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ENGINEERING
Newnan, Lavelle, and Eschenbach
ECONOMIC
ANALYSIS, 12/e Copyright © 2014 by Oxford University Press
 Chapter 5

Present Worth Analysis

Copyright Oxford University Press 2014

 Chapter Outline

• Assumptions in Solving Economic Analysis

Problems
• Economic Criteria
• Applying Present Worth Techniques
– Useful Lives Equal the Analysis Period
– Useful Lives Different from the Analysis Period
– Infinite Analysis Period

Copyright Oxford University Press 2014

 Learning Objectives

• Understand common assumptions in

solving economic analysis problems
• Apply present worth techniques in various
situations in selecting the best alternative

Copyright Oxford University Press 2014

 Where we have been:
• Equivalence concept
• Cash flows
• Compound interest factors

Where we are going in this chapter:

• Understanding economic criteria
• Applying present worth techniques
• Assumptions in solving economic analysis
problems

Engineering
5
Economic
 Assumptions in Solving Economic
Analysis Problems

• End-of-year convention (simplifies calculations)

• Viewpoint (generally the firm)
• Sunk costs (past has no bearing)
• Borrowed money (consider investing only)
• Effect of inflation (prices are not stable)
• Income taxes (must be considered for realism)

Engineering
6
Economic
 Assumptions in Solving
Economic Analysis Problems
• End-of-Year Convention: F
A A A A

0 1 2 n-1 n

• Viewpoint of Economic Analysis Studies

– Generally, the point of view from the total firm is
taken
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 Economic Criteria

Situation Criterion
Neither input nor output Maximize (Output – Input)
fixed
Fixed input Maximize output
Fixed output Minimize input

Methods:
• Present worth
• Annual cash flow
• Rate of return
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 Applying Present Worth Techniques

• Equivalence provides the logic by which we may

adjust the cash flow for a given alternative into
the same equivalent sum or series with
equivalent present consequences, then
compared it to chose the feasible alternatives.
• In this case, the consequences of each
alternative must be considered for this period of
time which is usually called the analysis period

9
 Applying Present Worth Techniques

Situation Criterion
Neither input nor output Maximize Net Present Worth
fixed: Typical cases (present worth of benefits
minus present worth of
costs)
Fixed input: amount of Maximize present worth of
money or other input benefits or other outputs
resources are fixed
Fixed output: fixed task, Minimize present worth of
benefit, or other outputs costs or other inputs

Copyright Oxford University Press 2014

 Economic Criteria - Example
Purchasing Building Space

Alt Situation Example Criterion

A Fixed $150,000 Maximum square feet of
input max building for the price

B Fixed 20,000 ft2 Negotiate for minimum

output building cost/ft2
available
C Neither $150,000 max Simultaneously negotiate
fixed 15-20,000 ft2 for maximum building
required size & minimum cost/ft2

Engineering
11
Economic
 Applying
Present Worth Techniques

• Analysis period must be considered

– Useful life of the alternative equals the
analysis period
– Alternatives have useful lives different from
the analysis period
– The analysis period is infinite, n = 

Engineering
12
Economic
 Example 5-1 Applying Present
Worth when Useful Lives are Equal
Device A Device B
4000 4500 5000
A=3000 3000 3500

0 1 2 3 4 5 0 1 2 3 4 5

P=10,000
P=13,500

𝑃𝑊𝐴 = −1000 + 3000(𝑃 𝐴, 7%, 5) = −10,000 + 3000 4.100 = $2300

𝑃𝑊𝐵 = −13,500 + 3000(𝑃 𝐴, 7%, 5) + 500(𝑃 𝐺, 7%, 5)

= −13,500 + 3000 4.100 + 500 7.647
= $2624

Copyright Oxford University Press 2014

 Example 5-2 Applying Present
Worth when Useful Lives are Equal
Build a full-sized facility for $400 million now, or build a
reduced-size facility now for $300 million and expand it 25
years hence for an additional $350 million, at 6% interest?

