Dr.

Nidal Hussein
 Present worth (PW)
 Future worth (FW)
 Annual worth (AW)
 Internal rate of return (IRR)
 External rate of return (ERR)
 Payback period (generally not appropriate as
a primary decision rule)
To be attractive, a capital project
must provide a return that exceeds
a minimum level established by
the organization. This minimum
level is reflected in a firm’s
Minimum Attractive Rate of
Return (MARR).
 Amount, source, and cost of money
available
 Number and purpose of good projects
available
 Perceived risk of investment
opportunities
 Type of organization
 In general, the decision making process involves the
identification of the best alternative among different
alternatives
 There may initially be many alternatives, nevertheless
only a few will be feasible and actually evaluated
 Therefore, each alternative is a stand-alone option that
involves description and best estimates of parameters
such as first cost (purchase prices, development,
installation), estimated annual incomes and expenses,
salvage value, interest rate, etc.
 To select an alternative among different ones, the
measure-of-worth values are compared

 This is simply the result of engineering economy

analysis

 Once the alternatives are evaluated and compared, the

best alternative is selected and implemented

 Keep in mind that the alternatives represent projects

that are economically and technologically viable
 To help formulate alternatives, projects are categorized
as one of the following:

 Mutually exclusive. Only one of the viable projects can

be selected by the economic analysis. Each viable
project is an alternative and compete among each
other

 Independent. More than one viable project may be

selected by the economic analysis. The projects do not
compete among each other
 Selection of the best power generation
engines from several engines
 Constructing a road between two cities with
an option of a road that crosses an
intermediate city or another option of a road
that circumvent that city
 Transporting goods between two river banks
either by boats or through building a bridge
 The do-nothing (DN) option is usually understood to be
an alternative when the evaluation is performed
 If it is absolutely required that one of the defined
alternatives to be selected, do nothing is not
considered an option. This may occur when a
mandated function must be installed for safety, legal,
or other purposes
 Selection of the DN alternative means that the current
situation is maintained; nothing new is initiated. No
new costs, revenues, or savings are generated by the
DN alternative
The present worth (PW) is found by
discounting all cash inflows and outflows to
the present time at an interest rate that is
generally the MARR.

A positive PW for an investment project

means that the project is acceptable (it
satisfies the MARR).
Consider a project that has an initial
investment of $50,000 and that returns
$18,000 per year for the next four years. If
the MARR is 12%, is this a good
investment?
 In present worth analysis, the P value, now
called PW, is calculated at the MARR for each
alternative
 MARR is the minimum attractive rate of return
and is higher than the rate expected from a
bank or some safe investment
 The expected rate of return must meet or
exceed the MARR for an alternative to be
financially viable
 The present worth method is popular because future cost
and revenue estimates are transformed into equivalent
dollars now
 This makes it easy to determine the economic advantage
of one alternative over another
 The PW comparison of alternatives with equal lives is
straightforward
 If alternatives are used for the same time period, they are
termed equal-service alternatives
EXAMPLE 5.1:
A piece of new equipment has been proposed by engineers to
increase the productivity of a certain manual welding operation.
The investment cost $25,000 and the equipment will have a
market value of $5,000 at the end of a study period of five years.
Increased productivity attributable to the equipment will amount
to $8,000 per year after extra operating costs have been
subtracted from the revenue generated by the additional
production. A cash flow diagram for this investment opportunity
is given below. If the firm’s MARR is 20% per year, is this
proposal a sound one? Use the PW method.
EXAMPLE 5.1:
Solution:
EXAMPLE 5.1:
Solution:
EXAMPLE 5.2:
EXAMPLE 5.2:
EXAMPLE 5.3:
EXAMPLE 5.3:
 In mutually exclusive alternatives, the following
guidelines are applied to select one alternative:
 One alternative. Calculate PW at the MARR. If PW ≥ 0,
the requested MARR is met or exceeded and 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 (less negative
or more positive), indicating a lower PW of cost cash
flows or larger PW of net cash flows of receipts minus
disbursements
 Note that the guideline to select one alternative with
the lowest cost or the highest income uses the
criterion of numerically largest
 This is NOT the absolute value of the PW amount,
because the sign matters

