Present Worth Analysis Basics

Economic evaluation of an alternative requires cash flow

estimates over a stated time period and a criterion for selecting
the best alternative
The alternatives are developed from project proposals to
accomplish a stated purpose
Some projects can be economically or technologically viable,
some are not
After the viable projects stand out among the others, these are the
alternatives to evaluate
In formulating alternatives;
1 Mutually Exclusive: Only one of the viable projects can be selected
2 Independent: More than one viable project may be selected

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 1 / 29

 Present Worth Analysis Basics

do-nothing (DN) option can be another alternative; no new costs

or revenues.
Mutually exclusive alternatives compete with each other, best
alternative is selected
Independent projects compete with the do-nothing alternative
instead of another project
If there are m independent projects; one, two or more of them can
be selected. (2m selections!)
Let we have m = 3, and three independent alternatives are
{A, B, C}
Then we have 23 = 8 possible selections:
{DN, A, B, C, AB, AC, BC, ABC}
Assumption: No budget limit!

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 2 / 29

 Present Worth Analysis Basics

It is important to recognize the nature or type of alternatives

before starting evaluation
Cash flows determine whether the alternatives are revenue-based
or service-based
1 Revenue-Based: Each alternative generates cost and revenue cash
flow estimates and possibly savings
2 Service-Based: Each alternative has only cost cash flow estimates
Revenues or savings are not dependent on alternatives
Revenues or savings are assumed to be equal among alternatives
Mostly public (government) initiatives
Evaluation on based on cost estimates
All alternatives evaluated in an engineering economy study must
be of the same type

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 3 / 29

 Present Worth Analysis Basics

Basic procedure for applying the Present Worth (PW) criterion:

1 Determine the interest rate (i) that the firm wishes to earn on its
investments. i = MARR is usually given to us.
2 Estimate the service life (n) of the project
3 Estimate the cash inflow for each period over the service life
4 Estimate the cash outflow for each period over the service life
5 Determine the net cash flows (An ) for each period (net cash flow =
cash inflow - cash outflow)
6 Find the present worth of each net cash flow at MARR. Add up
these present-worth figures; their sum is defined as the projects
PW :
A0 A1 AN
PW (i) = 0
+ 1
+ ··· +
(1 + i) (1 + i) (1 + i)N
N N
X An X
= = An (P/F , i, n)
(1 + i)n
n=0 n=0

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 4 / 29

 Present Worth Analysis Equal-life Alternatives

P value or now called Present Worth PW is calculated using

MARR for each alternative.
When the alternatives have equal lives, while carrying out the PW
analysis for MUTUALLY EXCLUSIVE ALTERNATIVES:
1 One Alternative: Calculate PW at MARR. If PW ≥ 0, the requested
MARR is met or exceeded and the alternative is financially viable.
2 Two or more Alternatives: Calculate PW of each alternative at
MARR. Select the alternative with the PW value that is numerically
largest. (not absolute value)
$ 110
F=P(1+i) i = 10%

PW = - 100 + 110/1.1 = 0
0
Let MARR=20%
1
PW = - 100 + 110/1.2 = - 8.33
This investment's return rate is < 20%
$ 100

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 5 / 29

 Present Worth Analysis Equal-life Alternatives

PW analysis is popular because future costs and revenue

estimates are all transformed into equivalent dollars now; all future
cash flows are converted into present dollars
Makes easier to determine the economic advantage of one
alternative over another
INFLOWS

OUTFLOWS

0 1

2 3 4 5

PW(MARR) inflow PW(MARR) > 0

Then ACCEPT !
0

PW(MARR) outflow

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 6 / 29

 Present Worth Analysis Equal-life Alternatives

Example
PW1 PW2 Selected One
$-1500 $-500 2
-500 1000 2
2500 -500 1
2500 1500 1

If the projects are INDEPENDENT (and revenue projects), the

selection guideline is as follows:
1 For one or more independent projects, select all projects with
PW ≥ 0 at the MARR
Example
PW1 PW2 Selected One
$-1500 $-500 DN
-500 1000 2
2500 -500 1
2500 1500 1,2
Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 7 / 29
 Present Worth Analysis Equal-life Alternatives

Example
Perform a present worth analysis of equal-service machines with the
costs shown below, if the MARR is 10% per year. Revenues for all
three alternatives are expected to be the same.
Electric- Gas- Solar-
Powered Powered Powered
First cost,$ $-2500 $-3500 -6000
Annual Operating cost, $ -900 -700 -50
Salvage value, $ 200 350 100
Life, years 5 5 5

Service alternatives
Salvage value considered as a negative cost, so + sign used
PW of each alternative is calculated at i = 10%, for n = 5 years.

