Engg Econ Lecture 3.2 - Present Worth

Engineering Economics
Lesson 3
Basic Economy Study Methods
Sullivan, et al. (2015). Engineering Economy, 16th ed., Chapter 5 (pp. 186-239)
Contents
1. The Minimum Attractive Rate of Return
2. The Present Worth Method
3. The Future Worth Method
4. The Annual Worth Method
5. The Internal Rate of Return Method
6. The External Rate of Return Method
7. The Payback Period
8. The Benefit/Cost Ratio Method
Engineering Economics
Lecture 3.2
The Present Worth Method
Sullivan, et al. (2015). Engineering Economy, 16th ed., pp. 189-196
The Present Worth (PW) Method
• The PW method is based on the concept of equivalent worth of all
cash flows relative to some base or beginning point in time called the
present.
• That is, all cash inflows and outflows are discounted to the present
point in time at an interest rate that is generally the MARR.
• A positive PW for an investment project is a dollar amount of profit
over the minimum amount required by investors.
• It is assumed that cash generated by the alternative is available for
other uses that earn interest at a rate equal to the MARR.
The Present Worth (PW) Method
• The relationship (Eqn. 5-1) is based on the assumption of a constant
interest rate throughout the life of a particular project.
• If the interest rate is assumed to change, the PW must be computed
in two or more steps.
• To apply the PW method of determining a project’s economic
worthiness, simply compute the present equivalent of all cash flows
using the MARR as the interest rate.
• If the present worth is greater than or equal to zero, the project is
acceptable.
The higher the
interest rate and
the farther into the
future a cash flow
occurs, the lower
its PW is.
• The PW of $1,000 10 years from now is

$613.90 when per year.
• However, if , that same $1,000 is only
worth $385.50 now
Ex. 5.1
of cash inflows of cash outflows
Solution
effective interest rate per interest period; number of interest periods; uniform series amount (occurs at the end of each interest period); future equivalent; present equivalent
Ex. 5-1 notes:
• The MARR is to be interpreted as an effective interest rate ().
• Here, per year.
• Cash flows are discrete, end-of-year (EOY) amounts.
Ex. 5-1 notes:
• If continuous compounding had been specified for a nominal interest
rate () of 20% per year, the PW would have been calculated by using
the interest factors presented in Appendix D:
Activity: Evaluate the economic advisability
of a solar-powered cooling and heating system
• Should a homeowner’s incremental investment of $10,000 be traded off
for energy savings of $130 per month?
• Assume a MARR of 1% per month and a 20-year useful life of the solar-
powered system.
• Determine the PW of the system.
• Is the investment favorable?
• If the solar-powered cooling and heating system can avoid 13 tons of CO₂
per year, how much can you avoid throughout the useful life of the
system?
• Compare the results with when MARR is 0.5%.
The PW of the system when MARR = 0.5%
• PW = −$10,000 + $130(P/A, 0.5%, per month, 240 months)
= −$10,000 + $130(139.5808)
= $8,145.50.
• The positive-valued PW signals a favorable investment.

• Additionally, 13 tons/year × 20 years = 260 tons of carbon dioxide will
be avoided.
1. Assumptions of the PW Method
• There are several noteworthy assumptions that we make when using
PW to model the wealth-creating promise of a capital investment
opportunity.
1. It is assumed that we know the future with certainty (we don’t live
in a certain world!).
- Ex. We presume to know with certainty future interest rates and other factors.
2. It is assumed we can borrow and lend money at the same interest
rate (i.e., capital markets are perfect).
• Regrettably, the real world has neither certainty nor perfect
(frictionless, e.g., no taxes and/or commissions) capital markets.
1. Assumptions of the PW Method
• The PW (and FW and AW, to follow) model is built on these seemingly
restrictive assumptions, but it is cost-beneficial in the sense that the cost
of using the PW model is less than the benefits of improved decisions
resulting from PW analysis.
• More sophisticated models exist, but they usually do not reverse
decisions made with the PW model.
• Therefore, our goal is to cost-beneficially recommend capital investments
that maximize the wealth of a firm to its owners (i.e., stockholders).
• A positive-valued PW (and FW and AW) means that accepting a project
will increase the worth, or value, of the firm.
2. Bond Value
• A bond is an IOU where you agree to lend the bond issuer money for
a specified length of time (say, 10 years).
• In return, you receive periodic interest payments (e.g., quarterly)
from the issuer plus a promise to return the face value of the bond
when it matures.
• A bond provides an excellent example of commercial value as being
the PW of the future net cash flows that are expected to be received
through ownership of an interest-bearing certificate.
• Thus, the value of a bond, at any time, is the PW of future cash
receipts.
2. Bond Value
• For a bond, let
• The owner of a bond is paid two types of payments by the borrower.

The first consists of the series of periodic interest payments he or she
will receive until the bond is retired.
2. Bond Value
• There will be such payments, each amounting to .
• These constitute an annuity of payments.
• In addition, when the bond is retired or sold, the bondholder will receive a
single payment equal in amount to .
• The PW of the bond is the sum of PWs of these two types of payments at
the bond’s yield rate ():
• The most common situations faced by you as a potential investor in bonds

are (1) for a desired yield rate, how much should you be willing to pay for
the bond and (2) for a stated purchase price, what will your yield be?
3. The Capitalized-Worth (CW) Method
• One special variation of the PW method involves determining the PW
of all revenues or expenses over an infinite length of time.
• This is known as the Capitalized-Worth (CW) method.
• If only expenses are considered, results obtained by this method are
sometimes referred to as capitalized cost.
• The CW method is a convenient basis for comparing mutually
exclusive alternatives when the period of needed service is
indefinitely long.
3. The Capitalized-Worth (CW) Method
Solution
end

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Engineering Economics

• The PW of $1,000 10 years from now is

• The positive-valued PW signals a favorable investment.

• The owner of a bond is paid two types of payments by the borrower.

• The most common situations faced by you as a potential investor in bonds

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