Lecture No.

5
Present Worth Analysis
1.Present Worth Analysis

The PW is always less than the actual cash flow for any interest rate greater than
zero because all P/F factors have a value <1, therefore, present worth values are
often referred to as discounted cash flows, DCF.
The interest rate is referred to as the discount rate.
Extensions of PW are also covered:
o Future worth
o Capitalized cost
o Payback period
o Life-cycle costing and
o Bond analysis

2. Mutually Exclusive Alternatives

Some projects are economically and technologically viable and others are not.
Once the viable projects are defined, it is possible to formulate alternatives.
Each project may be categorized as:
o Mutually exclusive. Only one of the projects can be selected, not both.
Each project is a stand-alone, viable alternative. These alternatives
compete with one another.
o Independent. More than one viable project may be selected by the
analysis. These alternatives do NOT compete with one another. The
comparison is between one project at a time and the do nothing
alternative. If there are m projects, zero, 1, 2 or more projects may be
selected yielding 2m mutually exclusive projects. If there are 3
independent alternatives, 23=8 possibilities exist: DN, A, B, C, AB, AC,
BC, ABC.
o DN, the do nothing alternative is usually understood to be an alternative
unless specifically excluded.
All the alternatives evaluated in one particular engineering economy study must
be of the same type.
o Revenue. Each alternative generates cost and revenue cash flow estimates
and possibly savings. Revenues are dependent upon which alternative is
selected.
o Service. Each alternative has only cash flow estimates. Revenues are NOT
dependent upon the alternative selected, so these cash flows are assumed
to be equal. Service evaluations may be legally mandated such as cutting
down sidewalk curbs for wheelchairs or safety considerations such as belts
and airbags.

Lecture No. 5 Present Worth Analysis Page No. 2

3. Present Worth Analysis of Equal Life Alternatives

In present worth analysis, the P value, now called PW, is calculated at the MARR,
minimum attractive rate of return, for each alternative.
The PW method is popular because future costs are transformed into equivalent
dollars now, which is straightforward. If both alternatives are used in identical
capacities for the same time period, they are termed equal-service alternatives.
A PW analysis requires a MARR for use as the i value in all PW relations.
Guidelines:
o One alternative. Calculate PW at the MARR. If PW0, the requested
MARR is met or exceeded and the alternative is financially viable.
o Two or more alternatives. Calculate the PW of each alternative at the
MARR. Select the alternative with the PW value that is numerically
largest, that is, less negative or more positive, indicating a PW of cost cash
flows or larger PW or net cash flows of receipts minus disbursements.
For one or more independent projects, select all projects with PW0 at the
MARR. This compares each project with the do nothing alternative.
Example p.5.1, p. 173.

Given: A civil engineering firm is considering 2 automobiles for company executives. The US model costs
$22,000, costs $2000 per year to operate and has a salvage value of 12 grand after 3 years. The Japanese
model is $26,000, cost $1200 per annum to operate and will be worth $15,000 after 3 years. Interest is 15%
per year.
Find: Which is the better deal?
PWus = -22,000 2000(P/A,15%,3) + 12,000(P/F,15%,3) =
PWus = -22,000 2000(2.2832) + 12,000(.6575)
PWus = $-18,676
PWjap = -26,000 1200(P/A,15%,3) + 15,000(P/F,15%,3) =
PWjap = -26,000 1200(2.2832) + 15,000(.6575)
PWjap = $-18,877
The US model is the better deal, lower cost.
Given: A chemical engineer is considering two styles of pipes for moving an alcoholic distillate from a
refinery to my wet bar. A small pipeline will be less to purchase but higher to operate, costing $1.7M and
$12,000/month to operate. The larger one costs $2.1M but only $9,000/month to operate. Interest is
1%/month. Assume a 10-year comparison period and a salvage value of 10%
Find: Which is the better deal?
PWsmall = -1,700,000-12,000(P/A,1%,120) + 170,000(P/F,1%,120)
PWsmall = -1,700,000-12,000(69.7005) + 170,000(.3030)
PWsmall = $-2,484,896
PWlarge= -2,100,000-9,000(P/A,1%,120) + 210,000(P/F,1%,120)
PWlarge = -2,100,000-9,000(69.7005) + 170,000(.3030)

Lecture No. 5 Present Worth Analysis Page No. 3

PWlarge = $-2,663,675
The small pipe size costs less and is therefore the better deal.

