3/5/2025

School of Management
Sciences

Engineering
Economics
(MS291)

Previous Week
• Nominal And Effective Interest Rates
• Present Worth Analysis: Alternative
Formulations

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Chapter 5
Present Worth Analysis

Engineering
Economics
(MS291)

Content of the Chapter

1. Formulate Alternatives
2. Present Worth of equal-life alternatives
3. Present Worth of different-life alternatives
4. Future Worth analysis
5. Capitalized Cost analysis

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Content of the Chapter

1. Formulate Alternatives
2. Present Worth of equal-life alternatives
3. Present Worth of different-life alternatives
4. Future Worth analysis
5. Capitalized Cost analysis

Present Worth (PW) Analysis:

Introduction

• Present Worth is also called “Net Present Value/NPV”

• It is a process of obtaining the equivalent worth of future cash

flows at present time

• That is, finding PW of cash flows

• We say that future cash flows are “discounted” to time 0

• The higher the PW, the better PW is…… evaluate based on an

interest rate, which is equal to the organization’s MARR

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Present Worth Analysis:

Procedure
• The PW analysis is quite popular in industry
because all future costs and revenues are
transformed to equivalent monetary units
NOW /Time “0”

This Criteria work as follows;

1. Convert all cash flows to Present Worth
(same as present value) using MARR
2. Precede costs by minus sign; receipts by plus
sign
3. The numerical value obtain is called NPV/PW

Present Worth Analysis:

Evaluation
Mutually exclusive projects
• For one project, it is economically viable if PW ≥ 0.
• For 2 or more alternatives, select the one with the
(numerically) largest PW value.

Independent Projects
• Select all projects with PW ≥ 0
• However, in practice a budget limit exists (details in chapter
12)

REMEMBER: This Evaluation is for the case when

alternatives have equal life

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Present Worth Analysis:

Example 1
For the alternatives shown below, which should be selected if
they are (a) mutually exclusive; (b) independent?

Project ID Present Worth

A $ 30,000
B $ 12,500
C $ - 4,000
D $ 2,000

Solution: (a) Select numerically largest PW; alternative A

(b) Select all with PW > 0; projects A, B & D

Present Worth Analysis: Example 2

• Alternative X has a first cost of $20,000, an operating cost of $9,000 per

year, and a $5,000 salvage value after 5 years.
• Alternative Y will cost $35,000 with an operating cost of $4,000 per year
and a salvage value of $7,000 after 5 years.
• At an MARR of 12% per year, which should be selected?

Solution: Cash flow diagram ? Any one ?

Find PW at MARR and select numerically larger PW value

PW X = —20,000 — 9000(P/A,12%,5) + 5000(P/F,12%,5) • Convert all cash

flows to Present
Worth (same as
= —$49,606 present value) using
PW Y = —35,000 — 4000(P/A,12%,5) + 7000(P/F,12%,5) MARR

= —$45,447 • Precede costs by

minus sign; receipts
by plus sign
Select alternative Y

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Class Practice
Electric Gas powered Solar
powered powered
First Cost($) ‒4500 ‒3500 ‒6000
Annual Operating Costs ‒900 ‒700 ‒50
($/year)
Salvage value S ($) 200 350 100
Life years 8 8 8
10% Single Payments Uniform Series Factors

n Compoun Present Sinking Compound Capital Present

d Amount Worth Fund (A/F) Amount Recovery Worth (P/A)
(F/P) (P/F) (F/A) (A/P)
8 2.1436 0.4665 0.08744 11.4359 0.18744 5.3349

PWE = ‒4500 ‒ 900( P/A ,10%,8) + 200( P/F ,10%,8) = ‒$9208

PWG = ‒3500 ‒ 700( P/A ,10%,8) + 350( P/F ,10%,8) =‒$7071
PWS = ‒6000 ‒ 50( P/A ,10%,8) + 100( P/F ,10%,8)= ‒$6220
‒$6220 Solar powered alternative should be selected
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Present Worth Analysis:

Different-Life Alternatives
• For alternatives with unequal lives the rule is:
“PW must be compared over the same number of years”

• This is called “equal service alternatives”

requirement (i.e., alternatives must end at the same
time)… Why its important ?

