Engineering Economic Analysis

FOURTEENTH EDITION

Donald G. Newnan
Chapter 5 San Jose State University

Present Worth
Ted G. Eschenbach
University of Alaska Anchorage

Analysis Jerome P. Lavelle

North Carolina State University

Neal A. Lewis
Fairfield University

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 Chapter Outline

 Assumptions in Solving Economic Analysis

Problems
 Economic Criteria
 Time Period for Analysis
 Multiple Alternatives
 Applications & Complications

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 Learning Objectives

 Apply the present worth (PW) criteria

 Compare 2 alternatives with PW
 Apply PW in cases with equal, unequal, & infinite
project lives
 Compare multiple alternatives
 Use spreadsheets for PW calculations
 Compute bond prices & yields

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 Vignette: Present Value of
30 Years of Benefits

 Columbia River has 1/3 of hydroelectric potential in U.S.;

watershed vulnerable to seasonal flooding
 U.S. & Canada signed treaty for dams to regulate flow &

harvest power
 Canada stores 15.5 million acre feet water using 3 dams

 British Columbia entitled to ½ of electrical power from dams

in U.S.
 Canada entitled to ½ flood control benefits in U.S.

 Value of 1st 30 years at 4.5% interest rate paid in lump sum of

$254.4M in 1964
 Annual payments of about $250M to $350M each year since 1994
from U.S. to British Columbia
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 Vignette: Present Value
of 30 Years of Benefits

1. Canadian Premier Bennett used $254M for Portage

Mountain Dam (now Bennett Dam) with a 2730 MW power
station. Was this a good use for the money?
2. Negotiating downstream rights is difficult; water flows
downhill. What are the ethical considerations from those
upstream & those downstream?
3. Was 4.5%, the discount rate used in 1964, a reasonable
one for the governments to choose?

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 Assumptions in Solving
Economic Analysis Problems

 End-of-year convention
 Viewpoint of the firm
 Sunk costs have no bearing on decisions
 Project alternatives need 2 separate decisions
 Financing: obtaining money at interest rate =
borrowed from bank or firm
 Investment: spending of money considering lifecycle
costs & benefits
 Inflation & deflation: assume stable prices until Ch.
14
 Income taxes introduced in Ch. 12

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 Economic Criteria

Input / Output Criterion

Neither input nor output fixed Maximize Net Present Worth
Fixed input Maximize PW of benefits
Fixed output Minimize PW of costs

Present Worth analysis: alternatives valued in terms

of equivalent present consequences

Value & worth are synonyms—except

in spreadsheet function names

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 Determine Present Value at i = 8%

Year Cash Flow Net Present Value is:

0 $−30 A. 27.30

1 20 B. 29.48

2 20 C. 40.00

3 30 D. None of the above

E. I don’t know

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 Determine Present Value at i = 8%

Net Present Value is:

A. 27.30

B. 29.48

C. 40.00

D. None of the above

E. I don’t know

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 Example 5-1 Applying PW when
Useful Lives are Equal

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 Example 5-1, Spreadsheet solution

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 Example 5-2 Applying PW when
Useful Lives are Equal

Build full-sized facility for $400M now, or build reduced-size

facility now for $300M & expand it 25 years later for another
$350M. At 6% interest which size?
For single-stage construction
𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡 = $400 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

For two-stage construction

𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡 = $300 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 + 350 𝑚𝑖𝑙𝑙𝑖𝑜𝑛(𝑃 𝐹, 6%, 25)
= $300 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 + 81.6 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 = $381.6 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

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 Example 5-2 Spreadsheet Solution

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 Example 5-3 Applying PW when
Useful Lives are Equal
Uniform Annual End-of-Useful-Life
Alternatives
Cost Benefit Salvage Value
Atlas $2000 $450 $200
Tom Thumb $3000 $600 $700

Atlas

Tom Thumb

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 Example 5-3 Spreadsheet Solution

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 Which construction is preferred,
standard or energy efficient?

Standard Energy A. Standard, PV is $4,100

1st cost building $2.45M $2.50M less
1st cost furnace 100K 85K B. Energy efficient, PV is
Annual heating 10.0K 6.0K $4,100 less
cost C. Energy efficient, PV is
Life = 40 years $39,100 less
i = 10%
D. Standard, PV is $39,100
less
E. So close it doesn’t
matter

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 Which construction is preferred,
standard or energy efficient?

