MODULE 5A
TOPIC: Methods for Evaluating the Viability of a
Proposed Project: PRESENT WORTH METHOD
I. Module Overview
A. Introduction
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, nonrecurring costs, and possible salvage value over an estimated useful life of the
product; process, or service.
This chapter will discuss the various methods for evaluating viability of a proposed
project, specifically the Present Worth Method.
B. Objectives
At the end of this topic, the student is expected to evaluate engineering economy
projects by using the present worth method.
II. Concept Discussion, Activities and Processing
A. PRESENT WORTH METHOD/ 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.
Besides PW, other terms frequently used are present value (PV) and net present value (NPV )
or net present worth (NPW).
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 are treated.
To understand how to organize an economic analysis, this chapter begins with a description of
independent and mutually exclusive projects as well as revenue and cost alternatives.
FORMULATING ALTERNATIVES
The evaluation and selection of economic proposals require cash flow estimates over a stated
period of time, mathematical techniques to calculate the measure of worth, and a guideline for
selecting the best proposal.
From all the proposals that may accomplish a stated purpose, the alternatives are formulated.
This progression is detailed in Figure 5–1. Up front, some proposals are viable from
technological, economic, and/or legal perspectives; others are not viable. Once the obviously
nonviable ideas are eliminated, the remaining viable proposals are fleshed out to form the
alternatives to be evaluated. Economic evaluation is one of the primary means used to select
the best alternative(s) for implementation.
The nature of the economic proposals is always one of two types:
• Mutually exclusive alternatives: Only one of the proposals can be selected. For
terminology purposes, each viable proposal is called an alternative.
• Independent projects: More than one proposal can be selected. Each viable proposal is
called a project.
The do-nothing (DN) proposal is usually understood to be an option when the evaluation is
performed. The DN alternative or project means that the current approach is maintained;
nothing new is initiated. No new costs, revenues, or savings are generated.
A mutually exclusive selection takes place, for example, when an engineer must select the best
diesel-powered engine from several available models. Only one is chosen, and the rest are
rejected. If none of the alternatives are economically justified, then all can be rejected and, by
default, the DN alternative is selected. For independent projects one, two or more, in fact, all of
the projects that are economically justified can be accepted, provided capital funds are
available. This leads to the two following fundamentally different evaluation bases:
• Mutually exclusive alternatives compete with one another and are compared pairwise.
• Independent projects are evaluated one at a time and compete only with the DN project.
Any of the techniques discussed previously (solving for Present worth, annual worth and future
worth) can be used to evaluate either type of proposal—mutually exclusive or independent.
When performed correctly as described in each chapter, any of the techniques will reach the
same conclusion of which alternative or alternatives to select. But for this module, we will focus
first on the present worth.
It is important to recognize the nature of the cash flow estimates before starting the
computation of a measure of worth that leads to the final selection. Cash flow estimates
determine whether the alternatives are revenue- or cost-based. All the alternatives or projects
must be of the same type when the economic study is performed. Definitions for these types
follow:
• Revenue: Each alternative generates cost (cash outflow) and revenue (cash inflow)
estimates, and possibly savings, also considered cash inflows. Revenues can vary for
each alternative.
• Cost: Each alternative has only cost cash flow estimates. Revenues or savings are
assumed equal for all alternatives; thus they are not dependent upon the alternative
selected. These are also referred to as service alternatives.
Present Worth Analysis of Equal-Life Alternatives
The PW comparison of alternatives with equal lives is straightforward. The present worth P is
renamed PW of the alternative. The present worth method is quite popular in industry because
all future costs and revenues are transformed to equivalent monetary units NOW; that is, all
future cash flows are converted (discounted) to present amounts (e.g., dollars) at a specific
rate of return, which is the MARR (minimum attractive rate of return). This makes it very
simple to determine which alternative has the best economic advantage. The required
conditions and evaluation procedure are as follows:
• If the alternatives have the same capacities for the same time period (life), the equal-
service requirement is met. Calculate the PW value at the stated MARR for each
alternative
• For mutually exclusive (ME) alternatives, whether they are revenue or cost
alternatives, the following guidelines are applied to justify a single project or to select
one from several alternatives
➢ One alternative: If PW > 0, the requested MARR is met or exceeded and the
alternative is economically justified.