PW1, $ PW2, $ Selected Alternative

Perform a present worth analysis of equal-service
machines with the costs shown below, if the MARR is
10% per year. Revenues for all the three alternatives
are expected to be the same
Electric- Gas- Solar-
Cost Type
Powered Powered Powered
First cost, $
Annual operating cost, $
Salvage value, $
Life, years
 The salvage values are considered a “negative” cost, so a “+”
sign precedes them
 The PW of each machine is calculated at i = 10% for n = 5
years
 When the present worth method is used to compare
mutually exclusive alternatives that have different lives,
then the PW of the alternatives must be compared over
the same number of years and end at the same time
 A fair comparison can be made only when the PW
values represent costs (and receipts) associated with
equal periods
 The equal-period requirement can be satisfied by
comparing the alternatives over a period of time equal
to the least common multiple (LCM) of their lives
 The LCM approach automatically makes
the cash flows for all alternatives extend
to the same time period
 For example, alternatives with expected
lives of 2 and 3 years are compared over
a 6-year time period
 A project engineer is assigned to start up a new
office in a city where a 6-year contract has been
finalized
 Two lease options are available, each with a first
cost, annual lease cost, and deposit-return
estimates as shown below:
Location A Location B
First cost, $
Annual lease cost, $
Deposit return, $
Lease term, years
 Determine which lease option should be
selected on the basis of a present worth
comparison, if the MARR is 15% per year
 Since the leases have different lives, compare
them over the
 Repeat the first cost in year 0 of each new
cycle
 Calculate PW at 15% over 18 years
 PWA =

 PWB =

 Location , since it costs less in PW terms;

that is, the value is numerically larger than
 The future worth of an alternative (FW) can
be used to compare alternatives
 Once the FW value is determined, the
selection guidelines are the same as with PW
analysis
 For one alternative, if FW ≥ 0 means the
MARR is met or exceeded
 For two mutually exclusive alternatives, select
the one with the numerically larger FW value
EXAMPLE 5.6:
EXAMPLE 5. 7:
 A company purchased a store chain for $75 million 3 years ago
 There was a net loss of $10 million at the end of year 1 of
ownership
 Net cash flow is increasing with an arithmetic gradient of $+5
million per year starting the second year, and this pattern is
expected to continue for the foreseeable future. Expected
MARR of 25% per year
 [1] The company has just been offered $159.5 million to sell
the store. Use FW analysis to determine if the MARR will be
realized at this selling price
 [2] If the company continues to own the chain, what selling
price must be obtained at the end of 5 years of ownership to
make the MARR?
[1] Find the future worth in year
3 at i = 25% per year and an
offer price of $159.5 million
[2] Determine the future
worth 5 years from now
at 25% per year
 The payback period (np) is the estimated time
in years it will take for the estimated revenues
and other economic benefits to recover the
initial investment
 The payback period analysis should provide
initial screening or supplemental information
in conjunction with an analysis performed
using present worth or another method
 In order to find np, the initial investment
should equal the present worth of net present
value of all estimated cash flows
 An engineering firm has just approved an
$18 million design contract
 The services are expected to generate
new annual net cash flows of $3 million
 Contract period is 10 years
 If i = 15%, compute the payback period
 Two machines are being considered for purchase by a company.
Machine 2 is expected to be versatile and technologically
advanced enough to provide net income longer than machine 1
 The quality manager used a rate of return of 15% per year and a
PC-based economic analysis package. The manager
recommended machine 1 because it has a shorter payback
period of 6.57 years at i = 15%. Is this right?

Machine 1 Machine 2
First cost, $ 12,000 8,000
Annual NCF, $ 3,000 1,000 (years 1-5)
3,000 (years 6-14)
Maximum life, years 7 14
 For Machine 1

 For Machine 2
 If we would like to use PW analysis to compare the
machines, then the following procedure ought to be
considered:
 For Machine 1

 For Machine 2
PW2 =
 Capitalized cost (CC) is the present worth of
an alternative that will last forever

 Public sector projects such as bridges, dams,

irrigation systems, and railroads fall into this
category
 The CC value can be computed from the following
equation:

where A is the annual worth

 If $10,000 earns 20% per year, compounded
annually, the maximum amount of money that can
be withdrawn at the end of every year for eternity is
$2,000, or the interest accumulated each year
 This leaves the original $10,000 to earn interest so
that another $2,000 will be accumulated the next
year
 A new computer system will be used for the indefinite
future, find the equivalent value (a) now and (b) for
each year hereafter
 The system has an installed cost of $150,000 and an
additional cost of $50,000 after 10 years. The annual
maintenance cost is $5,000 for the first 4 years and
$8,000 thereafter. In addition, it is expected to be a
recurring major upgrade cost of $15,000 every 13 years

