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GENG 360:
Engineering
Economics
Chapter 5. Present Worth
(PW) Analysis
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Contents
Formulating Alternatives
PW of Equal-Life Alternatives
PW of Different-Life alternatives
Future Worth Analysis
Capitalized Cost Analysis
Payback Period
Life-Cycle Costs
PW of Bonds
Spreadsheet Applications
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5.1. Formulating Mutually Exclusive
Alternatives
Firms have the capability to generate
potential projects for investment
Two types of investment categories
Mutually Exclusive Set
Independent Project Set
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Mutually Exclusive set
It is a set 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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Independent Project Set
Given a set of alternatives (more than one)
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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Mutually Exclusive Vs.
Independent 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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Type of Alternatives
(Revenue based or service-based)
Cash Flows determine whether the alternatives
are revenue based or service based.
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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Probl em
Do
Nothi ng
Al t.
1
Al t.
2
Al t.
m
Anal ysi s
Sel ecti on
Executi on
Selection depends upon data, life, discount rate, and assumptions made.
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5.2 Present Worth Approach with Equal-Lives
Simple: Transform all of the current and future
estimated cash flow back to a point in time (time t = 0)
Result is in equivalent dollars now!
P(i %) = P(+cash fl ows) +P(-cash fl ows)
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If P(%) is:
> 0 then the project is deemed acceptable.
< 0 the project is usually rejected
= 0 (Present worth of costs = Present
worth of revenues) Indifferent!
If P(%) = 0 that means
the project earned exactly
the discount rate that was
used to discount the cash
flows!
The interest rate that causes
a cash flows NPV to equal 0
is called the Rate of Return
of the cash flow!
The net present worth is purely a function of the
MARR (the discount rate one uses).
If one changes the discount rate, a different NPV will
result.
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For P(i%) > 0, the following holds true:
A positive present worth is a dollar amount
of " profit" over the minimum amount
required by the investors (owners).
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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PRESENT WORTH: Special Applications
Present Worth of Equal Lived Alternatives
Alternatives with unequal lives: Beware
Capitalized Cost Analysis
Both Calculations Require knowledge of the discount rate before
we conduct the analysis
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Present Worth of Equal Lived
Alternatives
Straightforward: Compute the PW of each
alternative and select the best,
i.e., smallest if cost and largest if profit
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Example:
Consider: Machine A Machine B
First Cost $2,500 $3,500
Annual Operating Cost 900 700
Salvage Value 200 350
Life 5 years 5 years
i =10% per year
Whi ch al ternati ve shoul d we sel ect?
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Solution:
Cash Flow Diagrams:
0 1 2 3 4 5
$2,500
A = $900
F
5
=$200
M
A
0 1 2 3 4 5
$3,500
F
5
=$350
A = $700
M
B
P
A
= 2,500 + 900 (P|A, 0.10, 5) 200 (P|F,0.10, 5)
= 2,500 + 900 (3.7908) - 200 (0.6209)
= 2,500 + 3,411.72 - 124.18 = $5,788
P
B
= 3,500 + 700 (P|A, 0.10, 5) 350 (P|F,0.10, 5)
= 3,500 + 2,653.56 - 217.31 = $5,936
Whi ch al ternati ve
shoul d we sel ect?
SELECT
MACHINE A:
Lower PW cost!