• Because if this condition is not meet, For COST

ALTERNATIVES (which involves only cost) will always
favor the shorter-lived mutually exclusive alternative,
even if it is not the more economical choice, because
fewer periods of costs are involved

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Present Worth Analysis:

Different-Life Alternatives
The following are two equal ways of “meeting the
equal service” requirements:
1. Least Common Multiple (LCM) of alternative
lives
Compare the PW of alternatives over a period of time
equal to the least common multiple (LCM) of their
estimated lives
2. Study Period Approach
Compare the PW of alternatives using a specified
study period of n years. This approach does not
necessarily consider the useful life of an alternative.
The study period is also called the planning horizon.
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Present Worth Analysis: LCM of

Alternative Lives Approach
• This approach compare the PW of alternatives
over a period of time equal to the least common
multiple (LCM) of their estimated lives
Three assumptions of LCM Approach
1. The service provided is needed for LCM years or
more.
2. The selected alternative is repeated over each
life cycle of the LCM in exactly the same manner.
3. Cash flow estimates are the same in every life
cycle (i.e., change are exactly by the inflation or deflation
rate only)

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Present Worth Analysis:

Evaluation Using LCM Approach

1. First, find the LCM for the life of alternatives

2. Second, expand the cash flows for each
alternatives till the LCM period …thus meeting
the equal service requirement
3. Calculate the present worth for all the
alternatives
4. Use the criteria used for “Equal Life Alternatives”
to evaluate the alternatives

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Present Worth Analysis:

Study Period Approach
• Compare the PW of alternatives using a
specified study period of n years. This
approach does not necessarily consider the
useful life of an alternative. The study period
is also called the planning horizon.

• A study period analysis is necessary if the

first assumption of LCM approach (i.e., The
service provided is needed for LCM years or more )
cannot be made.

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Present Worth Analysis: Evaluation

of PW Using a Study Period

• For the study period approach, a time horizon is chosen

over which the economic analysis is conducted, and only
those cash flows which occur during that time period are
considered relevant to the analysis

• Once a study period is specified, all cash flows after this time
are ignored

• Salvage value is the estimated market value at the end of

study period (at this stage we will just use Salvage value as it is)

• Short study periods are often defined by management when

business goals are short-term
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Present Worth Analysis: Examples for

Different-Life Alternatives

National Homebuilders, Inc., plans to purchase new

cut-and-finish equipment. Two manufacturers offered
the estimates below. Vendor B
Vendor A
First cost, $ 15,000 18,000
Annual cost, $/year 3,500 3,100
Salvage value, $ 1,000 2,000
Life, years 6 9

(a) Determine which vendor should be selected on the basis of a

present worth comparison, if the MARR is 15% per year.

(b) National Homebuilders has a standard practice of evaluating all

options over a 5-year period. If a study period of 5 years is used
and the salvage values are not expected to change, which vendor
should be selected?
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Vendor A Vendor B
First Cost, $ -15,000 -18,000
Annual M&O cost, $ per year -3,500 -31,000
Salvage value, $ 1,000 2,000
Life, years 6 9

(a) Determine which vendor should be selected on the basis of a

present worth comparison, if the MARR is 15% per year.
What is LCM of 6 and 9 ?
Solution: LCM = 18 years; We draw its cash flows to make things easy
To meet the criteria of equal
service alternatives …we
extended the project life from 6
years to 18 years for the first
alternative (& 9 to 18 for 2nd
alternative)

NOW You have equal life two

alternatives(equal service
condition meet) with cash
flows…you can use standard
procedure to obtain the present
value of both and compare it.

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PW Calculations
PWA = -15,000 ―15,000(P/F,15%,6) +1000(P/F,15%,6) ―15,000(P/F,15%,12)
+1000(P/F,15%,12) + 1000(P/F,15%,18) ― 3,500(P/A,15%,18)
= $ ― 45,036
PW B = -18,000 ― 18,000(P/F,15%,9)+ 2000(P/F,15%,9)+ 2000(P/F,15%,18)
― 3100(P/A,15%,18)
= $ – 41,384
Which one to select ? … A or B ? Select vender B

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Use of Study Period Approach

Solution (b): Now
comparison is required for
5 years. Since cash flows
are of 6 years …no cycle
repeat is required

Salvage value is the

estimated market
value at the end of
study period

We r told here…to
PWA = -15,000 ― 3,500(P/A,15%,5) +1000(P/F,15%,5) that salvage value is
= $ ― 26, 236 not expected to
change
PWB = -18,000 ― 3100(PA,15%,5) + 2000(P/F,15%,5)
= $ – 27,397

Which one to select ? … A or B ? Select vender A

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Present Worth Analysis: Different-

Life Alternatives for
independent alternatives

• Can we use LCM approach for Independent projects ?

