Minggu 5

Present Worth Analysis

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Economic Criteria
 Depending on the situation, the economic
criterion will be one of the following :
Situation Criterion
For fixed input Maximize output
For fixed output Minimize input
Neither input or Maximize
output fixed (output – input)

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 Applying Present Worth Techniques

 Equivalence provides the logic by which we may

adjust the cash flow for a given alternative into
the same equivalent sum or series with
equivalent present consequences, then
compared it to chose the feasible alternatives.
 In this case, the consequences of each
alternative must be considered for this period of
time whish is ususlly called the analysis period

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Applying Present Worth Techniques
 The tree criteria for economic efficiency are restated in
terms of present worth analysis:
Situation Criterion
Fixed Amount of money or other Maximize present worth of
input input resources are fixed benefits or other outputs

Fixed There is a fixed task, Minimize present worth of

output benefits or other output to costs or other inputs
be accomplished
Neither Neither amount of money, Maximize (present worth of
input nor or other inputs nor benefits – present worth of
output is amount of benefits or costs), that is maximize net
fixed other outputs is fixed present worth

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Three different analysis-period situations in economic
analysis problems

 The useful life of each alternative equals the analysis

period

 The alternatives have useful lives different from the

analysis period

 There is an infinite analysis period, n = 

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Useful lives equal the analysis period(1)
Example 1:
A firm is considering which of two mechanical
devices to install to reduce costs in a particular
situation. Both devices cost $1000 and have
useful lives of five years and no salvage value.
Device A can be expected to result in $300
savings annualy. Device B will provide cost
savings of $400 the first year but will decline $50
annually, making the second year savings $350,
the third year savings $300, and so forth. With
interest at 7% which device should the firm
purchase ?
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Useful lives equal the analysis period(2)

 The analysis period can conveniently be selected as the

useful life of the devices or 5 years.
 Devices A Devices B
400
A = 300 350
300
250
200

PW of benefits PW of benefits

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Useful lives equal the analysis period(3)

PW of benefits A = 300(P/A,7%,5) = 300(4,1)

= $1230
PW of benefits B = 400(P/A,7%,5) – 50(P/G,7%,5)
= 400(4,1) – 50(7,647)
= $1421,65

PW of benefits B > PW of benefits A,

therefore devices B preferred aternative
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Useful lives equal the analysis period(4)

Example 2:
Three mutually exclusive investment alternatives for
implementing an office automation plan in an engineering
design firm are being considered. Each alternative meets
the same service (support) requirements, but differences in
capital investment amounts and benefits (cost saving) exist
among them. The study periods 10 years, and the useful
lives af all three alternatives are also 10 years. Market
values of all alternatives are assumed to be zero at the end
of their useful lives. If the firm’s MARR is 10% per year,
which alternaitve should be selected in view of the following
etimates ?

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Useful lives equal the analysis period(5)
Alternative
A B C
Capital $390.000 $920.000 $660.000
investment

Annual cost $69.000 167.000 133.500

savings

Solution :
PWA = -$390.000 + $69.000 (P/A, 10%, 10) = $33,977
PWB = -$920.000 + $167.000 (P/A, 10%, 10) = $106,148
PWC = -$660.000 + $133.500 (P/A, 10%, 10) = $160,304
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Useful lives different from the analysis
period(1)
Example 1:
A purchasing agent is considering the purchase of
some new equipment for the mailroom. Two different
manufacturers have provided quotations. An analysis
of the quotations indicates the following :
Manufacturer Cost Useful life(year) salvage value
Speedy $ 1500 5 $ 200
Allied $ 1600 10 $ 325
Assume 7% interest and equal maintenance costs.

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Useful lives Different from the analysis
period(2)
 If the allied equipment has a useful life of ten years, and
the speedy equipment will last five years, one solution is
to select a ten year analysis period.
 Assume the replacement speedy equipment will also
cost $1500 five years hence
 Speedy Allied
200 200 325

1500 1500 1600

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Useful lives Different from the analysis
period(3)
PW of cost Speedy
= 1500 + (1500-200) (P/F,7%,5) – 200(P/F,7%,10)
= 1500 + 1300(0,713) – 200(0,5083)
= $ 2325,24
PW of cost Allied
= 1600 – 325(P/F,7%,10) = 1600 – 325(0,5083)
= $ 1434,803