4. Present Worth Analysis of Different-Life Alternatives

For mutually exclusive alternatives, the PW of the alternatives must be

compared over the same number of years.
A fair comparison can be made when the PW represents costs with equal
service. Equal service can be satisfied by either of two approaches:
o Compare the alternatives over a period of time equal to the least
common multiple, LCM, of their lives.
o Compare the alternatives using a study period of length n years, which
does not necessarily take into consideration the useful lives of the
alternatives also known as the horizon planning approach.
o Each alternative is calculated at the MARR.
The assumptions of a PW analysis of different-life alternatives are as follows:
o The service provided by the alternatives will be needed for the LCM of
the years or more
o The selected alternative will be repeated over each life cycle of the
LCM in exactly the same manner.
o The cash flow estimates will be the same in every life cycle.
Example 5.2, p. 175

Given: A mechanical engineer is considering two systems at 16% per annum.

Type X
Type Y
First cost, $
-7,650
-12,900
Maintenance, $/yr
-1200
-900
Salvage, $
0
2000
Life, years
2
4
Find: Which is the better deal?
The LCM is 4 years.
PWx = -7,650-7,650(P/F, 16%,2)-1200(P/A,16%,4)
PWx = -7,650-7,650(.7432)-1200(2.7982)
PWx = $-16,693
PWy = -12,900-900(P/A, 16%,4)+2000(P/F,16%,4)
PWy = -12,900-900(2.7982)+2000(.5523)
PWy= $-14,314
Y is cheaper.
Given: An environmental engineer is considering 3 methods for getting rid of a chemical sludge at
15%/annum as follows:
Land Application
Incineration
Contract
First cost, $
-110,000
-800,000
0
Annual Cost, $/yr
-95,000
-60,000
-190,000
Salvage, $
15,000
250,000
0
Life, years
3
6
2
Find: Whats the best deal?

Lecture No. 5 Present Worth Analysis Page No. 4

The LCM is 6.
PWland = -110,000-110,000(P/F,15%,3)-95,000(P/A,15%,6)+15,000[(P/F,15%,3)+(P/F,15%,6)]
PWland = -110,000-110,000(.6575)-95,000(3.7845)+15,000[(.6575)+(.4323)]
PWland = $-525,506
PWincin = -800,000-60,000(P/A,15%,6)+250,000(P/F,15%,6)
PWincin = -800,000-60,000(.3.7845)+250,000(.4323)
PWincin = $-918,995
PWcontract = -190,000(P/A,15%,6) = -190,000(3.7845)
PWcontract = $-719,055

First cost, $
Annual Cost, $/yr
Salvage, $
Life, years
PW

Land Application
-110,000
-95,000
15,000
3
$-525,506

Incineration
-800,000
-60,000
250,000
6
$-918,000

Contract
0
-190,000
0
2
$-719,055

Select land application

5. Future Worth Analysis

The future worth, FW, may be determined directly by calculating the future worth
value or by multiplying the PW by F/P at the MARR. Therefore, FW is an
extension of PW analysis.
The n value in F/P depends upon which time period was used to determine PW:
the LCM value or a specified study period.
FW is useful when:
o Applicable to large capital investment decisions when a prime goal is to
maximize the future worth of stock.
o If the asset might be sold at some time after its start-up but before the
expected life is reached. FW value at an intermediate year estimates the
alternatives worth at the time of sale.
o Projects that will not come online until the end of the investment period
such as electrical generation, toll roads or hotels.
FW0 means the MARR is met or exceeded for one alternative. For two or more
mutually exclusive alternatives, select the one with the numerically largest FW
value.
Example 5.3, p.178

Given: The machines listed wrap candy. Interest is 20% per year.
Machine C
First cost, $
-40,000
Annual Cost, $/yr
-10000
Salvage, $
12000
Life, years
3
Find: Which machine should be selected on the basis of FW?

