Present worth analysis

Introduction

I Given a set of ‘feasible’ alternatives, engineering economy

attempts to identify the ‘best’ (most viable) alternative(s)
from an economic perspective.
I Economic perspective requires quantitative criteria for
decision making.
I Next, we study the present worth analysis.
Types of economic projects
1. Mutually exclusive alternatives
I From a set of feasible alternatives, pick only one; e.g.,
which car to buy.
I For terminology purposes, each viable proposal is
called an ‘alternative’.
I Mutually exclusive alternatives ‘compete’ with each
other and are compared pairwise.
2. Independent projects
I From a set of feasible alternatives select as many as
possible to meet the economic criteria the most; e.g.,
where to invest money?
I In the absence of a budget constraint, choose all
alternatives that do better than the ‘do nothing’ (DN)
alternative.
I Independent projects are evaluated one at a time and
compete only with the DN project.
Do nothing (status-quo) alternative

I This is the alternative of not changing the current

situation; e.g., keep money in a savings account, rather
than in stocks.
Cash flow types for projects

1. Revenue: each alternative generates costs and revenues over

the life of the project; e.g., what product to introduce?
I Criteria: select the alternative that maximizes the
economic measure of merit, which is profit-based.
2. Cost: each alternative has only cost cash flows. Revenues
are the same for all alternatives; e.g., which 100-seat plane
to buy?
I These are also referred to as service alternatives.
I Criteria: select the alternative that minimizes the
economic measure of merit, which is cost-based.
Present worth (PW) analysis

I This is the process of obtaining the equivalent worth of

future cash flows at present time.
I That is, finding PW of cash flows.
I We say that future cash flows are ‘discounted’ to time 0.
I A future amount of money converted to its equivalent value
now has a present worth (PW) that is always less than that
of the future cash flow.
I For this reason, present worth values are often referred to
as discounted cash flows, and the interest rate is referred to
as the discount rate.
I The higher the PW, the better.
I PW is evaluated based on an interest rate, which is equal
to the organization’s MARR.
PW analysis of equal-life alternatives

I Mutually exclusive projects

I For one project, it is financially viable if PW ≥ 0.
I For 2 or more alternatives, select the one with the
(numerically) largest PW value.
I Independent Projects
I Select all projects with PW ≥ 0
I However, in practice a budget limit exists (Ch. 12)
I Note: the independent projects must have positive and
negative cash flows to obtain a PW value that can
exceed zero; that is, they must be revenue projects.
Example
I 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.

I These are cost alternatives. The salvage values are

considered a ‘negative’ cost, so a + sign precedes them.
I If it costs money to dispose of an asset, the estimated
disposal cost has a − sign.
Example

I Note: typo in table (first cost should be $−3500)

I i = 10%, n = 8 years
I P WE = −4500 − 900(P/A, 10%, 8) + 200(P/F, 10%, 8) =
$ − 9208
I P WG = −3500 − 700(P/A, 10%, 8) + 350(P/F, 10%, 8) =
$ − 7071
I P WS = −6000 − 50(P/A, 10%, 8) + 100(P/F, 10%, 8) =
$ − 6220
I The solar-powered machine is selected since the PW of its
costs is the lowest; it has the numerically largest PW value.
PW analysis of different-life alternatives

I For alternatives with unequal lives the rule is:

PW must be compared over the same number of years.
I This is called ‘equal service’ requirement.
I Equal service requirement can be met in two ways:
1. LCM
I Evaluate alternatives over the least common
multiple of lives. e.g., lives of 4 and 6, use n = 12.
I Assume reinvestment at same cash flow estimates
in each life cycle of the LCM planning horizon.
2. Study period
I Assume a fixed planning horizon and evaluate the
alternatives over it.
I Ignore cash flows beyond the planning horizon.
LCM assumptions

I The service provided is needed for LCM years or more.

I The selected alternative is repeated over each life cycle of
the LCM in exactly the same manner.
I Cash flow estimates are the same in every life cycle.
I The first cost of an alternative is reinvested at the
beginning of each life cycle, and the estimated salvage
value is accounted for at the end of each life cycle.
Study period and alternative life

I Depending on the life of an alternative, three cases could

occur when adopting the study period approach.
I 1. Alternative life equal to the study period. No
adjustment to the cash flow is required.
I 2. Alternative life longer than the study period. An
implied salvage value must be added to the alternative at
the end of the study period.
I All cash flows occurring beyond the study period are
ignored.
I The salvage value may be estimated based on the
market value of the asset generating the cash flows.
I The study period approach is useful when the LCM of
alternatives yields an unrealistic evaluation period, e.g.
5 and 9 years.
Study period and alternative life

I 3. Alternative life shorter than the study period.