• For independent projects , use of the LCM approach is

unnecessary since each project is compared to the do-nothing
alternative, not to each other

• Equal-service requirement is not a problem

• Use the MARR to determine the PW over the respective life of

each project, and select all projects with a PW 0

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Future Worth Analysis

• Future Worth is exactly like PW analysis, except
“Future Worth Must compare alternatives for equal
service (i.e. alternatives must end at the same time)”

• The selection guidelines for FW analysis are the

same as for PW analysis; FW ≥ 0 means the MARR
is met or exceeded

• For two or more mutually exclusive alternatives,

select the one with the numerically largest FW
value.

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Future Worth Analysis:

Unequal life alternatives
• If life of two alternatives are not equal, one need to fulfill
the equal service requirement for using FW criteria.

• Two ways to compare equal service:

1. Least common multiple (LCM) of lives
2. Specified study period

• Same way as used for Present Worth Analysis expect

once life of alternatives are equal for cash flows, one
need to compare the Future Worth instead of Present
Worth

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Future Worth Analysis: Example

An industrial engineer is considering two robots

for purchase by a fiber-optic manufacturing
company. Robot X will have a first cost of
$80,000, an annual maintenance and operation
(M&O) cost of $30,000, and a $40,000 salvage
value.
Robot Y will have a first cost of $97,000, an annual
M&O cost of $27,000, and a $50,000 salvage
value. Which should be selected on the basis of a
future worth comparison at an interest rate of 15%
per year? Use a 3-year study period.
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Future Worth Analysis:

Example
$40,000 $50,000

F=? i = 15%
i = 15%
F=?
0 1 2 3
0 1 2 3
A = $30,000 A = $27,000

$80,000 $97,000 Robot Y CF

Robot X CF

FWX = – 80,000(F/P,15%,3) – 30,000(F/A,15%,3) + 40,000

= – 80,000(1.5209) – 30,000(3.4725) + 40,000
= $-185,847
FWY = – 97,000(F/P,15%,3) – 27,000(F/A,15%,3) + 50,000
= – 97,000(1.5209) – 27,000(3.4725) + 50,000
= $ – 191,285 Select robot X
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Capitalized Worth Analysis

• The capitalized worth method is especially useful

in problems involving public projects with
indefinite lives, or permanent endowments(or
donations) for charitable organizations and
universities

• Capitalized worth is the present worth of all

revenues or expenses over an infinite length of
time

• If only expenses(cost alternative) are considered

this is referred as capitalized cost
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Capitalized Worth Analysis

• The Capitalized Worth of a series of end-of-period
uniform payments A, with interest at i% per period, is
CW (or CC) = A(P/A, i%, n) where n→∞
As N becomes very large (if the A are perpetual payments)
1
1−
• We already know that P/A is given as P/A= 𝐴 (1+𝑖)𝑛
𝑖
1
• The term in the bracket becomes as n tends to infinity
𝑖
• So, the above equations become as:
1
Capitaized Worth (or Capitalized Costs) = 𝐴
𝑖
𝐴 𝐴𝑊
CW or CC = or
𝑖 𝑖

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Capitalized Worth Analysis

• The equation can be understood by “thinking” of …..

“ What present amount invested today at “i” will enable an
investor to periodically withdraw an amount A forever”

• If investor withdraw more than amount A each period,

he/she will be withdrawing a portion of the initial principle
and eventually it will exhaust

• If amount being withdrawn each period is equals the

interest earned on the principal for that period, the
principal remains intact, thus series of withdraw will continue
forever

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Example: Capitalized Worth

(Costs) Problems

• Capitalized worth (or costs) type problems vary

from very simple to somewhat complex

• Consider a “simple” Capitalized Cost type

problem

• A person want to donate $100, 000 for

scholarships in a university. Consider, 20%
per year interest rate; How much money can
be withdrawn forever from this account?

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Example: Capitalized Worth

(Costs) Problems
• Draw a Cash Flow Diagram
$ A per year = ?

1 2 3 - - - - - - ∞

Solution: CC= A (or AW)

$100,000
i
Or AW= CC (i)

A = $100,000(0.20) = $20,000 per period

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Capitalized Worth (Costs)

―Recurring and Non-recurring

More complex problems will have two types of costs

associated;
1. Recurring – Periodic and repeat
2. Non-recurring– One time present or future cash flows

• For more complex CC problems one must separate the

recurring from the non-recurring

• You will not just face problems to calculate Capital

Costs of a single amount (like the previous example)
but you confronts situations in which you have to
make selection among alternatives using CC criteria

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Capitalized Cost Analysis

• For the comparison of two alternatives on the basis
of capitalized cost, you will use formula (CC = A/i)

• So find the A value & CCT (the sum of recurring and

non-recurring costs) for each alternative and select
the one which has lowest present worth of costs
(or equal to say… Lowest capitalized costs).

