Lecture 04

Project evaluation 1:
Present worth and annual worth

Using the various interest factors, we will examine several

approaches of project evaluation, including present worth
(PW), annual worth (AW), and internal rate of return (IRR)
analysis. This lecture focuses on the PW and AW analyses.

B. Koo 2023 M261: Engineering Economics 1

1. Project evaluation
 One of the main duties of a manager is to choose the best alternative
among multiple projects.
• The first step is to calculate the benefits and costs of each project.
• Various interest formulas in lecture 2 and 3 are used for the calculations.
• Once the benefits and costs of each project are calculated, how to choose the
best alternative?
 Methods of project evaluation
• Present worth (PW) analysis and annual worth (AW) analysis
• Internal rate of return (IRR) analysis
• Benefit cost (BC) analysis
• Payback period analysis
B. Koo 2023 4DefiantApproach
M261: Engineering Economics 2

1
 1.1. Present worth and annual worth
 Present worth (PW) and annual worth (AW) analyses
• You convert cash flows into either PW or AW and evaluate each project.
• Both are similar in concepts, and you can use either approach depending on the
type of information given.
• However, the AW approach is much simpler when project lives are different.
 Relation among projects
• For independent projects (e.g., buying a vacuum and a computer), choose all
projects which meet a certain criterion; PW > 0 or AW > 0. Ifthese metythgy
• For mutually exclusive projects (e.g., renting an apartment or townhouse), rank
all projects and choose the one with the highest PW or AW.
• Most engineering projects are mutually exclusive.

B. Koo 2023 M261: Engineering Economics 3

Ex 1-1. PW and AW calculations

 A firm plans to buy a new machine for $200,000. The machine will save
$50,000 in labor annually and require an annual maintenance cost of
$10,000. The salvage value after 10 year of its service is $15,000. Given
an interest rate of 10%, should the firm buy the machine?
50,000 50,000
50,000
15,000
0 1 2 9 10
10,000 10,000 10,000
200,000

PW 2000007 40000 PIA 1011,107 15000 PIF101 b

515824770
4
B. Koo 2023 AW 200000 AIP 10 107 40000 15000
M261: Engineering Economics
Alf101,107 8839 4
24 o

If 40 then can proceed

2
 Ex 1-2. PW: Helping grandparents
 Your grandparents are asking you for an advice on their pension plan.
They are now 65 years old and expect to live until 90.
• Collect pension now: They can collect $1,000 per month for the next 25 years.
• Wait until 70: They can collect $1,400 per month for the next 20 years.
 If the interest rate is 6%, which plan should you recommend?

65
infinities it
90 weirdie
nettsia
PW 1000 PIA0.51 3007 18155206
1 PW 1400PIA0.5 240
and ooo
x PIF0.5 607 5114487941
AW PWx HIP 0.5
B. Koo 2023 M261: Engineering Economics
30014893 5

1
5

Ex 1-3. First-class travel for life (1)

 AAirpass
• In 1981, American Airline introduced AAirpass which allowed members to have
“unlimited” first-class travels for life.
• The price for couple was $400,000 in 1981, $600,000 in 1990, and $1 million in
1993. (It was discontinued in 1994.)
• A total of 66 passes were sold.

B. Koo 2023 M261: Engineering Economics 6

3
 Ex 1-3. First-class travel for life (2)
 Was this program successful?
• One member had traveled to London 16 times in a month (worth $125,000), and
another member has accumulated 11 million miles.
• This program was considered "a huge disaster“ for American Airline (LA Times,
2012).
 What would be the present worth of this pass?
• If you travel once a month and each travel costs $15,000, your annual benefit
would be about $180,000.
• Suppose you purchase this pass at the age of 50 (rich enough to buy) and use it
for 20 years (healthy enough to travel). Assume the interest rate is 6%.
• PW = 180,000(P/A, 6%, 20) = 180,000(11.47) = $2.06 million

B. Koo 2023 M261: Engineering Economics 7

Ex 1-4. Claiming a car damage

 When your car is damaged, do you claim it to the insurance company?
• If so, the insurance premium (monthly payment) may increase for several years.
• Auto insurance is typically sold with deductibles: If your deductible is $1,000 and
you claim $1,200, you get only $200 from the insurance company.
 Suppose you had $2,000 damage in your car and the deductible is $500.
If you claim it, your monthly premium would increase from $150 to
$200 for 4 years. If the interest rate is 6%, should you claim the damage
to the insurance company or repair the car with your own money?

