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Module 4: Present Worth Analysis

SI-4151 Ekonomi Teknik

Outline Module 4
 Proposals for Investment Alternatives
 Selection of Alternatives
 Present-worth comparison
 Future Worth Analysis
 Capitalized-cost calculation

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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

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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

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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
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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
Expected
 More akin to Opportunity Cost of the money Rate of Return
on New Proposal
 Determined by Company Policy
Range for ROR
On accepted
proposals

All proposals
must offer at MARR
Least MARR
to be considered ROR on
Safe investment

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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

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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 = ?

?
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)

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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

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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;

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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

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Present-worth comparison
 System A:
R
SV

I
E

0 1 2

 System B:
R
SV
I
E

0 1 2 3 4

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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

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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

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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?

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Example 1: Cash Flow Diagrams

FSV = 200
A1: Electric

0 1 2 3 4 5
-2500 A = -900/Yr.
FSV = 350
A2: Gas

0 1 2 3 4 5
A = -700/Yr.
-3500
FSV = 100
A3:Solar

0 1 2 3 4 5
A = -50/Yr.
-6000 i = 10%/yr and n = 5
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Calculate the Present Worth's

 Present Worth's are:

1. PWElec. = -2500 - 900(P/A,10%,5) +
200(P/F,10%,5) = $-5788
2. PWGas = -3500 - 700(P/A,10%,5) +
350(P/F,10%,5) = $-5936
3. PWSolar = -6000 - 50(P/A,10%,5) +
100(P/F,10%,5) = $-6127
Select “Electric” which has the min. PW Cost!

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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

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Use LCM, where “n” = 18 yrs.

 The Cash Flow Diagrams are:

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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

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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.

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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%

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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.

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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!
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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.

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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.

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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.

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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.

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P/A where “n” goes to infinity

 The P/A factor is:

 (1 + i ) n − 1 
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 
 
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CC Derivation…

 Repeating:  1 
1 −
 (1 + i ) n 
P = A 
 i 
 
If “n” approaches  the above reduces
to:
A
P=
i
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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

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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
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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

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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

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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

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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

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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

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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
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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
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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!

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Homework
 The municipal government of Bandung is considering two
proposals to build new toll highway system.
 The first alternative calls for upgrading the existing system,
which would cost Rp. 225,75 B for construction and additional
Rp 210 M and Rp 250 M per year for maintenance and
operation cost
 The other option is to build a new elevated highway that is
estimated to cost Rp. 885 B for construction and annual
maintenance cost of Rp 325 M
 If either alternatives would yield Rp 815 M revenue per
year, and the interest rate is set at 8% p.a., which
alternative should the government go about realizing the
toll highway system?

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Homework
2. A manufacturing company is trying to decide among three different pieces of equipment that have the following characteristics:
equipment A equipment B equipment C
First cost Rp. 975.000.000,- Rp. 854.500.000,- Rp. 1.025.000.000,-
Annual M&O cost Rp. 89.700.000,- Rp. 95.000.000,- Rp. 75.000.000,-
Salvage value Rp. 161.000.000,- Rp. 205.000.000,- Rp. 321.000.000,-
Overhaul cost Rp. 175.000.000,- / 2 years Rp. 135.000.000,- / 3 years Rp. 175.000.000,- / 3 years
useful life = 6 years and interest rate of 12% per year.
3. Which of these two machines that have the following costs is to be selected for a continuous production process, if the i = 15%
p.a:
machine X machine Y
First cost Rp. 3.800.000.000,- Rp. 1.675.000.000,-
Annual operating cost Rp. 289.700.000,- Rp. 315.000.000,-
Salvage value Rp. 461.000.000,- Rp. 205.000.000,-
Life 5 years 3 years

4. Ganesha consulting firm is considering to build or lease an office space. For interest rate of 6% compounded semiannualy
compare and select alternative. build own lease
Construction cost Rp. 8.750.000.000,- -
Lease cost - Rp. 415.000.000,- / 3 years
Maintenance cost Rp. 110.000.000,- / year Rp. 75.000.000,- / year
Period ∞ 3 years

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