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 8 / 29

 Present Worth Analysis Equal-life Alternatives

Example
Electric- Gas- Solar-
Powered Powered Powered
First cost,$ $-2500 $-3500 -6000
Annual Operating cost, $ -900 -700 -50
Salvage value, $ 200 350 100
Life, years 5 5 5

PWE = −2500 − 900(P/A, 10%, 5) + 200(P/F , 10%, 5)

= −2500 − 900(3, 7908) + 200(0.6209) = $ − 5787.54
PWG = −3500 − 700(P/A, 10%, 5) + 350(P/F , 10%, 5)
= −3500 − 700(3, 7908) + 350(0.6209) = $ − 5936.245
PWS = −6000 − 50(P/A, 10%, 5) + 100(P/F , 10%, 5)
= −6000 − 50(3, 7908) + 100(0.6209) = $ − 6127.45

Select Electric-powered machine with PWE = $ − 5787.54

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 9 / 29
 Present Worth Analysis Different-Life Alternatives

When the present worth method is used to compare mutually exclusive

alternatives that have different lives, the procedure is same as before
except:
PW of alternatives must be compared over the same number of
years and end at the same time
A fair comparison can be made only when PW values represent
costs (and receipts) associated with equal service
The equal-service requirement can be satisfied by either of two
approaches:
1 Compare the alternatives over a period of time equal to least
common multiple (LCM) of their lives
2 Compare the alternatives using a study period of length of n years,
which does not necessarily take into consideration the useful lives
of the alternatives. (Planning horizon approach)

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 10 / 29

 Present Worth Analysis Different-Life Alternatives

In either case, MARR is used to calculate the PW of each

alternative
The LCM approach makes the cash flows for all alternatives
extend to the same time period
The LCM approach requires some assumptions to be made about
subsequent life cycles of the alternatives:
1 The service provided by alternatives will be needed for the LCM of
years or more
2 The selected alternative will be repeated over each life cycle of the
LCM in exactly the same manner
3 The cash flow estimates will be the same in every life cycle
The LCM requires that the estimated salvage values be included
in each life cycle

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 11 / 29

 Present Worth Analysis Different-Life Alternatives

For the study period approach, a time horizon is chosen over

which the economic analysis is conducted
Only the cash flows during this time period is considered relevant
to the analysis
All cash flows occurring beyond the study period are ignored
An estimated market value at the end of the study period must be
made.
Study period approach is often used in replacement analysis
The time horizon chosen may be relatively short
Also useful when LCM of alternatives yields unrealistically long
time horizons

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 12 / 29

 Present Worth Analysis Different-Life Alternatives

In Class Work 6
Eric Forman, a project engineer is assigned to start up a new office in
Wisconsin. Two lease options are available:
Location A Location B
First cost, $ $-15,000 $-18,000
Annual lease cost, $ per year -3,500 -3,100
Deposit return, $ 1,000 2,000
Lease term, years 6 9
a) Determine which lease option should be selected on the basis of a
present worth comparison if MARR is 10% per year.
b) If a study period of 5 years is used and the deposit returns are not
expected to change, which location should be selected
c) Which location should be selected if a 6-year study period and a
deposit return of $6,000 after 6 years at location B is used.

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 13 / 29

 Present Worth Analysis Different-Life Alternatives

a)
PW A=?
$1000 $1000 $1000

0 1 2 6 12 18

$3500

$15,000 $15,000 $15,000

PW B=?
$2000 $2000

0 1 2 9 18

$3100

$18,000 $18,000

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 14 / 29

 Present Worth Analysis Different-Life Alternatives

PWA = −15, 000 − 3, 500(P/A, 10%, 18) + 1, 000(P/F , 10%, 6)

− 15, 000(P/F , 10%, 6) − 15, 000(P/F , 10%, 12)
+ 1, 000(P/F , 10%, 12) + 1, 000(P/F , 10%, 18)
PWA = −15, 000 − 3, 500(8.2014) + 1, 000(0.5645)
− 15, 000(0.5645) − 15, 000(0.3186) + 1, 000(0.3186)
+ 1, 000(0.1799) = $ − 55, 888.4
PWB = −18, 000 − 3, 100(P/A, 10%, 18) + 2, 000(P/F , 10%, 9)
− 18, 000(P/F , 10%, 9) + 2, 000(P/F , 10%, 18)
= −18, 000 − 3, 100(8.2014) + 2, 000(0.4241)
− 18, 000(0.4241) + 2, 000(0.1799) = $ − 49, 850

Location B is selected.