500 t 50 PIA O5,487 5126297512000

Better to out
pay
of pocket
B. Koo 2023 M261: Engineering Economics 8

4
 Ex 1-5. AW of a machine (1)
 GP Co. is considering the purchase of a new computer system with a
price of $300,000.
• The company plans to borrow one-third of the purchase price from a bank at
10% interest rate, and the loan is to be repaid equal annual payments over a 5-
year period.
• The system is expected to last 8 years and the salvage value is $30,000.
• The system requires a technician with $40,000 per year, but will save $100,000
per year through increased efficiencies.
 Given 6% interest rate, what is the annual worth of this investment?

B. Koo 2023 M261: Engineering Economics 9

9
1000004P
AWMethods
101,5 26380 Convert all payments
gooooo gon to annuity and
with 104 interest annualpayments takeaverage

Ex 1-5. AW of a machine (2)

saves 100000
• The cash flow diagram is ly
100,000 100,000 100,000 100,000
30,000
5 8
Initial
0 1 6
40,000 40,000
40,000 40,000 yearsannathe
+ 26,380 + 26,380
200,000

AW 200000CABO1,87 60000 30000calf.ge zqggggjji.fig

40000
10 00

B. Koo 2023 M261: Engineering Economics 10

10

5
 1.2. Retirement incomes in Canada (1)
 Canada’s retirement benefits system is built around three main pillars.
 Old Age Security (OAS) pension
• It is a universal plan available to all Canadians above 65 years of age.
• To receive the full pension ($698 per month as of 2023), you have lived in Canada
for 40 years since the age of 18 (a minimum of 10 years).
• Low-income seniors get additional supports, and high-income seniors get less.
 Canada Pension Plan (CPP)
• It is a mandatory government-organized plan to all workers.
• You contribute about 5.95% of your income, which is matched by your employer.
• The maximum monthly pension is $1,306 as of 2023, and your benefit depends
on the length and amount of the contributions.
B. Koo 2023 M261: Engineering Economics 11

11

1.2. Retirement incomes in Canada (2)

 Voluntary Retirement Savings Plan
• Individuals can have the Employment Pension Plan and the Individual Retirement
Savings such as RRSP.
 RRSP (Registered Retirement Savings Plan)
• Introduced in 1957, it intends to encourage people to make their own retirement
plan and rely less on government benefits.
• In 2023, you can contribute 18% of the 2022 income, with a maximum of $30,780.
• You can invest the contribution on mutual funds, bonds, stocks, etc.
• The amount of RRSP contribution is tax deductible.
• However, you have to pay tax when receiving payments after retirement.
• RRSP saves tax because people tend to have lower income in retirement.
B. Koo 2023 M261: Engineering Economics 12

12

6
 Ex 1-6. RRSP and future worth
 If you make an annual deposit of $10,000 to RRSP from your 26th
birthday, what is the value of the RRSP at age 65, given the savings
earn an annual return of 3%?

F 10000 FIA 3 40 754010

 If you live for the next 25 years after retirement, how much do you get
every month, given the same interest rate?

A 754010 AIP O 25 306 3575

B. Koo 2023 M261: Engineering Economics 13

13

2. Analysis with equal service lives

 In project analysis, you should be careful on the time period covered by
each project.
• Any investment projects have a certain project life, called analysis period,
planning horizon or project life.
• In some industries with rapid technological changes, a short planning horizon (3
or 5 years) is considered.
• On the other hand, governments consider a long horizon of 50 years or more.
 We consider three different project life situations.
• The lives of each alternative are equal.
• The lives of each alternative are different.
• The period of analysis is infinite.
B. Koo 2023 M261: Engineering Economics 14

14

what is
this slide 7
 Ex 2-1. PW/AW, equal service lives (1)
 A firm is considering to select one of two devices to reduce costs. Both
devices have five years of service life with no salvage value.
• Device A costs $1,000 and can be expected to result in $300 savings annually.
• Device B costs $1,350 and provides cost savings of $300 in the first year with an
increase of $50 annually from the second year.
 With an interest rate of 7%, which device should the firm purchase?

• The analysis period is the same for both devices (5 years), and we choose the one
which has a higher PW or AW.
PWIA 1000 300 PIA 7h 5 230
PW B 1350 300 PA71,51 5047917 5
B. Koo 2023 M261: Engineering Economics
262 15

AW A 1000 AIP 71 51 t 300 5156

15

A MB 1330 Alp 7 1 I 300 501A14,71,57 5164

Ex 2-1. PW/AW, equal service lives (2)

