CHAPTER 5 Present Worth Analysis In the previous chapters two important tasks were accomplished. First, the concept of equivalence was presented. We are powerless to compare series of cash flows unless we can resolve them into some equivalent arrangement. Second, equivalence, with alteration of cash flows from one series to an equivalent sum or series of cash flows, created the need for compound interest factors. A whole series of compound interest factors were derived—some for periodic compounding and some for continuous compounding. This background sets the stage for the chapters that follow. Economic Criteria We have shown how to manipulate cash flows in a variety of ways, and in so doing we can now solve many kinds of compound interest problems. But engineering economic analysis is more than simply solving interest problems. The decision process (see Figure 2-2) requires that the outcomes of feasible alternatives be arranged so that they may be judged for economic efficiency in terms of the selection criterion. Depending on the situation, the economic criterion will be one of the following:! "This shor table summarizes the discussion on selection of criteria, early in Chapter 3. 167168 0 Chapter 5 Present Worth Analysis ‘Situation Criterion For fixed input Maximize output For fixed output Minimize input Neither input nor output fixed Maximize (output — input) We will now examine ways to resolve engineering problems, so that criteria for economic efficiency can be applied. Equivalence provides the logic by which we may adjust the cash flow for a given alternative into some equivalent sum or series, To apply the selection criterion to the outcomes of the feasible alternatives, we must first resolve them into comparable units. The question is, how should they be compared? In this chapter we'll learn how analysis can resolve alternatives into equivalent present consequences, referred to simply as present worth analysis. Chapter 6 will show how given alternatives are converted into an equivalent uniform annual cash flow, and Chapter 7 solves for the interest rate at which favorable consequences—that is, benefits—are equivalent to unfavorable consequences—or costs. As a general rule, any economic analysis problem may be solved by the methods Presented in this and in the two following chapters. This is true because present worth, annual cash flow, and rate of return are exact methods that will always yield the same solution in selecting the best alternative from among a set of mutually exclusive alternatives? Some problems, however, may be more easily solved by one method than another. For this reason, wenow focus on the kinds of problems that are most readily solved by present worth analysis, Applying Present Worth Techniques One of the easiest ways to compare mutually exclusive alternatives is to resolve their Consequences to the present time. The three criteria for economic efficiency are restated in terms of present worth analysis in Table 5-1. Present worth analysis is most frequently used to determine the present value of future money receipts and disbursements. It would help us, for example, to determine a present worth ofincome-producing property, like an oil well or an apartment house. If the future income and costs are known, then using a suitable interest rate, the present worth of the property may be calculated. This should provide a good estimate of the price at which the property could be “Mutually exclusive is where selecting one altemative precludes selecting any other altemative. An example of mutually exclusive altematives would be deciding between constructing a gas station ora drive-in restaurant on a particular piece of vacant land,Applying Present Worth Techniques 9 169 bought or sold. Another application might be determining the valuation of stocks or bonds based on the anticipated future benefits from owning them. In present worth analysis, careful consideration must be given to the time period covered by the analysis. Usually the task to be accomplished has a time period associated with it. In that case, the consequences of each alternative must be considered for this period of time which is usually called the analysis period, or sometimes the planning horizon. Table 5-1 PRESENT WORTH ANALYSIS. Situation Criterion Fixed input Amount of money or other Maximize present worth of input resources are fixed benefits or other outputs Fixed output ‘There is a fixed task, benefit, | | Minimize present worth of costs or other output to be or other inputs accomplished Neither input Neither amount of money, or Maximize (present worth of nor output is _other inputs, nor amount of benefits minus present worth of fixed benefits, or other output, is costs), that is, maximize net fixed present worth There are three different analysis-period situations that are encountered in economic analysis problems: 1. The useful life of each alternative equals the analysis period. 