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 15 / 29

 Present Worth Analysis Different-Life Alternatives

b) For a 5-year study period no cycle repeats are necessary.

PWA = −15, 000 − 3, 500(P/A, 10%, 5) + 1, 000(P/F , 10%, 5)
= −15, 000 − 3, 500(3, 7908) + 1, 000(0, 6209)
= $ − 27, 647
PWB = −18, 000 − 3, 100(P/A, 10%, 5) + 2, 000(P/F , 10%, 5)
= −18, 000 − 3, 100(3, 7908) + 2, 000(0, 6209)
= $ − 28, 509.7 Location A is selected.
c) For a 6-year study period, deposit return of $6,000 for location B
PWA = −15, 000 − 3, 500(P/A, 10%, 6) + 1, 000(P/F , 10%, 6)
= −15, 000 − 3, 500(4.3553) + 1, 000(0, 5645)
= $ − 29, 679
PWB = −18, 000 − 3, 100(P/A, 10%, 6) + 6, 000(P/F , 10%, 6)
= −18, 000 − 3, 100(4.3553) + 6, 000(0.5645)
= $ − 28, 114 Location B is selected.
Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 16 / 29
 Present Worth Analysis Future Worth Analysis

Future Worth (FW ) of an alternative can be found:

1 Directly from the cash flows by determining the future worth value
2 multiplying PW value by the F /P factor at
MARR
Therefore it is an extension of PW analysis
Used when the prime goal is to maximize the future wealth of the
company
Also used if the asset will be sold or traded before its expected life
is reached
FW value estimates the alternative’s worth at the time sale or
disposal
Selection guidelines are same as PW
1 One alternative: FW ≥ 0 means MARR is met
2 For two or more mutually exclusive: Select the numerically largest

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 17 / 29

 Present Worth Analysis Future Worth Analysis

Example
A British food distribution corporation purchased a Canadian food
store chain for 75 million dollars three years ago. There was a net loss
of $10 million at the end of year 1 of ownership. Net cash flow is
increasing with an arithmetic gradient of $+5 million per year starting
the second year. This means that breakeven net cash flow was
achieved this year. Because of the heavy debt financing used to
purchase the Canadian chain, the international board of directors
expects a MARR of 25% per year from any sale.
1 The British corporation has just been offered $159.5 million by a
French company for the ownership of the Canadian chain. Use
FW analysis to decide whether the MARR is met at this selling
price or not.
2 If the British corporation continues to own the chain, what selling
price must be obtained at the end of the year 5 to make the
MARR.

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 18 / 29

 Present Worth Analysis Future Worth Analysis

1 Cash flow diagram is:

159.5

MARR=25%

0 1 2 3
Years

5
10
75

FW3 = −75(1.25)3 − 10(1.25)2 − 5(1.25) + 159.5

= −8.86 <0, MARR of 25% not met

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 19 / 29

 Present Worth Analysis Future Worth Analysis

1 <0, MARR of 25% not met

2 cash flow diagram is:
F=?
10
5
MARR=25%

0 1 2 3 4 5
Years

5
10
75

FW3 = −75(1.25)5 − 10(1.25)4 − 5(1.25)3 + 5(1.25) + 10 + F

0 = F − 246.81
F = $246.81 million at least to meet MARR of 25%

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 20 / 29

 Present Worth Analysis Capitalized Cost

Capitalized Cost (CC) is the present worth of an alternative that

will last forever
Public sector projects such as bridges, dams, railroads fall into
this category
CC is derived from P = A(P/A, i%, n) as n → ∞

h (1 + i)n − 1 i
P = A
i(1 + i)n
h1 − 1 n i
(1+i)
= A
i

As n → ∞, the expression inside the bracket becomes 1/i, and

the symbol CC replaces P
A AW
CC = i = i

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 21 / 29

 Present Worth Analysis Capitalized Cost

The cash flows in a capitalized cost calculation are usually of two

types:
1 Recurring
2 Nonrecurring
The following procedure assists in calculating the CC for an infinite
sequence of cash flows.
1 Draw a cash flow diagram for all nonrecurring cash flows and at
least two cycles of all recurring cash flows
2 Find the present worth of all nonrecurring amounts. This will be
their CC value
3 Find the equivalent uniform annual worth (A) through one life cycle
of all recurring amounts. Add this to all other uniform amounts
occurring in years 1 through infinity and the result is total
equivalent uniform annual worth (AW )
4 Divide the AW obtained at step 3 by i to obtain a CC value
5 Add the CC values obtained in steps 2 and 4
Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 22 / 29
 Present Worth Analysis Capitalized Cost