B. Koo 2023 M261: Engineering Economics 16

16

8
 Ex 2-2. Choosing a stock (1)
 Jake wants to buy one out of six stocks. He plans to keep the stock for 5
years and requires a 10% rate of return. Which stock should he choose?
Dividend per Price at the end
Common stock Price per share
share of 5 yrs.
Western House $24 $1.5 $32
Fine Foods $45 $5 $48
Mobile Motors $30 0 $42
Spar Products $12 0 $22
Canada Tire $32 $2 $40
Wine Products $50 $3 $60

B. Koo 2023 M261: Engineering Economics 17

17

Ex 2-2. Choosing a stock (2) Whatisthis

column
 To compute the present worth of revenues, we need
• (P/A, 10%, 5) = 3.791; (P/F, 10%, 5) = 0.6209 I
Common stock PW PW/share PW/$1
Western House –24 + 1.5(3.791) + 32(0.6209) = $1.56 $0.06
Fine Foods –45 + 5(3.791) + 48(0.6209) = $3.76 $0.08
Mobile Motors –30 + 0(3.791) + 42(0.6209) = –$3.92 –$0.13
Spar Products –12 + 0(3.791) + 22(0.6209) = $1.66 $0.14
Canada Tire –32 + 2(3.791) + 40(0.6209) = $0.42 $0.01
Wine Products –50 + 3(3.791) + 60(0.6209) = –$1.37 –$0.03
• Fine Foods has the largest PW. Should you choose it?
• No, you should choose Spar Products. Why?
B. Koo 2023 M261: Engineering Economics 18

18

9
 Ex 2-3. Salary package
 Your new employer offered two salary arrangements.
• You will have $60,000 at the end of the first year, increasing by $5,000 each year.
• You will have constant $80,000 every year from the end of the first year, with a
signing bonus of $150,000 paid now.
 If the interest rate is 8% and you plan to work for the company for 30
years, which one should you choose?
PW 60000 PIA Y 307 5000PIG 81,30 1 192945
PW 150000 t 80000 PIA81,30 1 050622

B. Koo 2023 M261: Engineering Economics 19

19

2.1. If you buy a car, how to pay for it?

 Cash
• You have more freedom if you pay cash, but it is rare.
• With a low car loan rate, you can invest the cash in other assets.
 Financing (or loan)
• You get a loan from a bank (or a financing company), and pay monthly payments.
• The car is yours after the financing period is over, and it is most common.
 Leasing
• You pay monthly payments to the leasing company.
• You return the vehicle at the end of the leasing term, or you can buy the vehicle at
the residual value.
• About 30% of new cars are leased in the United States.
B. Koo 2023 M261: Engineering Economics 20

20

10
 Ex 2-4. Car payment types
 Suppose you need a car for 5 years, and decide to get Tesla Model 3 for
$55,000. If an interest rate is 6%, which option is the best?
• Option A (Pay cash): The cash price is $50,000 (with a $5,000 cash rebate). The
car can be sold for $15,000 at the end of 5 years.
• Option B (Leasing): The monthly payment is $730 on a 5-year lease, payable at
the end of each month. At the end of 5 years, the car is returned to the company.
• Option C (Leasing with an option to buy): You pay $750 a month for 60 months.
At the end of 5 years, you buy the car for $12,000 and sell it for $15,000.
Ac A 50000CA P61,5 15000 AIF 0.51 60 751
Ac B 730
Ac Cl 750 3006 AIR 0.54 60 707
B. Koo 2023 M261: Engineering Economics 21

21

3. Analysis with unequal service lives

 What if several alternatives have different service lives?
• Do you want to buy a shoes from Dollarama (with a short life) or from Payless
Shoes (with a long life), assuming the quality is the same?
 PW: Use the least common multiple (LCM) for each alternative to
equalize the lives.
• Then, what if the service lives are 7 years and 13 years, respectively?
• Assuming the service will be needed repeatedly, we consider a common time
period using the LCM, 91 years!
• Alternatively, we can consider a specific analysis period.
 AW: Calculate AW for each alternative based on its own service life.
• For unequal service lives, the AW approach is much simpler than PW.
B. Koo 2023 M261: Engineering Economics 22

22

11
 Ex 3-1. PW: Unequal service lives (1)
 Two manufacturers offered the estimates of new equipment. Assuming
10% interest rate, which one should be selected? Use the PW approach.