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Present Worth of Alternatives
with Different Lives
BASIC RULE: In an analysis one cannot effectively
compare the PW of one alternative with a study period
different from another alternative that does not have the
same study period.
Comparison must be made over equal time periods
Compare over the Least Common Multiple (LCM) for their lives
Example: You have different projects over {3,4, and 6}years
The LCM life is 12 years (6x2) Evaluate all over 12 years for a
PW analysis.
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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 domi nate a probl em i t i s customary to assi gn a
posi ti ve val ue to cost and negati ve to i nfl ows
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LCM(6,9) = 18 year study peri od wi l l appl y for present worth
A common
mistake is
to compute
the present
worth of
the 6-year
project and
compare it
to the
present
worth of
the 9-year
project.
i = 15% per year
0 1 2 3 4 5 6
$11,000
F
6
=$1,000
A
1-6
=$3,500
Machi ne A
0 1 2 3 4 5 6 7 8 9
F
6
=$2,000
A
1-9
=$3,100
$18,000
Machi ne B
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i = 15% per year
Machi ne A
LCM(6,9) = 18 year study peri od wi l l appl y for present worth
Cycl e 1 for A Cycl e 2 for A Cycl e 3 for A
6 years 6 years 6 years
Cycl e 1 for B Cycl e 2 for B
18 years
9 years 9 years
Machi ne B
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First, Calculate the PW of Machine A:
Machi ne A
Cycl e 1 for A Cycl e 2 for A Cycl e 3 for A
6 years 6 years 6 years
P
A6
= 11,000 + 3,500 (P|A, .15, 6) 1,000 (P|F, .15, 6)
= 11,000 + 3,500 (3.7845) 1,000 (.4323)
= $23,813, which occurs at time 0, 6 and 12
0 1 2 3 4 5 6
$11,000
F
6
=$1,000
A
1-6
=$3,500
Machi ne A
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0 6 12 18
$23,813 $23,813 $23,813
Machi ne A
P
A18
=23,813 +23,813 (P|F, 0.15, 6) +23,813 (P|F, 0.15, 12)
=23,813 +10,294 +4,451 =$38,558
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Calculate the Present Worth of a 9-year cycle for B
0 1 2 3 4 5 6 7 8 9
F
6
=$2,000
A
1-9
=$3,100
$18,000
P
B9
= 18,000+3,100(P|A, .15, 9) 2,000(P|F, .15, 9)
= 18,000 + 3,100(4.7716) - 2,000(.2843)
= $32, 223 which occurs at time 0 and 9
0 9 18
$32,508 $32,508
P
B18
= 32,508 + 32,508 (P|F, .15, 9)
= 32,508 + 32,508(.2843) = $41,750
Choose Machine A because it costs less
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11000
18 years
Alternative (A) cash flow:
3500 3500 3500
11000 11000
1000 1000 1000
Alternative (B) cash flow:
18000
3100 3100
18000
2000 2000
18 years
PW
A
= - 11,000 3,500 (P/A, 15%, 18) 10,000 (P/F, 15%, 6)
-10,000 (P/F, 15%, 12) + 1,000 (P/F, 15%, 18)= - 38,559
PW
B
= - 18,000 3,100 (P/A, 15%, 18) 16,000 (P/F, 15%, 9)
+ 2,000 (P/F, 15%, 18) = -41,384
We Select (A)
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5.4. FUTURE WORTH APPROACH
Compound all cash flows forward in time to some
specified time period using (F/P), (F/A), factors or,
Given P, the F =P(1+i)
N
Applications of FW Analysis:
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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FW Exercise
See Example 5.3
Calculate the Future Worth of determining
the selling price in order to earn exactly
25% on the investment
Draw the cash-flow diagram!!
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5.5 Capitalized Cost
Capitalized Cost: the PW of a project that lasts
forever, such as:
Government Projects
Roads, Dams, Bridges (projects that possess
perpetual life)
Infinite analysis period
Perpetual Investments: Investments that last
for such a long time (n ~)
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Derivation for Capitalized Cost:
Start with the closed form for the P/A factor:
Next, let N approach infinity and divide the
numerator and denominator by (1+i)
N
(1 ) 1
(1 )
N
N
i
P A
i i
( +
=
(
+