2. The alternatives have useful lives different from the analysis period. 3. There is an infinite analysis period, n = 2° 1. Useful Lives Equal the Analysis Period Since different lives and an infinite analysis period present some complications, we will begin with four examples where the useful life of each alternative equals the analysis period. EXAMPLE 5-1 A firm is considering which of two mechanical devices to install to reduce costs in a Particular situation. Both devices cost $1000 and have useful lives of five years and no salvage value. Device 4 can be expected to result in $300 savings annually. Device B will Provide cost savings of $400 the first year but will decline $50 annually, making the second year savings $350, the third year savings $300, and so forth. With interest at 7%, which device should the firm purchase?170 © Chapter 5 Present Worth Analysis Solution: The analysis period can conveniently be selected as the useful life of the devices, or five years. Since both devices cost $1000, we have a situation where, in choosing either ‘A or B, there is a fixed input (cost) of $1000. The appropriate decision criterion is to choose the alternative that maximizes the present worth of benefits. Device A: Device B: 400 350 A = 300 300 > 250 209 n= Syears n= Syears PW of Benefits PW of Benefits PW of benefits 4 = 300 (P/A,7%,5) = 300(4.100) = $1230 PW of benefits B = 400 (P/A,7%,5) - 50(P/G,7%,5) = 400(4.100) - 50(7.647) = $1257.65 Device B has the larger present worth of | ‘benefits and is, therefore, the preferred alternative. It is worth noting that, if we ignore the time value of money, both alternatives provide $1500 worth of benefits over the five-year period. Device B provides greater benefits in the first two years and smaller benefits in the last two years. This more rapid flow of benefits from B, although the total magnitude equals that of 4, results in a greater present worth of benefits. EXAMPLE 5-2 Wayne County will build an aqueduct to bring water in from the upper part ofthe state, Itcat be built at a reduced size now for $300 million and be enlarged 25 years hence for a additional $350 million. An alternative is to construct the full-sized aqueduct now for $406 million, oth alternatives would provide the needed capacity for the 50-year analysis perio’ Maintenance costs are small and may be ignored. At 6% interest, which alternative shoul be selected? Solution: This problem illustrates stage construction. The aqueduct may be builtin asingl stage, or in a smaller first stage followed many years later by a second stage 10 provide tt additional capacity when needed. For the two-stage construction. PW of cost = $300 million + 350 million (P/F,6%,25) 300 million + 81.6 million = $381.6 million For the single-stage construction: ——————— ssApplying Present Worth Techniques © 171 PW of cost = $400 million The two-stage construction has a smaller present worth of cost and is the preferred construction plan, ™ EXAMPLE 5-3 A purchasing agent is considering the purchase of some new equipment for the mailroom. Two different manufacturers have provided quotations. An analysis of the quotations indicates the following: Useful life, End-of-useful-life Manufacturer Cost inyears-—_ salvage value Speedy $1500 5 $200 Allied 1600 5 325 ‘The equipment of both manufacturers is expected to perform at the desired level of (fixed) output. For a five-year analysis period, which manufacturer's equipment should be selected? Assume 7% interest and equal maintenance costs. Solution: For fixed output, the criterion is to minimize the present worth of cost. Speedy: PW of cost = 1500 - 200(P/F,7%,5) = 1500 - 200(0.7130) 500 - 143 = $1357 Allied: PW of cost = 1600 - 325(P/F,7%,5) = 1600 - 325(0.7130) 600 - 232 = $1368 Since it is only the differences between alternatives that are relevant, maintenance costs may be left out of the economic analysis. Although the PW of cost for each of the alternatives