In Class Work 7
A new software for the purpose of monitoring property tax is installed.
The installation cost is $150,000 and there is an additional cost of
$50,000 after 10 years. The annual software contract cost is $5,000 for
the first 4 years and $8,000 thereafter. In addition, there is expected to
be a recurring major upgrade cost of $15,000 every 13 years. Assume
that MARR is 5%. If the new software will be used for the indefinite
future, find the equivalent value:
1 now
2 for each year thereafter

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 23 / 29

 Present Worth Analysis Capitalized Cost
MARR=5%
Years
0 2 4 6 8 10 12 14 16 18 20 24 26

5,000
8,000

150,000 15,000 15,000

50,000
MARR=5%
Years
0 2 4 6 8 10 12 14 16 18 20 24 26

5,000
3,000

15,000 15,000
Years
0 6 8 10 12 14 16 18 20 24 26

2 4
MARR=5%

50,000

150,000

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 24 / 29

 Present Worth Analysis Capitalized Cost

2)
1
CC1 = −150, 000 − 50, 000( )
(1.05)10
= $ − 180, 695
3)
A1 = −15, 000(A/F , 5%, 13)
= −15, 000(0.05646) = $ − 847
4)
−3, 000 1
CC2 = ( )
0.05 1.054
= $ − 49, 362
−5, 000 − 847
CC3 = A1 + A2 = = $ − 116, 940
0.05
5) CCT = −180, 695 − 49, 362 − 116, 940 = $ − 346, 997
b) A = Pi = −346, 997(0.05) = −17, 350
Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 25 / 29
 Present Worth Analysis Capitalized Cost

Example
Two alternative sites are considered for a bridge to cross a river in New
York.
1 A suspension bridge will cost $50 million with annual inspection
and maintenance costs of $35,000. In addition, the concrete deck
would have to resurfaced every 10 years at a cost of $100,000.
The cost of purchasing right-of-way is expected to be $2 million for
the suspension bridge.
2 A truss bridge and approach roads are expected to cost $25
million and annual maintenance costs of $20,000. The bridge
have to be painted every 3 years at a cost of $40,000. In addition,
the bridge would have to be sandblasted every 10 years at a cost
of $190,000. The cost of purchasing right-of-way is expected to be
$15 million for the truss bridge.
Compare the alternatives on the basis of their capitalized cost if the
interest rate is 6% per year.

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 26 / 29

 Present Worth Analysis Capitalized Cost

To compare two or more alternatives on the basis of capitalized

cost, find CCT for each alternative.
CCT represents the total present worth of financing and
maintaining an alternative forever
Alternative with the smallest capitalized cost should be selected

1 CC1 = −50 − 2 = $ − 52 million

A1 = −100, 000(A/F , 6%, 10)

= −100, 000(0.07587) = $ − 7587
A1 + A2 −7, 587 − 35, 000
CC2 = =
i 0.06
= −709, 783
CCS = CC1 + CC2 = $ − 52, 71 million

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 27 / 29

 Present Worth Analysis Capitalized Cost

1 CCS = $ − 52, 71 million

2 CC1 = −25 − 15 = $ − 40 million

A1 = −190, 000(A/F , 6%, 10)

= −190, 000(0.07587) = $ − 14, 415
A2 = −40, 000(A/F , 6%, 3)
= −40, 000(0.31411) = $ − 12, 564
A1 + A2 + A3 −14, 415 − 12, 564 − 20, 000
CC2 = =
i 0.06
= −782, 983
CCT = CC1 + CC2 = $ − 40, 78 million

Truss Bridge is selected.

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 28 / 29

 Present Worth Analysis Meaning of Present Worth

In present worth analysis, we assume that all the funds in a firm’s

treasury can ne placed in investments that yield a return equal to
MARR. We may view these funds as an investment pool.

Investment How much money would you have if

Pool the investment was made?
$454,000(F/P, 15%, 6)=$1,050,130
$681,000(F/P, 15%, 5)=$1,369,734
h $908,000(F/A,15%,4)(F/P, 15%, 1)=$4,534,007
$1,800,000 c as
t $1,268,000(F/P,15%,0)= $1,268,000
jec to
e pro turn ol $8,901,946
u r re p o
ll fut eipts ent How much money would you have if
A rec stm the investment was not made?
e
Take 1,800,000 out of inv
$1,800,000(F/P, 15%, 7)=$4,788,036
the investment pool and
invest in the project
What is the net gain from
$1,268,000
investing into the project?
MARR=15% $908,000 $8,901,946
$4,788,036
$681,000 $4,113,910
$454,000

1 2 3 4 5 6 7

Dr.Serhan Duran (METU) IE 347 Week 4 Industrial Engineering Dept. 29 / 29