5
Engineering Economy
ME2045
PRESENT WORTH ANALYSIS
Assoc. Prof. Dr. Le Ngoc Quynh Lam
Learning outcomes
• Utilize different present worth (PW) techniques to evaluate and
select alternatives.
• Identify mutually exclusive and independent projects; define revenue and
cost alternatives.
• Select the best of equal-life alternatives using present worth analysis.
• Select the best of different-life alternatives using present worth analysis
• Select the best alternative using future worth (FW) analysis
• Select the best alternative using capitalized cost (CC) analysis
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5.1 Formulating alternatives
The nature of the economic proposals Figure 5-1:
is always one of two types: Progression
from
Mutually exclusive alternatives: Only proposals to
one of the proposals can be selected. economic
For terminology purposes, each viable evaluation to
proposal is called an alternative. selection
Independent projects: More than one
proposal can be selected. Each viable
proposal is called a project.
The DN alternative or project means that the
current approach is maintained; nothing new is
initiated. No new costs, revenues, or savings
are generated.
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5.1 Formulating alternatives
• Parameters:
• First cost: P
• Expected life: n
• Effective interest rate: i
• Salvage value (trade-in value): SV
• Rework/upgrade cost
• Annual operating costs AOC
• Maintenance and operating cost: M&O
Revenue: Each alternative generates cost (cash outflow) and revenue (cash inflow)
Revenue-or estimates, and possibly savings, also considered cash inflows. Revenues can vary for
each alternative.
cost-based
Cost: Each alternative has only cost cash flow estimates. Revenues or savings are
alternatives assumed equal for all alternatives; thus, alternative selection is not dependent upon
their estimation. These may also be referred to as service alternatives.
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Decision making
Equal-life 5.2
alternatives
Present worth
(PW) analysis
Different-life 5.3
alternatives
Select the best
FW analysis
alternative 5.4
Capitalized
cost analysis 5.5
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5.2 PW Analysis of Equal-Life Alternatives
Ideas:
• all future costs and revenues are transformed to equivalent
monetary units NOW
• all future cash flows are converted to present amounts at a
specific rate of return, which is the MARR
èvery simple to determine which alternative has the best
economic advantage.
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5.2 PW Analysis of Equal-Life Alternatives
Required condition and alternative evaluation procedure:
- Equal service requirement: All alternatives have the same capacities for the same time
period (life)
If the required condition is met à calculate PW at the stated MARR for each alternative .
- Mutually exclusive selection:
- 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.
- Independent project selection:
- One or more independent projects: Select all projects with PW ≥ 0 at the MARR.
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5.2 PW Analysis of Equal-Life Alternatives
Example 5.1 (page134)
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.
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5.2 PW Analysis of Equal-Life Alternatives
Solution:
- Type: Cost alternatives
- Check the required condition: Yes. (equal- life)
- Present worth at MARR = 10%:
The solar-powered machine is selected since the PW of its costs is the lowest; it has the
numerically largest PW value.
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5.3 PW Analysis of Different-Life Alternatives
When the PW method is used to compare mutually exclusive alternatives
that have different lives, 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.
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5.3 PW Analysis of Different-Life Alternatives
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
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5.3 PW Analysis of Different-Life Alternatives
Example 5.3 (page 136):
National Homebuilders, Inc. plans to purchase new cut-and-finish equipment. Two
manufacturers offered the following estimates.
a) Determine which vendor should be selected on the basis of a PW 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?
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5.3 PW Analysis of Different-Life Alternatives
Example 5.3 (page 136): Solution
a. Since nA = 6 and nB = 9 à LCM = 18
Vendor B is selected, since it costs
less in PW terms; that is, the PWB
value is numerically larger than
PWA.
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5.3 PW Analysis of Different-Life Alternatives
Example 5.3 (page 136): Solution
b. For a 5-year study period, no cycle repeats are necessary.
The PW analysis is
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.
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5.4 Future Worth Analysis
• 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.
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5.4 Future Worth Analysis
Example 5.5 (page 139)
A British food distribution conglomerate purchased a Canadian food store chain for £75 million 3
years ago. There was a net loss of £10 million at the end of year 1 of ownership. Net cash flow is
increasing with an arithmetic gradient of £+5 million per year starting the second year, and this
pattern is expected to continue for the foreseeable future. Because of the heavy debt financing
used to purchase the Canadian chain, the international board of directors expects a MARR of 25%
per year from any sale.
a) The British conglomerate has just been offered £159.5 million by a French company wishing
to get a foothold in Canada. Use FW analysis to determine if the MARR will be realized at this
selling price.
b) If the British conglomerate continues to own the chain, what selling price must be obtained at
the end of 5 years of ownership to just make the MARR?
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5.4 Future Worth Analysis
Example 5.5 (page 139) –
Solution
Set up the FW relation in year 3 (FW3) at i = 25%
per year and an offer price of £159.5 million
FW3 = −75(F/P,25%,3) − 10(F/P,25%,2) −
5(F/P,25%,1) + 159.5
= −168.36 + 159.5 = £−8.86 million
Conclusion:
No, the MARR of 25% will not be realized if the
£159.5 million offer is accepted.
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5.4 Future Worth Analysis
Example 5.5 (page 139) –
Solution
Determine the future worth 5 years from now at
25% per year
FW5 = −75(F⁄P,25%,5) − 10(F⁄A,25%,5) +
5(A⁄G,25%,5)(F⁄A,25%,5) = £−246.81 million
The offer must be for at least £246.81 million to
make the MARR.
This is approximately 3.3 times the purchase price
only 5 years earlier, in large part based on the
required MARR of 25%.
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5.5 Capitalized Cost Analysis
• Many public sector projects such as bridges, dams, highways
and toll roads, railroads, and hydroelectric and other power
generation facilities have very long expected useful lives.
• A perpetual or infinite life is the effective planning horizon.
• Permanent endowments for charitable organizations and
universities also have perpetual lives.
• The economic worth of these types of projects or endowments
is evaluated using the present worth of the cash flows.
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5.5 Capitalized Cost Analysis
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5.5 Capitalized Cost Analysis
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5.5 Capitalized Cost Analysis
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5.5 Capitalized Cost Analysis
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CHAPTER SUMMARY
• The PW method of comparing alternatives involves converting all cash flows to
present dollars at the MARR.
• The alternative with the numerically larger (or largest) PW value is selected.
• When the alternatives have different lives, the comparison must be made for equal-
service periods.
• This is done by performing the comparison over either the LCM of lives or a specific study
period. Both approaches compare alternatives in accordance with the equal-service
requirement.
• When a study period is used, any remaining value in an alternative is recognized through the
estimated future market value.
• If the life of the alternatives is considered to be very long or infinite, capitalized cost is
the comparison method.
• The CC value is calculated as A/i, because the P⁄A factor reduces to 1⁄i in the limit of n = ∞.
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End of chapter 5
• Read all definitions and examples
• Do all exercises
• There will be a quiz (Bkel)
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