Lecture slides to accompany

Engineering Economy, 8thth edition

Leland Blank, Anthony Tarquin

©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.  No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 Chapter 5

Present Worth Analysis

©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom.  No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
 • LEARNING OUTCOMES
1. Formulate Alternatives
2. PW of equal-life alternatives
3. PW of different-life alternatives
4. Future Worth analysis
5. Capitalized Cost analysis

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 • Formulating Alternatives (1)

Twotypes
Two typesofofeconomic
economicproposals
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 (2)

Twotypes
Two typesofofcash
cashflow
flowestimates
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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 • PW Analysis of Alternatives
Convert all cash flows to PW using MARR

Precede costs by minus sign; receipts by plus sign

EVALUAT
ION
•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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 • Selection of Alternatives by PW
For the alternatives shown below, which should be selected
if they are (a) mutually exclusive; (b) independent?

Project ID Present Worth

A
$30,000
B $12,500
C $-4,000
D $ 2,000
•Solution:
  (a) Select numerically largest PW; alternative A
(b) Select all with PW 0; projects A, B & D

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 • Example: PW Evaluation of Equal-Life ME Alts.

AlternativeXXhas
Alternative hasaafirst
firstcost
costofof$20,000,
$20,000,an
anoperating
operatingcost
costofof$9,000
$9,000per
peryear,
year,and
and
aa$5,000
$5,000salvage
salvagevalue
valueafter
after55years.
years.Alternative
AlternativeYYwill
willcost
cost$35,000
$35,000with
withan
an
operatingcost
operating costofof$4,000
$4,000perperyear
yearand
andaasalvage
salvagevalue
valueofof $7,000
$7,000after
after55years.
years.AtAt
anMARR
an MARRofof12%12%per peryear,
year,which
whichshould
shouldbebeselected?
selected?

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

Select alternative Y

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 • PW of Different-Life Alternatives

Mustcompare
Must comparealternatives
alternativesfor equalservice
forequal service
(i.e.,alternatives
(i.e., alternativesmust
mustend
endatatthe
thesame
sametime)
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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 • Assumptions of LCM approach

Service provided is needed over the LCM or more years

Selected alternative can be repeated over each life cycle of

LCM in exactly the same manner

Cash flow estimates are the same for each life cycle (i.e.,
change in exact accord with the inflation or deflation rate)

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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

20,000 – 4,000 in
year 3

Select alternative B
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 • PW Evaluation Using a Study Period
Once a study period is specified, all cash flows after this time are
ignored

Salvage value is the estimated market value at the end of study

period

Short study periods are often defined by management when business

goals are short-term

Study periods are commonly used in equipment replacement analysis

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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

•   Marginally, select A; different selection than for LCM 6 years

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 • Future Worth Analysis

FWexactly
FW exactlylike
likePW
PWanalysis,
analysis,except
exceptcalculate
calculateFW
FW

Mustcompare
Must comparealternatives
alternativesfor equalservice
forequal service
(i.e.alternatives
(i.e. alternativesmust endatatthe
mustend thesame
sametime)
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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 • 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

Select B (Note: PW and FW methods will always result in same selection)

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 • Capitalized Cost (CC) Analysis
CCrefers
CC referstotothe
thepresent
presentworth
worthofofaaproject
projectwith
withaavery
verylong
long
life,that
life, thatis,
is,PW
PWas
asnnbecomes infinite
becomesinfinite

•   Basic equation is:

“A” essentially represents the interest on a perpetual investment

•  example,
For
•For  example,ininorder
ordertotobe
beable
abletotowithdraw
withdraw$50,000
$50,000per
peryear
yearforever
forever
atati i 10%
10%per
peryear,
year,the
theamount
amountofofcapital
capitalrequired
requiredisis50,000/0.10
50,000/0.10 $500,000
$500,000

For finite life alternatives, convert all cash flows into an A value
over one life cycle and then divide by i
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 • Example: Capitalized Cost
••   Compare
Comparethethemachines
machinesshown
shownbelow
belowon
onthe
thebasis
basisofoftheir
their
capitalized cost. Use i 10% per year
capitalized cost. Use i 10% per year
Machine11
Machine Machine22
Machine
Firstcost,$
First cost,$ 20,000
20,000 100,000
100,000
Annualcost,$/year
Annual cost,$/year 9000
9000 7000
7000
Salvagevalue,
Salvage value,$$ 4000
4000 -----
-----
Life,years
Life, years 33

•   Convert machine 1 cash flows into A and then divide by i

Solution:

Select machine 1
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 • Summary of Important Points
•   method converts all cash flows to present value at MARR
PW

Alternatives can be mutually exclusive or independent

Cash flow estimates can be for revenue or cost alternatives

PW comparison must always be made for equal service

Equal service is achieved by using LCM or study period

Capitalized cost is PW of project with infinite life; CC P A/i

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