Machine D
-65,000
-12,000
25,000
6

Lecture No. 5 Present Worth Analysis Page No. 5

Calculate FWs over LCM of 6 years
FWc = -40,000(F/P,20%,6)-40,000(F/P,20%,3)-10,000(F/A,20%,6)+12,000(F/P,20%,3)+12,000
-40,000(2.9860)-40,000(1.7280)-10,000(9.9299)+12,000(1.7280)+12,000
FWc = $-255,123
FWd = -65,000(F/P,20%,6)-12,000(F/A,20%,6)+25,000
FWd = -65,000(2.9860)-12,000(9.9299)+25,000
FWd = $-288,294
Machine C is the better deal.
Given: Two mutually exclusive alternatives are considered at i=15% per year.
Q
R
First cost, $
-42,000
-80,000
Annual Cost, $/yr
-6000
-7,000 1 increasing by
$1000 per year
Salvage, $
0
4,000
Life, years
2
4
Find: The better deal.
FWq = -42,000(F/P,15%,4)-42,000(F/P,15%,2)-6000(F/A,15%,4)
FWq = -42,000(1.7490)-42,000(1.3225)-6000(4.9934)
FWq = $-158,963
FWr = [-80,000-7,000(P/A,15%,4)-1000(P/G,15%,4)+4000(P/F,15%,4)](F/P,15%,4)
FWr = [-80,000-7,000(2.8550)-1000(3.7864)+4000(.5718)](1.7490)
FWr = $-177,496
Project Q is less expensive.

6. Capitalized Cost Calculation and Analysis, CC

CC, capitalized cost, is the PW of an alternative that lasts forever and

includes bridges, dams as well as permanent endowments.
CC is calculated from P = A(P/A,i,n) where n = .
CC =
If the A value is an annual worth, AW, determined through equivalence
calculations of cash flows over n years, the CC value is:
CC =
If $100,000 is invested at 15% per year, $15,000 is available each year, forever,
leaving the original $100,000 in tact. The amount A of new money generated each
consecutive interest period for an infinite number of periods is
A = Pi = CC(i)
Cash flows may be recurring: $10,000/year, $25,000 every 8 years or nonrecurring: one time payment in 2 years for $1M.
Procedure for infinite CC:
1. Draw a cash flow diagram
2. Find the PW, which is the CC value of all non-recurring amounts.

Lecture No. 5 Present Worth Analysis Page No. 6

3. Find the equivalent uniform annual, A, through one life cycle of all
recurring amounts. Add this to all other uniform amounts in years 1
through infinity. The result is a total AW.
4. Divide the AW by i to obtain CC.
5. Add the CC values in steps 2 and 4 for a total.
For the comparison of two or more alternatives, the alternative with the smaller
capitalized cost will represent the more economical one.
As in PW, it is only the difference in cash flow between the alternatives that must
be considered for comparative purposes. Whenever possible, the calculations
should be simplified by eliminating the elements of cash flow which are common
to both alternatives.
To determine capitalized cost for an alternative with a finite life, calculate the
equivalent A value for one life cycle and divide by the interest rate.
Examples 5.4, 5.5 and 5.6 p. 180.

Given: An alternative has a first cost of $32,000, an annual maintenance cost of $6000, a salvage value of
$8000 after its 4-year life and interest is 14% per year.
Find: What is the capitalized cost?
Find AW through one life cycle, then divide by i.
AW = -32,000(A/P,14%,4)-6000+8000(A/F,14%,4)
AW = -32,000(.34320)-6000+8000(.20320)
AW = $-15,356.80
CC = Pwcap=$-15,356.80/.14
CC = $-109,691
Given: An investment of $10,000/year for 100 years and an investment of $10,000/year forever at an
interest rate of 10% per year.
Find: Whats the difference.
PW100 = 10,000(P/A,10%,100) = 10,000(9.9993)
PW100 = $99,993
CC = Pwcap/i = 10,000/.01
CC = $100,000
Difference = $100,000-$99,993
Difference = $7
Given: Interest at 10%
Machine V
First cost, $
-50,000
Annual Cost, $/yr
-30,000
Salvage, $
10,000
Life, years
10
Find: Compare the alternatives on the basis of CC.
First find AW for V and divide by i.
AWv = -50,000(A/P,10%10)-30,000+10,000(A/F,10%,10)
AWv = -50,000(.16275)-30,000+10,000(.06275)
AWv = $-37,510
CCv = -37,510/.10

