Applying Present Worth

Techniques
 

HU 501 : Module 3–6

 One of the difficulties of problem solving is that most
problems tend to be very complex.

 It is apparent that some simplifying assumptions are

needed, to make the complex problems manageable.

 The trick is, to solve the simplified problem, and still be

satisfied that the solution is applicable to the real problem!

 In the following section, we look at 6 different items and the

customary assumptions that are made

 These assumptions apply to all problems, unless

any other assumptions are given
HU501/B.Tech/Prof. Aditi Ghosh 2
 End-of-Year Convention
 Viewpoint of Engineering Economic Analysis
 Sunk costs
 Borrowed money viewpoint
 Effect of Inflation & Deflation
 Taxes

HU501/B.Tech/Prof. Aditi Ghosh 3

 Assumptions
 For economic analyses, we use the “End-of-year”
convention
End of yr1 End of yr2
Dec 31 Jan1 Dec 31
Year 0
Jan 1

P A
A

F
 This makes “A” a end-of-period receipt or
disbursement

HU501/B.Tech/Prof. Aditi Ghosh 4

 Assumptions

 When we make engineering economic

calculations, we must proceed from a “Point
of reference”
 Generally, this point of reference is the Point
of view of a total firm when doing industrial
economic analyses

HU501/B.Tech/Prof. Aditi Ghosh 5

 Assumptions

We know that past costs have no bearing

on what we should do in the future (Sunk
Costs)
 It is the current and future differences
between alternatives that ARE
important
 So, we disregard Sunk Costs.

HU501/B.Tech/Prof. Aditi Ghosh 6

 Assumptions

In most economic analyses, the

proposed alternative, require money
to be spent
So, an integral part of the analysis
is to ask the source of that money
Thus, each problem has 2 monetary
aspects
HU501/B.Tech/Prof. Aditi Ghosh 7
 Assumptions

Thus,each problem has 2 monetary

aspects:
Financing : Obtaining the money
Investment : Spending of the money

These 2 concerns need to be

distinguished
HU501/B.Tech/Prof. Aditi Ghosh 8
 Assumptions
 When separated, the problems of
obtaining money and spending it are both
logical and straightforward
 Failure to separate the two produces
confusing results and poor decision
making
 The conventional assumption is that the
money required to finance alternatives is
obtained at a interest rate “i”
HU501/B.Tech/Prof. Aditi Ghosh 9
 Assumptions

 For general convention, we assume

that Prices are stable

## Inflation & Deflation can pose serious problems

for after-tax analysis, and for costs and revenues
whose inflation rates differ from rate the economy’s
inflation rates, but, for now, we assume stable prices

HU501/B.Tech/Prof. Aditi Ghosh 10

 Assumptions
 Taxes, like inflation & deflation, are
important to find the final pay-off of a
project
 Thus taxes affect our alternatives
 However, Conventional Assumption :
Without considering taxes
 If mentioned, or asked for, we introduce
taxes into our economic analyses
HU501/B.Tech/Prof. Aditi Ghosh 11
 We have learnt to manipulate cash flows and apply
it to solve complex compound interest problems
 But engineering economics is more than that
 The decision process requires that the outcomes of
feasible alternatives be arranged so that they may
be judged for economic efficiency in terms of the
selection criterion

*The economic criteria are on the following page….

HU501/B.Tech/Prof. Aditi Ghosh 12

 The economic criterion will be one of the following
depending on the situation

Situation Criterion

Neither input nor output Maximize ( Output – Input)

fixed
For fixed input Maximize Output

For fixed output Minimize Input

HU501/B.Tech/Prof. Aditi Ghosh 13

 Equivalence provides the logic to adjust the cash flow
of a given alternative into some equivalent sum or
series
 Then, we need to choose which comparable units to
use
 As a general rule, we can solve by any of the following :
 Present worth
 Annual Cash Flow
 Rate of Return

 In this section, we will look at applying Present Worth

Techniques
HU501/B.Tech/Prof. Aditi Ghosh 14
 The easiest way to compare mutually exclusive alternatives
is to resolve their future consequences to the present time
 Thus, the 3 criteria for economic efficiency are restated in
terms of PW analysis in the following way:
Situation Criterion
Neither input nor Typical, General case Maximize (Present worth of
output fixed benefits minus present worth of
costs) ie. Maximize Net Present
Worth/Value
For fixed input Amount of money or Maximize Present worth of benefits
other input resources or other outputs
are fixed
For fixed output There is a fixed, task, Minimize the Present worth of
benefit or output to be costs or other inputs
accomplished
HU501/B.Tech/Prof. Aditi Ghosh 15
 The consequences of each alternative has to be considered
for a period of time, which is called the Analysis period,
Planning horizon or Project Life.

 Three different analysis periods are encountered in

economic analysis problems with multiple alternatives:

 The useful life of each alternative equals the analysis

period
 The alternatives have useful lives different from the
period of analysis
 There is an infinite analysis period, n = ∞
HU501/B.Tech/Prof. Aditi Ghosh 16
 Example 1 :

A firm is considering a choice between 2 devices.

Both have 5 years of useful life and have no salvage
value. Device A costs `1000 and can be expected to
result in savings of ` 300 annually. Device B costs
`1350 and is expected to provide savings of `300
the 1st year, and then will increase `50 each year.
With interest rate of 7%, which should be the choice ?