is nearly identical, we would, nevertheless, choose the one with minimum present worth of cost unless there were other tangible or intangible differences that would change the decision. Buy the Speedy equipment. = EXAMPLE 5-4 A firm is trying to decide which of two alternate weighing scales it should install to check a package filling operation in the plant. The scale would allow better control of the filling operation and result in less overfilling. If both scales have lives equal to the six-year analysis Period, which one should be selected? Assume an 8% interest rate.172 0 Chapter 5 Present Worth Analysis Uniform — End-of-useful-life Alternatives Cost annual benefit salvage value Atlas scale $2000 $450 $100 Tom Thumb scale 3000 600 700 Solution: Atlas scale. PW of benefits ~ PW of cost = 450(P/4,8%,6) + 100(P/F,8%,6) - 2000 = 450(4.623) + 100(0.6302) - 2000 = 2080 + 63-2000 = $143 Tom Thumb scale. PW of benefits ~ PW of cost = 600(P/4,8%,6) + 700(P/F,8%,6) — 3000 = 600(4.623) + 700(0.6302) - 3000 = 2774+ 441 ~ 3000 = $215 The salvage value of the scale, it should be noted, is simply treated as another benefit of the alternative. Since the criterion is to maximize the present worth of benefits minus the present worth of cost, the preferred alternative is the Tom Thumb scale, Net Present Worth In Example 5-4, we compared two alternatives and selected the one where present worth of benefits minus present worth of cost was a maximum. The-criterion is called the net, {present worth criterion and written simply as NPW: Net present worth = Present worth of benefits — Present worth of cost NPW = PW of benefits — PW of cost 2. Useful Lives Different from the Analysis Period In present worth analysis, there always must be an identified analysis period. It follows, then, that each alternative must be considered for the entire period. In the previous Examples, the useful life of each alternative was equal to the analysis period. Often we can arrange it this way, but there will be many more situations where the alternatives have usefil lives different from the analysis period. This section examines the problem and describes how to overcome this difficulty. In Ex. 5-3, suppose that the Allied equipment was expected to have a ten year usefil life, or twice that of the Speedy equipment. Assuming the Allied salvage value would still be $325 ten years hence, which equipment should now be purchased? We will recompute the present worth of cost of the Allied equipment. Allied: PW of cost = 1600 — 325(P/F,7%,10) = 1600 — 325(0.5083) = 1600 — 165 = $1435SZEZ$ = ZOI ~ LZ6 + OOS = (€80s"0)002 - (O£1L'0)00EI + OST = (CO %L'4/d)007 ~ (S“%La/d (00Z ~ 00S 1) + 00ST = 3809 JO Md 07 02 ‘eouay szeaK aly 0OS1SIS09 osye [[1aM JUSUUdiNba 200 + 8 = 208 Withdrawal iP = 8 Year 2: $200 200+ 8= 208 Withdrawal iP= = _8 $200 and so on. Thus, for any initial present sum P, there can be an end-of-period withdrawal of A equal to iP each period, and these withdrawals may continue forever without diminishing the initial sum P. This gives us the basic relationship: Forn=, A= Pi This relationship is the key to capitalized cost calculations. We previously defined capitalized cost as the present sum of money that would need to be set aside at some interest rate to yield the funds to provide the desired task or service forever. Capitalized cost is therefore the P in the equation A = iP. It follows that: Capitalized cost P= a i If we can resolve the desired task or service into an equivalent A, the capitalized cost may be computed. The following examples illustrate such computations. EXAMPLE 5-5. How much should one set aside to pay $50 per year for maintenance on a gravesite if interest is assumed to be 4%? For perpetual maintenance, the principal sum must remain undiminished after making the annual disbursement. Solution: Annual disbursement A Capitalized cost P = 7 Interest rate # 22. $1250. 