ENGINEERING ECONOMY Fifth Edition

Blank and
Tarquin

c
M
Gra

Hill
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CHAPTER 5
PRESENT WORTH
ANALYSIS

Blank & Tarquin: 5-th Edition

Ch. 5 Authored By: Dr. Don Sm

LEARNING OBJECTIVES
PURPOSE OF THIS CHAPTER

FORMULATION OF MUTUALLY
EXCLUSIVE ALTERNITIVES
PROPER COMPARISON/ANALYSIS OF
MUTUALLY EXCLUSIVE ALTERNATIVES
PRESENT WORTH METHOD
EXTENSIONS OF THE PRESENT
WORTH METHOD
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5.1 FORMULATING MUTUALLY

EXCLUSIVE
ALTERNATIVES
Viable firms/organizations have the
capability to generate potential
beneficial projects for potential
investment
Two types of investment categories

Mutually Exclusive Set

Independent Project Set

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5.1 FORMULATING MUTUALLY

EXCLUSIVE
ALTERNATIVES
Mutually Exclusive set is where a
candidate set of alternatives exist
(more than one)
Objective: Pick one and only one
from the set.
Once selected, the remaining
alternatives are excluded.

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5.1 INDEPENDENT PROJECT SET

Given a set of alternatives (more
than one)
The objective is to:

Select the best possible combination of

projects from the set that will optimize
a given criteria.
Subjects to constraints
More difficult problem than the
mutually exclusive approach

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5.1 FORMULATING MUTUALLY

EXCLUSIVE
ALTERNATIVES
Mutually Exclusive alternatives
compete with each other
Independent alternatives may or
may not compete with each other
The independent project selection
problem deals with constraints and
may require a mathematical
programming or bundling technique
to evaluate.
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5.1 Type of Alternatives

Revenue/Cost the alternatives
consist of cash inflow and cash
outflows

Select the alternative with the

maximum economic value

Service the alternatives consist

mainly of cost elements

Select the alternative with the minimum

economic value (min. cost alternative)

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5.2 Present Worth Approach Equal-Lives

Simple Transform all of the
current and future estimated cash
flow back to a point in time (time t
= 0)
Have to have a discount rate before
the analysis in started
Result is in equivalent dollars now!

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5.2 THE PRESENT WORTH METHOD

P(i%) = P( + cash flows) + P( - cash

flows)
P(i%) = P(+) P(-).
If P(i%) > 0 then the project is deemed
acceptable.
If P(i%) < 0 the project is usually
rejected.
If P(i%) = 0 Present worth of costs =
Present worth of revenues
Indifferent!

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5.2 THE PRESENT WORTH METHOD

For P(i%) > 0, the following

holds true:
Acceptance or rejection of a
project is a function of the
timing and magnitude of the
project's cash flows, and the
choice of the discount rate.
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5.2 PRESENT WORTH: Special

Applications

Present Worth of Equal Lived

Alternatives
Alternatives with unequal lives:
Capitalized Cost Analysis

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5.2 PRESENT WORTH: Example

Consider: Machine A
Machine B
First Cost $2,500
$3,500
Annual Operating Cost
900
Salvage Value
200
350
Life 5 years 5 years

700

i = 10% per year

Which alternative should we select?
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5.2 PRESENT WORTH: Solving

PA = 2,500 + 900 (P|A, .10, 5)
200 (P|F, .10, 5)
= 2,500 + 900 (3.7908) - 200 (.6209)
= 2,500 + 3,411.72 - 124.18 = $5,788
PB = 3,500 + 700 (P|A, .10, 5)
350 (P|F, .10, 5)
= 3,500 + 2,653.56 - 217.31 = $5,936

SELECT MACHINE A: Lower PW cost!

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5.3 PRESENT WORTH: Different Lives

Comparison must be made over equal
time periods
Compare over the least common
multiple, LCM, for their lives
Remember if the lives of the
alternatives are not equal, one must
create or force a study period where
the life is the same for all of the
alternatives
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5.3 PRESENT WORTH: Example

Unequal lives
EXAMPLE
Machine A
Machine B
First Cost $11,000 $18,000
Annual Operating Cost
3,500
3,100
Salvage Value
1,000
2,000
Life 6 years 9 years
i = 15% per year
Note: Where costs dominate a problem it is customary to
assign a positive value to cost and negative to inflows

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5.3 Example: Unequal Lives Solving

LCM = 18 years
Calculate the present worth of a 6 year cycle
for A
PA = 11,000 + 3,500 (P|A, .15, 6)
1000 (P|F, .15, 6)
= 11,000 + 3,500 (3.7845) - 1000 (.4323)
= $23,813 which occurs at time 0, 6 and
12
PA= 23,813+23,813 (P|F, .15, 6)+
23,813 (P|F, .15, 12)=38,558

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5.3 9-Year Cycle for B

Calculate the Present Worth of a 9 year cycle
for B
PB = 18,000+3,100(P|A, .15, 9)
1,000(P|F, .15, 9)
= 18,000 + 3,100(4.7716) - 1,000(.2843)
= $32,508 which occurs at time 0 and 9
PB = 32,508 + 32,508 (P|F, .15, 9)
= 32,508 + 32,508(.2843) = $41,750
Choose Machine A
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5.3 Unequal Lives Assumed Study

Period
Assume a 5-yr. Study period
Estimate a salvage value for the 7
year project at the end of t = 5
Truncate the 7-yr project to 5 years
Alt-1: N = 5 yrs
Alt-2: N= 7 yrs

Now, evaluate
both over 5 years
using the PW
method!

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5.4 Applications of Future Worth

Projects that do not come on line
until the end of the investment
period

Commercial Buildings
Marine vessels
Power Generation Facilities
Public Works projects

Key long time periods involving

construction activities
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5.5 CAPITALIZED COST

CAPITALIZED COST- the present

worth of a project which lasts
forever.
Government Projects
Roads, Dams, Bridges, project that
possess perpetual life
Infinite analysis period
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5.5 Derivation for Capitalized Cost

Start with the closed form for the P/A
factor

(1 i ) N 1

P A
N
i
(1

i
)

Next, let N approach infinity and divide

the numerator and denominator by (1+i)N
Now, let n approach infinity and the right
hand side reduces to.

P A
i

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5.5 CAPITALIZED COST

Assume you are called on to
maintain a cemetery site forever if
the interest rate = 4% and $50/year
is required to maintain the site?

P0 = $50[1/0.04]
P0 = $50[25] = $1250.00

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5.5 CAPITALIZED COST: Endowments

Assume a wealth donor wants to endow a chair
in an engineering department.
The fund should supply the department with
$200,000 per year for a deserving faculty
member.
How much will the donor have to come up with
to fund this chair if the interest rate = 8%/yr.
P = $200,000/0.08 = $2,500,000
If $2,500,000 is invested at 8% then the
interest per year = $200,000

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5.5 Capitalized Cost Example

EXAMPLE
Calculate the Capitalized Cost of a
project which has an initial cost of
$150,000. The annual operating
cost is $8000 for the first 4 years
and $5000 thereafter. There is an
recurring $15000 maintenance cost
each 15 years. Interest is 15% per
year.
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Summary: Present Worth

Present Worth is the basic analysis
approach for most engineering economy
studies.
It also forms a basis for the Internal Rate
of Return method to be presented later
Requires knowledge of the discount rate
as part of the analysis
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