1
1
(1 )
N
i
P A
i
(

(
+
= (
(
(

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Now, let n approach infinity and the right hand side
reduces to.
(

= =

i
A P
n
1
Cost d Capitalize
Or,
CC(i%) = A/i
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Example:
Calculate the Capitalized Cost of a project
that has an initial cost of $150,000. The
annual operating cost is $8,000 for the
first 4 years and $4,000 thereafter. There
is an recurring $15,000 maintenance
cost each 15 years. Interest is 15% per
year.
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Cash Flow Diagram:
$4,000
0 1 2 3 4 5 6 7 15 30
$150,000
$8,000
$15,000 $15,000 $15,000 $15,000
How much $$ at t = 0
is required to fund
this project?
The capi tal i zed cost i s the
total amount of $ at t = 0,
when i nvested at the
i nterest rate, wi l l provi de
annual i nterest that covers
the future needs of the
project.
i =15%/ YR
Solution:
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1. Consider $4,000 of the $8,000 cost for the
first four years to be a one-time cost, leaving
a $4,000 annual operating cost forever:
P
0
= 150,000 + 4,000 (P|A, .15, 4) = $161,420
Recurring annual cost is $4,000 plus the
equivalent annual of the 15,000 end-of-cycle
cost.
.
0 15 30 45 60 ..
Take any 15-year period and find the equivalent
annuity for that period using the F/A factor.
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Take any 15-year period and find the equivalent
annuity for that period using the F/A factor
$15,000
A for a 15-year peri od
0 15 30 45 60 ..
.
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2. Recurring annual cost is $4,000 plus
the equivalent annual of the 15,000 end-
of-cycle cost.
A= 4,000 + 15,000 (A|F, .15, 15)
= 4,000 + 15000 (.0210) = $4,315/yr
Recurring costs = $4,315/i = 4,315/0.15
=$28,767
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Capitalized Cost = 161,420 + 4315/.15
= $190,187
Thus, if one invests $190,187 at time t = 0,
then the interest at 15% will supply the end-
of-year cash flow to fund the project so long
as the principal sum is not reduced or the
interest rate changes (drops).
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Example:
Find the capitalized cost for the following project (use i =15%).
Time $
Initial Cost At end of year 0 150,000
Additional Cost At end of year 10 50,000
Annual Cost From end of year 1 to end of year 4 5000
Annual Cost From end of year 5 to 8000
Operation Cost End of every13 years 15000
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Solution:
| |
( ) ( )
( )
8 15 ( / ,15%,13)
150 50 ( / ,15%,10) 5 8 ( / ,15%,4)
0.15 0.15
15 0.02911 8
150 50 0.1229 3 5.8474
0.15 0.15
$194.847K
K K A F
P K K P F K K P A
K K
K K K
= + + + +
= + + +
=
5000
150000
8000
50000
15000 15000 15000

0 1
4
5 10 13 26 39
| |( )
( ) ( )
13 years
8 15
150 50 ( / ,15%,10) 5 8 / ,15%,4
0.15
8 15
150 50 0.1229 3 5.8474
0.15 5.1528
$194.847K
K K
P K K P F K K P A
K K
K
i
K K
= + + + +
= + + +
=
OR:
i
13 years
=(1+0.15)
13
1 =5.1528
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Example:
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Which one do you choose?
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Incremental Analysis:
The value of the present worth can be
calculated by using either incremental
method or individual method.
Both methods should lead to the same
answer.
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Example:
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Solution (Individual Analysis):
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Alternative Solution (Incremental
Analysis):
Caution: This
analysis can only be
carried out if the
lifetimes are equal
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5.6 Payback Period Analysis
Payback period is the period of time it
takes for the cash flows to recover the
initial investment.
Two forms for this method
Discounted Payback Period (uses an interest
rate)
Conventional Payback Period (does not use
an interest rate)
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Payback period is only a rough estimator of desirability
Use it as an initial screening method
Avoid using this method as a primary analysis technique
for selection projects
Totally avoid the no-return payback period
The No-return method (example follows):
Does not employ the time value of money
Disregards all cash flows past the payback time period
If used, can lead to conflicting selections when compared to
more technically correct methods like present worth!
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Discounted Payback Approach:
Find the value of n
p
such that:
1
0 ( / , , )
p
t n
t
t
P NCF P F i t
=
=
= +