0.04—- a Applying Present Worth Techniques 0 177 One should set aside $1250. = EXAMPLE 5-6 A city plans a pipeline to transport water from a distant watershed area to the city. The pipeline will cost $8 million and have an expected life of seventy years. The city anticipates it will need to keep the water line in service indefinitely. Compute the capitalized cost assuming 7% interest. Solution: We have the capitalized cost equation: p=4 i thatis simple to apply when there are end-of-period disbursements 4. Here we have renewals of the pipeline every seventy years. To compute the capitalized cost, it is necessary to first compute an end-of-period disbursement A that is equivalent to $8 million every seventy years. $8 million $8 million $8 million $8 million 70 years 140 years - Capitalized Cost ? The $8 million disbursement at the end of seventy years may be resolved into an equivalent A. $8 million178 0 Chapter 5 Present Worth Analysis A= F(A/Fin) = $8 million(A4/F,7%,70) = $8 million(0.00062) = $4960 Each seventy-year period is identical to this one and the infinite series is shown in Fig, 5-2. Capitalized cost P= $8 million oo = $8 million + 4960 i 0.07 = $8,071,000 $8 million A= 4960 tittetttttt Capitalized Cost P Figure 5-2 Infinite series computed using the sinking fund factor. Alternate Solution: Instead of solving for an equivalent end-of-period payment A based on a future $8 million disbursement, we could find A, given a present $8 million disbursement. A= P(A/P,i,n) = $8 million(A/P,7%,70) = $8 million(0.0706) = $565,000 On this basis, the infinite series is shown in Fig. 5-3. Carefully note the difference between this and Fig. 5-2. Now: Capitalized cost P= 42 385.009 _ §6.971,000 . 70.07 A = 565,000 Figure 5-3 Infinite series computed using the capital recovery factor.Applying Present Worth Techniques © 179 Alternate Solution Two: Another way of solving the problem is to assume the interest is 70 years. Compute an equivalent interest rate for the 70 year period. Then the capitalized cost may be computed Using Eq. 4-33 for m= 70 droge = (I4dyp)” 1 = (140.07)” -1 = 112989 Capitalized cost = $8 million +8 million _ >, = $8,071,000 = 112.989 : Multiple Alternatives So far the discussion has been based on examples with only two alternatives. But multiple- alternative problems may be solved by exactly the same methods employed for problems with two alternatives. (The only reason for avoiding multiple alternatives was to simplify the examples.) Examples 5-7 and 5-8 have multiple alternatives. EXAMPLE 5-7 A contractor has been awarded the contract to construct a six-miles-long tunnel in the mountains. During the five-year construction period, the contractor will need water from a nearby stream. He will construct a pipeline to convey the water to the main construction yard. An analysis of costs for various pipe sizes is as follows: Pipe size 2 4M 6" Installed cost of pipeline and pump $22,000 $23,000 $25,000 $30,000 Cost per hour for pumping $1.20 $0.65 $0.50 «$0.40 The pipe and pump will have a salvage value at the end of five years equal to the cost to remove them. The pump will operate 2000 hours per year. The lowest interest rate at which the contractor is willing to invest money is 7%. (The minimum required interest rate for invested money is called the minimum attractive rate of return, ot MARR.) Select the alternative with the least present worth of cost. Solution: We can compute the present worth of cost for each alternative. For each pipe size, the Present worth of cost is equal to the Installed cost of the pipeline and pump plus the Present worth of five years of pumping costs.180 © Chapter 5 Present Worth Analysis Pipe size 2" 3" 4" 6 Installed cost of pipeline and pump $22,000 $23,000 $25,000 $30,000 1.20 x 2000 hr * 9,840 (P/A,7%,5) 0.65 2000 hr 4,100 5,330 0.50 x 2000 hr * 4.100 4,100 0.40 x 2000 hr * 4.100 _ 3,280 Present worth of cost $31,840 $28,330 $29,100 $33,280 Select the 3" pipe size. ™ EXAMPLE 5-8 ‘An investor paid $8000 to a consulting firm to analyze what he might do with a small parcel of land on the edge of town that can be bought for $30,000. In their report, the consultants suggested four alternatives: Total investment Uniform net_——Terminal value at Alternatives including land* annual benefit end of 20 yr ‘A: Do nothing oO so s 0 B: Vegetable market 50,000 5,100 30,000 C: Gas station 95,000 10,500 30,000 D: Small motel 350,000 36,000 150,000 ‘Includes the land and structures but does not include the $8000 fee to the consulting firm. Assuming 10% is the minimum attractive rate of return, what should the investor do? Solution: Alternative A represents the "do nothing" alternative. Generally, one of the feasible alternatives in any situation is to remain in the present status and do nothing. In this problem, the investor could decide that the most attractive alternative is not to purchase the property and develop it. This is clearly a “donothing” decision. We note, however, that even