Machine W
-500,000
-1,000
500,000

Lecture No. 5 Present Worth Analysis Page No. 7

CCv = $-375,100
For alternative W, CC of the salvage is zero, since n=.
CCw = -500,000-1000/.10
CCw = $510,000
Alternative V is better.
Given:A stockbroker claims she can consistently earn 15% per year. If she invests $10,000 now, $30,000
three years from now and $8000 per year for 5 years starting 4 years from now.
Find: How much money can the client withdraw every year forever beginning 12 years from now.
Disregard taxes.
Determine the future principal amount F11 accumulated in year 11.
F11 = 10,000(F/P,15%,11)+30,000(F/P,15%,8)+8000(F/A,15%,5)(F/P,15%,3)
F11 = 10,000(4.6524)+30,000(3.0590)+8000(6.7424)(1.5209)
F11 = $220,330
Re-label F11 to P relative the perpetual withdrawal series, then multiply by i.
A = Pi = 220,3330(.15)
A = $33,050 per year forever

7. Payback Period Analysis

Payback analysis, also payout analysis, is another extension of the PW method.

Payback can take two forms:i>0% and i=0%
The payback period np is the estimated time it will take for the estimated revenues
to recover the initial investment. This method is very commonly used by upper
level executives because it so easy to understand e.g. CEO: How long to make
our money back? Flunkie: 2 years. If another project is 1 yr or 5 yr to recover
funds, the comparison is obvious. Ironically, payback period analysis should NOT
be used as a primary analysis method.
The np should never be used as the primary measure of worth to select an
alternative. Rather is should be determined in order to provide initial screening in
conjunction with an analysis performed using PW or another method.
To find the discounted payback period at a stated rate i>0%, calculate the years np
that make the following expression correct.
0 = -P + NCFt(P/F,i,t)
P is the initial investment, NCF is the estimated net cash flow for each year t.
NCF = receipts disbursements. If NCF are equal each year, P/A may be used yielding:
0 = -P + NCF(P/A,i,np)
After np years, the cash flows will recover the investment and a return of i%.
It is very important to realize that in payback analysis all net flows occurring after
np years are neglected, unlike other analyzes. This np assumption may be quite
unfair which is why this method should only be used as a screening or
supplemental technique.
No return or simple payback determines np at i=0%. For i=0%, the preceding
equations become:
0 = -P + NCFt and np =
It is incorrect to use the no-return payback period to make final selections
because:
o It neglects any required return since the time value of money is omitted.

Lecture No. 5 Present Worth Analysis Page No. 8

o It neglects all net cash flows after time np including positive cash flows
that may contribute to the return of the investment.
Examples 5.7, 5.8 p. 187

Given: Two machines produce titanium parts.

Semiautomatic
First cost, $
-40,000
Net Annual Income, $/yr
-10000
Maximum life, years
10
Salvage value at end of
20,000
life, years

Automatic
-90,000
-15,000
20
30,000

Find: Which alternatives should be retained. Alternatives must have a payback of 5 years, i=0% and i=10%
A.0%
Semiautomatic
n=40,000/10,000
n=4 years
Automatic
n=90,000/15,000
n=6years
Retain Semiautomatic
B.10%
Semiautomatic
0=-40,000+10,000(P/A,10%,n)
(P/A,10%,n)=4.0
From 10% table
Np = 5.4 years
Automatic
0 = -90,000+ 15,000(P/A,10%,n)
(P/A,10%,n) = 6.0
From 10% table
Np = 9.6 years
Neither alternative
Given: An ANCO imaging system costs $10,000 with a salvage value of $900 after 5 years. The system is
expected to save $1700/year.
Find: The payback time at 8% per annum. The manager wants a payback time of 6 years or less should
they go for it.
Set up a PW relationship, then us T&E or a spreadsheet for np.
0 = -10,000 + 1700(P/A,8%,n) + 900(P/F,8%,5)
np = 7.7 years
Do NOT purchase.