➢ Two or more alternatives: Select the alternative with the PW that is numerically
largest, that is, less negative or more positive. This indicates a lower PW of cost for cost
alternatives or a larger PW of net cash flows for revenue alternatives.
Note that the guideline to select one alternative with the lowest cost or highest revenue uses
the criterion of numerically largest. This is not the absolute value of the PW amount, because
the sign matters. The selections below correctly apply the guideline for two alternatives A and
B.
For independent projects, each PW is considered separately, that is, compared with the DN
project, which always has PW = 0. The selection guideline is as follows:
One or more independent projects: Select all projects with PW > 0 at the MARR.
The independent projects must have positive and negative cash flows to obtain a PW value that
can exceed zero; that is, they must be revenue projects.
Example. Present Worth Analysis of Equal Life Alternatives
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.
Solution:
These are cost alternatives. The salvage values are considered a “negative” cost (because you
don’t dispose this cost but rather earn them), so a +sign precedes them. (If it costs money to
dispose of an asset, the estimated disposal cost has a -sign.) The PW of each machine is
calculated at i =10% for n =8 years.
The approach for this problem is get the equivalent present worth of each cost (first cost,
annual operating cost, and salvage value) of each alternative. Get their net present worth then
compare them.
For electric powered:
➢ Start with first cost.
FC=-4500
First cost is already considered a present worth. So no need for further conversion. But since
this is a cost spent by company, a negative sign precedes it. Hence,
PWfirst cost = -4500
➢ Next, let us consider the annual operating cost:
0 1 2 3 4 5 6 7 8
A=-900
As can be seen in the cash flow diagram, this is a case of an ordinary annuity with periodic
payments, A = 900. Since we are doing a present worth analysis, we need to convert this A into
its equivalent present worth using the ordinary annuity formula P/A. Recall:
(𝟏 + 𝒊)𝒏 − 𝟏
𝑷=𝑨 [ ]
𝒊 (𝟏 + 𝒊)𝒏
Hence,
(𝟏 + 𝟎. 𝟏𝟎)𝟖 − 𝟏
𝑷𝑾 = −𝟗𝟎𝟎 [ ]
𝟎. 𝟏𝟎 (𝟏 + 𝟎. 𝟏𝟎)𝟖
𝑃𝑊 = −4801.43
The equivalent present worth the annual operating cost (AOC) is:
PWAOC = -4801.43
➢ Now let us proceed to the Salvage Cost.
Note that a salvage value is considered as an “earning” in the company because they get money
from disposal of an equipment. Therefore salvage cost has a + sign. Also, since it occurs at the
end of life of equipment, salvage cost is a future value.
SV=F=200
0 1 2 3 4 5 6 7 8
As we can see from the CFD, it can be said that this a case of a single cash flow with future value
of 200 dollars. To get its equivalent present worth, we need to convert the future value using
the single cash flow formula P/F. Recall:
1
𝑃=𝐹 [ ]
(1 + 𝑖)𝑛
Hence,
1
𝑃𝑊 = 200 [(1+0.10)8 ] = 93.30
Therefore the Present worth of the salvage value is:
PWSV = 93.30
Now we can solve for the net present worth of the electric powered:
PWnet_electric powered = -4500+(-4801.43)+93.30 = -9208.13
For gas powered:
Start with first cost.
FC=-3500
First cost is already considered a present worth. So no need for further conversion. But since
this is a cost spent by company, a negative sign precedes it. Hence,
PWfirst cost = -3500
Next, let us consider the annual operating cost:
0 1 2 3 4 5 6 7 8
A=-700
As can be seen in the cash flow diagram, this is a case of an ordinary annuity with periodic
payments, A = 700. Since we are doing a present worth analysis, we need to convert this A into
its equivalent present worth using the ordinary annuity formula P/A. Recall:
(𝟏 + 𝒊)𝒏 − 𝟏
𝑷=𝑨 [ ]
𝒊 (𝟏 + 𝒊)𝒏
Hence,
(𝟏 + 𝟎. 𝟏𝟎)𝟖 − 𝟏
𝑷𝑾 = −𝟕𝟎𝟎 [ ]
𝟎. 𝟏𝟎 (𝟏 + 𝟎. 𝟏𝟎)𝟖
𝑃𝑊 = −3734.44
The equivalent present worth the annual operating cost (AOC) is:
PWAOC = -3734.44
Now let us proceed to the Salvage Cost. Note that a salvage value is considered as an “earning”
in the company because they get money from disposal of an equipment. Therefore salvage cost
has a + sign. Also, since it occurs at the end of life of equipment, salvage cost is a future value.
