Blankchapter 5

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1 Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.
CHAPTER V
PRESENT WORTH
ANALYSIS
M
c

Graw
Hill
ENGINEERING ECONOMY Fifth Edition
Blank and Tarquin
LEARNING OBJECTIVES
PURPOSE OF THIS CHAPTER
FORMULATION OF MUTUALLY EXCLUSIVE
ALTERNITIVES
PROPER COMPARISON/ANALYSIS OF
MUTUALLY EXCLUSIVE ALTERNATIVES
PRESENT WORTH METHOD
EXTENSIONS OF THE PRESENT WORTH
METHOD
CHAPTER TOPICS
Formulating Alternatives
PW of Equal-Life Alternatives
PW of Different-Life alternatives
Future Worth Analysis
Capitalized Cost Analysis
Payback Period
Life-Cycle Costs
PW of Bonds
Spreadsheet Applications
5.1 FORMULATING MUTUALLY EXCLUSIVE
ALTERNATIVES
Viable firms/organizations have the
capability to generate potential
beneficial projects for potential
investment
Two types of investment categories
Mutually Exclusive Set
Independent Project Set
ALTERNATIVES
Mutually Exclusive set is where a
candidate set of alternatives exist
(more than one)
Objective: Pick one and only one from
the set.
Once selected, the remaining
alternatives are excluded.
5.1 INDEPENDENT PROJECT SET
Given a set of alternatives (more than
one)
The objective is to:
Select the best possible combination of
projects from the set that will optimize a
given criteria.
Subjects to constraints
More difficult problem than the mutually
exclusive approach
ALTERNATIVES
Mutually exclusive alternatives compete
with each other.
Independent alternatives may or may
not compete with each other
The independent project selection
problem deals with constraints and may
require a mathematical programming or
bundling technique to evaluate.
5.1 Type of Alternatives
Revenue/Cost the alternatives consist
of cash inflow and cash outflows
Select the alternative with the maximum
economic value
Service the alternatives consist mainly
of cost elements
Select the alternative with the minimum
economic value (min. cost alternative)
5.1 Evaluating Alternatives
Part of Engineering Economy is the
selection and execution of the best
alternative from among a set of
feasible alternatives
Alternatives must be generated
from within the organization
One of the roles of engineers!
5.1 Evaluating Alternatives
In part, the role of the engineer to
properly evaluate alternatives from
a technical and economic view
Must generate a set of feasible
alternatives to solve a specific
problem/concern
5.1 Alternatives
Problem
Do
Nothing
Alt.
1
Alt.
2
Alt.
m
Analysis
Selection
Execution
5.1 Alternatives: The Selected Alternative
Problem
Alt.
Selected
Execution
Audit and Track
Selection is dependent upon the data, life,
discount rate, and assumptions made.
5.2 Present Worth Approach Equal-Lifes
Simple Transform all of the current
and future estimated cash flow back to
a point in time (time t = 0)
Have to have a discount rate before the
analysis in started
Result is in equivalent dollars now!
5.2 THE PRESENT WORTH METHOD

At an interest rate usually equal to or
greater than the Organizations
established MARR.
A process of obtaining the
equivalent worth of future cash
flows to some point in time
called the Present Worth

P(i%) = P(+) P(-).
P(i%) = P( + cash flows) +
P( - cash flows)
OR, . . .

If P(i%) > 0 then the project is
deemed acceptable.

If P(i%) < 0 the project is usually
rejected.

If P(i%) = 0 Present worth of costs = Present
worth of revenues Indifferent!

If the present worth of a project turns out to =
0, that means the project earned exactly the
discount rate that was used to discount the cash
flows!
The interest rate that causes a cash flows NPV
to equal 0 is called the Rate of Return of the
cash flow!