HU501/B.Tech/Prof. Aditi Ghosh 17

 Solution: The analysis period can be conveniently
selected as the life of both devices is 5 years

PWA = –1000 + 300(P/A,7%,5) = –1000 + 300(4.1)

= `230

PWB = –1350 + 300(P/A,7%,5) + 50(P/G,7%,5)

= –1350 + 300(4.1) + 50(7.647) = `262.40

So, Device B has greater PW & is the chosen alternative

HU501/B.Tech/Prof. Aditi Ghosh 18
 Example 2:

Manufacturer Cost Useful life Salvage

(`) (years) Value (`)
Speedy 1500 5 200
Allied 1600 5 325

Both are supposed to perform at a desired (fixed) output level.

For a 5 year analysis period, which one should be selected
assuming 7% interest and equal maintenance costs?

HU501/B.Tech/Prof. Aditi Ghosh 19

 Solution: For fixed output, the criterion is to minimize the
PW of cost

PW of Cost Speedy = 1500 – 200 P/F,7%,5)

= 1500 – 200(0.7130)
= 1500 – 143 = `1357

PW of cost Allied = 1600 – 325(P/F,7%,5)

=1600 – 325(0.7130)
= 1600 – 232 = `1368

So, Speedy has lower PW of cost & is the chosen alternative

HU501/B.Tech/Prof. Aditi Ghosh 20

 The criterion used is, therefore :
Net Present Worth Criterion or simply NPW
NPW=Present worth of benefits–Present worth of costs
Or, NPW = PW of benefits – PW of costs
 The following terms are used synonymously:
 Present Worth (PW)
 Present Value (PV)
 Net Present Worth (NPW)
 Net Present Value (NPV)

 The word net is used sometimes to emphasize that both costs and
benefits have been taken into consideration
HU501/B.Tech/Prof. Aditi Ghosh 21
 Example 3 : Modifying example 2 :

Manufacturer Cost Useful life Salvage

(`) (years) Value (`)
Speedy 1500 5 200
Allied 1600 10 325

And reworking the problem ….

HU501/B.Tech/Prof. Aditi Ghosh 22

 Earlier :
PWSpeedy of Cost = `1357
PWAllied of cost = `1368

 Now :
PWSpeedy of Cost = `1357
PWAllied of cost = 1600 – 325(P/F,7%,10)
=1600 – 325(0.5083)
= 1600 – 165 = `1435

HU501/B.Tech/Prof. Aditi Ghosh 23

 One method is to select the Least Common
Multiple of their useful lives.

 Modifyingthe example of Speedy and Allied,

we compare 10yr life of allied with 5yr life of
Speedy, plus replacement of old Speedy with
a new Speedy or the balance 5yrs.
(Assuming Speedy still costs `1500 after
5yrs)

HU501/B.Tech/Prof. Aditi Ghosh 24

 Therefore recalculating for Speedy :

PWSpeedy of Cost = 1500 + (1500 – 200)( P/F,7%,5) – 200( P/F,7%,10)

= 1500 + 1300(0.7130)– 200(0.5083)
= 1500 + 927 = `2325

 For Allied
PWAllied of cost = 1600 – 325(P/F,7%,10)
= 1600 – 325(0.5083)
= 1600 – 165 = `1435

HU501/B.Tech/Prof. Aditi Ghosh 25

 Infinite analysis period : n = ∞, may be
encountered in governmental analyses, where a
service or condition has to maintained for an
infinite period.

 In such situations, PW of cost analysis has to be

done over infinite period, and is known as
Capitalized Cost

HU501/B.Tech/Prof. Aditi Ghosh 26

 Capitalized cost is the present sum of money
that , we need to set aside today at some
interest rate, to yield the service (or whatever
output) indefinitely

 To accomplish this, the money set aside for

future expenditures must not decline.
 The interest received on the money set aside
can be spent, but not the principal.
HU501/B.Tech/Prof. Aditi Ghosh 27
We know :
Amount at the end of a period is (Principal sum +
Interest earned for the period) : P + iP
Year 1 : P + iP
wdr –iP
Year 2: P + iP
wdr –iP
Year 3 : P + iP
wdr –iP , and so on ….

HU501/B.Tech/Prof. Aditi Ghosh 28

Thus, for any initial present sum, P, there can be an end-of-
period withdrawal of A = iP each period, and can continue for
ever without diminishing P (initial sum) This gives us the
relationship :

For n = ∞, A = Pi
Therefore, by previous definition, P is the Capitalized Cost.

Hence ,
Capitalized Cost : P = A / i

HU501/B.Tech/Prof. Aditi Ghosh 29

 Example 4 :
How much should one set aside to pay `50 per year for
maintenance on a gravesite if interest is assumed to be 4%?
For perpetual maintenance, the principal sum must remain
undiminished after annual disbursement is made.

Capitalized cost, P = A/i = ` 50 / 0.04 = ` 1250

HU501/B.Tech/Prof. Aditi Ghosh 30

So far, the discussion has been on only 2
alternatives

But, multiple alternative problems can be

solved in exactly the same methods

HU501/B.Tech/Prof. Aditi Ghosh 31

 32 

HU501/B.Tech/Prof. Aditi Ghosh