 Assume that i = 5% per year

1. Draw the cash flow diagram
2. Find the present worth of the nonrecurring costs of
$150,000 now and $50,000 in year 10 at i = 5%.
Label this CC1 where CC1 = – 150,000 –
50,000(P/F,5%,10) = $ –180,695
3. Convert the recurring cost of $15,000 every 13 years
into an annual worth A1 for the first 13 years. A1 = –
15,000(A/F,5%,13) = $ – 847. The same value, A1 = $
–847, applies to all the other 13-year periods as well
4. The capitalized cost for the two annual
maintenance cost series can be determined by
considering a series of $ –5,000 from now to
infinity and find the present worth of $ –8,000 –
($ –5,000) = $ –3,000 from year 5 on. The
annual cost (A2) is $ –5,000 forever
The capitalized cost CC2 of $ –3,000 from year 5
to infinity is found using the present value at
year 4 (A/i) and then multiply this by the P/F
factor 
CC2 = (– 3,000/0.05)(P/F,5%,4) = $ –49,362
4. The two annual cost series are converted
into a capitalized cost CC3 
5. CC3 = (A1 + A2)/i = (-847 + (-5,000))/0.05
= $ –116,940
6. The total capitalized cost CC is obtained
by adding the three CC values = –
180,695 – 49,362 – 116,940 = $ –346,997
1. Draw a cash flow diagram showing all nonrecurring (one-
time) cash flows and at least two cycles of all recurring
(periodic) cash flows
2. Find the present worth of all nonrecurring amounts. This
is their CC value
3. Find the equivalent uniform annual worth (A value)
through one life cycle of all recurring amounts. This is
the same value in all succeeding life cycles. Add this to
all other uniform amounts occurring in years 1 through
infinity and the result is the total equivalent uniform
annual worth (AW)
4. Divide the AW obtained in step 3 by the interest rate i to
obtain a CC value
5. Add the CC values obtained in steps 2 and 4
 Eliminates the LCM problem
 Only you evaluate one life cycle of a
project
 The result is reported in terms of
$/period
 Therefore, if two or more alternatives
possess unequal lives then one need
only evaluate the AW for any given cycle
6-year project Find the AW of any 6 – year cycle

9-year project Find the AW of any 9 – year cycle

And then compare the AW6/yr to AW9/yr

EXAMPLE 5. 9:
 Consider a project with a $3,000 annual operating cost
and a $5,000 investment required each 5 years.
Assume i = 10%
 For one cycle:
AW =

 For two cycles:

AW =
 Capital recovery (CR) is the equivalent annual
cost of owning the asset plus the return on
the initial investment

 CR = - P(A/P,i,5) + S(A/F,i,5)
S

P S

P $/year (CR)
 Initial investment (P): this is the total first cost
required to initiate the alternative. When portions of
these investments take place over several years,
their present worth is an equivalent initial
investment
 Salvage value (S): this is the estimated value of
assets at the end of their useful life
 If we have annual costs (A) of the alternatives then
the annual worth (AW) value for an alternative is
comprised of two components: capital recovery for
the initial investment P (plus the return on the initial
investment) and the equivalent annual amount A
 S

× S

×P
$/year (AW) = $/year (CR) + $/year (A)
 An equipment is expected to require an
investment of $13 million with $8 million
committed now and the remaining $5 million
will be paid at the end of year 1 of the project
 Annual operating costs for the system are
expected to start the first year and continue
at $0.9 million per year
 The useful life is 8 years with a salvage value
of $0.5 million
 Compute the AW value for the system if MARR
is 12%
 CR = – {[8 + 5(P/F,12%,1)](A/P,12%,8)} +
0.5(A/F,12%,8) = – (12.46)(0.2013) + 0.04 =
$ -2.47 (in millions/year)
 The $ -2.47 indicates that each and every year
for 8 years we have to have a revenue of at least
$2,470,000 just to recover the initial worth
investment plus the required return of 12% per
year
 This does not include the $0.9 million each year
 Total AW = -2.47 – 0.9 = $ -3.37 million per
year
 Two pumps are being considered for purchase.
If interest is 7%, which pump should be
bought?
Pump A B
Initial cost $7,000 $5,000
Salvage value $1,500 $1,000
Useful life, years 12 6
AWA =

AWB =
 Three plans are considered for an engineering design
problem:
 Plan A: purchase an equipment at $650,000 with a 10
year lifetime and a $17,000 salvage value. Equipment
annual operating cost is $50,000 while the annual cost
of a control program is $120,000
 Plan B: Initial cost is $4 million, annual maintenance
cost is $5,000, repairs occurs every 5 years at $30,000.
However, this plan provides a permanent solution
 Plan C: Initial cost is $ 6 million and the annual
maintenance cost is $3,000 with a lifetime of 50 years
 Assume i = 5%
 We need to compute AW for each plan for one cycle
 Plan A:
CRA =
A1 =
AWA =
 Plan B:
CRB =
A=
Repair cost =
AWB =
 Plan C:
CRC =
A=
is selected
AWC =
due to the lowest
AW of costs
Reference