Chapter 5
Present Worth
Analysis
Lecture slides to accompany
Engineering Economy
7th edition
Leland Blank
Anthony Tarquin
© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
5-1
LEARNING OUTCOMES
1. Formulate Alternatives
2. PW of equal-life alternatives
3. PW of different-life alternatives
4. Future Worth analysis
5. Capitalized Cost analysis
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5-2
Formulating Alternatives
Two types of economic proposals
Mutually Exclusive (ME) Alternatives: Only one can be selected;
Compete against each other
Independent Projects: More than one can be selected;
Compete only against DN
Do Nothing (DN) – An ME alternative or independent project to
maintain the current approach; no new costs, revenues or savings
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5-3
Formulating Alternatives
Two types of cash flow estimates
Revenue: Alternatives include estimates of costs (cash outflows)
and revenues (cash inflows)
Cost: Alternatives include only costs; revenues and savings assumed equal
for all alternatives; also called service alternatives
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5-4
PW Analysis of Alternatives
Convert all cash flows to PW using MARR
Precede costs by minus sign; receipts by
plus sign
EVALUATION
For one project, if PW > 0, it is justified
For mutually exclusive alternatives, select
one with numerically largest PW
For independent projects, select all with PW > 0
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5-5
Selection of Alternatives by PW
For the alternatives shown below, which should be selected
ifselected selected
they are (a) mutually exclusive; (b) independent?
Project ID Present Worth
A $30,000
B $12,500
C $-4,000
D $ 2,000
Solution: (a) Select numerically largest PW; alternative A
(b) Select all with PW > 0; projects A, B & D
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5-6
Example: PW Evaluation of Equal-Life ME Alts.
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: Find PW at MARR and select numerically larger PW value
PWX = -20,000 - 9000(P/A,12%,5) + 5000(P/F,12%,5)
= -$49,606
PWY = -35,000 - 4000(P/A,12%,5) + 7000(P/F,12%,5)
= -$45,447
Select alternative Y
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5-7
PW of Different-Life Alternatives
Must compare alternatives for equal service
(i.e., alternatives must end at the same time)
Two ways to compare equal service:
Least common multiple (LCM) of lives
Specified study period
(The LCM procedure is used unless otherwise specified)
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5-8
Assumptions of LCM approach
Service provided is needed over the LCM or
more years
Selected alternative can be repeated over
each life cycle of LCM in exactly the same
manner
Cash flow estimates are the same for each life
cycle (i.e., change in exact accord with the
inflation or deflation rate)
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1-9
Example: Different-Life Alternatives
Compare the machines below using present worth analysis at i = 10% per year
Machine A Machine B
First cost, $ 20,000 30,000
Annual cost, $/year 9000 7000
Salvage value, $ 4000 6000
Life, years 3 6
LCM = 6 years; repurchase A after 3 years
Solution:
PWA = -20,000 – 9000(P/A,10%,6) – 16,000(P/F,10%,3) + 4000(P/F,10%,6)
= $-68,961
20,000 – 4,000 in
PWB = -30,000 – 7000(P/A,10%,6) + 6000(P/F,10%,6) year 3
= $-57,100
Select alternative B 5-10 © 2012 by McGraw-Hill All Rights Reserved
PW Evaluation Using a Study Period
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
Short study periods are often defined by management
when business goals are short-term
Study periods are commonly used in equipment
replacement analysis
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1-11
Example: Study Period PW Evaluation
Compare the alternatives below using present worth analysis at i = 10% per year
and a 3-year study period
Machine A Machine B
First cost, $ -20,000 -30,000
Annual cost, $/year -9,000 -7,000
Salvage/market value, $ 4,000 6,000 (after 6 years)
10,000 (after 3 years)
Life, years 3 6
Study period = 3 years; disregard all estimates after 3 years
Solution:
PWA = -20,000 – 9000(P/A,10%,3) + 4000(P/F,10%,3) = $-39,376
PWB = -30,000 – 7000(P/A,10%,3) + 10,000(P/F,10%,3) = $-39,895
Marginally, select A; different selection than for LCM = 6 years
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5-12
Future Worth Analysis
FW exactly like PW analysis, except calculate FW
Must compare alternatives for equal service
(i.e. alternatives must end at the same time)
Two ways to compare equal service:
Least common multiple (LCM) of lives
Specified study period
(The LCM procedure is used unless otherwise specified)
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5-13
FW of Different-Life Alternatives
Compare the machines below using future worth analysis at i = 10% per year
Machine A Machine B
First cost, $ -20,000 -30,000
Annual cost, $/year -9000 -7000
Salvage value, $ 4000 6000
Life, years 3 6
LCM = 6 years; repurchase A after 3 years
Solution:
FWA = -20,000(F/P,10%,6) – 9000(F/A,10%,6) – 16,000(F/P,10%,3) + 4000
= $-122,168
FWB = -30,000(F/P,10%.6) – 7000(F/A,10%,6) + 6000
= $-101,157
Select B (Note: PW and FW methods will always result in same selection)
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5-14
Capitalized Cost (CC) Analysis
CC refers to the present worth of a project with a
very long life, that is, PW as n becomes infinite
Basic equation is: CC = P = A
i
“A” essentially represents the interest on a perpetual investment
For example, in order to be able to withdraw $50,000 per year forever
at i = 10% per year, the amount of capital required is 50,000/0.10 = $500,000
For finite life alternatives, convert all cash flows into
an A value over one life cycle and then divide by i
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5-15
Example: Capitalized Cost
Compare the machines shown below on the basis of their
capitalized cost. Use i = 10% per year
Machine 1 Machine 2
First cost,$ -20,000 -100,000
Annual cost,$/year -9000 -7000
Salvage value, $ 4000 -----
Life, years 3 ∞
Solution: Convert machine 1 cash flows into A and then divide by i
A1 = -20,000(A/P,10%,3) – 9000 + 4000(A/F,10%,3) = $-15,834
CC1 = -15,834 / 0.10 = $-158,340
CC2 = -100,000 – 7000/ 0.10 = $-170,000
Select machine 1
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5-16
Question 5.17
An electric switch manufacturing company has to choose one of three different
assembly methods. Method A will have a first cost of $40,000, an annual
operating cost of $9000, and a service life of 2 years. Method B will cost $80,000
to buy and will have an annual operating cost of $6000 over its 4-year service life.
Method C will cost $130,000 initially with an annual operating cost of $4000 over
its 8-year life. Methods A and B will have no salvage value, but method C will
have some equipment worth an estimated $12,000. Which method should be
selected? Use present worth analysis at an interest rate of 10% per year.
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1-17
Question
The Government is considering building apartments for government
employees working in a foreign country and currently living in locally-owned
housing. A comparison of three possible buildings indicates the following:
Building X Building Y Building Z
Original
investment
$8,000,000 $12,000,000 $10,000,000
Estimated annual
maintenance costs
$240,000 $180,000 $210,000
Savings in annual rent
now being paid to $1,960,000 $1,320,000 $1,640,000
house employees
Service life 18 27 25
Assuming that the do-nothing alternative is not feasible and using an interest
rate of 10%, make a selection recommendation about the best option using
Present Worth Analysis for a study period of 18 years.
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1-18
Payback Period
One of the primary concerns of most businesspeople is
whether and when the money invested in a project can be
recovered
Payback period:
It is the length of time required to recover the
cost of an investment.
It is a method of screening out certain obviously
unacceptable investment alternatives before progressing
to an analysis of potentially acceptable ones
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1-19
Payback Period
Two methods:
1. Conventional payback method : It ignores the time
value of money
2. Discounted payback method: it takes into account
the time value of money, i.e. the cost of funds
(interest) used to support the project.
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1-20
Payback Period
Conventional payback method
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1-21
EXAMPLE 5.3 Conventional Payback
Period with Salvage Value
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1-22
Payback Period
Discounted payback method
Modify the procedure so that it takes into account
the time value of money
we may define the discounted payback period as
the number of years required to recover the
investment from discounted cash flows
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1-23
Payback Period
Discounted payback method
i = 15%
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1-24
Payback Period
Discounted payback method
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1-25
Payback Period
Discounted payback method
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1-26
Example:
For the following projects, find the NPV and Project Payback
period (discounted) using i =10%, which would you select?
Project N 0 1 2 3 4 5 6
A NCF -120 20 25 30 35 40 45
B NCF -140 60 50 30 20 20 10
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1-27
Summary of Important Points
PW method converts all cash flows to present value at MARR
Alternatives can be mutually exclusive or independent
Cash flow estimates can be for revenue or cost alternatives
PW comparison must always be made for equal service
Equal service is achieved by using LCM or study period
Capitalized cost is PW of project with infinite life; CC = P = A/I
Payback Period
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5-28