A positive present worth is a dollar
amount of "profit" over the minimum
amount required by the investors
(owners).
For P(i%) > 0, the following holds true:

Depends upon the Discount Rate Used

The present worth is purely a
function of the MARR (the
discount rate one uses).
If one changes the discount rate, a
different present worth will result.
For P(i%) > 0, the following
holds true:
Acceptance or rejection of a
project is a function of the timing
and magnitude of the project's
cash flows, and the choice of the
discount rate.
5.2 PRESENT WORTH: Special
Applications
Present Worth of Equal Lived
Alternatives
Alternatives with unequal lives: Beware
Capitalized Cost Analysis
Require knowledge of the discount rate
before we conduct the analysis
5.2 PRESENT WORTH: Equal Lives
Present Worth of Equal Lived
Alternatives straightforward

Compute the Present Worth of each
alternative and select the best, i.e.,
smallest if cost and largest if profit.
5.2 Equal Lives Straightforward!
Given two or more alternatives with
equal lives.
Alt. 1
Alt. 2
Alt. N
N = for all
alternatives
Find PW(i%) for each alternative then compare
5.2 PRESENT WORTH: Example
Consider: Machine A Machine B
First Cost $2,500 $3,500
Annual Operating Cost 900 700
Salvage Value 200 350
Life 5 years 5 years

i = 10% per year

Which alternative should we select?
5.2 PRESENT WORTH: Cash Flow Diagram
Which alternative should we select?
0 1 2 3 4 5
$2,500
A = $900
F
5
=$200
M
A
0 1 2 3 4 5
$3,500
F
5
=$200
A = $700
M
B
5.2 PRESENT WORTH: Solving
P
A
= 2,500 + 900 (P|A, .10, 5)
200 (P|F, .01, 5)
= 2,500 + 900 (3.7908) - 200 (.6209)
= 2,500 + 3,411.72 - 124.18 = $5,788

P
B
= 3,500 + 700 (P|A, .10, 5)
350 (P|F, .10, 5)
= 3,500 + 2,653.56 - 217.31 = $5,936

SELECT MACHINE A: Lower PW cost!
5.3 PRESENT WORTH: Different Lives
Present Worth of Alternatives with
Different Lives

Comparison must be made over equal
time periods

Compare over the least common multiple,
LCM, for their lives
5.3 PRESENT WORTH: Unequal Lives
Present Worth of Alternatives with
Different Lives
Remember if the lives of the
alternatives are not equal, one must
create or force a study period where
the life is the same for all of the
alternatives
5.3 Present Worth with Unequal Lives: The Rule
In an analysis one cannot effectively
compare the PW of one alternative with
a study period different from another
alternative that does not have the same
study period.
This is a basic rule!

5.3 PRESENT WORTH: Lowest Common
Multiple of Lives
If the alternatives have different study
periods, you find the lowest common
life for all of the alternatives in
question.
Example: {3,4, and 6} years. The
lowest common life is 12 years.
Evaluate all over 12 years for a PW
analysis.
5.3 PRESENT WORTH: Example Unequal
Lives
EXAMPLE
Machine A Machine B
First Cost $11,000 $18,000
Annual Operating Cost 3,500 3,100
Salvage Value 1,000 2,000
Life 6 years 9 years

i = 15% per year
Note: Where costs dominate a problem it is customary to assign a
positive value to cost and negative to inflows
5.3 PRESENT WORTH: Example Unequal
Lives
A common mistake is to
compute the present
worth of the 6-year
project and compare it to
the present worth of the
9-year project.
NO! NO! NO!
5.3 PRESENT WORTH: Unequal Lives
i = 15% per year

0 1 2 3 4 5 6
$11,000
F
6
=$1,000
A
1-6

=$3,500
Machine A
0 1 2 3 4 5 6 7 8 9
F
6
=$2,000
A
1-9

=$3,100
$18,000
Machine B
LCM(6,9) = 18 year study period will apply for present worth
5.3 Unequal Lives: 2 Alternatives
i = 15% per year
Machine A
LCM(6,9) = 18 year study period will apply for present worth
Cycle 1 for A Cycle 2 for A Cycle 3 for A
6 years 6 years 6 years
Cycle 1 for B Cycle 2 for B
18 years
9 years 9 years
Machine B
5.3 Example: Unequal Lives Solving
LCM = 18 years

