3/4/2016

Chapter 5
Present Worth
Analysis
Engineering Economy

Content of the
Chapter
1.

Formulate Alternatives

2.

Present Worth of equal-life alternatives

3.

Present Worth of different-life alternatives

4.

Future Worth analysis

5.

Capitalized Cost analysis

3/4/2016

Formulating
Alternatives
Two types of economic proposals:
1. Mutually Exclusive (ME) Alternatives: Only one proposal
can be selected; Compete against each other and are
compared pairwise. These proposals are normally called
alternatives
e.g., A selection of Best diesel powered engine among the
available models

2.

Independent Projects: More than one can be selected , these

proposals are called projects; it competes only against DN

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

maintain the current approach; no new costs, revenues or savings
In this chapter, we will learn Present Worth Method to evaluate either type
of proposal ..in next chapters we will learn some more such techniques.

Project or alternatives types

based on Cash flows
There are two types of alternatives based on Cash flows
1. Revenue each alternative project being evaluated generate
costs and revenues over life period of alternative.
E.g., new systems, products/services that involve capital costs
Criteria of selection is to maximize the economic measure (e.g.,
profit in case of introducing new product).
2. Cost ( or service based) Each alternative has only cost cash
flow estimates (revenues are same for all alternatives)
E.g., which 100-seat plane to buy?
Criteria of selection is to minimize the economic measures (e.g.,
in this case cost of buying 100-seat plane)

3/4/2016

Present Worth Analysis Evaluation

for equal Life Alternatives
Mutually exclusive projects

For one project, it is financially viable if PW 0.

For 2 or more alternatives, select the one with the (numerically)
largest PW value.

Independent Projects

Select all projects with PW 0

However, in practice a budget limit exists (details in chapter 12)

This Criteria work as follows;

Convert all cash flows to Present Worth (same as present
value) using MARR
Precede costs by minus sign; receipts by plus sign

Class Practice
Electric
powered
First Cost($)
Annual Operating Costs
($/year)
Salvage value S ($)
Life years
10%

Gas powered

Solar
powered

4500

3500

600

900

700

50

200

350

100

8
Single Payments

Uniform Series Factors

Compoun
d Amount
(F/P)

Present
Worth
(P/F)

Sinking
Fund (A/F)

Compound Capital
Amount
Recovery
(F/A)
(A/P)

Present
Worth (P/A)

2.1436

0.4665

0.08744

11.4359

5.3349

0.18744

PWE = 4500 900( P/A ,10%,8) + 200( P/F ,10%,8) = $9208

PWG = 3500 700( P/A ,10%,8) + 350( P/F ,10%,8) =$7071
PWS = 6000 50( P/A ,10%,8) + 100( P/F ,10%,8)= $6220
$6220

Solar powered alternative should be selected

3/4/2016

PW of Different-Life
Alternatives
For alternatives with unequal lives the rule is:
PW must be compared over the same number of years
This is called equal service alternatives
requirement (i.e., alternatives must end at the same
time) Why its important ?
Because if this condition is not meet, For COST
ALTERNATIVES (which involves only cost) will always
favor the shorter-lived mutually exclusive alternative,
even if it is not the more economical choice, because
fewer periods of costs are involved

PW of Different-Life
Alternatives
The following are two equal ways of meeting the
equal service requirements:
1. Least Common Multiple (LCM) of alternative
lives
Compare the PW of alternatives over a period of time
equal to the least common multiple (LCM) of their
estimated lives
2. Study Period Approach
Compare the PW of alternatives using a specified
study period of n years. This approach does not
necessarily consider the useful life of an alternative.
The study period is also called the planning horizon.

