Chapter 5

Present Worth
Analysis
Engineering Economy

Background

An engineering project or alternative is formulated to make or purchase a product,

to develop a process, or to provide a service with specified results

An engineering economic analysis evaluates cash flow estimates for parameters

such as initial cost, annual costs and revenues, etc., over an estimated useful life of
the product; process, or service

We have learned some basic tools in pervious chapters

In this chapter (and next few chapters.Stage 2) we are going to use the basic tools
(we learnt already) with some more techniques to evaluate one or more
alternatives using the factors and formulas learned in Stage 1

After completing these chapters, you will be able to evaluate most engineering
project proposals using a well-accepted economic analysis technique, such as
present worth, future worth, capitalized cost, life-cycle costing, annual worth, rate
of return, or benefit /cost analysis

Why we need this Chapter ?

(Present Worth Analysis)
A future amount of money converted to its equivalent value now has a
present worth (PW) that is always less than that of the future cash flow,
because all P/F factors have a value less than 1.0 for any interest rate
greater than zero
For this reason, present worth values are often referred to as
discounted cash flows (DCF) , and the interest rate is referred to as the
discount rate
Up to this point, present worth computations have been made for one
project or alternative
In this chapter, techniques for comparing two or more mutually
exclusive alternatives by the present worth method. Full details of
contents of the chapter is on next slide

Content of the Chapter

1.

Formulate Alternatives

2.

Present Worth of equal-life alternatives

3.

Present Worth of different-life alternatives

4.

Future Worth analysis

5.

Capitalized Cost analysis

From Chapter 1:
Steps in an Engineering Economy Study
Step 1 in
Study

Problem description
Objective statement

Step 2

Available data
Alternatives for solution

Step 3

Cash flows and other

estimates

Step 4

Measure of worth criterion

(PW, B/C, IRR etc)

Step 5

Engineering Economic
Analysis

Step 6

Best alternative Selection

Step 7

Implementation and
Monitoring

One or more approaches to

meet objectives

Expected life
Revenues
Costs
Taxes
Project Financing

Tools u will be learning in

this course are used here

Time Passes

Step 1 in
Study

New Problem description

New engineering economic

study begins

Two types of the Events: basic

concept from probability theory

Mutually Exclusive events

If two events cannot occur at the

same time, it is called mutually
exclusive events

Mutually exclusive means two

outcomes cannot happen
simultaneously

An example is tossing a coin

once, which can result in either
heads or tails, but not both.

Independent Events
One event is independent of
the other event
In this case the occurrence of
one event is totally
independent of another
event
E.g., it rained today. And a
chair broke down in office
today. These are two
independent events

Formulating Alternatives
Two types of economic proposals:
1.

Mutually Exclusive (ME) Alternatives: Only one proposal can be

selected; Compete against each other and are compared pairwise. These
proposals are normally called alternatives
e.g., A selection of Best diesel powered engine among the available models

2.

Independent Projects: More than one can be selected , these proposals are
called projects; it competes only against DN

Do Nothing (DN) An ME alternative or independent project to

maintain the current approach; no new costs, revenues or savings
In this chapter, we will learn Present Worth Method to
evaluate either type of proposal ..in next chapters we will learn
some more such techniques.

Project or alternatives types

based on Cash flows
There are two types of alternatives based on Cash flows
1. Revenue each alternative project being evaluated generate
costs and revenues over life period of alternative.
E.g., new systems, products/services that involve capital costs
Criteria of selection is to maximize the economic measure (e.g.,
profit in case of introducing new product).
2. Cost ( or service based) Each alternative has only cost cash
flow estimates (revenues are same for all alternatives)
E.g., which 100-seat plane to buy?
Criteria of selection is to minimize the economic measures (e.g.,
in this case cost of buying 100-seat plane)