Calculate the present worth of a 6-year cycle
for A
P
A
= 11,000 + 3,500 (P|A, .15, 6)
1,000 (P|F, .15, 6)
= 11,000 + 3,500 (3.7845) 1,000 (.4323)
= $23,813, which occurs at time 0, 6 and 12
5.3 Example: Unequal Lives

P
A
= 23,813+23,813 (P|F, .15, 6)+
23,813 (P|F, .15, 12)
= 23,813 + 10,294 + 4,451 = 38,558
0 6 12 18
$23,813 $23,813 $23,813
Machine A
5.3 Unequal Lives Example: Machine B
Calculate the Present Worth of a 9-year
cycle for B

0 1 2 3 4 5 6 7 8 9
F
6
=$2,000
A
1-9

=$3,100
$18,000
5.3 9-Year Cycle for B
Calculate the Present Worth of a 9-year cycle
for B
P
B
= 18,000+3,100(P|A, .15, 9)
1,000(P|F, .15, 9)
= 18,000 + 3,100(4.7716) - 1,000(.2843)
= $32,508 which occurs at time 0 and 9

5.3 Alternative B 2 Cycles
P
B
= 32,508 + 32,508 (P|F, .15, 9)
= 32,508 + 32,508(.2843)
P
B
= $41,750
Choose Machine A
0 9 18
$32,508 $32,508
Machine A: PW =$38,558
5.3 Unequal Lives Assumed Study
Period
Study Period Approach
Assume alternative: 1 with a 5-year life
Alternative: 2 with a 7-year life
Alt-1: N = 5 yrs
Alt-2: N= 7 yrs
LCM = 35 yrs
Could assume a study period of, say, 5 years.
5.3 Unequal Lives Assumed Study
Period
Assume a 5-yr. Study period
Estimate a salvage value for the 7-year
project at the end of t = 5
Truncate the 7-yr project to 5 years
Alt-1: N = 5 yrs
Alt-2: N= 7 yrs
Now, evaluate both
over 5 years using
the PW method!
5.4 FUTURE WORTH APPROACH
FW(i%) is an extension of the present
worth method
Compound all cash flows forward in
time to some specified time period
using (F/P), (F/A), factors or,
Given P, the F = P(1+i)
N

5.4 Applications of Future Worth
Projects that do not come on line until
the end of the investment period
Commercial Buildings
Marine Vessels
Power Generation Facilities
Public Works Projects
Key long time periods involving
construction activities
5.4 Future Worth Example (Figure 5.3)
See Example 5.3
Calculate the Future Worth of
determining the selling price in order to
earn exactly 25% on the investment
Draw the cash-flow diagram!!
5.5 CAPITALIZED COST
CAPITALIZED COST- the present worth
of a project that lasts forever.
Government Projects
Roads, Dams, Bridges (projects that
possess perpetual life)
Infinite analysis period
5.5 Derivation for Capitalized Cost
Start with the closed form for the P/A factor

Next, let N approach infinity and divide the
numerator and denominator by (1+i)
N

(1 ) 1
(1 )
N
N
i
P A
i i
(
+
=
(
+

5.5 Derivation - Continued
Dividing by (1+i)
N
yields

Now, let n approach infinity and the
right hand side reduces to.

1
1
(1 )
N
i
P A
i
(
(
+
= (
(
(

5.5 Derivation - Continued
1 A
P A
i i
(
= =
(

Or,
CC(i%) = A/i
Assume you are called on to maintain a
cemetery site forever if the interest rate
= 4% and $50/year is required to
maintain the site.
Find the PW of an infinite annuity flow
1 2 3 4 5 .. N=inf.
A=$50/yr
P = ?
..
1 2 3 4 5 .. N=inf.
A=$50/yr
P = ?
Find the PW of an infinite annuity flow
..
P
0
= A[P/A,i%,N]
(1 ) 1
, let N
(1 )
(1 ) 1 1
lim
(1 )
N
N
N
N
N
i
P A
i i
i
i i i
(
+
=
(
+