Standard Energy A. Standard, PV is

PV $2,647,800 $2,643,700 $4,100 less
B. Energy efficient, PV
is $4,100 less
C. Energy efficient, PV
is $39,100 less
or D. Standard, PV is
PVstd = 2550K + 10K(P/A,10%,40) = $2,647,800 $39,100 less
Pven = 2585K + 6K(P/A,10%,40) = $2,643,700
E. So close it doesn’t
For planning purposes, this may be too close to call. matter

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 Different Lives

 Even if two alternatives have different lives—MUST

compare over same study period
 Can use least common multiple (smallest # they both divide
into)
 Exp. 3 & 6 years and 2 & 3 years both have lcm of 6

 If A’s life is 3 years & B’s life is 6 years, the PW for A

occurs twice—at time 0 & year 3

 If A’s life is 2 years & B’s life is 3 years, the PW for A

occurs 3 times—at time 0, year 2, & year 4. The PW for B

occurs twice—at time 0 & year 3
 Choose a study period & estimate a salvage value for 1 or
both alternatives

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 Comparing pumps
Brass at 3 years, Stainless at 4 years

What is the comparison period?

A. 3 years
B. 6 years
C. 12 years
D. You cannot compare

E. I don’t know

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 Comparing pumps
Brass at 3 years, Stainless at 4 years

What is the comparison period?

A. 3 years
B. 6 years
C. 12 years Least common multiple is
3 𝗑 4 = 12 years
D. You cannot compare

E. I don’t know

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 Example 5-4

Pump A Pump B
Initial Cost $7000 $5000
End of useful life salvage value $1200 $1000
Useful life, in years 12 6

Pump B

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 Example 5-4, Spreadsheet Solution

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 Example 5-4, Table Solution

Pump A

Pump B

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 Example 5-5 Applying PW using
Analysis Period
Alternatives i = 8% Alt. 1 Alt. 2
Initial Cost $50,000 $75,000
Estimated salvage value at end of useful life $10,000 $12,000
Useful Life 7 years 13 years
Estimated market value, end of 10-year $20,000 $15,000
𝑁𝑃𝑊𝐴𝑙𝑡.1 = −50,000 + (10,000 − 50,000)(𝑃 𝐹, 8%, 7) + 20,000(𝑃 𝐹, 8%, 10)
= −50,000 − 40,000 0.5835 + 20,000 0.4632
= −$64,076
𝑁𝑃𝑊𝐴𝑙𝑡.2 = −75,000 + 15,000(𝑃 𝐹, 8%, 10)
= −75,000 + 15,000 0.5835
= −$68,052

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 Present Worth with Infinite Analysis
Period (Capitalized Cost)

(5-2)

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 Example 5-6 Capitalized Cost

How much set aside now to pay $5000/year to

maintain small park if interest = 4%?

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 Example 5-7 Capitalized Cost
0 70 140 ∞

$8 million $8 million $8 million $8 million

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 Example 5-7 Capitalized Cost
(Alternate Solution 1)
0 70 140 ∞

$8 million $8 million $8 million $8 million

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 Example 5-7 Capitalized Cost
(Alternate Solution 2)
0 70 140 ∞

$8 million $8 million $8 million $8 million

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 Example 5-8 Multiple Alternatives
pump operates 2000 hours/year

Pipe Size (in.)

2 3 4 5
Initial Cost $22,000 $23,000 $25,000 $30,000
Cost of pumping ($/hr) $1.20 $0.65 $0.50 $0.40

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 Multiple Alternatives, Ex. 5-8

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 Example 5-9 Multiple Alternatives
Total Uniform Net Terminal
Alternatives
Investment Annual Benefit Value
A: Do nothing $0 $0 $0
B: Vegetable market $50,000 $5,100 $30,000
C: Gas station $95,000 $10,500 $30,000
D: Small motel $350,000 $36,000 $150,000
𝑁𝑃𝑊𝐴 = $0
𝑁𝑃𝑊𝐵 = −50,000 + 5,100(𝑃 𝐴, 10%, 20) + 30,000(𝑃 𝐹, 10%, 20) = −$2,120
𝑁𝑃𝑊𝐶 = −95,000 + 10,500(𝑃 𝐴, 10%, 20) + 30,000(𝑃 𝐹, 10%, 20) = −$1,140
𝑁𝑃𝑊𝐷 = −350,000 + 36,000(𝑃 𝐴, 10%, 20) + 150,000(𝑃 𝐹, 10%, 20) = −$21,210

Do nothing alternative is stated alternative here. Often an unstated available choice.