Mandates, Ideas, identifications,

experience, Plans, Estimates

Not viable

viable

B
C

Formulating
Alternatives

Mutually
Exclusive
Alternatives

Select
only
one

Not viable

Either of
these

1
2
3
.
.
.
m

E
Independent
projects

Select
all
justifi
ed

1
2
3
.
.
.
DN

Type of Cash flow Estimates

- Revenue Alternatives
- Cost Alternatives
Revenues and costs
Costs only

Performance evaluation and make selection

Example 1: Selection of Alternatives

by Present Worth Criteria

For the alternatives shown below, which should be selected if they

are (a) mutually exclusive; (b) independent?
Project ID

Solution:

Present Worth

A
B

$ 30,000
$ 12,500

$ 4,000

2,000

(a) Select numerically largest PW; alternative A

(b) Select all with PW > 0; projects A, B & D

Present Worth (PW) analysis

This is the process of obtaining the equivalent worth of future
cash flows at present time

That is, finding PW of cash flows

We say that future cash flows are discounted to time 0

The higher the PW, the better PW is evaluate based on an

interest rate, which is equal to the organizations MARR

Present Worth Analysis

Evaluation
Mutually exclusive projects
For one project, it is financially viable if PW 0.
For 2 or more alternatives, select the one with the
(numerically) largest PW value.

Independent Projects

Select all projects with PW 0

However, in practice a budget limit exists (details in chapter 12)

REMEMBER: This Evaluation is for the case when

alternatives have equal life

PW Analysis Procedure
The present worth method is quite popular in industry
because all future costs and revenues are transformed
to equivalent monetary units NOW
This Criteria work as follows;
Convert all cash flows to Present Worth (same as
present value) using MARR
Precede costs by minus sign; receipts by plus sign

Example 2: PW evaluation of equal-life

Mutually Exclusive alternatives
Alternative X has a first cost of $20,000, an operating cost of $9,000 per year, and a
$5,000 salvage value after 5 years.
Alternative Y will cost $35,000 with an operating cost of $4,000 per year and a salvage
value of $7,000 after 5 years.
At an MARR of 12% per year, which should be selected?

Solution:

Cash flow diagram ? Any one ?

Find PW at MARR and select numerically larger PW value

PWX = 20,000 9000(P/A,12%,5) + 5000(P/F,12%,5)

Convert all cash flows to

Present Worth (same
as present value) using
MARR

Precede costs by
minus sign; receipts by
plus sign

= $49,606
PWY = 35,000 4000(P/A,12%,5) + 7000(P/F,12%,5)
= $45,447
Select alternative Y

Practice: Example 5.1

Class Practice: 5 minutes

A university lab is a research contractor to NASA for in-space

fuel cell systems that are hydrogen and methanol-based. During
lab research, three equal-service machines need to be
evaluated economically. Perform the present worth analysis
with the costs shown below. The MARR is 10% per year.
Electric powered

First Cost($)
Annual Operating Costs ($/year)
Salvage value S ($)
Life years

Gas powered

4500
900
200

3500
700
350

600
50
100

Single Payments

10%

Solar powered

Uniform Series Factors

Compound
Amount

Present
Worth

Sinking Fund

(A/F)

Compound
Amount

2.1436

0.4665

0.08744

11.4359 0.18744 5.3349

(F/P)

(P/F)

Capital
Recovery

(F/A)

Present
Worth

(A/P)

(P/A)

Class Practice
Electric powered
First Cost($)
Annual Operating Costs ($/year)
Salvage value S ($)
Life years
10%

Gas powered

Solar powered

4500

3500

600

900

700

50

200

350

100

Single Payments

Uniform Series Factors

Compound
Amount (F/P)

Present
Sinking Fund
Worth (P/F) (A/F)

Compound
Amount
(F/A)

2.1436

0.4665

11.4359 0.18744 5.3349

0.08744

Capital
Recovery
(A/P)

Present
Worth
(P/A)

PWE = 4500 900( P/A ,10%,8) + 200( P/F ,10%,8) = $9208

PWG = 3500 700( P/A ,10%,8) + 350( P/F ,10%,8) =$7071
PWS = 6000 50( P/A ,10%,8) + 100( P/F ,10%,8)= $6220
$6220 Solar powered alternative should be
selected