Assumptions must be made on what happens in the
additional years between end of life and end of study
period.
I For service (cost) alternatives, one can estimate the
costs of continuing service over the additional years.
I For revenue alternatives, one may assume that the net
receipts are invested at MARR for the additional
years.
I Cases 1-2 are covered in the next example.
PW analysis of different-life alternatives

I Note: for independent projects, use of the LCM approach

is unnecessary since each project is compared to the
do-nothing alternative, not to each other, and satisfying
the equal-service requirement is not a problem.
I Simply use the MARR to determine the PW over the
respective life of each project, and select all projects with a
PW ≥ 0.
Example
I National Homebuilders, Inc., plans to purchase new
cut-and-finish equipment. Two manufacturers offered the
estimates below.

I (a) Determine which vendor should be selected on the basis

of a present worth comparison, if the MARR is 15%/year.
I (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?
Example

I LCM(6,9) = 18 years.
I Note: the first cost is repeated in year 0 of each new cycle,
which is the last year of the previous cycle.
Example
Example

I (a)
I P WA =
−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) − 3,500(P/A, 15%, 18) = $ − 45,036
I Note: The $1000 cash flow series can also be evaluated to
PW using: 1000(A/F, 15%, 6)(P/A, 15%, 18)
I P WB =
−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
I Vendor B is selected, since P WB value is numerically larger
than P WA .
Example

I (b) 5-year study period:

I P WA = −15,000 − 3500(P/A, 15%, 5) + 1000(P/F, 15%, 5)
I =⇒ P WA = $ − 26,236
I P WB = −18,000 − 3100(P/A, 15%, 5) + 2000(P/F, 15%, 5)
I =⇒ P WB = $ − 27,397
I Vendor A is now selected.
I 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.
Future worth (FW) analysis
I Similar to PW analysis but uses future instead of present
values. (MARR is also used to find future values)
I Utilized when:
I A prime goal is to maximize future wealth of
stockholders.
I Asset may be sold after some time of startup (e.g., buy
a company and sell it in three years).
I Projects will not ‘come online’ until end of investment
period (e.g., construction projects).
I FW and PW criteria are equivalent in comparing
alternatives.
I The selection guidelines for FW analysis are the same as
for PW analysis; FW ≥ 0 =⇒ MARR is met or exceeded.
I For two or more mutually exclusive alternatives, select the
one with the numerically largest FW value.
Example

I 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. This means that breakeven net cash flow was
achieved this year. 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.
I (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.
Example

I (a) In $1 million units:

I F W3 =
−75(F/P, 25%, 3)−10(F/P, 25%, 2)−5(F/P, 25%, 1)+159.5
I F W3 = $ − 168.36 + 159.5 = $ − 8.86
I No, the MARR of 25% will not be realized if the $159.5
million offer is accepted.
Example

I (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?

I F W5 = −75(F/P, 25%, 5) − 10(F/A, 25%, 5) +

5(P/G, 25%, 5)(F/P, 25%, 5)
I F W5 = $ − 246.81
I Alternatively (textbook):
I F W5 = −75(F/P, 25%, 5) − 10(F/A, 25%, 5) +
5(A/G, 25%, 5)(F/A, 25%, 5)
I F W5 = $ − 246.81
I The offer must be for at least $246.81 million to make the
MARR.
Capitalized cost (CC) analysis

I Capitalized cost is the present worth of a project that lasts

forever.
I This occurs in:
I Public sector projects. e.g., roads, bridges, dams.
I Not-for-profit organization endowments; e.g.
permanent endowments for charitable organizations
and universities.
I For these projects, the life cycle, n, is either very long (>35
or 40 years), indefinite, or infinity.
I The CC for an infinite uniform series of cash flows (with
annuity A) is:
 
A 1 A
I CC = limn→∞ 1− = (i.e. ≡ A(P/A, i, ∞))
i (1 + i)n i
Capitalized cost (CC) analysis
I To evaluate CC for any cash flow, do the following:
I For nonrecurring (one-time only) cash flows
I The CC of the cash flows is their PW.
I For a recurring cash flow of value R, that repeats every nR
years:
I Find equivalent uniform annual worth through one life
cycle of recurring amounts, AR = R(A/F, i, nR )
I Find equivalent CC for the AR series, CCR = AR /i
Capitalized cost (CC) analysis

I Alternatives that have infinite lives can be compared on

the basis of CC, which is equivalent to PW criteria.
I When an alternative with a finite life is to be compared
with another having infinite life, CC can be used for finite
life:
I (i) Find equivalent A over 1 life cycle (this also
extends to ∞)
I (ii) CC= A/i
Example

I If $20,000 is invested now (this is the capitalization) at

10% per year, what is the maximum amount of money that
can be withdrawn at the end of every year for eternity?
Example

I If $20,000 is invested now (this is the capitalization) at

10% per year, what is the maximum amount of money that
can be withdrawn at the end of every year for eternity?
I A=?
I A = P (A/P, i, ∞) = $20,000 × i = $20,000 × 0.1 = $2000.
Example

I The Haverty County Transportation Authority (HCTA)

has just installed new software to charge and track toll
fees. The director wants to know the total equivalent cost
of all future costs incurred to purchase the software system.
If the new system will be used for the indefinite future, find
the equivalent cost (a) now, a CC value, and (b) for each
year hereafter, an AW value.
I The system has an installed cost of $150,000 and an
additional cost of $50,000 after 10 years. The annual
software maintenance contract cost is $5000 for the first 4
years and $8000 thereafter. In addition, there is expected
to be a recurring major upgrade cost of $15,000 every 13
years. Assume that i = 5% per year for county funds.
Example

I (a) i = 5% per year, CC= ?

