Module 4: Present Worth

Analysis
Outline Module 4

• Proposals for Investment Alternatives

• Selection of Alternatives
• Present-worth comparison
• Future Worth Analysis
• Capitalized-cost calculation
Proposals for Investment Alternatives

• An investment is usually established from (engineering)

proposal.
• Every proposal can be considered as an investment
alternatives, but
• An investment alternative can consist of a group or set
of proposals, which in turn may include option to “do
nothing”
 Independent Proposal
• The condition at which the acceptance of a proposal from a set of proposals
has not effect on the acceptance of any of the other proposals in the set.
 Dependent Proposal
• The condition at when the acceptance of a proposal from the set will influence
the acceptance of the others
• Mutually exclusive → the acceptance of a proposal from the set precludes
the acceptance of any others
Selection of Alternatives

• Decision criteria in an economic analysis can be

done comparing mutually exclusive alternatives:
• The differences between alternatives
• highest inflow or lowest outflow
• The minimum attractive rate of return
• highest rate of return
• Payback period
• shortest payback period
• Do nothing
Selection of Alternatives

• Selection of two or more (investment) alternatives by

comparing their economic values.
• Method for comparison of alternatives:
• present values,
• future worth,
• capitalized cost,
• annual values,
• rate of returns, or
• payback period
• Conditions of comparison:
• equal lives
• different lives
MARR

• Minimum Acceptable Rate of Return

• Minimum amount the investor is willing to accept for the use of money
Rate of Return
• Different from lending rates
• More akin to Opportunity Cost of the money Expected
Rate of Return
• Determined by Company Policy on New Proposal

Range for ROR

On accepted
proposals

All proposals
must offer at MARR
Least MARR
to be considered ROR on
Safe investment
Present-worth comparison

The comparison of alternatives is made by

transforming all future receipts and expenditures
into equivalent today’s rupiah
Example:
• Two types of production systems are being considered based on
MARR of 12% per year and the following characteristics:
system A system B

Initial cost Rp. 625.000.000,- Rp. 570.000.000,-

Monthly expenses Rp. 45.750.000,- Rp. 55.750.000,-

Receipts Rp. 152.000.000,- / quarter Rp. 140.000.000,- / 4 months

Salvage value Rp. 225.000.000,- Rp. 190.000.000,-

Life 3 tahun 3 tahun

 Present-worth comparison
SV
• System A:
R R R R R R R R R R R R
I
E

0 1 2 3

Effective monthly interest rate, iA = i / 12 = 1%

?
PA = -I - E(P/A, iA, 36) + R(P/F, iA, 3) + R(P/F, iA, 6) + … + R(P/F, iA, 36) + SV(P/F, iA, 36)
 Present-worth comparison
SV
• System B:

R R R R R R R R R
I
E

0 1 2 3

PB = -I - E(P/A, iB, 36) + R(P/F, iB, 4) + R(P/F, iB, 8) + … + R(P/F, iB, 36) + SV(P/F, iB, 36)

Select System A if PA > PB

Present-worth comparison

To have a fair comparison of alternatives with

different lives, the time span over must made equal:
a) The time period of comparison is made equal to
the least common multiple (LCM) for their lives.
Cash flows of the shorter period will be extended up to
the remaining time period of comparison
b) At any time span to be considered (the study
period approach or planning horizon approach),
when LCM is impossible to perform.
Only cash flows up to the time span is to be considered;
 Present-worth comparison
Example:
Two types of production systems are being considered based on MARR of 12% per
year and the following characteristics:

system A system B

Initial cost Rp. 625.000.000,- Rp. 770.000.000,-

Monthly expenses Rp. 45.750.000,- Rp. 55.750.000,-

Monthly receipts Rp. 32.000.000,- Rp. 40.000.000,-

Salvage value Rp. 225.000.000,- Rp. 110.000.000,-

Life 2 tahun 4 tahun

 Present-worth comparison
• System A:
R
SV

I
E

0 1 2

 System B:
R
SV
I
E

0 1 2 3 4
 Present-worth comparison (LCM)
• System A:
R1 R2
SV SV2

I I2
E1 E2

0 1 2 3 4

 System B:
R
SV
I
E

0 1 2 3 4
 Present-worth comparison (Study Periods: 2
years)
• System A:
R
SV

I
E

0 1 2

 System B:
R Estimated SV
I
E

0 1 2 3 4
 Example 1: Three Alternatives
• Assume i = 10% per year

A1 A2 A3
Electric Power Gas Power Solar Power
First Cost: -2500 First Cost: -3500 First Cost: -6000
Ann. Op. Cost: -900 Ann. Op. Cost: -700 Ann. Op. Cost: -50
Sal. Value: +200 Sal. Value: +350 Sal. Value: +100
Life: 5 years Life: 5 years Life: 5 years