3/4/2016

LCM of Alternative Lives

Approach
This approach compare the PW of alternatives
over a period of time equal to the least common
multiple (LCM) of their estimated lives

Three assumptions of LCM Approach

1. The service provided is needed for LCM years or
more.
2. The selected alternative is repeated over each
life cycle of the LCM in exactly the same manner.
3. Cash flow estimates are the same in every life
cycle (i.e., change are exactly by the inflation or deflation
rate only)

Evaluation of Present Worth

Using a LCM Approach
1. First, find the LCM for the life of alternatives
2. Second, expand the cash flows for each
alternatives till the LCM period thus meeting
the equal service requirement
3. Calculate the present worth for all the
alternatives
4. Use the criteria used for Equal Life Alternatives
to evaluate the alternatives

3/4/2016

Study Period Approach

Compare the PW of alternatives using a
specified study period of n years. This
approach does not necessarily consider the
useful life of an alternative. The study period
is also called the planning horizon.
A study period analysis is necessary if the
first assumption of LCM approach (i.e., The
service provided is needed for LCM years or more )

cannot be made.

Evaluation of Present Worth

Using a Study Period
For the study period approach, a time horizon is chosen
over which the economic analysis is conducted, and only
those cash flows which occur during that time period are
considered relevant to the analysis
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 (at this stage we will just use Salvage value as it is)
Short study periods are often defined by management when
business goals are short-term

3/4/2016

Example:
Use of PW criteria for Different-Life
Alternatives
National Homebuilders, Inc., plans to purchase new cut-and-finish
equipment. Two manufacturers offered the estimates below.
First cost, $
Annual cost, $/year
Salvage value, $
Life, years

Vendor A
15,000
3,500
1,000
6

Vendor B
18,000
3,100
2,000
9

(a) Determine which vendor should be selected on the basis of a

present worth comparison, if the MARR is 15% per year.
(b) National Homebuilders has a standard practice of evaluating all
options over a 5-year period. If a study period of 5 years is used
and the salvage values are not expected to change, which vendor
should be selected?

(a) Determine which vendor should be selected on the basis of a present worth
comparison, if the MARR is 15% per year.

Solution:

What is LCM of 6 and 9 ?

LCM = 18 years; We draw its cash flows to make things easy

To meet the criteria of equal service
alternatives we extended the
project life from 6 years to 18
years for the first alternative (& 9 to
18 for 2nd alternative)
NOW You have equal life two
alternatives(equal service
condition meet) with cash
flowsyou can use standard
procedure to obtain the present
value of both and compare it.

3/4/2016

PW Calculations
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) 3,500(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 vender B

Which one to select ? A or B ?

Use of Study Period Approach

Solution (b): Now
comparison is required for
5 years. Since cash flows
are of 6 years no cycle
repeat is required

Salvage value is the

estimated market
value at the end of
study period

PWA = -15,000 3,500(P/A,15%,5) +1000(P/F,15%,5)

= $ 26, 236

We r told hereto
that salvage value is
not expected to
change

PWB = -18,000 3100(PA,15%,5) + 2000(P/F,15%,5)

= $ 27,397

Which one to select ? A or B ?

Select vender A

3/4/2016

PW of Different-Life Alternatives
for independent alternatives
Can we use LCM approach for Independent
projects ?
For independent projects , use of the LCM approach is
unnecessary since each project is compared to the donothing alternative, not to each other
Equal-service requirement is not a problem
Use the MARR to determine the PW over the respective
life of each project, and select all projects with a PW 0

Future Worth Analysis

Future Worth is exactly like PW analysis, except
Future Worth Must compare alternatives for equal
service (i.e. alternatives must end at the same time)
The selection guidelines for FW analysis are the same
as for PW analysis; FW 0 means the MARR is met or
exceeded
For two or more mutually exclusive alternatives, select
the one with the numerically largest FW value.

3/4/2016

Future Worth Analysis

If life of two alternatives are not equal, one need to fulfill the
equal service requirement for using FW criteria.
Two ways to compare equal service:
1. Least common multiple (LCM) of lives
2. Specified study period

Same way as used for Present Worth Analysis expect once

life of alternatives are equal for cash flows, one need to
compare the Future Worth instead of Present Worth

Example: Future Worth Analysis

(Problem 5.26)

An industrial engineer is considering two robots

for purchase by a fiber-optic manufacturing
company. Robot X will have a first cost of
$80,000, an annual maintenance and operation
(M&O) cost of $30,000, and a $40,000 salvage
value. Robot Y will have a first cost of $97,000,
an annual M&O cost of $27,000, and a $50,000
salvage value. Which should be selected on the
basis of a future worth comparison at an interest
rate of 15% per year? Use a 3-year study period.