NCF
t
= Net Cash
Flow at time t
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Example 5.8 (Discounted Analysis)
Machi ne A: N=7
i = 15%
Payback
i s
between
6 and 7
yeas
(6.57
yrs)
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Non-Discounted Analysis
At a 0
i nterest rate
the PB ti me
i s seen to
equal 4
years!
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Machine B (Discounted):
Machi ne B: N=14
i = 15%
Payback for B i s
between 9 and
10 years!
Longer ti me
peri od to
recover the
i nvestment.
9.52 years
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Machine B (Undiscounted):
Payback for B at
0% i s 6 years!
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Example Summary
Discounted
Machine A: 6.57 years
Machine B: 9.52 years
Undiscounted
Machine A: 4.0 years
Machine B: 6.0 years
Go with Machine A lower time period payback
to recover the original investment
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5.8 Present Worth of Bonds
Bonds represent a source of funds for the
firm.
Bonds are sold (floated) by investment
banks for firms in order to raise additional
debt capital
A bond is similar to an IOU
Bonds are evidence of Debt
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Bond Types:
Treasury bonds
Issued by Federal Government
Full backing of the Government
Conservative-type investment
State and Municipal Bonds
Issued by states and local governments
Generally tax-exempt by the Federal Government
Used to finance state and local projects
Backed by future tax and user fees to pay the interest
and face value
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Mortgage Bonds
Issued by Corporations
Secured by the firms assets
Money received by the firm is used to fund projects
Referred to a Debt Capital
Buyers of these bonds are not owners they are lenders to the
firm
Debenture Bond
Issued by Corporations
Not backed by specific assets
Backing good faith of the firm
Pays higher interest rates
Higher risks involved
Bond interest rate may float
Could be convertible to common stock
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PW of Bonds - Overview
The Fi rm
Investment Bankers
Proceeds from
The sal e
Sel l the Bonds to
The l endi ng publ i c
Bondhol ders
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Basics of Bonds:
The bond itself is just a piece of paper
Bonds are negotiable instruments
Can be traded by the current bondholder
Source of funds to the firm (Debt capital)
Bondholders are loaning $$ to the firm, they Earn periodic
interest
They can sell the bonds at any time
The bondholders are lenders not owners
The firm pays periodic interest payments to the current
bond holders
At the end of the bonds life, the bonds are redeemed
(bought back) from the current bond holder
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Bonds Notations:
P
0
: The time (t =0) selling price of the bond the cost to
the buyer of the bond
V: The face value of the bond
The value printed on the bond
Face values are usually: $100, $1,000, $5,000, $10,000 increments
N: The life of the bond in years (Defining the Maturity Date)
r: The nominal annual bond interest rate
Given the nominal annual bond interest rate, the payment
frequency of the interest (monthly, quarterly semi-annually, etc.) is
also stated
(Facevalue)(Bondinerestrate)
Numberof paymentperiodperyear
I = I : Amount of interest
paid per period
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Example:
Calculate the Bond Semiannual interest if:
V =$5,000 (face value)
r =4.5% per year paid semiannually
N =10 years
Solution:
0.045
$5,000( ) $5,000(0.0225)
2
$112.50 every 6 months
I
I
= =
=
The bondhol der,
buys the bond
and wi l l recei ve
$112.50 every 6
months for the
l i fe of the bond
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Example 5.11
Given
V =$5,000 (Face value of the bond)
r =4.5% paid semiannually
N =10 years or 20 interest periods
$I per 6 months =$5,000(0.045/2) =$112.50 paid to
the current bondholder
The buyer will consider buying this bond if he can
earn a nominal rate of return of 8%/yr c.q.
(compounded quarterly)
Calculate the acceptable purchase price
Bonds are bought and sol d i n a bond market. Thus the pri ce
of the bond i s subject to the pressures of the bond market.
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Solution:
What is fixed?
The future interest payments are fixed
The future face value of the bond is fixed
What can vary?
The purchase price such that the buyer can earn at least the 8%/yr c.q.
8% c.q is the same as
0.08/4 =0.02 =2% per quarter.
Bond interest flows every 6 months
Need an effective 6-month rate
The effective 6-month rate is then
(1.02)
2
1 =0.0404 =4.04%/6 months
This is the potential buyers required interest rate
The objective is to determine the purchase price of this bond
discounted at the buyers required rate of 4.04% per 6 months
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Draw the cash-flow diagram
Work the problem with N =20 (not 10):
We have 20 interest payments (every 6 months for 10 years)
A = 112.50/ 6 months
0 1 2 3 4 . .. 19 20
P=??
$5,000
i =4.04%/ 6 months
Fi nd the PW(4.04%) of the future cash
fl ows to the potenti al bond buyer
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P =$112.50(P/A,4.04%,20)+
$5,000(P/F,4.04%,20)
=$3,788
IF the buyer can buy this bond for $3,788 or
less, he/she will earn at least the 8% c.q. rate.
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Example:
A 15-year bond with a face value of
$10,000 is offered for sale.
The rate of interest on the bond is 6%,
paid semi-annually.
Assume that MARR = 8% nominal
compounded semi-annually,
what would be the selling price of the
bond?
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Solution:
( )( ) (10000)(0.06)
$300
2
Facevalue Bondinerest rate
I
Number of payment period per year
= = =
I =$300
Priceof bond =?
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Facevalue=$ 10,000
P =300(P/A, 4%, 30) +10,000(P/F, 4%, 30) =$8,270.6