PW of Different-Life Alternatives
For alternatives with unequal lives the rule is:
PW must be compared over the same number of years
This is called equal service alternatives requirement (i.e.,
alternatives must end at the same time) Why its
important ?
Because if this condition is not meet, For COST
ALTERNATIVES (which involves only cost) will always favor
the shorter-lived mutually exclusive alternative, even if it is
not the more economical choice, because fewer periods of
costs are involved

PW of Different-Life Alternatives
The following are two equal ways of meeting the equal
service requirements:
1. Least Common Multiple (LCM) of alternative lives
Compare the PW of alternatives over a period of time
equal to the least common multiple (LCM) of their
estimated lives
2. Study Period Approach
Compare the PW of alternatives using a specified study
period of n years. This approach does not necessarily
consider the useful life of an alternative. The study period
is also called the planning horizon.

LCM of Alternative Lives

Approach
This approach compare the PW of alternatives over a
period of time equal to the least common multiple
(LCM) of their estimated lives

Three assumptions of LCM Approach

1. The service provided is needed for LCM years or
more.
2. The selected alternative is repeated over each life
cycle of the LCM in exactly the same manner.
3. Cash flow estimates are the same in every life cycle
(i.e., change are exactly by the inflation or deflation rate only)

Evaluation of Present Worth

Using a LCM Approach
First, find the LCM for the life of alternatives
Expand the cash flows for each alternatives till the
LCM period thus meeting the equal service
requirement
Calculate the present worth for all the alternatives
Use the criteria used for Equal Life Alternatives to
evaluate the alternatives

10

Study Period Approach

Compare the PW of alternatives using a specified
study period of n years. This approach does not
necessarily consider the useful life of an
alternative. The study period is also called the
planning horizon.
A study period analysis is necessary if the first
assumption of LCM approach (i.e., The service
provided is needed for LCM years or more ) cannot be
made.

Evaluation of Present Worth

Using a Study Period
For the study period approach, a time horizon is chosen over
which the economic analysis is conducted, and only those
cash flows which occur during that time period are
considered relevant to the analysis
Once a study period is specified, all cash flows after this time
are ignored
Salvage value is the estimated market value at the end of
study period (at this stage we will just use Salvage value as it is)
Short study periods are often defined by management when
business goals are short-term

11

Example: Different-Life Alternatives

National Homebuilders, Inc., plans to purchase new cut-and-finish

equipment. Two manufacturers offered the estimates below.
First cost, $
Annual cost, $/year
Salvage value, $
Life, years

Vendor A
15,000
3,500
1,000
6

Vendor B
18,000
3,100
2,000
9

(a) Determine which vendor should be selected on the basis of a present

worth comparison, if the MARR is 15% per year.
(b) National Homebuilders has a standard practice of evaluating all options over
a 5-year period. If a study period of 5 years is used and the salvage values
are not expected to change, which vendor should be selected?

(a)

Determine which vendor should be selected on the basis of a present worth

comparison, if the MARR is 15% per year.

Solution:

LCM = 18 years; We draw its cash flows to make things easy

To meet the criteria of equal
service alternatives we extended
the project life from 6 years to 18
years for the first alternative (& 9
to 18 for 2nd alternative)
NOW You have equal life two
alternatives(equal service
condition meet) with cash
flowsyou can use standard
procedure to obtain the present
value of both and compare it.

12

Example 5.3: Different-Life Alternatives

Solution:
PWA = -15,000 15,000(P/F,15%,6) +1000(P/F,15%,6) 15,000(P/F,15%,12)
+1000(P/F,15%,12) + 1000(P/F,15%,18) 3,500(P/A,15%,18)

= $ 45,036
PWB = -18,000 18,000(P/F,15%,9)+ 2000(P/F,15%,9)+ 2000(P/F,15%,18)
3100(P/A,15%,18)
= $ 41,384

Select vender B

Which one to select ? A or B ?

Example 5.3: Different-Life Alternatives

Solution (b): Now

comparison is required for
5 years. Since cash flows
are of 6 years no cycle
repeat is required
PWA = -15,000 3,500(P/A,15%,5) +1000(P/F,15%,5)

= $ 26, 236
PWB = -18,000 3100(PA,15%,5) + 2000(P/F,15%,5)
= $ 27,397

Which one to select ? A or B ?