10

3/4/2016

Future Worth Analysis

(Problem 5.26)
$50,000

$40,000
i = 15%

F=?

i = 15%

F=?
0

Robot X CF

A = $27,000

A = $30,000
$80,000

$97,000

Robot Y CF

FWX = -80,000(F/P,15%,3) 30,000(F/A,15%,3) + 40,000

= -80,000(1.5209) 30,000(3.4725) + 40,000
= $-185,847
FWY = -97,000(F/P,15%,3) 27,000(F/A,15%,3) + 50,000
= -97,000(1.5209) 27,000(3.4725) + 50,000
= $-191,285

Select robot X

Capitalized Worth Analysis

The capitalized worth method is especially useful in
problems involving public projects with indefinite lives,
or permanent endowments(or donations) for charitable
organizations and universities
Capitalized worth is the present worth of all revenues
or expenses over an infinite length of time
If only expenses(cost alternative) are considered this is
referred as capitalized cost

11

3/4/2016

Capitalized Worth Analysis

The Capitalized Worth of a series of end-of-period uniform
payments A, with interest at i% per period, is
CW (or CC) = A(P/A, i%, n) where n
As N becomes very large (if the A are perpetual payments)
We already know that P/A is given as P/A=

The term in the bracket becomes

as n tends to infinity

So, the above equations become as: 1

Capitaized Worth (or Capitalized Costs) =

CW or CC =

or

Capitalized Worth Analysis

The equation can be understand by thinking of ..

What present amount invested today at i will enable an
investor to periodically withdraw an amount A forever
If investor withdraw more than amount A each period, he/she
will be withdrawing a portion of the initial principle and
eventually it will exhausted
If amount being withdrawn each period is equals the interest
earned on the principal for that period, the principal remains
intact, thus series of withdraw will continue forever

12

3/4/2016

Example: Capitalized Worth

(Costs) Problems
Capitalized worth (or costs) type problems vary from
very simple to somewhat complex
Consider a simple Capitalized Cost type problem
A person want to donate $100, 000 for scholarships
in a university. Consider, 20% per year interest
rate; How much money can be withdrawn forever
from this account?

Example: Capitalized Worth

(Costs) Problems
Draw a Cash Flow Diagram
$ A per year = ?

$100,000

Solution:
Or

CC= A (or AW)

i
AW= CC (i)

A = $100,000(0.20) = $20,000 per period

13

3/4/2016

Capitalized Worth (Costs)

Recurring and Non-recurring
More complex problems will have two types of costs associated;
1. Recurring Periodic and repeat
2. Non-recurring One time present or future cash flows

For more complex CC problems one must separate the

recurring from the non-recurring

You will not just face problems to calculate Capital Costs

of a single amount (like the previous example) but you
confronts situations in which you have to make selection
among alternatives using CC criteria

Capitalized Cost Analysis

For the comparison of two alternatives on the basis of
capitalized cost, you will use formula (CC = A/i)
So find the A value & CCT (the sum of recurring and nonrecurring costs) for each alternative and select the one which
has lowest present worth of costs (or equal to say Lowest
capitalized costs).
Alternatives are automatically compared for same life
period because CCT represents the total present worth of
financing and maintaining a given alternative forever (i.e.,
infinity).