Which Alternative – if any, should be selected based upon a

present worth analysis?
Example 2:
• Two Location Alternatives, A and B where one can
lease one of two locations.
• Which option is preferred if the interest rate is
15%/year?

Location A Location B
First cost, $ -15,000 -18,000
Annual lease cost,
$ per year -3,500 -3,100
Deposit return,$ 1,000 2,000
Lease term, years 6 9
Use LCM, where “n” = 18 yrs.
• The Cash Flow Diagrams are:
Unequal Lives: 2 Alternatives

A
6 years 6 years 6 years

Cycle 1 for A Cycle 2 for A Cycle 3 for A

B
9 years 9 years

Cycle 1 for B Cycle 2 for B

18 years

i = 15% per year

LCM(6,9) = 18 year study period will apply for present worth

LCM Present Worth's
• Since the leases have different terms (lives),
compare them over the LCM of 18 years.
• For life cycles after the first, the first cost is
repeated in year 0 of the new cycle, which is the
last year of the previous cycle.
• These are years 6 and 12 for location A and year 9
for B.
• Calculate PW at 15% over 18 years.
PW Calculation for A and B -18 yrs
• PWA = -15,000 - 15,000(P/F,15%,6) +
1000(P/F,15%,6)- 15,000(P/F,15%,12) +
1000(P/F,15%,12) + 1000(P/F,15%,18) -
3500(P/A,15%,18)= $-45,036
• PWB = -18,000 - 18,000(P/F,15%,9) +
2000(P/F,15%,9) + 2000(P/F,15%,18) - 3100(P/A,15
%,18)
• = $-41,384 Select “B”: Lowest PW Cost
@ 15%
Use The Study Period Approach
• An alternative method; Impress a study period (SP)
on all of the alternatives;
• A time horizon is selected in advance;
• Only the cash flows occurring within that time
span are considered relevant;
• May require assumptions concerning some of the
cash flows.
• Common approach and simplifies the analysis
somewhat.
Example Problem with a 5-yr SP
• Assume a 5- year Study Period for both options:

For a 5-year study period no cycle repeats are necessary.

PWA = -15,000 - 3500(P/A,15%,5) + 1000(P/F,15%,5)
= $-26,236
PWB = -18,000- 3100(P/A,15%,5) + 2000(P/F,15%,5)
= $-27,397
Location A is now the better choice.

Note: The assumptions made for the A and B alternatives! Do not expect
the same result with a study period approach vs. the LCM approach!
Future Worth Analysis
• In some applications, management may prefer a
future worth analysis;
• Analysis is straight forward:
• Find P0 of each alternative:
• Then compute Fn at the same interest rate used to
find P0 of each alternative.
• For a study period approach, use the appropriate value
of “n” to take forward.
Future Worth Approach (FW)
• Applications for the FW approach:
• Wealth maximization approaches;
• Projects that do not come on line until the end
of the investment (construction) period:
• Power Generation Facilities
• Toll Roads
• Large building projects
• Etc.
Capitalized Cost Calculations
• CAPITALIZED COST- the present worth of a project
which lasts forever.
• Government Projects;
• Roads, Dams, Bridges, project that possess perpetual
life;
• Infinite analysis period;
• “n” in the problem is either very long, indefinite, or
infinity.
Derivation of Capitalized Cost
• We start with the relationship:
• P = A[P/A,i%,n]
• Next, what happens to the P/A factor when we let n
approach infinity.
• Some “math” follows.
P/A where “n” goes to infinity
• The P/A factor is:

 (1 + i ) − 1 
n
P = A n 
 i (1 + i ) 
On the right hand side, divide both
numerator and denominator by (1+i)n
 1 
1 − (1 + i ) n 
P = A 
 i 
 
