LECTURE 4:

APPLICATIONS OF TIME VALUE

MONEY
 Scenario
You are working in a wafer fabrication facility. Say your company plan to
produce a new product. This new product requires additional processing
machine.

The new machine cost RM125,000. It will save RM17,000 of annual rent.
Maintenance cost would be RM15,000 annually and the salvage value is
RM25,000. Machine lifespan is 12 years.

Assuming the interest rate is 8%, is this investment will be beneficial to

your company ?
 LEARNING OUTCOME
• Present Worth Analysis (PW)

• Future Worth Analysis (FW)

• Annual Worth Analysis (AW)

 1.0 Present Worth Analysis
The Goal

To convert a series of COSTS and BENEFITS over a period of time into

ONE equivalent Present Time Value (PW).

In this method of comparison, the cash flows of each alternative will be

reduced to time zero by assuming an interest rate i (r). Then, depending on
the type of decision, the best alternative will be selected by comparing the
present worth amounts of the alternatives.
Rules

One alternative. Calculate PW at the MARR or given compound interest rate.

If PW ≥ 0, the alternative is financially viable.

Two or more alternatives. Calculate the PW of each alternative at the

MARR. Select the alternative with the PW value that is numerically largest,
that is, less negative or more positive.

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Steps

1. Define various Costs and Benefits identified for the period of entire
investment.
2. Select the desired Rate of Return (MARR), or normally given as an
interest rate.
3. Use Present Worth Analysis formula, based on the given interest
rate, convert it to the present value.
4. If the PW < 0, probably not a good investment (future cost will be
greater than the future benefits).

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 Problem 1.1
You are working with a wafer fabrication facility. Say your company plan to introduce
a new product. This new product requires additional processing machine.

The new machine cost RM125,000. It will save RM17,000 of annual rent.
Maintenance cost would be RM15,000 annually and the salvage value is RM25,000.
Machine lifespan is 12 years.

Assuming the interest rate is 8%, is this investment will be beneficial to your company
?

1-7
Solution

To determine what the present worth value is for all the future money received and
disbursement of this particular investment.

Step 1; define costs and benefits

A1 = RM17,000 annually (saving from the rent),
S = RM25,000
P = - RM125,000
A2 = - RM15,000
t = 12 years

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Step 2; determine the rate of return (MARR), or the interest rate.
i = r =8% = 0.08

Step 3; use the right PW formula (remember the single and multiple cash flows
concepts and formulas)

a) Cost
b) Benefit

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Step 3; use the right PW formula (remember the single and multiple cash flows
concepts and formulas)

a) Cost
b) Benefit

a) PW = initial cost + saving + maintenance + salvage

PW = - (PV)initial cost, t=0 + (PV) saving, t=0 + (PV)maintenance, t=0 + (PV)salvage, t=0

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a) PW = initial cost + saving + maintenance + salvage
PW = - (PV)initial cost, t=0 + (PV) saving, t=0 + (PV)maintenance, t=0 + (PV)salvage, t=0

PW = - RM 99,990
Therefore, the present worth for the total investment over 12 years period is
- RM 99,990.

Is this a good investment ?

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 Problem 1.2
Perform a present worth analysis of equal-service machines with the costs
shown below, if the MARR is 10% per year. Revenues for all three alternatives
are expected to be the same.

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Which alternative would you choose ?

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 2.0 Future Worth Analysis
The Goal

Evaluates a project or investment based on based upon the basis of various

COSTS and BENEFITS that will be accumulated at some future point in
time, into one equivalent Future Value.

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Rules

One alternative. Calculate FW at the MARR or given compound interest rate.

If FW ≥ 0, the alternative is financially viable.

Two or more alternatives. Calculate the FW of each alternative at the MARR.

Select the alternative with the FW value that is numerically largest, that is, less
negative or more positive.

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Steps

1. Define various Costs and Benefits identified for the period of entire
investment.
2. Select the desired Rate of Return (MARR), or normally given as an
interest rate.
3. Use Future Worth Analysis formula, based on the given interest
rate, convert it to the future value.
4. Look for the maximized benefits over the investment period.

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 Problem 2.1
Perform a future worth analysis of a company investment for 8 years period,
which the initial cost of RM500,000 and yearly revenue of RM750,000 with
the MARR set at 10%. The cost time-line diagram as shown.