Salvage value is
the estimated
market value at the
end of study period

Select vender A

13

LCM or Study Period

Approach
In Previous Example LCM suggest to select Vendor B
Study Period approach suggest to select Vendor A
In such situations, the standard practice of using a fixed
study period should be carefully examined
It should be ensured that the appropriate approach,
that is, LCM or fixed study period, is used to satisfy the
equal-service requirement

PW of Different-Life Alternatives for

independent alternatives

For independent projects , use of the LCM

approach is unnecessary since each project is
compared to the do-nothing alternative, not to
each other
Equal-service requirement is not a problem
Use the MARR to determine the PW over the
respective life of each project, and select all
projects with a PW 0

14

Future Worth Analysis

Future Worth is exactly like PW analysis, except
Future Worth Must compare alternatives for equal
service (i.e. alternatives must end at the same time)
The selection guidelines for FW analysis are the same
as for PW analysis; FW 0 means the MARR is met or
exceeded
For two or more mutually exclusive alternatives, select
the one with the numerically largest FW value.

Future Worth Analysis

If life of two alternatives are not equal, one need to fulfill the
equal service requirement for using FW criteria.
Two ways to compare equal service:
1. Least common multiple (LCM) of lives
2. Specified study period

Same way as used for Present Worth Analysis expect once

life of alternatives are equal for cash flows, one need to
compare the Future Worth instead of Present Worth

15

Try: Future Worth Analysis

(Problem 5.26)
An industrial engineer is considering two robots
for purchase by a fiber-optic manufacturing
company. Robot X will have a first cost of
$80,000, an annual maintenance and operation
(M&O) cost of $30,000, and a $40,000 salvage
value. Robot Y will have a first cost of $97,000, an
annual M&O cost of $27,000, and a $50,000
salvage value. Which should be selected on the
basis of a future worth comparison at an interest
rate of 15% per year? Use a 3-year study period.

Future Worth Analysis

(Problem 5.26)
$50,000

$40,000
i = 15%

F=?

i = 15%

F=?
0

Robot X CF

A = $27,000

A = $30,000
$80,000

$97,000

Robot Y CF

FWX = -80,000(F/P,15%,3) 30,000(F/A,15%,3) + 40,000

= -80,000(1.5209) 30,000(3.4725) + 40,000
= $-185,847
FWY = -97,000(F/P,15%,3) 27,000(F/A,15%,3) + 50,000
= -97,000(1.5209) 27,000(3.4725) + 50,000
= $-191,285

Select robot X

16

Capitalized Worth Analysis

Capitalized worth is the present worth of all revenues
or expenses over an infinite length of time
If only expenses are considered this is referred as
capitalized cost
The capitalized worth method is especially useful in
problems involving public projects with indefinite lives,
or permanent endowments(or donations) for charitable
organizations and universities

The Capitalized Worth Analysis

The Capitalized Worth of a series of end-of-period uniform
payments A, with interest at i% per period, is
CW (or CC) = A(P/A, i%, n) where n
As N becomes very large (if the A are perpetual payments)
We already know that P/A is given as P/A=

The term in the bracket becomes as n tends to infinity

So, the above equations become as:

Capitaized Worth (or Capitalized Costs) =
CW or CC =

or

17

Example: Capitalized Worth

(Costs) Problems
Capitalized worth (or costs) type problems vary from
very simple to somewhat complex
Consider a simple Capitalized Cost type problem
A person want to donate $100, 000 for scholarships
in a university. Consider, 20% per year interest rate;
How much money can be withdrawn forever from
this account?

Example: Capitalized Worth

(Costs) Problem
Draw a Cash Flow Diagram
$ A per year = ?

$100,000

Solution:

CC= A (or AW)

i
Or AW= CC (i)
A = $100,000(0.20) = $20,000 per period

18

The Capitalized Worth Analysis

The equation can be understand by thinking of ..