Vendor A Vendor B

First cost $15,000 $18,000

Annual operating cost $3,500 $3,100

LCM
Salvage value $1,000 $2,000

Service life 6 years 9 years to

B. Koo 2023 M261: Engineering Economics 23

23

MIDTERM UPTO LECTURE06

Ex 3-1. PW: Unequal service lives (2)

PWCA
00
15000 14000 P F lo1 6 127 1000 PIF101,18
14000 PIF 101
490515
3500pA10

PW B 18000 16000 PIF101,97 2000PIFv01 18 3100 PIA 10 18

CA
AW 3500 15000 AP 101,6 1000 Alf 10 6
AWB 3100 18000CHIP101,9 2000 Alf 10 9

B. Koo 2023 M261: Engineering Economics 24

24

12
 IMPORTANT Easy
whereer seria life AW appt WAY
different use
is
Ex 3-2. AW: Unequal service lives
 Two pumps are being considered for purchase. If interest rate is 7%,
which pump should be bought?
Pump A Pump B
Initial cost 9,000 7,000
End-of-life salvage value 2,000 1,000
Useful life (years) 20 12 LCM 60
ACCA 9000 AIP H 207 2000 Alf 71,201 800
ACB 7000 AIP7 1 12 1000 AIF 71,127 825

B. Koo 2023 M261: Engineering Economics 25

25

4. Analysis with infinite service life

 Government projects sometimes must be maintained for an infinite
period (e.g. bridges, pipelines).
 Capitalized cost: P = A/i P A PVA i n
• It is the present sum that is required to provide the service indefinitely.
• In general, a sum of money (often called “endowment”) is set aside, and interest
from the fund is used forever (e.g., WEEF).
• Only the interest is used, and the principal lasts forever.
 Growing perpetuity: If cash flows increase by g% per period (i > g).
A A(1  g) A(1  g)2 A(1  g)n1 A

D
P    ...   ... 
(1  i ) (1  i ) 2
(1  i ) 3
(1  i ) n
ig

B. Koo 2023 M261: Engineering Economics 26

26

13
 Ex 4-1. Cash for life
 OLG (Ontario Lottery and Gaming) has a lottery game,
“Cash for Life.” A winner receives $1,000 a week for life.
 You have an option of the weekly payment or a lump
sum payment of $675,000. Which one will you choose?
 What is the present worth of this lottery if it is paid
infinitely and the interest rate is 8%?
10
P 1.152 Becauseweekly 650,000
 If the payment is only for 20 years, what would be the
present worth of this lottery?

P 1000 PIA 2,10407

578601
B. Koo 2023 M261: Engineering Economics 27

27

Emil
Ex 4-2. Capitalized cost (1)
 A city plans to install a water pipeline which will cost $8 million with an
Eli iii kill
expected life of 70 years. If the city keeps it indefinitely, what is the
capitalized cost with 7% interest rate?

 Method 1: Make the 70-year as a single period

Because year
compoundedevery

he I t o o7 F info
computed
everyyear
P
B. Koo 2023
Tie t 841 8,071,000
M261: Engineering Economics
7 Eventyearsyou 28

leftwith it grin
28 Became payment
madeimmediately w be And
y ooo compounded
intentfor 70years
14
amorally
 Ex 4-2. Capitalized cost (2)

t.tt
 Method 2: Annualize the cost that starts from now.
A Emil Alp71,70 565000
xA
P 567000 0.07 8071000 mn
 Method 3: Annualize the cost that starts 70 years from now.

A 8min AIF 71,70 4960

4
P 7 t omit 8071000
B. Koo 2023 M261: Engineering Economics 29

29

Ex 4-3. Perpetual scholarship

 Samuel has made a fortune in his business and wants to start a
perpetual scholarship for students at UW.
• The scholarship provides one student with an annual stipend of $10,000 for 4
years, plus $20,000 at the end of the 4th year.
• Students graduate in four years, and a new award is given every 4 years.
• The money is paid at the end of each year, and the interest rate is 8%.

iii t.it i
 What is the annual cost of providing the scholarship?
A 10000 20000 AlF 81,47 144310
 If this cost increases by 2% per year, how much money should Samuel
donate to UW?

B. Koo 2023
P 0 87
M261: Engineering Economics
24061
30

30

15
 Ex 4-4. Multiple alternatives
p
 Consider the three mutually exclusive alternatives. A P i
A B C
Initial cost 10,000 15,000 20,000
Annual benefit 1,000 1,800 5,200
Useful life (years) ∞ 20 5
 Assuming 8% interest rate, which option should be selected?
ANCA 1000 1000010.087 200
AWCB 1800 15000 AlP 81,207
272
AWC 5200 20000 AIPW 5 190
B. Koo 2023 M261: Engineering Economics 31

31

5. Loans (1)
 A loan is a type of debt that should be repaid over time.
• The borrower is responsible to repay both principal and interest until the debt is
fully repaid.
• In some cases, interest paid can be deducted from taxable income.
 What are the types of loan repayment?
 Pure discount loan
• A borrower repays a single payment at the end of the term, including the
principal plus all accumulated interest.
• The Government of Canada borrows money by selling Treasury bills (or T-bills),
usually for 3 – 12 months. shortterm loan
• It pays back (or purchases the T-bills) at the end of the term.
B. Koo 2023 M261: Engineering Economics 32

