Present Worth Analysis

Engineering Economics 1
 LEARNING OUTCOMES

1.Formulate Alternatives
2.PW of equal-life alternatives
3.PW of different-life alternatives
4.Future Worth analysis
5.Capitalized Cost analysis

Engineering Economics 2
Formulating Alternatives 方案
Two types of economic proposals

Mutually Exclusive (ME) Alternatives 互斥: Only one

can be selected; Compete against each other

Independent Projects 獨立: More than one can be

selected; Compete only against DN 不做處置

Do Nothing (DN) – An ME alternative or independent project to

maintain the current approach; no new costs, revenues or savings

Engineering Economics 3
 Formulating Alternatives

Two types of cash flow estimates

收益方案 Revenue: Alternatives include estimates of costs

(cash outflows) and revenues (cash inflows)

成本方案 Cost: Alternatives include only costs; revenues and savings

assumed equal for all alternatives;
also called service alternatives

Engineering Economics 4
Present-Worth Analysis of Alternatives
Convert all cash flows to PW using MARR
(minimum attractive rate of return; 最低吸引報酬率)
Precede costs by minus sign; receipts by plus sign

EVALUATION
For one project, if PW > 0, MARR is justified
For mutually exclusive alternatives, select
one with numerically largest PW

For independent projects, select all with PW > 0

Engineering Economics 5
Selection of Alternatives by PW
For the alternatives shown below, which should be selected
if they are (a) mutually exclusive; (b) independent?

Project ID Present Worth

A $30,000
B $12,500
C $-4,000
D $ 2,000

Solution: (a) Select numerically largest PW; alternative A

(b) Select all with PW > 0; projects A, B & D

Engineering Economics 6
 Example: PW Evaluation of Equal-Life ME
Alternatives
Alternative X has a first cost of $20,000, an operating cost of $9,000 per year,
and a $5,000 salvage value (殘值) after 5 years.
Alternative Y will cost $35,000 with an operating cost of $4,000 per year and a
salvage value of $7,000 (殘值) after 5 years.
At an MARR of 12% per year, which should be selected?

Solution: Find PW at MARR and select numerically larger PW value Salvage value is the
estimated market value
PWX = -20,000 - 9000(P/A,12%,5) + 5000(P/F,12%,5) at the end
= -$49,606

PWY = -35,000 - 4000(P/A,12%,5) + 7000(P/F,12%,5)

= -$45,447

Select alternative Y
Engineering Economics 7
PW of Different-Life Alternatives
Must compare alternatives for equal service
(i.e., alternatives must end at the same time)

Two ways to compare equal service:

Least common multiple (LCM; 最小公倍數) of lives
Specified study period 研究週期
(The LCM procedure is used unless otherwise specified)

Engineering Economics 8
 Assumptions of LCM approach
• Service provided is needed over the LCM or more years

• Selected alternative can be repeated over each life cycle of LCM in

exactly the same manner

• Cash flow estimates are the same for each life cycle (i.e., change by
exactly the inflation or deflation rate; otherwise, we have to consider
inflation/deflation)
Inflation 通貨膨脹: increase in the general price level of goods and services
Deflation 通貨緊縮: decrease in the general price level of goods and services

Engineering Economics 9
PW Evaluation Using a Study Period
• Once a study period is specified, all cash flows after
this time are ignored

• Salvage value is the estimated market value at the

end of study period

Short study periods are often defined by management

when business goals are short-term

Study periods are commonly used in equipment

replacement analysis

Engineering Economics 10
Example 5.3 Different-Life Alternatives
House Builder plans to purchase a new equipment. Two vendors offer their estimation.
(a) Determine which vendor should be selected on the basis of PW. Given MARR=15% per
year
(b) Suppose the study period is 5 years while the salvage values at the end of year 5 are not
expected to change. Which vendor should be selected?
Cost items Vendor A Vendor B
First Cost ($) -15,000 -18,000
Annual M&O cost ($ per year) -3,500 -3,100
Salvage value ($) 1,000 2,000
Life (years) 6 9