For the single-stage construction

𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡 = $400 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
For the two-stage construction
𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡 = $300 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 + 350 𝑚𝑖𝑙𝑙𝑖𝑜𝑛(𝑃 𝐹, 6%, 25)
= $300 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 + 81.6 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
= $381.6 𝑚𝑖𝑙𝑙𝑖𝑜𝑛

Copyright Oxford University Press 2014

 Example 5-3 Applying Present
Worth when Useful Lives are Equal
End-of-Useful-Life
Manufacturer Cost Useful Life
Salvage Value
Speedy $1500 5 years $200
Allied $1600 5 years $325

Speedy
𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡 = 1500 − 200(𝑃 𝐹, 7%, 5)
= 1500 − 200 0.7130 = $1357
Allied
𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡 = 1600 − 325(𝑃 𝐹, 7%, 5)
= 1600 − 325 0.7130 = $1368

Copyright Oxford University Press 2014

 Example 5-4 Applying Present
Worth when Useful Lives are Equal
Uniform Annual End-of-Useful-Life
Alternatives Cost
Benefit Salvage Value
Atlas $2000 $450 $100
Tom Thumb $3000 $600 $700

Atlas 𝑁𝑃𝑊 = 450(𝑃 𝐴, 8%, 6) + 100(𝑃 𝐹, 8%, 6) − 2000

= 450 4.623 + 100 0.6302 − 2000
= $143
Tom Thumb
𝑁𝑃𝑊 = 600(𝑃 𝐴, 8%, 6) + 700(𝑃 𝐹, 8%, 6) − 3000
= 600 4.623 + 700 0.6302 − 3000
= $215

Copyright Oxford University Press 2014

 Present Worth when Useful Lives
are Different from Analysis Period
• Least Common Multiple of Useful Lives from
Various Alternatives
• Assuming service will be needed indefinitely
• Repeating same cash flows in each cycle for
each alternative

• Analysis Period
• Need to estimate the terminal values for all
alternatives at the end of the analysis period

Copyright Oxford University Press 2014

 Useful lives different from the
analysis period(1)
•Example 1 :
A purchasing agent is considering the purchase of
some new equipment for the mailroom. Two different
manufacturers have provided quotations. An analysis
of the quotations indicates the following :
Manufacturer Cost Useful life(year) salvage value
Speedy $ 1500 5 $ 200
Allied $ 1600 10 $ 325
Assume 7% interest and equal maintenance costs.

18
 Useful lives Different from the
analysis period(2)
• If the allied equipment has a useful life of ten years, and
the speedy equipment will last five years, one solution is
to select a ten year analysis period.
• Assume the replacement speedy equipment will also
cost $1500 five years hence
• Speedy Allied
200 200 325

1500 1500 1600

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Useful lives Different from the analysis
period(3)
PW of cost Speedy
= 1500 + (1500-200) (P/F,7%,5) – 200(P/F,7%,10)
= 1500 + 1300(0,713) – 200(0,5083)
= $ 2325,24
PW of cost Allied
= 1600 – 325(P/F,7%,10) = 1600 – 325(0,5083)
= $ 1434,803

PW of cost Allied < PW of cost Speedy ,

therefore Allied preferred aternative

20
 Useful lives Different from the analysis
period(4)
•Example 2 :
The following data have been estimated for two mutually
exclusive investment alternatives, A and B associated with a
small engineering project for which revenues as well as
expenses are involved. They have useful lives of four and six
years, respectively. If the MARR = 10% per year, show which
alternative is more desirable by using equivalent worth methods.
Use the repeatability assumption.
A B
Capital Investment $3.500 $5.000
Annual Cash Flow 1.255 1.480
Useful Life (years) 4 6
Market value at end of useful 0 0
life
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 Useful lives Different from the analysis
period(5)
• Solution :
• The least common multiple of the useful lives of
alternatives A and B is 12 years.
• PWA = -$3.500 - $3.500 [(P/F,10%,4) + (P/F,10%,8)]
+ $1.255 (P/A,10%,12)
= $1.028

22
 When the least of multiple lives is
impractical, use TERMINAL VALUE

Engineering
23
Economic
 Example 5-5 Applying Present
Worth using Analysis Period
Alternatives 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

Copyright Oxford University Press 2014

 Infinite Analysis Period (1)

• In governmental analysis, at times there are

circumstances where a service or condition is to be
maintained for an infinite period. We call this particular
analysis Capitalized Cost
• Capitalized Cost, is the present sum of money that would
need to be set aside now, at some interest rate, to yield
the funds required to provide the service indefinitely.
Assume cost of maintenance is equal every year.