750,000

1 2 3 4 5 6 7 8
i = r = 0.1
500,000

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 3.0 Annual Worth Analysis
AW is an equal annual series of dollar amounts, over a stated period (N, t),
equivalent to the cash inflows and outflows at interest rate (i , r) that is
generally MARR. AW is annual equivalent revenues / disbursement (A)
minus the equivalent annual cost (CR).

Financial Language; AW = A – CR
Mathematically; AW = A + CR

CR is equivalent annual cost of obtaining the initial asset (P) plus the
salvage (S).
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Method: Compute AW of the original cost and add the AW of the salvage value.

AW = A + CR

CR = - P(A / P, i, N) + S(A / F, i, N)
Rules

One alternative. Calculate AW at the MARR or given compound interest rate.

If AW ≥ 0, the alternative is financially viable.

Two or more alternatives. Calculate the AW of each alternative at the MARR.

Select the alternative with the AW value that is numerically largest, that is,
less negative or more positive.

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 Problem 3.1
A contractor purchased a used crane for RM11,000. His operating cost will be
RM2700 per year, and he expects to sell it for RM5000 five years from now.
What is the equivalent annual worth (AW) of the crane at an interest rate of 10%
?
A contractor purchased a used crane for RM11,000. His operating cost will be
RM2700 per year, and he expects to sell it for RM5000 five years from now.
What is the equivalent annual worth (AW) of the crane at an interest rate of 10%
?

S (RM5000)

1 2 3 4 5

A (RM2700)
P (RM11,000)
i = r = 0.1
 S (RM5000)

1 2 3 4 5

A (RM2700)
P (RM11,000) i = r = 0.1

AW = A + CR
CR = - P(A / P, i, N) + S(A / F, i, N)

CR = -11,000(A/P, 10%, 5) +5000(A/F,10%,5)

AW = -11,000(A/P, 10%, 5) +5000(A/F,10%,5) + (- 2700)
= -11,000 (i (1+ i)N / (1+ i)N-1) + 5000 (i /(1 + i )N -1) – 2700
= -11,000 (0.1 (1+ 0.1)5 / (1+ 0.1)5-1) + 5000 (0.1 /(1 + 0.1 )5 -1) – 2700
= -11,000 (0.1 *1.6105 / 0.6105) + 5000 (0.1 /(0.6105) – 2700
 S (RM5000)

1 2 3 4 5

A (RM2700)
P (RM11,000) i = r = 0.1

AW = A + CR
CR = - P(A / P, i, N) + S(A / F, i, N)

AW = -11,000(.2638) + 5000(.1638) – 2700

AW= - RM4782.8
 Problem 3.2
Perform a future worth analysis of a company investment for 8 years period,
which the initial cost of RM500,000 and yearly revenue of RM750,000 with
the MARR set at 10%. The cost time-line diagram as shown.

750,000

1 2 3 4 5 6 7 8
i = r = 0.1
500,000

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

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 750,000

1 2 3 4 5 6 7 8
i = r = 0.1
500,000
AW = A + CR
CR = - P(A / P, i, N) + S(A / F, i, N)
 750,000

1 2 3 4 5 6 7 8
i = r = 0.1
500,000
AW = A + CR
CR = - P(A / P, i, N) + S(A / F, i, N)
AW = -(PW (A / P, i% , N)) + 750,000
= - PW( 𝑖(1 + 𝑁𝑖)𝑁 ) + 750,000
(1 + 𝑖) −1

0.1(1 + 0.1)8
AW = - PW ( ) + 750,000
(1 + 0.1)8 −1
= -(500,000 * .1874) + 750,000 = 750,000 – 93703 = 656,297
 Exercise (Problem 1.2) – using Functions
Perform a present worth analysis of equal-service machines with the costs
shown below, if the MARR is 10% per year. Revenues for all three alternatives
are expected to be the same.

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Solve Problem 1.2 using functions.
(b) (Past Year Question) Three alternatives for KORTAL Bhd. to consider the
installation of a gas scrubber project are presented in cash flow diagrams. Each
alternative meets the same service requirements, but differences in capital investment
amounts and benefit exist among them. The study period is 10 years and the useful
lives of all three alternatives are also 10 years. Market values of all alternatives are
assumed to be zero at the end of their useful lives. If the company’s MARR is 10% per
year, which alternative should be selected, based on;
i) PW method
ii) AW method
iii)FW method

Alternative A

Alternative B Alternative C