Tutorial 2

Chapter 2
• Present worth index tells you how much you'd need in today's equivalent
currency to earn a specific amount in the future. We use present worth to
evaluate the equivalent worth of the business as of today.
• Present value states that an amount of money today is worth more than the same
amount in the future.
• The process which involved in calculating PW of an amount of money from future to
present called discounting.
• Discounting process could be performed using coefficient from interest table or
formula.

• Future worth index tells you how much an investment made today will be worth
in the future. We use future worth to evaluate the possible profitability of
particular business in future.
• Future worth (FW) is the value of a current amount of money at a future date based
on an assumed rate of growth(interest rate).
• The future value is important to investors and financial planners as they use it to
estimate how much an investment made today will be worth in the future.
• The process which involved in calculating FW of an amount of money from present
to future called compounding.
• Compounding process could be performed using coefficient from interest table or
formula.
 Question 1
An engineering technology group just purchased new cad software for 5000$. It is
anticipated that using this software they could generate 600$ annually as income
starting from year 3. If this project will take 8 years. What would be the present worth
of the project considering 8% interest rate?

Answer
Note: the general assumption in all the calculation of life cycle cost is all the interests
are compounded based ( it means we use compound interest instead of simple
interest) unless it is stated otherwise.

Step 1 : drawing cash flow diagram

Step 2 : Simplification of cash flow ( It means conversion of uniform or gradient
series to single value number using either of formula or table )
As it demonstrated in the table below, there are three major types of cash flow
including single , uniform and gradient. Eventually in the first step of calculating
present worth uniform and gradient series need to be converted to single value.
Since here we just have a single value at year 0 as initial cost and a series of identical
values as annual payment therefore, using formula we are going to convert our uniform
series to single value. After calculating the present value of uniform series (p) the
aforementioned single value will goes back 1 year from the beginning of uniform
series:
𝑃 1+𝑖 𝑛 −1
𝑃 𝑓𝑟𝑜𝑚 𝐴, =𝐴
𝐴 𝑖 1+𝑖 𝑛

Where A= amount of uniform cash flow

i = interest rate
n = number of arrows in uniform series (number of years in which this uniform
payment occurred)

So
𝑃 1+0.08 6 −1
= 600 × = 2773.72 ( placed on year 2)
𝐴 0.08 1+0.08 6

It means instead of having 6 equal payment of 600 $ starting from year 3 we will
could pay single amount of 2773.72. In other word 2773.72 in year 2 is equivalent
to 500 equal payment for 6 years starting year 3.
Step 3: discounting entire single values in cash flows to year 0
The formula for this process is:
P 1
P from F =F
F 1+i n
Where P= present worth
F= future worth ( single amount in future)
i = interest rate
n = number of years to be discounted ( to go back to year 0)

P 1
= 2773.72 × = 2378.02
F 1+0.08 2

Step 4: calculation of total present worth (including initial cost)

total present worth value = ෍ present worth of all the values

Total present worth = 2378.02 - 5000 = - 2621.98

 Question 2
Two method could be employed in manufacturing aerated blocks. method A costs
initially 80,000 $ and the operating cost of 30,000 $ annually and will have a
salvage value of 15000$ after 3 years. Method B but with capital investment of
120,000 $ and 8000 $ operating cost per year and 40,000 $ salvage value at the
end of year 3. considering 8% discount rate, which method should be used on the
basis of present worth method?

Answer
Note: Generally all the calculation of life cycle cost are compounded based unless
it is stated otherwise.
Method A:
Step 1 : drawing cash flow diagram
• Step 2 : conversion of cash flow ( it means conversion of uniform or gradient series
to single value number using either of formula or table. Which in this question
interest table utilized to convert following series to single value )
In this question out of three type of cash flow involved for method A, two are already a
single value ( initial cost and salvage value) but there is also a uniform cash flow from
year 1 to year 3 which has to be converted to single value. Therefore using table we are
going to convert a uniform series to single value which goes back 1 year from the
beginning of uniform series:
𝑃 𝑃
𝑃 𝑓𝑟𝑜𝑚 𝐴, = 𝐴 × ( , i, n)
𝐴 𝐴
𝑃
where , i, n is a coefficient
𝐴
i = interest rate
n = number of arrows in uniform series
So following procedure must be performed to use table for conversion
1) Find the table according to requested interest rate. Note that if the table is available
in the formula sheet you can use it directly otherwise you need to perform
interpolation to find out the coefficient accordingly ( interpolation method is
already explained in the lecture note)
2) From the table find the corresponding row based on the requested number of years
3) At the end from that row find the coefficient according to the column that you are
looking for.
• So for operating cost (uniform series)
𝑃 𝑃
= 𝐴 × ( , i, n) = (P/A)= -30,000×(P/A, 8%, 3) = -30,000 × (2.577) = -77,310
𝐴 𝐴

Once uniform series is converted to single value, as it is evident, by 1 year step back it
placed in year 0. so it is not necessary to implement further present value conversion.
now in our cash flow all the value except salvage value is placed on the base year (year
0) so the next step would be converting salvage value from single value in future to
single value in present.
Using the table again find appropriate coefficient to convert F to P so:
𝑃 𝑃
𝑃 𝑓𝑟𝑜𝑚 𝐹, = 𝐹 × ( , i, n)= (P/F)= 15,000 ×(P/F, 8%, 3)
𝐹 𝐹
From the table we have (P/F, 8%, 3)= 0.7938 so (P/F)= 15,000 × 0.7938=11,907
Step 4: calculation of total present worth (including initial cost)
total present worth value = ෍ present worth of all the values

total present worth = -80,000- 77,310+ 11,907= -145,403 ( for method A)

For method B same procedure applies .