(
+
=
(
+

P
0
=A(1/i)
P
0
= $50[1/0.04]
P
0
= $50[25] = $1,250.00
Invest $1,250 into an account that
earns 4% per year will yield $50 of
interest forever if the fund is not
touched and the i-rate stays constant.
5.5 CAPITALIZED COST: Endowments
Assume a wealthy donor wants to endow a
chair in an engineering department.
The fund should supply the department with
$200,000 per year for a deserving faculty
member.
How much will the donor have to come up
with to fund this chair if the interest rate =
8%/yr.
5.5 CAPITALIZED COST: Endowed Chair
The department needs $200,000 per year.
P = $200,000/0.08 = $2,500,000
If $2,500,000 is invested at 8% then the
interest per year = $200,000
The $200,000 is transferred to the department,
but the principal sum stays in the investment to
continue to generate the required $200,000
EXAMPLE
Calculate the Capitalized Cost of a
project that has an initial cost of
$150,000. The annual operating cost is
$8,000 for the first 4 years and $5000
thereafter. There is an recurring
$15,000 maintenance cost each 15
years. Interest is 15% per year.
5.5 Capitalized Cost Example
$4,000
0 1 2 3 4 5 6 7 15 30
$150,000
$8,000
$15,000 $15,000 $15,000 $15,000
i=15%/YR
N=
How much $$ at t = 0 is required to fund this
project?
The capitalized cost is the total amount of $ at t
= 0, when invested at the interest rate, will
provide annual interest that covers the future
needs of the project.
5.5 Cash Flow Diagram
5.5 CAPITALIZED COST - Example
Continued
1. Consider $4,000 of the $8,000 cost
for the first four years to be a one-time
cost, leaving a $4,000 annual operating
cost forever.
P
0
= 150,000 + 4,000 (P|A, .15, 4) =
$161,420
2.855
5.5 CAPITALIZED COST - Continued
Recurring annual cost is $4,000 plus the
equivalent annual of the 15,000 end-of-
cycle cost.
.
0 15 30 45 60 ..
Take any 15-year period and find the equivalent
annuity for that period using the F/A factor.
5.5 CAPITALIZED COST: One Cycle
Take any 15-year period and find the equivalent
annuity for that period using the F/A factor

$15,000
A for a 15-year period
0 15 30 45 60 ..
.
2. Recurring annual cost is $4,000 plus
the equivalent annual of the 15,000
end-of-cycle cost.
A= 4,000 + 15,000 (A|F, .15, 15)
= 4,000 + 15000 (.0210) = $5,315
Recurring costs = $5,315/i =
5,315/0.15 =$3,443/yr
Capitalized Cost = 161,420 + 5315/.15
= $196,853
Thus, if one invests $196,853 at time t
= 0, then the interest at 15% will
supply the end-of-year cash flow to
fund the project so long as the principal
sum is not reduced or the interest rate
changes (drops).
5.6 Payback Period Analysis
Two forms for this method
Discounted Payback Period (uses an interest
rate)
Conventional Payback Period (does not use
an interest rate)
Payback is the period of time it takes for
the cash flows to recover the initial
investment.
5.6 Payback Period Analysis
Discounted Payback Approach
Find the value of n
p
such that:

1
0 ( / , , )
p
t n
t
t
P NCF P F i t
=
=
= +
5.6 Payback Period Analysis - Example
Example 5.8
Machine 1: N=7
Machine 2: N=14
i = 15%
5.6 Payback Period Analysis - Example 5.8
Tabular Format: Machine 1
5.6 Payback Period Analysis- Machine A
Payback
is
between
6 and 7
yeas
(6.57 yrs)
PW(15%)= +$481.00
5.6 Non-Discounted Analysis Machine A
At a 0
interest rate
the PB time
is seen to
equal 4
years!
5.6 Payback for Machine B at 15%, N = 14 yrs
Payback for B is
between 9 and
10 years!
Longer time
period to
recover the
investment.
9.52 years
5.6 Payback at 0% for Machine B
Payback for B at
0% is 6 years!
5.6 Payback for Example 5.8
Discounted
Machine A: 6.57 years
Machine B: 9.52 years
Undiscounted
Machine A: 4.0 years
Machine B: 6.0 years
Go with Machine A lower time period
payback to recover the original
investment
5.6 Payback Method Summarized
Payback is only a rough estimator of
desirability
Use as an initial screening method
Avoid using this method as a primary
analysis technique for selection projects
Totally avoid the no-return payback
period
5.6 Payback Method Summarized
The No-return method
Does not employ the time value of money
Disregards all cash flows past the payback
time period
If used, can lead to conflicting selections
when compared to more technically correct
methods like present worth!
5.7 Life Cycle Costs (LCC)
Extension of the Present Worth method
Used for projects over their entire life
span where cost estimates are
employed
Used for:
Military/Defense Projects
New Product Lines
Large construction projects
5.7 Life Cycle Defined Detailed Phases
Needs Assessment Phase
Conceptual Design Phase
Detailed Design Phase
Production/Construction Phase
Operation (upgrading to extend)
Phase
Retirement/Disposal Phase
The life can be for years into the future
5.7 Life Cycle: Two General Phases
TIME
Cost-$
Acquisition Phase Operation Phase
Cumulative Life Cycle
Costs
5.7 Life-Cycle Costs: Impact of Design
Changes
Cost of a design change tends to
multiply by 10 with each phase
Any design changes that might occur
late in the life cycle drastically increase
the total life cycle costs!
5.7 Life-Cycle Costs: Acquisition Phase
Needs Assessment Conceptual Design Detailed Design
Acquisition Phase
Costs - $
Rule: About 80% of LCC are locked in
by the end of the Acquisition Phase.
Emphasis is on good design!
5.7 Life-Cycle Costs Purpose
Make explicit as possible the
relationship of costs over the total life
span of a product/system
Design Process Objective
Minimize the life-cycle costs
And meet other performance requirements
By making correct trade-offs between costs
in the acquisition phase and costs during
the operations phase
5.7 Life-Cycle Costs Warning
Beware of introducing certain cost-
cutting measures in the acquisition
phase and early production phase
Such cost-cutting measures could
impact the future operations and
degrade safety or require modifications
later on
These cost-cutting measures can be
misleading and dangerous!
5.7 Life-Cycle Costs Warning
Engineers have a ethical and moral
responsibility to ensure that designs
are:
Economically sound
Functional
Safe
Perform as expected
5.8 Present Worth of Bonds
Bonds represent a source of funds for
the firm.
Bonds are sold (floated) by investment
banks for firms in order to raise
additional debt capital
A bond is similar to an IOU
Bonds are evidence of Debt
5.8 Bond Types Treasury Bonds
Treasury bonds
Issued by Federal Government
Full backing of the Government
1 year or less; 2-10 year issues; and 10-30
year issues
Conservative-type investment
5.8 Bond Types Municipal Bonds
State and Municipal Bonds
Issued by states and local governments
Generally tax-exempt by the Federal
Government
Used to finance state and local projects
Backed by future tax and user fees to pay
the interest and face value
5.8 Bond Types Mortgage Bonds
Mortgage Bonds
Issued by Corporations
Secured by the firms assets
Money received by the firm is used to fund
projects
Referred to a Debt Capital
Buyers of these bonds are not owners they
are lenders to the firm
5.8 Bond Types Debentures
Debenture Bond
Issued by Corporations
Not backed by specific assets
Backing good faith of the firm
Pays higher interest rates
Higher risks involved
Bond interest rate may float
Could be convertible to common stock
5.8 Present Worth of Bonds Overview
The Firm
Investment Bankers
Commissions/Fees
Proceeds from
The sale
Sell the Bonds to
The lending public
Bondholders
5.8 Bonds Basics
Bonds are negotiable instruments
Can be traded by the current
bondholder
Source of funds to the firm
Debt capital
Bondholders are loaning $$ to the firm
Earn periodic interest
Sell the bonds at any time