SV=F=350
0 1 2 3 4 5 6 7 8
As we can see from the CFD, it can be said that this a case of a single cash flow with future value
of 350 dollars. To get its equivalent present worth, we need to convert the future value using
the single cash flow formula P/F. Recall:
1
𝑃=𝐹 [ ]
(1 + 𝑖)𝑛
Hence,
1
𝑃𝑊 = 350 [(1+0.10)8 ] = 163.28
Therefore the Present worth of the salvage value is:
PWSV = 163.28
Now we can solve for the net present worth of the gas powered:
PWnet_gas powered = -3500+(-3734.44)+163.28 = -7071.16
For solar powered:
Start with first cost.
FC=-6000
First cost is already considered a present worth. So no need for further conversion. But since
this is a cost spent by company, a negative sign precedes it. Hence,
PWfirst cost = -6000
Next, let us consider the annual operating cost:
0 1 2 3 4 5 6 7 8
A=-50
As can be seen in the cash flow diagram, this is a case of an ordinary annuity with periodic
payments, A = 50. Since we are doing a present worth analysis, we need to convert this A into
its equivalent present worth using the ordinary annuity formula P/A. Recall:
(𝟏 + 𝒊)𝒏 − 𝟏
𝑷=𝑨 [ ]
𝒊 (𝟏 + 𝒊)𝒏
Hence,
(𝟏 + 𝟎. 𝟏𝟎)𝟖 − 𝟏
𝑷𝑾 = −𝟓𝟎 [ ]
𝟎. 𝟏𝟎 (𝟏 + 𝟎. 𝟏𝟎)𝟖
𝑃𝑊 = −266.75
The equivalent present worth the annual operating cost (AOC) is:
PWAOC = -266.75
Now let us proceed to the Salvage Cost. Note that a salvage value is considered as an “earning”
in the company because they get money from disposal of an equipment. Therefore salvage cost
has a + sign. Also, since it occurs at the end of life of equipment, salvage cost is a future value.
SV=F=100
0 1 2 3 4 5 6 7 8
As we can see from the CFD, it can be said that this a case of a single cash flow with future value
of 100 dollars. To get its equivalent present worth, we need to convert the future value using
the single cash flow formula P/F. Recall:
1
𝑃=𝐹 [ ]
(1 + 𝑖)𝑛
Hence,
1
𝑃𝑊 = 100 [(1+0.10)8 ] = 46.65
Therefore the Present worth of the salvage value is:
PWSV = 46.65
Now we can solve for the net present worth of the solar powered:
PWnet_solar powered = -6000+(-266.75)+46.65 = -6220.10
Comparing the net present worth of the three alternatives:
Electric powered -9208
Gas powered -7071
Solar powered -6220
The solar-powered machine is selected since the PW of its costs is the lowest; it has the
numerically largest PW value.
Present Worth Analysis of Different-Life Alternatives
When the present worth method is used to compare mutually exclusive alternatives that have
different lives, the equal-service requirement must be met
The PW of the alternatives must be compared over the same number of years and must end at
the same time to satisfy the equal-service requirement.
This is necessary, since the present worth comparison involves calculating the equivalent PW
of all future cash flows for each alternative. A fair comparison requires that PW values
represent cash flows associated with equal service. For cost alternatives, failure to compare
equal service 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. The equal-service
requirement is satisfied by using either of two approaches:
• LCM: Compare the PW of alternatives over a period of time equal to the least common
multiple (LCM) of their estimated lives.
• Study period: 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.
For either approach, calculate the PW at the MARR and use the same selection guideline as that
for equal-life alternatives. The LCM approach makes the cash flow estimates extend to the same
period, as required. For example, lives of 3 and 4 years are compared over a 12-year period.
The first cost of an alternative is reinvested at the beginning of each life cycle, and the estimated
salvage value is accounted for at the end of each life cycle when calculating the PW values over
the LCM period. Additionally, the LCM approach requires that some assumptions be made
about subsequent life cycles.