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 Example 5-9 Multiple Alternatives
Total Uniform Net Terminal
Alternatives
Investment Annual Benefit Value
A: Do nothing $0 $0 $0
B: Vegetable market $50,000 $5,100 $30,000
C: Gas station $95,000 $10,500 $30,000
D: Small motel $350,000 $36,000 $150,000

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 Example 5-10
5000
Year Alt. A Alt. B 4500
4000 4000 4000

0 −$15,000 −$12,000
1 5,000 3,500 0 1 2 3 4 5

2 4,500 3,500
3 4,000 3,500 Alt. A

4 4,000 3,600
15,000 3500 3500 3500 3600 3700
5 4,000 3,700

i = 8% 0 1 2 3 4 5

Which alternative should Alt. B

be selected?
12,000

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 Example 5-10

Cash flows are so irregular, easier and clearer as individual

data block entries.

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 Example 5-10
Year Alt. A
0 −$15,000
1 5,000
2 4,500
3 4,000
4 4,000
5 4,000

𝑁𝑃𝑊𝐴 = −15,000 + 4000(𝑃 𝐴, 8%, 5) + 1000(𝑃 𝐴, 8%, 3) − 500(𝑃 𝐺, 8%, 3)

= −15,000 + 4000 3.993 + 1000(2.577) − 500 2.445 = $2,326

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 Example 5-10
Year Alt. B
0 −$12,000
1 3,500
2-5 3,500
6 3,500
7 3,600
8 3,700
𝑁𝑃𝑊𝐵
= −12,000 + 3500(𝑃 𝐴, 8%, 5) + 100(𝑃 𝐺 , 8%, 3)(𝑃 𝐹, 8%, 2)
= −12,000 + 3500 3.993 + 100 2.445)(0.8573 = $2185

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 Example 5-11 Strip mining coal ($M)

Year Cash Flow

0 -$610
1-10 +200 per year
10 -1500

𝑁𝑃𝑊 = −610 + 200(𝑃 𝐴, 10%, 10) − 1500(𝑃 𝐹, 10%, 10)

= −610 + 200 6.145 − 1500 0.3855
= $41
At rates below 4.07% or above 18.29% the NPW is negative.
In rare cases NPW results can be unreliable. Appendix 7A addresses this.

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 Example 5-12

New product sales are expected to be 1.2, 3.5, 7, 5, and 3

million units per year for 5 years. Supply chain costs decline
10% per year from $140 per unit in the first year. Price is
$200 per unit the 1st 2 years, then $180, $160, and $140 for
the next 3 years. The remaining costs are $300 million. i =
15%. What is the PW of the new product?

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 Example 5-12

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 Example 5-13 Using XNPV to find
PW of progress payments

XNPV finds PW of cash flows on specific dates.

Time spans need not be uniform.
Time 0 must be specified—even if cash flow = $0
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 Bond Pricing

 Bond pricing is a time value of money problem

 Has a face value
 Interest is paid, usually semi-annually
 At maturity, face value is repaid
 Bonds are bought & sold over their life
 Prices vary with market interest rates

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 Example 5-14

A 15-yr municipal bond was issued 5 yrs ago; the coupon

interest rate = 4%, paid semi-annually. Face value is $1000.
What is the bond’s price if the market rate is 6.09%.

(1 + 𝑖)2 = 1 + 𝑖𝑎 = 1.0609, 𝑠𝑜 1 + 𝑖 = 1.03

i = 3% semiannual interest rate

PW = 20(P/A, 3%, 20) + 1000(P/F, 3%, 20) = $851.24

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