APPLICATIONS OF MONEY-TIME

RELATIONSHIPS

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 Scenario
You are working with a wafer fabrication facility. Say your company plan
to produce a new product. This new product requires additional processing
machine.

The new machine cost RM125,000. It will save RM17,000 of annual rent.
Maintenance cost would be RM15,000 annually and the salvage value is
RM25,000. Machine lifespan is 12 years.

Assuming the interest rate is 8%, is this investment will be beneficial to

your company ?
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 Important Concept
Money Today ≠ Money at some other Points in Time

Therefore we need

Formulas
Tools When comparing Alternatives
Tables

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 LEARNING OUTCOME
• Present Worth Analysis (PW)

• Future Worth Analysis (FW)

• Annual Worth Analysis (AW)

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 Formulating Alternatives

Two types of economic proposals

Mutually Exclusive (ME) Alternatives: Only one can be selected;

Compete against each other

Independent Projects: More than one can be selected;

Compete only against DN

Do Nothing (DN) – An ME alternative or independent project to

maintain the current approach; no new costs, revenues or savings
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 Formulating Alternatives

Two types of cash flow estimates

Revenue: Alternatives include estimates of costs

(cash outflows) and revenues (cash inflows)

Cost: Alternatives include only costs; revenues and savings

assumed equal for all alternatives;
also called service alternatives

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 1.0 Present Worth Analysis
The Goal

To convert a series of COSTS and BENEFITS over a period of time into

ONE equivalent Present Time Value (PW).

In this method of comparison, the cash flows of each alternative will be

reduced to time zero by assuming an interest rate i (r). Then, depending on
the type of decision, the best alternative will be selected by comparing the
present worth amounts of the alternatives.

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 PW Analysis of Alternatives
Convert all cash flows to PW using MARR
Precede costs by minus sign; receipts by
plus sign

EVALUATION
For one project, if PW > 0, it is justified
For mutually exclusive alternatives, select
one with numerically largest PW

For independent projects, select all with PW > 0

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Rules

One alternative:
Calculate PW at the MARR or given compound interest rate. If PW ≥ 0, the
alternative is financially viable.

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.

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Steps

1. Define various Costs and Benefits identified for the period of entire
investment.
2. Select the desired Rate of Return (MARR), or normally given as an
interest rate.
3. Use Present Worth Analysis formula, based on the given interest
rate, convert it to the present value.
4. If the PW < 0, probably not a good investment (future cost will be
greater than the future benefits).

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Alternative X has a first cost of $20,000, an operating cost of $9,000 per year,
and a $5,000 salvage value after 5 years. Alternative Y will cost $35,000
with an operating cost of $4,000 per year and a salvage value of $7,000
after 5 years. At an MARR of 12% per year, which should be selected?

Solution: Find PW at MARR and select numerically larger PW value

PWX = -20,000 - 9000(P/A,12%,5) + 5000(P/F,12%,5)

= -$49,606

PWY = -35,000 - 4000(P/A,12%,5) + 7000(P/F,12%,5)

= -$45,447

Select alternative Y
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 Problem 1.1
You are working with a wafer fabrication facility. Say your company plan to introduce
a new product. This new product requires additional processing machine.

The new machine cost RM125,000. It will save RM17,000 of annual rent.
Maintenance cost would be RM15,000 annually and the salvage value is RM25,000.
Machine lifespan is 12 years.

Assuming the interest rate is 8%, is this investment will be beneficial to your company
?

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Solution

To determine what the present worth value is for all the future money received and
disbursement of this particular investment.

Step 1; define costs and benefits

A1 = RM17,000 annually (saving from the rent),
S = RM25,000
P = - RM125,000
A2 = - RM15,000
t = 12 years

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Step 2; determine the rate of return (MARR), or the interest rate.
i = r =8% = 0.08

Step 3; use the right PW formula (remember the single and multiple cash flows
concepts and formulas)

a) Cost
b) Benefit

Step 4; conclude

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Step 3; use the right PW formula (remember the single and multiple cash flows
concepts and formulas)

a) Cost
b) Benefit

a) PW = initial cost + saving + maintenance + salvage

PW = - (PV)initial cost, t=0 + (PV) saving, t=0 + (PV)maintenance, t=0 + (PV)salvage, t=0

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a) PW = initial cost + saving + maintenance + salvage
PW = - (PV)initial cost, t=0 + (PV) saving, t=0 + (PV)maintenance, t=0 + (PV)salvage, t=0

PW = - RM 99,990
Therefore, the present worth for the total investment over 12 years period is
- RM 99,990.