What present amount invested today at i will enable an
investor to periodically withdraw an amount A forever
If investor withdraw more than amount A each period, he/she
will be withdrawing a portion of the initial principle and
eventually it will exhausted
If amount being withdrawn each period is equals the interest
earned on the principal for that period, the principal remains
intact, thus series of withdraw will continue forever

Capitalized Worth (Costs) Recurring

and Non-recurring
More complex problems will have two types of costs associated;
1. Recurring Periodic and repeat
2. Non-recurring One time present or future cash flows

For more complex CC problems one must separate the

recurring from the non-recurring

You will not just face problems to calculate Capital Costs

of a single amount (like the previous example) but you
confronts situations in which you have to make selection
among alternatives using CC criteria

19

Capitalized Cost Analysis

For the comparison of two alternatives on the basis of
capitalized cost, you will use formula (CC = A/i)
So find the A value (& CCT (the sum of recurring and nonrecurring costs) for each alternative and select the one which
has lowest present worth of costs (or equal to say Lowest
capitalized costs).
Alternatives are automatically compared for same life period
because CCT represents the total present worth of financing and
maintaining a given alternative forever (i.e., infinity).

Summary: How to calculate CC and A and how to use

CC criteria to select an alternative
Cost (cash flows)
(Step 1)
Non-recurring
One time present or future cash
flows (e.g., first cost, cost once
in 25th year etc)

Non-recurring
Convert it to PW (will be PW of
all non-recurring costs for
whole life)

Recurring

Periodic and repeated

A in a only one cost
Cycle: e.g., cash flow
every 5th year or every
20th year

Convert this to a Uniform

Series (say A1)

(Step 2)

Add values of step 4 and Step 2

to obtain CC of overall cash
flows

(Step 5)

Select the alternative with

lowest capitalized costs

Uniform Equal
Recurring Amounts:
e.g., Annuity Series
(say A2)

Divide the value of Uniform

Annuity Series by i" (using
CC= A/i) to get the value of
Capitalized worth for
uniform series
(Step 4)

Add A1 and A2 to
get one Uniform
Series (Annuity
Series) starting
from time 0 and
continue till infinity

(Step 3)

Step 3 can be skipped if you convert both recurring costs

directly to present worth

20

Example:
The Haverty County Transportation Authority (HCTA) has just installed
new software to charge and track toll fees. The director wants to know
the total equivalent cost of all future costs incurred to purchase the
software system. If the new system will be used for the indefinite future,
(a) find the equivalent cost now: i.e., a CC value. (b) for each year
hereafter, an AW value.
The system has an installed cost of $150,000 and an additional cost of
$50,000 after 10 years. The annual software maintenance contract cost
is $5000 for the first 4 years and $8000 thereafter. In addition, there is
expected to be a recurring major upgrade cost of $15,000 every 13 years.
Assume that i is 5% per year for county funds.
Can you try to draw its cash flow with you for 2 cycle of recurring costs?

Step 1: Draw cash flow Diagram

(for at least 2 recurring cost cycles)

The system has an installed cost of $150,000 and an additional cost of $50,000 after 10
years. The annual software maintenance contract cost is $5000 for the first 4 years and
$8000 thereafter. In addition, there is expected to be a recurring major upgrade cost of
$15,000 every 13 years. Assume that i is 5% per year for county funds.

21

Step 1: Draw cash flow Diagram

(for at least 2 recurring cost cycles)

Non- Recurring Costs: $150,000 and $50,000

Recurring Costs (A in a life cycle): $15000
Recurring Costs (uniform A series): $5000, $8000

Step 2: Convert Non-

Recurring costs into PW

Non- Recurring Costs:

$150,000 (Initial Costs) and
$50,000 (in year 10th)
CC1 = 150,000 50,000(P/F, 5%, 10)

CC1 = $-180,695

22

Step 3 & 4: Convert Recurring Costs (A in one life

cycle) into Uniform Costs and add it with Uniform
Recurring Costs
Recurring Costs (A in one life cycle): $15000
A1 = 15000(A/F, 5%, 13)
= $ 847 cost of one cycle
CC2 = 847 / 0.05
= $ 16,940 (for all cycles)
Recurring Costs (uniform):