• Alternatives are automatically compared for

same life period because CCT represents the total
present worth of financing and maintaining a given
alternative forever (i.e., infinity).
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Summary: How to calculate CC and A and how to use

CC criteria to select an alternative
Cost (cash flows) Recurring
(Step 1) Periodic and repeated

Non-recurring A in only one cost Uniform Equal

One time present or future Cycle: e.g., cash
cash flows (e.g., first cost, Recurring
cost once in 25th year etc)
flow every 5th year or Amounts: e.g.,
every 20th year Annuity Series (say
A2)
Non-recurring Convert this to a Uniform
Convert it to PW (will be PW Series (say A1)
of all non-recurring costs
for whole life)
(Step 2) Add A1 and A2 to
get one Uniform
Series (Annuity
Divide the value of Uniform
Annuity Series by “i" Series) starting
Add values of step 4 and
Step 2 to obtain CC of (using CC= A/i) to get the from time 0 and
overall cash flows value of “Capitalized worth” continue till infinity
(Step 5) for uniform series (Step 3)
(Step 4)
Select the alternative
with lowest capitalized Step 3 can be skipped if you convert both recurring costs
costs directly to present worth

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Example:
• The Haverty County Transportation Authority (HCTA) has just installed
new software to charge and track toll fees. The director wants to know
the total equivalent cost of all future costs incurred to purchase the
software system. If the new system will be used for the indefinite
future, (a) find the equivalent cost now: i.e., a CC value. (b) for each
year hereafter, an AW value.

• The system has an installed cost of $150,000 and an additional cost

of $50,000 after 10 years. The annual software maintenance contract
cost is $5000 for the first 4 years and $8000 thereafter. In addition,
there is expected to be a recurring major upgrade cost of $15,000 every
13 years. Assume that i is 5% per year for county funds.
• Please try yourself to draw the cash flow ..for 2 cycle of costs

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Step 1: Draw cash flow Diagram

(for at least 2 recurring cost cycles)

The system has an installed cost of $150,000 and an additional cost of

$50,000 after 10 years. The annual software maintenance contract cost
is $5000 for the first 4 years and $8000 thereafter. In addition, there is
expected to be a recurring major upgrade cost of $15,000 every 13 years.
Assume that i is 5% per year for county funds.

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Step 1: Draw cash flow Diagram

(for at least 2 recurring cost cycles)

Non- Recurring Costs: $150,000 and $50,000

Recurring Costs (A in a life cycle): $15000
Recurring Costs (uniform A series): $5000, $8000

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Step 2: Convert Non-

Recurring costs into PW

Non- Recurring Costs:

$150,000 (Initial Costs) and
$50,000 (in year 10th)

CC1 = ―150,000 ― 50,000(P/F, 5%, 10)

CC1 = $-180,695

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Step 3 & 4: Convert Recurring Costs (A in

one life cycle) into Uniform Costs and add it
with Uniform Recurring Costs
Recurring Costs (A in one life cycle): $15000
A1 = ― 15000(A/F, 5%, 13)
= $ ― 847 …cost of one cycle
CC2 = ― 847 / 0.05
= $ ― 16,940 (for all cycles)
Recurring Costs (uniform):
$5000, $8000
CC3 = ―5000 (P/A, 5%, ∞)
= ― 5000/i or 5000/0.05
CC3 = = ― $ 100,000

Alternative:
A1 = $ ― 847
A2= $ ― 5000
A = A1+A2 = $ ― 5847
CCA = $5847(P/A, 5%, ∞)
= 5487/0.05 = $116940
(same as CC2 + CC3 above)

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Step 3 & 4: Convert Recurring Costs (A

in one life cycle) into Uniform Costs(for
whole life) and add it with Uniform
Recurring Costs

Recurring Costs (uniform):

If we calculate the present worth of A = $−3000 (which is starting
from year 5)…it will be on 4th year…. Need to multiply it with
single factor for four year to bring it to time 0.
CC4 = (A/i)(P/F, 5%, 4) A/i will convert the series of
―3000 (1/0.05) (P/F, 5%, 4) 3000 starting from year 5 till
CC4 = = ― 49,362 infinity to P’ but at year 4,
when multiplied with (P/F, 5%
, 4), It will convert it to P
value.
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Step 5: Add values of Step 2 and Step