8. Life-Cycle Costs, LCC

LCC is another PW analysis in which the PW at a stated MARR is used to

evaluate one or more alternatives. The LCC method is commonly applied to
alternatives with cost estimates over the entire system life span.
Typical applications of LCC are new product lines such as an automobile, defense
systems or an airplane.
LCC is most effectively applied when a substantial percentage of the total costs
over the system life span relative to the initial investment will be operating and

Lecture No. 5 Present Worth Analysis Page No. 9

maintenance costs i.e. post-purchase costs such as labor, energy, upkeep and
materials.
LCC is required for most defense and aerospace industries where LCC is called
Design to Cost. LCC is usually not applied to public sector projects.
LCC may be divided into acquisition and operations:
o Acquisition: Definition of requirements, preliminary design, detailed
design.
o Operations: Construction, Usage, Phase out.
o

Given: A medium sized town plans to develop software that they will use for project selection for the next
10 years.
Find: Use life cycle analysis to identify the best alternative at 10% per year.
Alternative
Cost Component
Cost
A
Development
$100,000 now,
$150,000 year 1
Programming
$45,000 now, $35,000
year 1
Operation
$50,000/year, 1-10
Support
$30,000/year, 1-10
B
Development
10,000 now
Programming $45,000 year 0, $30,000
year 1
Operation
$80,000, 1-10
Support
$40,000, 1-10
C
Operation
$150,000, 1-10
PWA = -145,000-185,000(P/F,10%,1)-80,000(P/A,10%,10)
PWA = -145,000-185,000(.9091)-80,000(6.1446)
PWA = $-810,752
PWB = -55,000-30,000(P/F,10%,1)-120,000(P/A,10%,10)
PWB = -55,000-30,000(.9091)-120,000(6.1446)
PWB = $-819,625
PWC = -150,000(P/A,10%,10)
PWC = $-921,690
Alternative A

9. Present Worth of Bonds

A bond is a long-term note, an IOU, issued by a corporation or government who

then becomes the borrower.
The borrower receives money NOW in return for a promise to pay the face value
V of the bond on a stated maturity date. Face values are usually $100, $1000,
$5000 or $10,000.
Bond interest, i, also called bond dividend, is paid periodically between the time
the money is borrowed and the time the face value is repaid. The bond interest is
paid c times per year usually quarterly or semi-annually. The amount of interest is
determined using the stated interest rate, called the bond coupon rate, b.
i==

Lecture No. 5 Present Worth Analysis Page No. 10

Bonds are classified in T5-1 p.194.

Treasury bonds are considered very safe and therefore the rate of return is
correspondingly smaller than riskier ventures.
Debenture bonds are issued by corporations but are not backed by any particular
form of collateral.
The PW value of a bond is another extension of PW analysis. The amount paid at
purchase time establishes the rate of return for the remainder of the bond life. The
steps to calculate the PW of bond are as follows:
o Determine i
o Construct diagram
o Establish MARR
o Calculate the PW of the bond interest payments and the face value at
i=MARR
PWbond purchase price; MARR is met or exceeded, buy the
bond
PW<bond purchase rice; MARR is not met, no not buy the bond
Example 5.11, p.196

Given: A $50,000 bond that has quarterly interest payments of $1500 and a 20 year maturity rate.
Find: What is the bond interest rate?
i==
1500 = 50,000b/4
B=12% per year, payable quarterly
Given: A retiring engineer plans to buy a $50,000 bond that has an interest rate of 14% per year payable
semi-annually and maturity date 20 years from now. The rate now is 14%/per year compounded
semiannually.
Find: How much should he be able to sell the bond for in 15 if the market rate then is 8% compounded
semiannually. Secondly, if he did sell the bond after 15 years and if he earned a return of 10% per year,
compounded semiannually, on all his bond interest receipts, how much money would he have immediately
after he sold the bond.
The cost of the bond now is $50,000 because the bond interest rate and market interest rate are the same. In
15 years, there are 5 years of interest left, so sales price will be the PW then PW15.
i = 50,000(.14)/2
i = 3500 every 6 months
PW15 = 3500(P/A,4%,10)+ 50,000(P/F,4%,10)
PW15 = 3500(8.1109)+ 50,000(.6756)
PW15 = $62,168
F is the amount earned from bond interest payments+amount received from the sale of bond in part a.
F = 3500((F/A,5%,30)+62,168
F = $294,704