$5000, $8000
CC3 = 5000 (P/A, 5%, )
= 5000/i or 5000/0.05
CC3 = = $ 100,000
Alternative:
A1 = $ 847
A2= $ 5000
A = A1+A2 = $ 5847
CCA = $5847(P/A, 5%, )
= 5487/0.05 = $116940
(same as CC2 + CC3 above)

Step 3 & 4: Convert Recurring Costs (A in one

life cycle) into Uniform Costs(for whole life)
and add it with Uniform Recurring Costs

Recurring Costs (uniform):

If we calculate the present worth of A = $3000 (which is starting

from year 5)it will be on 4th year. Need to multiply it with single
factor for four year to bring it to time 0.
CC4 = (A/i)(P/F, 5%, 4)
3000 (1/0.05) (P/F, 5%, 4)
CC4 = = 49,362

23

Step 5: Add values of Step 2 and Step 4 to

Obtain CC

CCT = CC1 + CC2 + CC3 + CC4

= 180,695 16,940 100,000 49,362
= 346,997
Interpretation: The $-346,997
represents the one-time t = 0
amount that if
b) CC = A/i
invested at 5%/year would fund the
AW= CCT (i)
future cash flows as
= 346.997 (0.05)
shown on the cash flow diagram
= $17,350
from now to infinity!
Interpretation: This means Haverty County officials have committed the
equivalent of $17,350 forever to operate and maintain the toll
management software

Capitalized Cost Analysis

If you have more than one alternative and you
have to chose one out of it on Capitalized Cost
Analysis.
You need to calculate the CC for every
alternative as explained in 5 step procedure
and then you select the alternative which
value is lowest

24

Capitalized cost analysis for a

finite-life alternative
If a finite-life alternative is compared to one with an infinite
life on the basis of their capitalized costs, proceed as
follows:
To determine capitalized cost for the alternative with a
finite life, calculate the equivalent A value for one life cycle
and divide by the interest rate.
It maybe noted that CC/CW method can be applied for
alternatives whose lives are not necessary infinite.

Example

Given the following two mutually exclusive

alternatives, use the Capitalized Worth method to
determine which project you should invest in (MARR
= 15%):
First Cost, $
Annual Operating Cost, $ per year
Salvage value, $
Life, years

A
$12000
2200
0
10

B
$40000
1000
10000
25

25

Solution

First, find AW of each alternative: (bz CC = AW/i)

AWA = $12,000(A/P, 15%, 10) $2,200
= $4,592
AWB = $40,000(A/P, 15%, 25) $1,000 +
$10,000(A/F, 15%, 25)
= $7,141

Solution

Second, find CW of each alternative:

CWA = AWA/i = -$4,592/0.15 = -$30,613
CWB = AWB/i = -$7,141/0.15 = -$47,607
Since CW of alternative A yields less cost, it
should be selected.

26

Practice: Finite versus Infinite life

alternatives
Compare the alternatives shown on the basis of their capitalized costs
using an interest rate of 10% per year
Alternative M
First Cost, $
Annual Operating Cost, $ per year
Salvage value, $
Life, years
10%

Single Payments

150000
50,000
8000
5

Alternative N

800000
12000
1000000

Uniform Series Factors

Compoun
d Amount
(F/P)

Present
Worth
(P/F)

Sinking
Fund
(A/F)

Compound Capital
Amount
Recovery
(F/A)
(A/P)

Present
Worth
(P/A)

1.6105

0.6209

0.16380

6.1051

3.7908

0.26380

Solution!!!!
For M, first find AW and then divide by i to find CC.
CCM = AWM/i but we don't know AWM
To calculate Annual worth one need to convert all cash
flows into Uniform series!!!!!!
AWM = 150,000(A/P,10%,5) 50,000 + 8000(A/F,10%,5)
= 150,000(0.26380) 50,000 + 8000(0.16380)
= $ 88,260
Salvage value for
CCM = 88,260/0.10
alternative with
= $ 882,600
infinite life is
never realized
CCN = 800,000 12,000/0.10
because n is
= $ 920,000
never reached.
Select alternative M

27

Thank You

28