CC Derivation…
• Repeating:  1 
1 − (1 + i ) n 
P = A 
 i 
 
If “n” approaches  the above reduces
to:
A
P=
i
CC Explained
• For this class of problems, we can use the term
“CC” in place of P.
• Restate: A
CC =
i
• Or,
AW
CC =
i
• AW: annual worth
CC Problem: Public Works Example
• Problem Parameters
The suspension bridge will cost $50 million with annual inspection and
maintenance - costs of $35,000. In addition, the concrete deck would have
to be resurfaced every 10 years at a cost of $100,000. The truss bridge and
'approach roads' are expected to cost $25 million and have annual
maintenance costs of $20,000. The bridge would have to be painted every
3 years at a cost of $40,000. In addition, the bridge would have to be
sandblasted every 10 years at a cost of $190,000. The cost of purchasing
right-of-way is expected to be $2 million for the suspension bridge and
$15 million for the truss bridge. Compare the alternatives on the basis of
their capitalized cost if the interest rate is 6% per, year.

Two, Mutually Exclusive Alternatives: Select the best

alternative based upon a CC analysis
 Bridge Alternatives: Suspension
• Cash Flow Diagrams

Suspension Bridge Alternative

0 1 2 3 4 ..... 9 10 11 ……..

$35,000/yr
i = 6%/year
$50 Million
$100,000
$2 Million
Suspension Bridge Analysis
• CC1= -52 million at t = 0.
A1 = −$35, 000
A 2 = −100, 000( A / F , 6%,10) = −$7,587
A1 + A2 −35, 000 + (−7,587)
CC2 = = = −$709, 783.
i 0.06

Total CC – suspension bridge is:

-52 million + (-709,783) = -$52.71 million
Truss Bridge Alternative
• For the Truss Bridge Alternative: Cash Flow
Diagram:

Truss Design:

/////
0 1 2 3 4 5 6 7 8 / 9 10 11 …..
A. Maint. = $20,000/yr

n=
Paint: -40,000 Paint: -40,000 Paint: -40,000

-25M +(-15M) Sandblast: -

i = 6%/year 190,000
Truss Bridge Alternative
1. CC1 Initial Cost:
-$25M + (-15M) = -$40M

Truss Design:

/////
0 1 2 3 4 5 6 7 8 / 9 10 11 …..
A. Maint. = $20,000/yr

n=
Paint: -40,000 Paint: -40,000 Paint: -40,000

-25M +(-15M) Sandblast: -

i = 6%/year 190,000
Truss Bridge Alternative
2. Annual Maintenance is already an “A” amount so:
A1 = -$20,000/year

Truss Design:

/////
0 1 2 3 4 5 6 7 8 / 9 10 11 …..
A. Maint. = $20,000/yr

n=
Paint: -40,000 Paint: -40,000 Paint: -40,000

-25M +(-15M) Sandblast: -

i = 6%/year 190,000
 Truss Bridge Alternative
3, A2: Annual Cost of Painting
i = 6%/year
Truss Design:
/////
0 1 2 3 4 5 6 7 8 / 9 10 11 …..
A. Maint. = $20,000/yr

Use A/F,6%,3 n=

Paint: -40,000 Paint: -40,000 Paint: -40,000

-25M +(-15M) Sandblast: -

190,000

For any given cycle of painting compute:

A2 = -$40,000(A/F,6%,3) = -$12,564/year
 Truss Bridge Alternative
3, A3 Annual Cost of Sandblasting
i = 6%/year
Truss Design:
/////
0 1 2 3 4 5 6 7 8 / 9 10 11 …..
A. Maint. = $20,000/yr

Use The A/F,6%,10 to convert to an equivalent $/year amount n=

Paint: -40,000 Paint: -40,000 Paint: -40,000

-25M +(-15M) Sandblast: -

190,000

For any given cycle of Sandblasting Compute

A3 = -$190,000(A/F,6%,10) =-$14,421
Bridge Summary for CC(6%)
• CC2 = (A1+A2+A3)/i
• CC2 = -(20,000+12,564+14,421)/0.06
• CC2 – $783,083
• CCTotal = CC1 + CC2 =-40.783 million
•CCSuspension = -$52.71 million
•CCTruss - -40.783 million
•Select the Truss Design!