The assumptions when using the LCM approach are that
1. The service provided will be needed over the entire LCM years or more.
2. The selected alternative can be repeated over each life cycle of the LCM in exactly the same
manner.
3. Cash flow estimates are the same for each life cycle.
A study period analysis is necessary if the first assumption about the length of time the
alternatives are needed cannot be made. For the study period approach, a time horizon is
chosen over which the economic analysis is conducted, and only those cash fl ows which occur
during that time period are considered relevant to the analysis. All cash fl ows occurring
beyond the study period are ignored. An estimated market value at the end of the study period
must be made. The time horizon chosen might be relatively short, especially when short-term
business goals are very important. The study period approach is often used in replacement
analysis. It is also useful when the LCM of alternatives yields an unrealistic evaluation period,
for example, 5 and 9 years.
EXAMPLE. Present worth analysis of different life alternatives
National Homebuilders, Inc., plans to purchase new cut-and-finish equipment. Two
manufacturers offered the estimates below.
(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?
Solution
(a) Since the equipment has different lives, compare them over the LCM of 18 years (the LCM
of 6 and 9 is 18). For life cycles after the first, the first cost is repeated in year 0 of each new
cycle, which is the last year of the previous cycle. These are years 6 and 12 for vendor A and
year 9 for B. The cash flow diagram is shown in Figure 5–2. Calculate PW at 15% over 18 years.
VENDOR A:
Solving the present worth of the first costs. First Costs (which occurs at year 0, year 6 and year
12) can be considered as single cash flow problems and therefore the equivalent present worth
1
can be solved using the P/F formula of single cash flow which is: 𝑃 = 𝐹 [(1+𝑖)𝑛 ]
1
For first cost at year 0, the 𝑃𝑊 = −15000 [(1+0.15)0] = -15000
1
For first cost at year 6, the 𝑃𝑊 = −15000 [(1+0.15)6] = -6484.91
1
For first cost at year 12, the 𝑃𝑊 = −15000 [(1+0.15)12 ] = -2803.61
Solving the present worth of the annual costs A. The annual costs of 3500 for a period of 18
years is considered as an ordinary annuity. Therefore the P value can be calculated using the
ordinary annuity , formula P/A (P given A) which is:
(𝟏 + 𝒊)𝒏 − 𝟏
𝑷=𝑨 [ ]
𝒊 (𝟏 + 𝒊)𝒏
Therefore, the present worth of the annual costs of 3500 is:
(𝟏+𝟎.𝟏𝟓)𝟏𝟖 −𝟏
𝑷𝑾𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒐𝒔𝒕𝒔 = −𝟑𝟓𝟎𝟎 [𝟎.𝟏𝟓 (𝟏+𝟎.𝟏𝟓)𝟏𝟖 ] = −𝟐𝟏𝟒𝟒𝟕. 𝟖𝟖
Solving the present worth of the salvage values. Salvage values (which occurs at year 6, year
12 and year 18) can be considered as single cash flow problems and therefore the equivalent
1
present worth can be solved using the P/F formula of single cash flow which is: 𝑃 = 𝐹 [(1+𝑖)𝑛 ]
1
For salvage value at year 6, the 𝑃𝑊 = 1000 [(1+0.15)6] =432.33
1
For salvage value at year 12, the 𝑃𝑊 = 1000 [(1+0.15)12 ] = 186.91
1
For salvage value at year 18, the 𝑃𝑊 = 1000 [(1+0.15)18 ] = 80.81
Therefore the net present worth for Vendor A is:
NPWA = -15000 +(-6484.91) + (-2803.61) +(-21447.88)+ 432.33+186.91+80.81
= -45036.35
VENDOR B:
Solving the present worth of the first costs. First Costs (which occurs at year 0, year 9) can be
considered as single cash flow problems and therefore the equivalent present worth can be
1
solved using the P/F formula of single cash flow which is: 𝑃 = 𝐹 [(1+𝑖)𝑛 ]
1
For first cost at year 0, the 𝑃𝑊 = −18000 [(1+0.15)0] = -18000
1
For first cost at year 9, the 𝑃𝑊 = −18000 [(1+0.15)9] = -5116.72
Solving the present worth of the annual costs A. The annual costs of 3100 for a period of 18
years is considered as an ordinary annuity. Therefore the P value can be calculated using the
ordinary annuity , formula P/A (P given A) which is:
(𝟏 + 𝒊)𝒏 − 𝟏
𝑷=𝑨 [ ]
𝒊 (𝟏 + 𝒊)𝒏
Therefore, the present worth of the annual costs of 3100 is:
(𝟏+𝟎.𝟏𝟓)𝟏𝟖 −𝟏
𝑷𝑾𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒐𝒔𝒕𝒔 = −𝟑𝟏𝟎𝟎 [𝟎.𝟏𝟓 (𝟏+𝟎.𝟏𝟓)𝟏𝟖 ] = −𝟏𝟖𝟗𝟗𝟔. 𝟔𝟗
Solving the present worth of the salvage values. Salvage values (which occurs at year 9 and
year 18) can be considered as single cash flow problems and therefore the equivalent present
1
worth can be solved using the P/F formula of single cash flow which is: 𝑃 = 𝐹 [(1+𝑖)𝑛]
.