I Non-recurring costs:
CC1 = −150,000 − 50,000(P/F, 5%, 10) = $ − 180,695
I Recurring costs:
I A = −15,000(A/F, 5%, 13) = $ − 847 (over cycle of 13 yrs)
I CC2 = −847(P/A, 5%, ∞) = −847/i = −847/(0.05)
I CC2 = $ − 16,940
Example

I Now, suppose $5000 cost continues indefinitely and $3000

is added to the cost starting year 5.
I CC3 = −5000(P/A, 5%, ∞) = −5000/0.05 = $ − 100,000
I CC4 = −3000(P/A, 5%, ∞)(P/F, 5%, 4)
| {z }
=P4
1
I CC4 = −3000 × × (P/F, 5%, 4) = $ − 49,362
0.05
I CCT = CC1 + CC2 + CC3 + CC4 = $ − 346,997
Example

I (b) Equivalent AW = ?, (extending forever)

I CCT = AW/i
I AW = CCT × i = $346,997(0.05) = $17,350
I This means Haverty County officials have committed the
equivalent of $17,350 forever to operate and maintain the
toll management software.
Example

I Suppose two options with the following PW values in $1

million units:
I Seawater: PS = $ − 20; AOCS = $ − 1.94; nS = 10 years;
refurbishment, year 5 = $ − 10; SS = 0.05 (20) = $1.00;
P WS = $ − 36.31
I Groundwater: PG = $ − 22; AOCG = $ − 2.10; nG = 10
years; SG = 0.10(22) = $2.2; P WG = $ − 33.16
I What is the present worth of the long-term options at the
selected MARR of 12% per year. What are these
capitalized costs for the two options using the estimates
made thus far?
Example

I Find the equivalent A value for each option over its

respective life, then determine the CC value as if the life
cycle (and A) repeat indefinitely.
I Seawater:
AS = P WS (A/P, 12%, 10) = −36.31(0.17698) = $ − 6.43
I CCS = −6.43/0.12 = $ − 53.58
I Groundwater:
AG = P WG (A/P, 12%, 10) = −33.16(0.17698) = $ − 5.87
I CCG = −5.87/0.12 = $ − 48.91
I In terms of capitalized cost, the groundwater alternative is
cheaper.
Example
I The State Legislature has mandated a statewide recycling
program to include all types of plastic, paper, metal, and
glass refuse. The goal is zero landfill by 2020. Two options
for the materials separation equipment are outlined below.
The interest rate for state-mandated projects is 5% per
year.
I Contractor option (C): $8 million now and $25,000 per year
will provide separation services at a maximum of 15 sites.
No contract period is stated; thus the contract and services
are offered for as long as the State needs them.
I Purchase option (P): Purchase equipment at each site for
$275,000 per site and expend an estimated $12,000 in
annual operating costs (AOC) per site. Expected life of the
equipment is 5 years with no salvage value.
I (a) Perform a capitalized cost analysis for a total of 10
recycling sites.
Example

I Option C (infinite life):

I CCC = $ − 8,000,000 − $25,000/(i = 0.05) = $ − 8,500,000
I Option P (finite life of 5 years):
I A = −275,000 × 10(A/P, 5%, 5) − 12,000 × 10 = $ − 755,181
I CCP = A/i = −755,181/0.05 = $ − 15,103,620
I Select Option C

I (b) Determine the maximum number of sites at which the

equipment can be purchased and still have a capitalized
cost less than that of the contractor option.
Example

I (b) Determine the maximum number of sites at which the

equipment can be purchased and still have a capitalized
cost less than that of the contractor option.

I Change the number of sites so that CCP > CCC :

I (−15,103,620/10) ∗ x > −8,500,000 =⇒ x < 5.63.
I Thus if the number of sites is 5 or less, CCP > CCC , i.e.
favors purchasing equipment over contracting.
Payback period analysis

I Payback period is the estimated time it will take for the

revenues of a project to recover the initial investment.
I The payback period, nP , is such that:
I 0 = −P + nt=1
P P
N CFt (P/F, i, t)
I where P is the initial investment and N CFt is the net cash
flow at time t.
I This equation can be solved using trial an error or using a
computer package (e.g., Excel solver).
Payback period analysis

I If i = 0%, then 0 = −P + nt=1

P P
N CFt
I If, in addition, N CFt = N CF for all t, nP = P/N CF .
I This method estimate of nP is often used in practice for
quick initial screening.
I Payback period analysis should not be used as the primary
means of making an accept/reject decision on an
alternative.
I e.g., one reason for caution with payback analysis is that it
ignores cash flows after time nP .