if he does nothing, the total venture would not be a very satisfactory one. This is due to the fact that the investor spent $8000 for professional advice on the possible uses of the property. But because the $8000 is a past cost, it is a sunk cost. Sunk cost is the name given to past costs. The only relevant costs in an economic analysis are present and future costs; past events and past costs are gone and cannot be allowed to affect future planning. (The only place where past costs may be relevant is in computing depreciation charges and income taxes.) It should not deter the investor from making the bestApplying Present Worth Techniques 0 181 decision now, regardless of the costs that brought him to this situation and point of time. This problem is one of neither fixed input nor fixed output, so our criterion will be to maximize the Present worth of benefits minus the Present worth of cost, or, simply stated, maximize net present worth. Alternative A, Do nothing. NPW=0 Alternative B, Vegetable market: NPW =~50,000 + 5100(P/4,10%,20) + 30,000(P/F,10%,20) 50,000 + 5100(8.514) + 30,000(0.1486) 50,000 + 43,420 + 4460 =-2120 Alternative C, Gas station. NP’ —95,000 + 10,500(P/4,10%,20) + 30,000(P/F,10%,20) 95,000 + 89,400 + 4460 1140 Alternative D, Small motel: NPW = —350,000 + 36,000(P/A,10%,20) + 150,000(P/F,10%,20) 350,000 + 306,500 + 22,290 21,210 The criterion is to maximize net present worth. In this situation, one alternative has NPW equal to zero, and three alternatives have negative values for NPW. We will select the best of the four alternatives, namely, the do-nothing Alt. A with NPW equal to zero. @ EXAMPLE 5-9 A piece of land may be purchased for $610,000 to be strip-mined for the underlying coal. Annual net income will be $200,000 per year for ten years. At the end of the ten years, the surface of the land will be restored as required by a federal law on strip mining. The cost of reclamation will be $1,500,000 more than the resale value of the land after it is restored. Using a 10% interest rate, determine whether the project is desirable. Solution: The investment opportunity may be described by the following cash flow: Year — Cash flow, in thousands 0 -3610 1-10 +200 (per year) 10 15001820 Chapter 5 Present Worth Analysis NPW =-610 + 200(P/4,10%,10) ~ 1500(P/F,10%, 10) =-610 + 200(6.145) ~ 1500(0.3855) =~610 + 1229-578 =+41 Since NPW is positive, the project is desirable. = EXAMPLE 5-10 Two pieces of construction equipment are being analyzed: Year Alternative A Alternative B 0 $2000 $1500 1 +1000 +700 2 +850 +300 3 +700 +300 4 +550 +300 5 +400 +300 6 +400 +400 7 +400 +500 8 +400 +600 Based on an 8% interest rate, which alternative should be selected? Solution: Alternative A PW of benefits = 400(P/4,8%,8) + 600(P/A,8%,4) — 150(P/G,8%,4) = 400(5.747) + 600(3.312) — 150(4.650) = 3588.50 PW of cost = 2000 Net present worth = 3588.50 — 2000 = +1588.50Assumptions In Solving Economic Analysis Problems 183 Alternative B. PW of benefits = 300 (P/A,8%,8) + (700 — 300\(P/F,8%, 1) + 100(P/G,8%,4)(P/F,8%,4) = 300(5.747) + 400(0.9259) + 100(4.650)(0.7350) PW of cost Net present worth = 2436.24 — 1500 = 4936.24 To maximize NPW, choose Alt. A, Assumptions In Solving Economic Analysis Problems One of the difficulties of problem solving is that most problems tend to be very complicated. It becomes apparent that some simplifying assumptions are needed to make such problems manageable. The trick, of course, is to solve the simplified problem and still be satisfied that the solution is applicable to the real problem! In the paragraphs that follow, we will consider six different items and explain the customary assumptions that are made. End-of-Year Convention As we indicated in Chapter 4, economic analysis textbooks follow the end-of-year convention. This makes "A" a series of end-of-period receipts or disbursements. (We generally assume in problems that all series of receipts or disbursements occur at the end of the interest period. This is, of course, a very self-serving assumption, for it allows us to use values from our Compound Interest Tables without any adjustments.)184 0 Chapter 5 Present Worth Analysis A cash flow diagram of P, A, and F for the end-of-period convention is as follows: Year 0 (End of Year 1 (End off Year 2 Jan Dec 31 Jan Dec 31 J | 4 P F If one were to adopt a middle-of-period convention, the diagram would be: Middle Middle End of of of Year 0 Year! Year? Year 2 Jan | Jun 30 Dec 31 Jan t Jun 30 Dec 31 4 4 P F ‘As the diagrams illustrate, only A shifts; P remains at the beginning-of-period and F at the end-of-period, regardless of the convention. The Compound Interest Tables in the Appendix are based on the end-of-period convention. Viewpoint of Economic Analysis Studies ‘When we make economic analysis calculations, we must proceed from a point of reference. Generally, we will want to take the point of view of a total firm when doing industrial economic analyses. Example 2-1 vividly illustrated the problem: a firm's shipping department decided it could save money having its printing work done outside rather than by the in-house printing department. An analysis from the viewpoint of the shipping department supported this, as it could get for $688.50 the same printing it was paying $793.50 for in-house. Further analysis showed, however, that its printing department costs would decline /ess than using the commercial printer would save. From the viewpoint of the firm, the net result would be an increase in total cost. From Ex. 2-1 we see it is important that the viewpoint of the study be carefully considered, Selecting a narrow viewpoint, like the shipping department, may result in a suboptimal decision from the viewpoint of the firm. For this reason, the viewpoint of the total firm is the normal point of reference in industrial economic analyses.Assumptions In Solving Economic Analysis Problems © _185 Sunk Costs We know that it is the differences between alternatives that are relevant in economic analysis. Events that have occurred in the past really have no bearing on what we should do in the future. When the judge says, "$200 fine or three days in jail," the events that led to these unhappy alternatives really are unimportant. What is important are the current and future differences between the alternatives. Past costs, like past events, have no bearing on deciding between alternatives unless the past costs somehow affect the present or future costs. In general, past costs do not affect the present or the future, so we refer to them as sunk costs and disregard them. Borrowed Money Viewpoint In most economic analyses, the proposed alternatives inevitably require money to be spent, and so it is natural to ask the source of that money. The source will vary from situation to situation. In fact, there are vo aspects of money to determine: one is the financing—the obtaining of money—problem; the other is the investment—the spending of money—problem. Experience has shown that these two concerns should be distinguished. When separated, the problems of obtaining money and of spending it are both logical and straightforward. Failure to separate them sometimes produces confusing results and poor decision making. The conventional assumption in economic analysis is that the money required to finance alternatives/solutions in problem solving is considered to be borrowed at interest rate i. Effect of Inflation and Deflation For the present we will assume that prices are stable. This means that a machine that costs $5000 today can be expected to cost the same amount several years hence. Inflation and deflation is a serious problem in many situations, but we will disregard it for now. Income Taxes This aspect of economic analyses, like inflation-deflation, must be considered if a realistic analysis is to be done. We will defer our introduction of income taxes into economic analyses until later. Spreadsheets and Present Worth Spreadsheets make it easy to build more accurate models with shorter time periods. When using factors, it is common to assume that costs and revenues are uniform for N'years. With spreadsheets it is easy to use 120 months instead of 10 years, and the cash flows can be estimated for each month. For example, energy costs for air conditioning peak in the summer186 0 Chapter 5 Present Worth Analysis and in many areas construction during the winter is limited. Cash flows that depend on population often increase at x% per year, such as for electric power and transportation costs. In spreadsheets any interest rate is entered exactly — so no interpolation is needed. This makes it easy to calculate the monthly repayment schedule for a car Joan or a house mortgage. Examples 5-11 and 5-12 illustrate using spreadsheets to calculate PW’s. EXAMPLE 5-11 NLE Construction is bidding on a project whose costs are divided into $30,000 for startup and $240,000 