Step 1:
Step 2 : for uniform series ( annual operating cost)
𝑃 𝑃
𝑃 𝑓𝑟𝑜𝑚 𝐴, = 𝐴 × ( , i, n)= (P/A)= -8000 × (P/A, 8%, 3)
𝐴 𝐴
From the table (P/A, 8%, 3) = 2.577 so (P/A)= -8,000 × 2.577 = -20,616 which already
placed in base year so there is no need for further conversion.

𝑃 𝑃
For salvage value 𝑃 𝑓𝑟𝑜𝑚 𝐹, = 𝐹 × ( , i, n)= (P/F)= 40,000 × (P/F, 8%, 3)
𝐹 𝐹
From the table (P/F, 8%, 3) = 0.7938 so (P/F)= 40,000 × 0.7938 = 31,572
Step 4: calculation of total present worth (including initial cost)
total present worth value = ෍ present worth of all the values

total present worth = -120,000- 20,616 + 31,572 = -109,044 ( for method B)

Finally comparing both the method together

-145,403 ( for method A) > -109,044 ( for method B)

The cost for method A is more than method B therefore method B is more preferable.
 Question 3
Compare the alternatives shown in the table below and select the optimal one. Annual
interest rate considered to be 10%. The annual revenue for project A2 starts at year 2
A1 A2
Initial payment ($) 200000 15000
Annual operating cost ($/Year) 30000 21950
Annual revenue ($/Year) 60000 45000
salvage value ($) 170000 40000
life span (Years) 3 3

Answer
Alternative A1
Step 1 : drawing cash flow diagram
Step 2 : simplification of cash flow (in this case it means combination of different
existing series in cash flow). In this cash flow we have 2 different uniform series so for
more than one uniform series involved in cash flow there are two option to simplify the
cash flow.
First : if uniform series are not overlapping each other in terms of the years of
payments, each series have to be converted to single value separately and discounted
back to base year.
Second : if uniform series are overlapping each other in terms of the years of
payments, it is possible to convert them to single uniform series (by adding or
subtracting them) and then proceed with conversion and discounting process.
Now in this case since both the annual cost and revenue happens in the same year from
year 1 to 3 it is possible to convert them to single uniform payment as follow:
Step 3: conversion of obtained uniform series to single value.
The conversion of uniform series to single value using interest table performed as
follow.

𝑃 𝑃
= 𝐴 × ( , i, n)
𝐴 𝐴
(P/A)= 30,000 × (P/A, 10%, 3)
(P/A)= 30,000 × 2.487 = 74,610

It is notable that since the uniform series

started from year 1 therefore while converting
It to single value it goes back 1 year to base
year so in order to calculate present worth
it is already discounted.
Step 4: discounting process
Since all the values are converted to single value now all remaining scattered value
across the cash flow have to be brought back to base year to enable us to calculate total
present worth.
𝑃 𝑃
In this case just salvage value remained in year 3 so using =𝐹× , i, n we
𝐹 𝐹
discount (P/F)= 170,000 ×(P/F, 10%, 3) = 170,000 × 0.7513 = 127,721
Step 5: calculation of total present worth (including initial cost)
total present worth value = ෍ present worth of all the values

total present worth = -200,000 + 74,610 + 127,721= 2,331 ( for alternative A1)

Alternative A2
Step 1 : drawing cash flow diagram
Step 2 : identification of types of values in cash flow
Step 3: conversion of cost uniform series to single value. Since the converted single
value placed at one year prior to uniform series so it is placed to year 0 and no more
discounting process required.
For uniform series(cost):
𝑃 𝑃
= 𝐴 × ( , i, n)= (P/A)= -21,950 × (P/A, 10%, 3)= -21,950 × 2.487= -54589.65
𝐴 𝐴
For uniform series(revenues):
In the case of revenues uniform series since the conversion will place at year 1 one more
process for discounting value is required
𝑃 𝑃
= 𝐴 × ( , i, n)= (P/A)= 45,000 × (P/A, 10%, 2)= 45,000 × 1.736 = 78,120
𝐴 𝐴

Here since 78,1250 placed at year 1 so we need to discount it to year 0 therefore:

𝑃 𝑃
= 𝐹 × (𝐹 , i, n)= (P/F)= 78,120 × (P/F, 10%, 1)= 78,120 × 0.9091=71,018 so the
𝐹
discounted value to year 0 would be 71,018
For the salvage value since we only have a single value therefore we directly discount it back to
year 0.
𝑃 𝑃
= 𝐹 × (𝐹 , i, n)= (P/F)= 40,000 × (P/F, 10%, 3)= 40,000 × 0.7513=30,052
𝐹
Step 4: calculation of total present worth total present worth value
= σ present worth of all the values in the base year
Total present worth = -15,000- 54,589 + 71,018+30,052 = 31481( for alternative A2)

Finally by comparing both the method it is realized that method A2 with 31481 is
more optimal than method A1 with 2,331.