5.8 Bonds Firms View
Firm authorizes a bond sale
Bonds are sold by an outside agency
Firm pays a commission to the selling
agency
The firm receives the proceeds from the
sale
This is now DEBT capital to the firm
5.8 Bond Basics Continued
The bondholders are not owners
They are lendors
The firm pays periodic interest
payments to the current bond holders
At the end of the bonds life, the bonds
are redeemed (bought back) from the
current bond holder
5.8 Bond Basics - Continued
The bond itself is just a piece of paper
Evidence of the debt the firm has
incurred
The firm may be able to call the bonds
back by paying the current bondholder a
calculated sum
5.8 Bonds Notation
P
0
The time t = 0 selling price of the
bond the cost to the buyer of the bond
V The face value of the bond
The value printed on the bond
Face values are usually:
$100, $1,000, $5,000, $10,000 increments
N The life of the bond in years
r The nominal annual bond interest
rate

5.8 Bonds Notation and Example
Given the nominal annual bond interest
rate, the payment frequency of the
interest (monthly, quarterly semi-
annually, etc.) is also stated
Example:
V = $5,000 (face value)
r = 4.5% per year paid semiannually
N = 10 years

5.8 Bonds Example Continued
The interest the firm would pay to the
current bondholder is calculated as:

0.045
$5, 000( ) $5, 000(0.0225)
2
$112.50 every 6 months
I
I
= =
=
The bondholder, buys the bond and will receive
$112.50 every 6 months for the life of the bond
5.8 Bonds Example 5.11
Given
V = $10,000 (Face value of the bond)
r = 4.5% paid semiannually
N = 10 years or 20 interest periods
$I/6 months = $5,000(0.045/2) = $112.50
paid to the current bondholder

Bonds are bought at sold in a bond market. Thus
the price of the bond is subject to the pressures of
the bond market.
5.8 Example 5.11
Key Point The purchase price of the
bond can be considered a value that is
determined by a willing buyer and a
willing seller.
Assume the potential buyer of this bond
requires a interest rate of no less than
8%/year compounded quarterly.
5.8 Example 5.11 Continued
The purchaser will consider this bond if
he/she can earn 8%/yr c.q.
What is fixed?
The future interest payments are fixed
The future face value of the bond in fixed
What can vary?
The purchase price such that the buyer can
earn at least the 8%/yr c.q.
5.8 Example 5.1 Continued
8% c.q is the same as
0.08/4 = 0.02 = 2% per quarter.
Bond interest flows every 6 months
Need an effective 6-month rate
The effective 6-month rate is then
(1.02)
2
1 0.0404 = 4.04%/6 months
This is the potential buyers required
interest rate
5.8 Example 5.11 Solving
The objective is to determine the
purchase price of this bond discounted
at the buyers required rate of 4.04%
per 6 months
Draw the cash-flow diagram
Work the problem with N = 20 (not 10)
We have 20 interest payments (every 6
months) = 10 years
5.8 Example 5.11 Cash-Flow Diagram
A = 112.50/6 months
0 1 2 3 4 . .. 19 20
P=??
$5,000
i=4.04%/6 months
Find the PW(4.04%) of the future cash
flows to the potential bond buyer
5.8 Example 5.11 Solving
P = $112.50(P/A,4.04%,20)
+ $5,000(P/F,2%,40)
P = $3,788
IF the buyer can buy this bond for
$3,788 or less, he/she will earn at least
the 8% c.q. rate.
Summary: Present Worth
Present Worth is the basic analysis approach for
most engineering economy studies.
It also forms a basis for the Internal Rate of
Return method to be presented later
Requires knowledge of the discount rate as part
of the analysis
Summary: Present Worth
PW represents a family of methods
Annual worth
Future Worth
Capitalized Cost
Life-cycle cost analysis application
Bond Problems application
End of Chapter 5 Lecture Set

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