32

16
 5. Loans (2)
 Interest-only loan
• A borrower pays only interest in each period and repays the principal at the end
of term.
• Examples: line of credit (without a definite term), bonds (with a definite term).
• Firms often use it to cover immediate costs (called short-term bridge capital).
 Amortized loans
• A borrower pays both interest and principal in each period, often the constant
amount in each period.
• Examples: auto loans, mortgage (home loans)
• The portion of interest decreases over time, and our calculation of A refers to
this type of payment.

B. Koo 2023 M261: Engineering Economics 33

33

5.1. Mortgage in Canada

 Mortgage is an amortized loan.
• It is a long-term amortized loan for buying real estates (e.g., land or house).
• When you buy a house, you pay a “down-payment,” usually 5% – 20% of the house
value, and get the mortgage for the remaining amount.
• The duration of loan payment is called “amortization period,” typically 25–30 years.
• The interest rate used in this loan is called “mortgage rate.”
 Mortgage in Canada
• The mortgage rate can be fixed (for 5 years) or variable depending on the market.
• If the down-payment is less than 20%, it is called a high-ratio mortgage, requiring
to purchase a mortgage insurance.
• Interest only mortgage: Pay only the interest for a certain period (e.g., 5 years).
B. Koo 2023 M261: Engineering Economics 34

34

17
 5.1. Canadian mortgage (and prime) rate
25
Source: Bank of Canada, Data and Statistics Office

Prime rate 5-year mortgage rate

20

15

10

0
1975-01-01 1980-01-01 1985-01-01 1990-01-01 1995-01-01 2000-01-01 2005-01-01 2010-01-01 2015-01-01 2020-01-01

B. Koo 2023 M261: Engineering Economics 35

35

Ex 5-1. Mortgage payment

 Garcia bought a house for $500,000 with a down payment of $100,000.
The 25-year mortgage loan is paid monthly with a mortgage rate of
4.8%. What is his monthly mortgage payment?
A 400000 AIP 0.41,3007 2291
 After 10 years (with 120 payments), he decided to pay the remaining
balance. What is the remaining balance at the end of 10 years?
P420month 2291 PIA O41 1807 8293561
Taming
 If the mortgage rate is 6.5%,
balance
what would be his monthly mortgage
payment?

A 400000 Alp 300 2700

B. Koo 2023 M261: Engineering Economics 36

36

18
 Ex 5-2. Refinancing mortgage
 Silvia borrowed $600,000 for her house at 6% mortgage rate to be
repaid in 30 annual payments. After making 10 payments, she found
she could refinance the balance at 5% interest for the remaining period.
• To refinance the loan, she pays the original lender the balance due on the loan,
plus a penalty charge of 3% of the balance due, and $5,000 service charge.
 Should she refinance the loan for the remaining 20 years?
Original 600000 AIP61,307 43590
A
Remaining 43590 PIA 61,20 499976
backto originallender
Howmushshehastopay
499970 t 31 x 499970 5000 519970
New
refinance
A 519970 Alp51,20 41723 should
she
B. Koo 2023 M261: Engineering Economics 37

37

Ex 5-3. Amortization schedule

 The majority of early mortgage payment is an interest expense.
• Silvia’s $600,000 mortgage for 30 years: Annual payment is $43,590 with 6%.
Year Interest paid Principal paid Ending balance Share of interest
0 $600,000
1 $36,000 $7,590 $592,410 83%

0
2 $35,545 $8,045 $594,365 82%
3 $35,062 $8,528 $575,836 80%
4 $34,550 $9,040 $566,797 79%
5 $34,008 $9,582 $557,214 78%
6 $33,433 $10,157 $547,057 77%
7 $32,823 $10,767 $536,291 75%
B. Koo 2023 M261: Engineering Economics 38

38

19
 Summary of lecture 04
 Decision rule under PW and AW analysis
• Analysis with equal service lives
• Analysis with unequal service lives: PW (LCM) vs. AW (direct calculation)
• Analysis with infinite service life: Capitalized cost; Growing perpetuity
 Loan and mortgage

 Selective end-of-chapter problems

• Newnan Ch5: 5, 11, 15, 24, 31, 36, 38, 49, 52, 59, 64, 85, 93, 129
• Newnan Ch6: 8, 15, 16, 19, 25, 28, 31, 38, 50, 54, 57

B. Koo 2023 M261: Engineering Economics 39

39

20