growth rate of return). This can be represented as

lOOO(F/P, icB, 3) = 1534, where i GBequals the growth rate of return for Project B. Therefore, iGB answers
the question, How fast must this investment grow to equal $1534 by year 3?

Solving, ioB is found to be 15%

 D.S. Remer, A.P. Nietollnt. J. Production Economics 42 (1995) 79-96 95

Both Projects A and B are favorable because their growth rates of return are greater than the MARR.
However, since ice > iGA, Project B has a better growth rate and should be chosen.
If the year of analysis was chosen to be year 5, the growth rate of return would have been equal to the
external rate of return calculated in Example 6. Similarly, if the year of analysis was year 0, the growth rate
of return would have equaled the internal rate of return calculated in Example 5. Also, in this example, the
decision to select Project B would not have been different for an analysis performed at any other year because
the initial investments were the only negative cash flows. This may not always be the case as different project
proposals may have other negative cash flows in addition to the initial investments. Thus, depending on the
year selected for analysis, a project may prove to be most favorable at one year, while another project may be
more favorable at different year.

The growth rate of return method depends solely upon the time period or year of analysis chosen for
discounting and/or resolving all cash flows. Therefore, it only yields one growth rate of return for each
selected time period or year of analysis. However, it does provide the investor with a method for calculating
the rate of return a project promises to give at a certain time for a given investment.
The rate of return methods calculate the rate of return by solving for 7. Part 2 of this two-part paper
continues with a description of the Ratio Methods which calculate the rate of return from ratios usually
based upon equivalent worth values. Part 2 also discusses payback and accounting methods and provides
a recap, comparison, and full summary of all 25 project evaluation techniques presented in this two-part paper.

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