14

3/4/2016

Summary: How to calculate CC and A and how to use

CC criteria to select an alternative
Cost (cash flows)
(Step 1)
Non-recurring
One time present or future
cash flows (e.g., first cost,
cost once in 25th year etc)

Non-recurring
Convert it to PW (will be PW
of all non-recurring costs
for whole life)

Recurring
Periodic and repeated

A in only one cost

Cycle: e.g., cash
flow every 5th year or
every 20th year
Convert this to a Uniform
Series (say A1)

(Step 2)

Add values of step 4 and

Step 2 to obtain CC of
overall cash flows

(Step 5)
Select the alternative
with lowest capitalized
costs

Uniform Equal
Recurring
Amounts: e.g.,
Annuity Series (say
A2)

Divide the value of Uniform

Annuity Series by i"
(using CC= A/i) to get the
value of Capitalized worth
for uniform series
(Step 4)

Add A1 and A2 to
get one Uniform
Series (Annuity
Series) starting
from time 0 and
continue till infinity

(Step 3)

Step 3 can be skipped if you convert both recurring costs

directly to present worth

Example:
The Haverty County Transportation Authority (HCTA) has just installed
new software to charge and track toll fees. The director wants to know
the total equivalent cost of all future costs incurred to purchase the
software system. If the new system will be used for the indefinite
future, (a) find the equivalent cost now: i.e., a CC value. (b) for each
year hereafter, an AW value.

The system has an installed cost of $150,000 and an additional cost of

$50,000 after 10 years. The annual software maintenance contract cost
is $5000 for the first 4 years and $8000 thereafter. In addition, there is
expected to be a recurring major upgrade cost of $15,000 every 13 years.
Assume that i is 5% per year for county funds.
Please try yourself to draw the cash flow ..for 2 cycle of costs

15

3/4/2016

Step 1: Draw cash flow

Diagram (for at least 2
recurring cost cycles)

The system has an installed cost of $150,000 and an additional cost of

$50,000 after 10 years. The annual software maintenance contract cost
is $5000 for the first 4 years and $8000 thereafter. In addition, there is
expected to be a recurring major upgrade cost of $15,000 every 13 years.
Assume that i is 5% per year for county funds.

Step 1: Draw cash flow

Diagram (for at least 2
recurring cost cycles)

Non- Recurring Costs: $150,000 and $50,000

Recurring Costs (A in a life cycle): $15000
Recurring Costs (uniform A series): $5000, $8000

16

3/4/2016

Step 2: Convert NonRecurring costs into PW

Non- Recurring Costs:

$150,000 (Initial Costs) and
$50,000 (in year 10th)
CC1 = 150,000 50,000(P/F, 5%, 10)

CC1 = $-180,695

Step 3 & 4: Convert Recurring Costs (A in

one life cycle) into Uniform Costs and add it
with Uniform Recurring Costs
Recurring Costs (A in one life cycle): $15000
A1 = 15000(A/F, 5%, 13)
= $ 847 cost of one cycle
CC2 = 847 / 0.05
= $ 16,940 (for all cycles)
Recurring Costs (uniform):

$5000, $8000
CC3 = 5000 (P/A, 5%, )
= 5000/i or 5000/0.05
CC3 = = $ 100,000
Alternative:
A1 = $ 847
A2= $ 5000
A = A1+A2 = $ 5847
CCA = $5847(P/A, 5%, )
= 5487/0.05 = $116940
(same as CC2 + CC3 above)

17

3/4/2016

Step 3 & 4: Convert Recurring Costs (A

in one life cycle) into Uniform
Costs(for whole life) and add it with
Uniform Recurring Costs

Recurring Costs (uniform):

If we calculate the present worth of A = $3000 (which is starting

from year 5)it will be on 4th year. Need to multiply it with single
factor for four year to bring it to time 0.
CC4 = (A/i)(P/F, 5%, 4)
3000 (1/0.05) (P/F, 5%, 4)
CC4 = = 49,362

Step 5: Add values of Step 2 and Step

4 to Obtain CC

CCT = CC1 + CC2 + CC3 + CC4

= 180,695 16,940 100,000 49,362
= 346,997
Interpretation: The $-346,997
represents the one-time t = 0
amount that if
b) CC = A/i
invested at 5%/year would fund the
AW= CCT (i)
future cash flows as
= 346.997 (0.05)
shown on the cash flow diagram
= $17,350
from now to infinity!
Interpretation: This means Haverty County officials have committed the
equivalent of $17,350 forever to operate and maintain the toll
management software

18

3/4/2016

Capitalized Cost
Analysis
If you have more than one alternative and
you have to chose one out of it on
Capitalized Cost Analysis.
You need to calculate the CC for every
alternative as explained in 5 step procedure
and then you select the alternative which
value is numerically largest (or had lowest
cost)

Capitalized cost analysis

for a finite-life alternative
Important
I.
II.