for the first year. If the interest rate is 1% per month or 12.68% per year, what is the present worth with monthly compounding? Solution Figure 5-4 illustrates the spreadsheet solution with the assumption that costs are distributed evenly throughout the year (-20,000 = -240,000/12). K z c D 4 1% i 2] -30,000 initial cash flow 3] -240,000 annual amount z 3} Month Cash Flow 6} 0 30,000 7 1 -20000 a] 2 -20000 a] 3 -20000 mp 2 20000 i4 5 -20000 2] 6 20000 43 = -20000, 44 8 20000, 15] 9 -20000 16] 10 “20000 47 4 -20000 48 12 -20000 49 NPV ~$255,102_=NPV(A1,B7:B18)+B6 Figure 5-4 Spreadsheet with monthly cash flows. Since the costs are uniform, the factor solution is:Assumptions In Solving Economic Analysis Problems _© _187 PWernus = ~30,000 ~ 240,000-(P/F,12.68%,1) = - 30,000 - 240,000 /1.1268 = - $242,993 PWpea~30,000 ~20,000-(P/4,1%,12) = ~$255,102 ‘These two values differ by more than $12,000, because $20,000 at the end of months 1 through 12 is not the same as $240,000 at the end month 12. The effective interest rates are the same. EXAMPLE 5-12 Regina Industries has a new product whose sales are expected to be 1.2, 3.5, 7, 5, and 3 million units per year over the next 5 years. Production, distribution, and overhead costs are stable at $120 per unit. The price will be $200 per unit for the first 2 years, and then $180, $160, and $140 for the next 3 years. The remaining R&D and production costs are $400 million. If i is 15%, what is the present worth of the new product? Solution Itis easiest to calculate the yearly net revenue per unit before building the spreadsheet shown in Figure 5-5. Those values are the yearly price minus the $120 of costs, which equals $80, $80, $60, $40, and $20. A B c D E 7 12% 7 2 Net Cash 3 Year Sales(M) Revenue Flow ($M) 4 0 -300 3S 1 12 80 96 6 2 35 80 280 7 3 7 64 448 g 4 : 40 200 3 5 20 60 10 DAsNPvY (A1,D5:D9)= __$489 Million Figure 5-5 Present worth of a new product. .188 9 Chapter 5 Present Worth Analysis SUMMARY Present worth analysis is suitable for almost any economic analysis problem. But it is particularly desirable when we wish to know the present worth of future costs and benefits, And we frequently want to know the value today of such things as income-producing assets, stocks, and bonds. For present worth analysis, the proper economic criteria are: Fixed input Maximize the PW of benefits Fixed output Minimize the PW of costs Neither input nor Maximize (PW of benefits ~ PW of costs) or, output is fixed more simply stated: Maximize NPW To make valid comparisons, we need to analyze each alternative in a problem over the same analysis period or planning horizon. If the alternatives do not have equal lives, some technique must be used to achieve a common analysis period. One method is to select an analysis period equal to the least common multiple of the alternative lives. Another method is to select an analysis period and then compute end-of-analysis-period salvage values for the alternatives. Capitalized cost is the present worth of cost for an infinite analysis period (n= =). When =o , the fundamental relationship is 4 = iP, Some form of this equation is used whenever there is a problem with an infinite analysis period. There are a number of assumptions that are routinely made in solving economic analysis problems. They include the following: 1. Present sums P are beginning of period and all series receipts or disbursements 4 and future sums F occur at the end of the interest period, The compound interest tables were derived on this basis. 2. Inindustrial economic analyses, the appropriate point of reference from which to compute the consequences of alternatives is the total firm. Taking a narrower view of the consequences can result in suboptimal solutions. 3. Only the differences between the alternatives are relevant. Past costs are sunk costs and generally do not affect present or future costs. For this reason they are ignored, 4. The investment problem shouldbe isolated from the financing problem. We generally assume that all required money is borrowed at interest rate ;Problems 0 189 5. For now, stable prices are assumed. The problem of inflation-deflation is deferred to Chapter 13. Similarly, income taxes are deferred to Chapter 11. Problems 5-1 Compute P for the following diagram. 5-2 Compute the value of P that is equivalent to the four cash flows in the diagram below. 30 30 i= 15% 5-3 What is the value of P for the situation shown below?