Is this a good investment ?

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PW of Different-Life Alternatives
Must compare alternatives for equal service
(i.e., alternatives must end at the same time)

Two ways to compare equal service:

Least common multiple (LCM) of lives

Specified study period

(The LCM procedure is used unless otherwise specified)

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Example: Different-Life Alternatives
Compare the machines below using present worth analysis at i = 10% per year

Machine A Machine B
First cost, $ 20,000 30,000
Annual cost, $/year 9000 7000
Salvage value, $ 4000 6000
Life, years 3 6

Solution: LCM = 6 years; repurchase A after 3 years

PWA = -20,000 – 9000(P/A,10%,6) – 16,000(P/F,10%,3) + 4000(P/F,10%,6)

= $-68,961
20,000 – 4,000 in
PWB = -30,000 – 7000(P/A,10%,6) + 6000(P/F,10%,6) year 3
= $-57,100

Select alternative B
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 Example: Study Period PW Evaluation
Compare the alternatives below using present worth analysis at i = 10% per year
and a 3-year study period
Machine A Machine B
First cost, $ -20,000 -30,000
Annual cost, $/year -9,000 -7,000
Salvage/market value, $ 4,000 6,000 (after 6 years)
10,000 (after 3 years)
Life, years 3 6
Solution: Study period = 3 years; disregard all estimates after 3 years

PWA = -20,000 – 9000(P/A,10%,3) + 4000(P/F,10%,3) = $-39,376

PWB = -30,000 – 7000(P/A,10%,3) + 10,000(P/F,10%,3)= $-39,895
Marginally, select A; different selection than for LCM = 6 years
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 Problem 1.2
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.

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Which alternative would you choose ?

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 2.0 Future Worth Analysis
The Goal

Evaluates a project or investment based on based upon the basis of various

COSTS and BENEFITS that will be accumulated at some future point in
time, into one equivalent Future Value.

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 Future Worth Analysis
FW exactly like PW analysis, except calculate FW

Must compare alternatives for equal service

(i.e. alternatives must end at the same time)

Two ways to compare equal service:

Least common multiple (LCM) of lives

Specified study period

(The LCM procedure is used unless otherwise specified)
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Rules

One alternative. Calculate FW at the MARR or given compound interest rate.

If FW ≥ 0, the alternative is financially viable.

Two or more alternatives. Calculate the FW of each alternative at the MARR.

Select the alternative with the FW value that is numerically largest, that is, less
negative or more positive.

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Steps

1. Define various Costs and Benefits identified for the period of entire
investment.
2. Select the desired Rate of Return (MARR), or normally given as an
interest rate.
3. Use Future Worth Analysis formula, based on the given interest
rate, convert it to the future value.
4. Look for the maximized benefits over the investment period.

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FW of Different-Life Alternatives
Compare the machines below using future worth analysis at i = 10% per year

Machine A Machine B
First cost, $ -20,000 -30,000
Annual cost, $/year -9000 -7000
Salvage value, $ 4000 6000
Life, years 3 6

Solution: LCM = 6 years; repurchase A after 3 years

FWA = -20,000(F/P,10%,6) – 9000(F/A,10%,6) – 16,000(F/P,10%,3) + 4000
= $-122,168
FWB = -30,000(F/P,10%.6) – 7000(F/A,10%,6) + 6000
= $-101,157
Select B (Note: PW and FW methods will always result in same selection)
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 Problem 2.1
Perform a future worth analysis of a company investment for 8 years period,
which the initial cost of RM500,000 and yearly revenue of RM750,000 with
the MARR set at 10%. The cost time-line diagram as shown.

750,000

1 2 3 4 5 6 7 8
i = r = 0.1
500,000

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 3.0 Annual Worth Analysis
AW is an equal annual series of dollar amounts, over a stated period (N, t),
equivalent to the cash inflows and outflows at interest rate (i , r) that is
generally MARR. AW is annual equivalent revenues or disbursement (A)
minus the equivalent annual cost or capital recovery (CR).

