Engineering

Economics
Module No. 07
Present Worth Method of
Comparison

By
Muhammad Shahid Iqbal

Introduction

In this method of comparison, the cash flows of each

alterative will be reduced to time zero by assuming an
interest rate i.
The best alternative will be selected depending on the type
of decision by comparing the present worth amounts of the
alternatives.
The alternatives being considered may require different
amounts of capital investment
The alternatives may have different useful lives
The subject of this section will help:
Analyze and compare feasible alternatives
Select the preferred alternative

Cash Flow Analysis Methods

The cash-flow analysis methods (PW) used in this process.

The alternative that requires the minimum investment and
produces satisfactory functional results will be chosen unless
the incremental capital associated with an alternative having a
larger investment can be justified with respect to its incremental
savings (or benefits ).
The sign of various amounts in a cash flow is decided on the
type of decision problem.
In Revenue dominated cash flows, the profit, revenue, salvage
value (all inflows) will be assigned positive sign while the all
costs (outflows) will be assigned with negative sign.
In cost dominated cash flows the cost will be assigned with
positive signs and all inflows will be assigned negative sign.

Rule For Choosing Among Alternatives

In case the decision to select the alternative with the

minimum cost, the alternative with the least present worth
amount will be selected.
In the decision is to select the alternative with the
maximum profit, the alternative with the maximum present
worth will be selected.

Revenue-Dominated cash flow analysis

Revenue-dominated cash flow analysis is given as:

PW = - P + R1[1/(1 +i)1] + R2[1/(1 +i)2] + .+ Rn[1/(1
+i)n] + S [1/(1 +i)n]
P = Initial investment
Rn = Net revenue at the end of nth year.
S = Salvage value at the end of nth year.

In this formula expenditures are assigned negative sign and

revenues are assigned positive signs.
If there are more alternatives which are to be compared,
the alternative with the maximum present worth amount
should be selected as the best alternative.

Cost-Dominated cash flow analysis

Cost-dominated cash flow analysis is given as:

PW = P + C1[1/(1 +i)1] + C2[1/(1 +i)2] + .+ Cn[1/(1 +i)n]
- S [1/(1 +i)n]
P = Initial investment
Cn = cost of operation at the end of nth year.
S = Salvage value at the end of nth year.

In this formula expenditures are assigned positive sign

and revenue a negative sign.
If there are more alternatives which are to be compared,
comparing PW, the alternative with the minimum present
worth amount should be selected as the best alternative.