Engineering Economics 11
Example 5.3 Different-Life Alternatives (a)
LCM = 18 years; repeat A after 6 years; B after 9 years Solution:
PWA = -15000
-15000(P/F,15%,6) +1000 (P/F,15%,6)
-15000(P/F,15%,12) +1000 (P/F,15%,12)
+1000(P/F,15%,18) -3500(P/A,15%,18)
=-$45,036

PWB = -18000
-18000(P/F,15%,9) +2000 (P/F,15%,9)
+2000(P/F,15%,18) -3100(P/A,15%,18)
=-$41,384

Select vendor B

Engineering Economics 12
Example 5.3 Different-Life Alternatives (b)
Solution:
S=$1000

PWA = -15000 - 3500(P/A,15%,5) + 1000(P/F,15%,5)

=-$26,236
A=$3500

Select vendor A
S=$2000

PWB = -18000 - 3100(P/A,15%,5) + 2000(P/F,15%,5)

=-$27,397
A=$3100

Engineering Economics 13
Example: Different-Life Alternatives
Compare the machines below using present worth analysis at i = 10% per year

Machine A Machine B
First cost, $ 20,000 30,000
Annual cost, $/year 9000 7000
Salvage value, $ 4000 6000
Life, years 3 6

Solution: LCM = 6 years; repurchase A after 3 years

PWA = -20,000 – 9000(P/A,10%,6) – 16,000(P/F,10%,3) + 4000(P/F,10%,6)

= $-68,961
20,000 – 4,000 in
PWB = -30,000 – 7000(P/A,10%,6) + 6000(P/F,10%,6) year 3
= $-57,100

Select alternative B
Engineering Economics 14
 Example: Study Period PW Evaluation
Compare the alternatives below using present worth analysis at i = 10% per year
and a 3-year study period
Machine A Machine B
First cost, $ -20,000 -30,000
Annual cost, $/year -9,000 -7,000
Salvage/market value, $ 4,000 10,000 (after 3 years)
6,000 (after 6 years)
Life, years 3 6

Solution: Study period = 3 years; disregard all estimates after 3 years

PWA = -20,000 – 9000(P/A,10%,3) + 4000(P/F,10%,3) = $-39,376

PWB = -30,000 – 7000(P/A,10%,3) + 10,000(P/F,10%,3) = $-39,895
Select A; different selection than for LCM = 6 years

Engineering Economics 15
 Future-Worth Analysis
FW is similar to PW analysis

Must compare alternatives for equal service

(i.e. alternatives must end at the same time)

Two ways to compare equal service:

Least common multiple (LCM) of lives

Specified study period

(The LCM procedure is used unless otherwise specified)

Engineering Economics 16
FW of Different-Life Alternatives
Compare the machines below using future worth analysis at i = 10% per year

Machine A Machine B
First cost, $ -20,000 -30,000
Annual cost, $/year -9000 -7000
Salvage value, $ 4000 6000
Life, years 3 6

Solution: LCM = 6 years; repurchase A after 3 years

FWA = -20,000(F/P,10%,6) – 9000(F/A,10%,6) – 16,000(F/P,10%,3) + 4000
= $-122,168
FWB = -30,000(F/P,10%.6) – 7000(F/A,10%,6) + 6000
= $-101,157
Select B (Note: PW and FW methods will always result in same selection)

Engineering Economics 17
Example 5.5 Future Worth Analysis
A Canadian food store was purchased for ₤75 million 3 years ago.
A net loss of ₤ 10 million and ₤ 5 million were experienced at the
end of years 1 and 2, respectively.
The owner is planning to sell the store and expects a MARR of 25%
per year from any sale.
(a) The owner has been offered ₤ 159.5 million by a French buyer.
Use FW analysis to determine if the MARR will be realized at the
price.
(b) The owner continues to own the store. She expects no net loss
at the end of year 3 and will gain ₤ 5 million and ₤ 10 million at the
end of years 4 and 5.
What selling price must be obtained at the end of year 5 just to make
the MARR?
Engineering Economics 18
Example 5.5 Future Worth Analysis (a)
Solution:

FW3 = -75(F/P,25%,3) -10(F/P,25%,2) -5(F/P,25%,1) + 159.5

= ₤ -8.86 million

No, the MARR of 25% will NOT be realized for this selling price

Engineering Economics 19
Example 5.5 Future Worth Analysis (b)
Solution:

FW5 = -75(F/P,25%,5) -10(F/A,25%,5) + 5(A/G,25%,5)(F/A,25%,5)

= ₤ - 246.81 million

The offer must be for at least ₤ 246.81 million to make the

MARR=25%.

The selling price is almost 3.3 times the purchase price (₤ 75

million) only 5 years ago. This is primarily due to the high MARR.

Engineering Economics 20
Capitalized Cost (CC) Analysis 資本化成本
CC refers to the present worth of a project with
a very long life, that is, PW as n becomes infinite
Note:
A 1−
1
Basic equation is: CC = P = i 𝑃 = lim 𝐴
(1 + 𝑖)𝑛
=
𝐴
𝑛→∞ 𝑖 𝑖

“A” essentially represents the interest on a perpetual investment

For example, in order to be able to withdraw $50,000 per year forever (永續資本)
at i = 10% per year, the amount of capital required is 50,000/0.10 = $500,000

For finite life alternatives, convert all cash flows into

an A value over one life cycle and then divide by i

Engineering Economics 21
 Example: Capitalized Cost
Compare the machines shown below on the basis of their
capitalized cost. Use i = 10% per year
Machine 1 Machine 2
First cost,$ -20,000 -100,000
Annual cost,$/year -9000 -7000
Salvage value, $ 4000 -----
Life, years 3 ∞
Solution: Convert machine 1 cash flows into A and then divide by i
A1 = -20,000(A/P,10%,3) – 9000 + 4000(A/F,10%,3) = $-15,834
CC = A / i CC1 = -15,834 / 0.10 = $-158,340
CC2 = -100,000 – 7000/ 0.10 = $-170,000
Select machine 1

Engineering Economics 1-22

Procedure to determine CC
1. Draw the cash flow diagram (at least two cycles of all recurring cash
flows.
2. Find the present worth of all non-recurring (single) amounts as their
CC value
3. Find the A value through one life cycle; add this to all other uniform
amounts through infinity. The result is the total equivalent uniform
annual worth (AW)
4. Divide the AW by the interest rate i to obtain CC CC = A / i
5. Add the CC values obtained in Steps 2 and 4

Engineering Economics 23
Example 5.6 Capitalized Cost Analysis
For single amounts
CC1 = -150,000 - 50,000(P/F,5%,10)
= $-180,695

For recurring costs

A = -15000(A/F,5%,13) = $-847
CC2 = -847 / 0.05 = $-16,940
CC = CC1 + CC2 + CC3 + CC4 = $-346,997 For uniform amounts
CC3 = -5000 / 0.05 = $-100,000
If we are interested in the equivalent A
AW = CC×i = $-346,997 × 0.05 = $-17,350 For (8000-5000) series
CC4 = -3000 / 0.05 (P/F,5%,4) = $-49,362
$346,997 should be prepared now to cover all the costs
$17,350 should be committed forever to cover the cost
Engineering Economics 24
Summary of Important Points
PW method converts all cash flows to present value at MARR

Alternatives can be mutually exclusive or independent

Cash flow estimates can be for revenue or cost alternatives

PW comparison must always be made for equal service

Equal service is achieved by using LCM or study period

Capitalized cost is PW of project with infinite life; CC = P = A / i

Engineering Economics 25