Financial Language; AW = A – CR
Mathematically; AW = A + CR

CR is equivalent annual cost of obtaining the initial asset (P) plus the
salvage (S). CR = -P(A/P,i%,n) + S(A/F,i%,n)
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 Capital Recovery and AW
Capital recovery (CR) is the equivalent annual amount that
an asset, process, or system must earn each year to just
recover the first cost and a stated rate of return over its
expected life. Salvage value is considered when calculating
CR.
CR = -P(A/P,i%,n) + S(A/F,i%,n)

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Method: Compute AW of the original cost and add the AW of the salvage value.

AW = A + CR

CR = - P(A / P, i, N) + S(A / F, i, N)
Rules

One alternative. Calculate AW at the MARR or given compound interest rate.

If AW ≥ 0, the alternative is financially viable.

Two or more alternatives. Calculate the AW of each alternative at the MARR.

Select the alternative with the AW value that is numerically largest, that is,
less negative or more positive.

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A company is considering two machines. Machine X has a first cost of
$30,000, AOC of $18,000, and S of $7000 after 4 years.
Machine Y will cost $50,000 with an AOC of $16,000 and S of $9000 after
6 years.
Which machine should the company select at an interest rate of 12% per
year?

Solution: AWX = -30,000(A/P,12%,4) –18,000 +7,000(A/F,12%,4)

= $-26,412
AWY = -50,000(A/P,12%,6) –16,000 + 9,000(A/F,12%,6)
= $-27,052
Select Machine X; it has the numerically larger AW value
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 Problem 3.1
A contractor purchased a used crane for RM11,000. His operating cost will be
RM2700 per year, and he expects to sell it for RM5000 five years from now.
What is the equivalent annual worth (AW) of the crane at an interest rate of 10%
?
A contractor purchased a used crane for RM11,000. His operating cost will be
RM2700 per year, and he expects to sell it for RM5000 five years from now.
What is the equivalent annual worth (AW) of the crane at an interest rate of 10%
?

S (RM5000)

1 2 3 4 5

A (RM2700)
P (RM11,000)
i = r = 0.1
 S (RM5000)

1 2 3 4 5

A (RM2700)
P (RM11,000) i = r = 0.1

AW = A + CR
CR = - P(A / P, i, N) + S(A / F, i, N)

CR = -11,000(A/P, 10%, 5) +5000(A/F,10%,5)

AW = -11,000(A/P, 10%, 5) +5000(A/F,10%,5) + (- 2700)
= -11,000 (i (1+ i)N / (1+ i)N-1) + 5000 (i /(1 + i )N -1) – 2700
= -11,000 (0.1 (1+ 0.1)5 / (1+ 0.1)5-1) + 5000 (0.1 /(1 + 0.1 )5 -1) – 2700
= -11,000 (0.1 *1.6105 / 0.6105) + 5000 (0.1 /(0.6105) – 2700
 S (RM5000)

1 2 3 4 5

A (RM2700)
P (RM11,000) i = r = 0.1

AW = A + CR
CR = - P(A / P, i, N) + S(A / F, i, N)

AW = -11,000(.2638) + 5000(.1638) – 2700

AW= - RM4782.8
 Problem 3.2
Perform an annual worth analysis of a company investment for 8 years period,
which the initial cost of RM500,000 and yearly revenue of RM750,000 with
the MARR set at 10%. The cost time-line diagram as shown.

750,000

1 2 3 4 5 6 7 8
i = r = 0.1
500,000

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 750,000

1 2 3 4 5 6 7 8
i = r = 0.1
500,000
AW = A + CR
CR = - P(A / P, i, N) + S(A / F, i, N)
 750,000

1 2 3 4 5 6 7 8
i = r = 0.1
500,000
AW = A + CR
CR = - P(A / P, i, N) + S(A / F, i, N)
AW = -(PW (A / P, i% , N)) + 750,000
= - PW( ) + 750,000

AW = - PW ( ) + 750,000
= -(500,000 * .1874) + 750,000 = 750,000 – 93703 = 656,297
 Exercise (Problem 1.2) – using Functions
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.

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Solve Problem 1.2 using functions.
 Relationship between AW, PW and FW
AW = PW(A/P,i%,n) = FW(A/F,i%,n)
n is years for equal-service comparison (value of LCM or
specified study period)

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