25
 Infinite Analysis Period (2)

• For one year period :

If i x P is cost of maintenance every period, then
for each period there will be an expenditure of iP.
• For n =  , the expenditure will be A = i x P then

𝐴
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃=
𝑖

26
 Example 5-6 Capitalized Cost

How much should one set aside to pay $50 per

year for maintenance on a gravesite if interest is
assumed to be 4%?

𝐴 50
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃= = = $1250
𝑖 0.04

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 Example 5-7 Capitalized Cost

0 70 140 ∞

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

n=70
0 70 =

A
$8 million

𝐴 = 8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛(𝐴 𝐹, 7%, 70) = $4960

𝐴 4960
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃 = 8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 + = = $8,071,000
𝑖 0.07

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

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

n=70
0 70 =

A
$8 million

𝐴 = 8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛(𝐴 𝑃, 7%, 70) = $565,000

𝐴 565000
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃= = = $8,071,000
𝑖 0.07

Copyright Oxford University Press 2014

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

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

𝑖70 𝑦𝑒𝑎𝑟 = (1 + 7%)70 = 113.989

𝐴 8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃 = 8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 + = = $8,071,000
𝑖 113.989

Copyright Oxford University Press 2014

 Example 5-8 Multiple Alternatives

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

𝑃𝑊 𝑜𝑓 𝐶𝑜𝑠𝑡2" = 22,000 + 1.20 × 2000(𝑃 𝐴, 7%, 5) = $31,840

𝑃𝑊 𝑜𝑓 𝐶𝑜𝑠𝑡3" = 23,000 + 0.65 × 2000(𝑃 𝐴, 7%, 5) = $28,330
𝑃𝑊 𝑜𝑓 𝐶𝑜𝑠𝑡4" = 25,000 + 0.50 × 2000(𝑃 𝐴, 7%, 5) = $29,100
𝑃𝑊 𝑜𝑓 𝐶𝑜𝑠𝑡5" = 30,000 + 0.40 × 2000(𝑃 𝐴, 7%, 5) = $33,280

Copyright Oxford University Press 2014

 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

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 Example 5-10

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

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 Example 5-10

Year Alt. B
700
0 -$1500 400 500 600
300 300 300 300
1 +700
2-5 +300 0 1 2 3 4 5 6 7 8
6 +400
7 +500
1500
8 +600

𝑁𝑃𝑊𝐵
= −1500 + 300(𝑃 𝐴, 8%, 8) + 400(𝑃 𝐹, 8%, 1) + 100(𝑃 𝐺, 8%, 4) (𝑃 𝐹, 8%, 4)
= −1500 + 300 5.747 + 400 0.9259 + 100 4.650 (0.7350)
= $936.24

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 Example 5-11

Year Alt. A 1000 850

700 550
0 -$2000 400 400 400 400
1 +1000
0 1 2 3 4 5 6 7 8
2 +850
3 +700
4 +550 2000
5-8 +400

𝑁𝑃𝑊𝐴 = −2000 + 400(𝑃 𝐴, 8%, 8) + 600(𝑃 𝐴, 8%, 4) − 150(𝑃 𝐺, 8%, 4)

= −2000 + 400 5.747 + 600(3.312) − 150 4.650
= $1588.50

Copyright Oxford University Press 2014

 Example 5-13

A 15-yr municipal bond was issued 5 yrs ago. Its

coupon interest rate is 8%, interest payments are
made semi-annually, with face value of $1000. What
should be the bond’s price if market rate is 12.36%. 1000

40

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

(1 + 𝑖𝑠𝑒𝑚𝑖−𝑎𝑛𝑛𝑢𝑎𝑙 )2 = 1 + 0.1236
𝑖𝑠𝑒𝑚𝑖−𝑎𝑛𝑛𝑢𝑎𝑙 = 6%
𝑃𝑊 = 40 𝑃 𝐴 , 6%, 20 + 1000 𝑃 𝐹 , 6%, 20 = $770.60

Copyright Oxford University Press 2014