4 to Obtain CC

CCT = CC1 + CC2 + CC3 + CC4

= ―180,695 ―16,940 ―100,000 ― 49,362
= ― 346,997
Interpretation: The $-346,997
represents the one-time t = 0
amount that if
b) CC = A/i invested at 5%/year would
AW= CCT (i) fund the future cash flows as
= 346.997 (0.05) shown on the cash flow
= $17,350 diagram from now to infinity!
Interpretation: This
means Haverty County officials have
committed the equivalent of $17,350 forever to operate and
maintain the toll management software

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Capitalized Cost
Analysis
• If you have more than one alternative and
you have to chose one out of it on Capitalized
Cost Analysis.

• You need to calculate the CC for every

alternative as explained in 5 step procedure
and then you select the alternative which value
is numerically largest (or had lowest cost)

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Capitalized cost analysis

for a finite-life alternative
• Important
I. “CC/CW” method can be applied for alternatives
whose lives are not necessary infinite.
II. Its possible to compare an alternative having finite life with
alternative having infinite life .. Computation are explained
below:
➢ We already know how to calculate the CC/CW for
infinite life alternative
➢ To determine CC for finite life alternative… calculate
the equivalent A value for one life cycle and divide by
the interest rate (i.e. A/i)

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Example
Given the following two mutually exclusive
alternatives, use the Capitalized Worth method to
determine which project you should invest in (MARR =
15%):
A B
First Cost, $
‒$12000 ‒$40000
Annual Operating Cost, $ per year
‒2200 ‒1000
Salvage value, $
0 10000
Life, years
10 25

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Solution

• First, find AW of each alternative: (bz CC = AW/i)

• AWA = ‒$12,000(A/P, 15%, 10) ‒ $2,200
= ‒ $4,592
• AWB = ‒$40,000(A/P, 15%, 25) ‒ $1,000 +
$10,000(A/F, 15%, 25)
= ‒$7,141

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Solution

Second, find CW of each alternative:

CWA = AWA/i = -$4,592/0.15 = -$30,613
CWB = AWB/i = -$7,141/0.15 = -$47,607

Since CW of alternative A yields less cost,

it should be selected.
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Example: Finite versus

Infinite life alternatives
Compare the alternatives shown on the basis of their capitalized costs using an
interest rate of 10% per year

Alternative M Alternative N
First Cost, $
‒150000 ‒800000
Annual Operating Cost, $ per year
‒50,000 ‒12000
Salvage value, $
8000 1000000
Life, years
5 ∞
10 Single Payments Uniform Series Factors
%
n Compoun Present Sinking Compoun Capital Present
d Amount Worth Fund d Amount Recovery Worth
(F/P) (P/F) (A/F) (F/A) (A/P) (P/A)
5 1.6105 0.6209 0.16380 6.1051 0.26380 3.7908
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Solution!!!!

Alternative M
For M, first find AW and then divide by i to find CC.

CCM = AWM/i but we don't know AWM

To calculate Annual worth …one need to convert all cash flows into Uniform
series!!!!!!
AWM = ‒150,000(A/P,10%,5) – 50,000
+ 8000(A/F,10%,5)
= ‒ 150,000(0.26380) – 50,000
+ 8000(0.16380)
= $ ‒ 88,260
CCM = ‒ 88,260/0.10
= $ ‒ 882,600
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Solution!!!!

Alternative N
• Since -800,000 is already at present point of an infinite Salvage value
series…and its not repeated …so we do not need to do for alternative
anything with it with infinite life
• We only need to “convert the uniform series of “- $12000” is never
to present value and add it to the already present worth
realized
calculated values.
because “n” is
CCN = ‒ $800,000 – 12,000/0.10 never reached.

CCN = ‒ 80,000 – 12,000/0.10

= $ ‒920,000
Select alternative M

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Summary so far…
- Introduction (Chapter 1)
- How time and interest effect money (Chapter 2)
- Combining spread sheet and functions (Chapter 3)
- Nominal & effective interest rates (Chapter 4)
- Present worth analysis (Chapter 5)
-Present Worth: Convert all cash flows to a single sum
equivalent at time zero using the MARR
-Future Worth: Convert all cash flows to a single sum
equivalent at the end of the planning horizon using the
MARR
-Capitalized Worth Method: Determine the single sum at
time zero that is equivalent at i=MARR to a cash flow
pattern that continues indefinitely
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Thank You

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