PW of cost Allied < PW of cost Speedy ,

therefore Allied preferred aternative

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Useful lives Different from the analysis
period(4)
Example 2:
The following data have been estimated for two mutually
exclusive investment alternatives, A and B associated with a
small engineering project for which revenues as well as
expenses are involved. They have useful lives of four and six
years, respectively. If the MARR = 10% per year, show which
alternative is more desirable by using equivalent worth methods.
Use the repeatability assumption.
A B
Capital Investment $3.500 $5.000
Annual Cash Flow 1.255 1.480
Useful Life (years) 4 6
Market value at end of useful 0 0
life 14
Useful lives Different from the analysis
period(5)
 Solution :
 The least common multiple of the useful lives of
alternatives A and B is 12 years.
 PWA = -$3.500 - $3.500 [(P/F,10%,4) + (P/F,10%,8)]
+ $1.255 (P/A,10%,12)
= $1.028

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Infinite Analysis Period (1)
 In governmental analysis, at times there are
circumstances where a service or condition is to be
maintained for an infinite period. We call this particular
analysis Capitalized Cost
 Capitalized Cost, is the present sum of money that would
need to be set aside now, at some interest rate, to yield
the funds required to provide the service indefinitely.
Assume cost of maintenance is equal every year.

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Infinite Analysis Period (2)

 For one year period :

If iP is cost of maintenance every period,F = P +
iP, if iP adalah biaya perawatan untuk setiap
periode, maka di setiap periode terjadi
pengeluaran sebesar iP, sehingga untuk n = 
dapat dinyatakan sebagai A = iP dan
Capitalized cost (P) = A / i.

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Infinite Analysis Period (3)
example :
A city plans a pipeline to transport water from a distance
watershed area to the city. The pipeline will cost $8 million and
have an expected live of seventy years. The city anticipates it will
need to keep the water line in service indefinitely.
Compute the capitalized cost assuming 7% interest?

Solution :
Here we have renewals of the pipeline every seventy years
$ 8 juta $ 8 juta $ 8 juta $ 8 juta

70 tahun 140 tahun n= 

P

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Infinite Analysis Period (4)
 To compute the capitalized cost, it is necessary to
first compute an end-of-period disbursement A that
is equivalent to $8 million every seventy years
$ 8 juta
n = 70

A = F(A/F,i,n) = $ 8 juta(A/F,7%,70)
= $ 8 juta( 0,00062) = $ 4960
Capitalized cost P = $ 8juta + A/i = $ 8juta +4960/0,07
= $ 8.071.000
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Present Worth analysis for multiple alternatif(1)

Example :
An investor paid $8000 to a consulting firm to analyze
what he might do with a small parcel of land on the edge of town
that can be bought for $30.000. In their report, the consultants
suggested four alternatives :

Total Annual Terminal value at

Alternative
investment benefit end of 20 year
A: Do nothing $ - $ - $ -
B: Vegetable Market 50000 5100 30000
C: Gas Station 95000 10500 30000
D: Small Motel 350000 36000 150000
Assuming MARR is 10%, what should the investor do?
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 Present Worth analysis for multiple alternatif(2)

 This Problem is one of neither fixed input nor fixed

output, so our criterion will be to maximize the present
worth of benefit minus the present worth of cost, or,
simply stated, maximize net present worth.

Alternative A : NPW = 0 (do nothing)

Alternative B (vegetable market) :

NPW = -50000 + 5100(P/A,10%,20) +30000(P/F,10%,20)
= -50000 + 5100(8,514) + 30000(0,1486)
= -2120,6

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Present Worth analysis for multiple alternatif(3)

Alternative C (gas station):

NPW = -95000 + 10500(P/A,10%,20) + 30000(P/F,10%,20)
= -1145

Alternative D (small motel) :

NPW = -350000 + 36000(P/A,10%,20) +
150000(P/F,10%,20)
= -21206

In this situation alternative A has NPW equal to zero, and

others alternative have negative NPW. We will select the
best alternatives, namely, the do nothing (alt. A).

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Assumptions in solving economic analysis
problem(1)
 End-of-year convention
The annual expense / revenue occur in end-of-year.
Example :

Tahun 0 (Akhir) Tahun 1 (Akhir) Tahun 2

1 Jan 31 Des 1 Jan 31 Des
A
A
P F

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Assumptions in solving economic analysis
problem(2)
 Middle-of-period convention
The annual expense / revenue occur in middle-of-year.
Example :

Pertengahan Pertengahan Akhir Tahun 2

Tahun 0 Tahun 1 Tahun 2 31 Des
31 Des 1 Jan
1 Jan 30 Juni 30 Juni

A A
P F

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