CC/CW method can be applied for alternatives whose

lives are not necessary infinite.
Its possible to compare an alternative having finite life with
alternative having infinite life .. Computation are explained
below:
We already know how to calculate the CC/CW for
infinite life alternative
To determine CC for finite life alternative calculate
the equivalent A value for one life cycle and divide by
the interest rate (i.e. A/i)

19

3/4/2016

Example
Given the following two mutually exclusive
alternatives, use the Capitalized Worth method to
determine which project you should invest in (MARR =
15%):
First Cost, $
Annual Operating Cost, $ per year
Salvage value, $
Life, years

A
$12000
2200
0
10

B
$40000
1000
10000
25

Solution

First, find AW of each alternative: (bz CC = AW/i)

AWA = $12,000(A/P, 15%, 10) $2,200
= $4,592
AWB = $40,000(A/P, 15%, 25) $1,000 +
$10,000(A/F, 15%, 25)
= $7,141

20

3/4/2016

Solution

Second, find CW of each alternative:

CWA = AWA/i = -$4,592/0.15 = -$30,613
CWB = AWB/i = -$7,141/0.15 = -$47,607
Since CW of alternative A yields less cost,
it should be selected.

Practice: Finite versus

Infinite life alternatives
Compare the alternatives shown on the basis of their capitalized costs using an
interest rate of 10% per year

Alternative M
First Cost, $
Annual Operating Cost, $ per year
Salvage value, $
Life, years

150000
50,000
8000
5

10
%

Single Payments

Compoun Present
d Amount Worth
(F/P)
(P/F)

Sinking
Fund
(A/F)

1.6105

0.16380 6.1051

0.6209

Alternative N

800000
12000
1000000

Uniform Series Factors

Compoun
d Amount
(F/A)

Capital
Recovery
(A/P)

Present
Worth
(P/A)

0.26380

3.7908

21

3/4/2016

Solution!!!!

Alternative M
For M, first find AW and then divide by i to find CC.
CCM = AWM/i but we don't know AWM
To calculate Annual worth one need to convert all cash flows into Uniform
series!!!!!!
AWM = 150,000(A/P,10%,5) 50,000
+ 8000(A/F,10%,5)
= 150,000(0.26380) 50,000
+ 8000(0.16380)
= $ 88,260
CCM = 88,260/0.10
= $ 882,600

Solution!!!!

Alternative N
Since -800,000 is already at present point of an infinite

seriesand its not repeated so we do not need to do

anything with it
We only need to convert the uniform series of - $12000
to present value and add it to the already present worth
calculated values.
CCN = $800,000 12,000/0.10

Salvage value
for alternative
with infinite life
is never
realized
because n is
never reached.

CCN = 80,000 12,000/0.10

= $ 920,000
Select alternative M

22

3/4/2016

Mid-Term Instructions!!!
For mid-term You must have your own
calculators and Factor Tables
Formula sheet will be provided.
No Exchange of Calculator or factor table will
be allowed
A word on Cheating !!!!!
NO QUESTIONS from Teacher/TA or
Invigilating Staff questions will be clear and
self-explanatory

Mid-Term
Mid-term Pattern:
MCQs versus Questions
Theory versus Numerical
All course covered till TODAY
There will be in total 40 MCQs/True False
Include both theory(1 mark each) and Numerical (2 marks
each)
Answers must be filled up in Table given on last page of
Booklet.
Total time is 55 minutes this includes 2 minutes for
reading instructionsand 8 minutes filling MCQs table

23

3/4/2016

Thank You
&
Best of Luck!!!

24