1
For salvage value at year 9, the 𝑃𝑊 = 2000 [(1+0.15)9] =568.52
1
For salvage value at year 18, the 𝑃𝑊 = 2000 [(1+0.15)18 ] = 161.61
Therefore the net present worth for Vendor B is:
NPWB = -18000 +(-5116.72) +(-18996.69)+ 568.52 + 161.61 = -41383.28
Comparing the net present worths:
Vendor A: NPW = -45036.35
Vendor B: NPW = -41383.28
Vendor B is selected, since it costs less in PW terms; that is, the PW B value is numerically
larger than PW A .
b. For a 5-year study period, no cycle repeats are necessary. The PW analysis is based on a 5
year period.
Therefore, solving the present worth of each costs, we have:
VENDOR A:
PW first cost = -15000
(𝟏+𝟎.𝟏𝟓)𝟓 −𝟏
𝑷𝑾𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒐𝒔𝒕𝒔 = −𝟑𝟓𝟎𝟎 [𝟎.𝟏𝟓 (𝟏+𝟎.𝟏𝟓)𝟓 ] = −𝟏𝟏𝟕𝟑𝟐. 𝟓𝟒
1
𝑷𝑾𝑺𝒂𝒍𝒗𝒂𝒈𝒆 𝒗𝒂𝒍𝒖𝒆 = 1000 [(1+0.15)5] =497.18
NPWA = -15000+(-11732.54)+497.18 =-26235.36
VENDOR B:
PW first cost = -15000
(𝟏+𝟎.𝟏𝟓)𝟓 −𝟏
𝑷𝑾𝒂𝒏𝒏𝒖𝒂𝒍 𝒄𝒐𝒔𝒕𝒔 = −𝟑𝟏𝟎𝟎 [𝟎.𝟏𝟓 (𝟏+𝟎.𝟏𝟓)𝟓 ] = −𝟏𝟎𝟑𝟗𝟏. 𝟔𝟖
1
𝑷𝑾𝑺𝒂𝒍𝒗𝒂𝒈𝒆 𝒗𝒂𝒍𝒖𝒆 = 2000 [(1+0.15)5] =994.35
NPWB = -18000+(-10391.68)+994.35 =-27397.33
Vendor A is now selected based on its smaller PW value. This means that the shortened study
period of 5 years has caused a switch in the economic decision. In situations such as this, the
standard practice of using a fixed study period should be carefully examined to ensure that the
appropriate approach, that is, LCM or fixed study period, is used to satisfy the equal-service
requirement.
Module Assessment
Name : ___________________________Section : __________________ Score : _____________
The following assessment comprises problem solving to assess your level of understanding and
analysis on the topics discussed.
Show complete solution.
1.) An Electro-mechanical Technologist is considering two equipment for use in a certain
manufacturing plant. All estimates are made, shown in the table. Which should be selected
on the basis of a present worth comparison at an interest rate of 12% per year?
A B
First Cost, $ -15000 -35000
Maintenance cost, $, per year -9000 -7000
Salvage Value , $ 2000 20000
Life, years 5 5
2) An electric switch manufacturing company has to choose one of two different assembly
methods. Method A will cost $80,000 to buy and will have an annual operating cost of $6000 over
its 4-year service life. Method B will cost $130,000 initially with an annual operating cost of $4000
over its 4-year life. Methods A will have no salvage value, but method B 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.
