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ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007

Chapter 7 Present Worth Analysis Describing Project Cash Flows Initial Project Screening Method Present Worth Analysis Bank Loan vs. Investment Project Bank Loan Loan
Bank
Repayment
Investment Project

Customer Company

Investment  Return

Project

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 Describing Project Cash Flows Year Cash Inflows Cash Net (n) (Benefits) Outflows Cash Flows (Costs) 0 0 \$650,000 -\$650,000 1 215,500 53,000 162,500 2 215,500 53,000 162,500 … … … … 8 215,500 53,000 162,500 Example Payback Period

 N Cash Flow Cum. Flow 0 -\$105,000+\$20,000 -\$85,000 1 \$35,000 -\$50,000 2 \$45,000 -\$5,000 3 \$50,000 \$45,000 4 \$50,000 \$95,000 5 \$45,000 \$140,000 6 \$35,000 \$175,000  Payback period should occurs somewhere between N = 2 and N = 3.

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 \$45,000
\$45,000
\$35,000
\$35,000
\$25,000
\$15,000
0
12
3
4
5
6
Years
\$85,000
150,000
3.2 years
100,000
Payback period
50,000
0
-50,000
-100,000
0
12
3
456
Years (n)
Cumulative cash flow (\$)
Annual cash flow Payback Period

Principle:

How fast can I recover my initial investment? Method:

Based on cumulative cash flow (or accounting profit) Screening Guideline:

If the payback period is less than or equal to some specified payback period, the project would be considered for further analysis. Weakness:

Does not consider the time value of money

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 Discounted Payback Period Calculation
Period
Cash Flow
Cost of Funds
Cumulative
(15%)*
Cash Flow
0 -\$85,000
0
-\$85,000
1 15,000
-\$85,000(0.15)= -\$12,750
-82,750
2 25,000
-\$82,750(0.15)= -12,413
-70,163
3 35,000
-\$70,163(0.15)= -10,524
-45,687
4 45,000
-\$45,687(0.15)=-6,853
-7,540
5 45,000
-\$7,540(0.15)= -1,131
36,329
6 35,000
\$36,329(0.15)= 5,449
76,778

Payback period has been increased by a year ! Net Present Worth Measure

Principle: Compute the equivalent net surplus at n = 0 for a given interest rate of i. Decision Rule: Accept the project if net surplus > 0 0
1
2
3
4
5
PW( i) inflow
0
PW( i) outflow

Inflow

Outflow Net surplus
PW( i) > 0

Gives a measure of profitability of the project

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 Example - Tiger Machine Tool Company inflow
\$55,760
\$27,340
\$24,400
0
1
2
3
\$75,000
i = 15%

outflow

 PW ( 15% ) inflow = \$24, 400 ( P / F , 15% ,1 ) + \$27, 340 ( P / F , 15% ,2 ) + \$55, 760 ( P / F , 15% ,3 ) PW 15%) ( outflow = = \$78, 553 \$75, 000 PW ( 15%) = \$78, 553 − \$75, 000 = \$3, 553 > 0 Accept ,

what if i = 0%?

what if i = 20%? Present Worth Amounts at Varying Interest Rates i (%) PW(i) i(%) PW(i) 0 \$32,500 20 -\$3,412 2 27,743 22 -5,924 4 23,309 24 -8,296 6 19,169 26 -10,539 8 15,296 28 -12,662 10 11,670 30 -14,673 12 8,270 32 -16,580 14 5,077 34 -18,360 16 2,076 36 -20,110 17.45* 0 38 -21,745 18 -751 40 -23,302

*Break even interest rate

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 Present Worth Profile 40
Accept
Reject
30
20
Break even interest rate
(or rate of return)
10
\$3553
17.45%
0
-10
-20
-30
0
5
10
15
20
25
30
35
40
i
PW (i) (\$ thousands)

i = Minimum Attractive Rate of Return (MARR)

PresentPresent WorthWorth AnalysisAnalysis Net Present Worth of initial and future cash flows can be used to select among alternative projects.

It is important to understand what Net Present Worth means, especially when the cash flows include both revenue and expenses.

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 TerminologyTerminology

Salvage Value – the amount of money you can expect to receive by selling an asset when you are done with it. What value does it have when you are done with it?

MARR – Minimum Attractive Rate of Return – I expect or need this return in order to be willing to invest my money. ExampleExample ProblemProblem

Project A costs \$10,000 and will last for 10 years. Annual, end of the year revenues will be \$3,000, and expenses will be \$1,000. There is no salvage value.

Project B costs \$10,000 and will also last for 10 years. Annual revenues will be \$3,000 with annual expenses of \$1,500. Salvage value is

\$5,000.

Conduct an economic analysis to select the preferred project using a MARR of 10% per year, compounded annually.

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 ExampleExample ProblemProblem

Project A costs \$10,000 and will last for 10 years. Annual, end of the year revenues will be \$3,000, and expenses will be \$1,000. There is no salvage value.

GIVEN:

LIFETIME = 10 YRS MARR = 10%/YR, CPD ANNUALLY FIRST COST = \$10,000 ANNUAL REVENUES = \$3 000/YR ANNUAL COSTS = \$1,000/YR SALVAGE VALUE = \$0 FIND NPW A :

DIAGRAM: NPW A ?
0
123 4
\$10,000

\$3,000

10

\$1,000

NET ANNUAL = ANNUAL REVENUES – ANNUAL COSTS

= \$3,000/YR – \$1,000/YR = \$2,000/YR NPW A = A(P|A,i,N) – 1 ST COST

= \$2,000(P|A,10%,10) – \$10,000

= \$2,000(6.1446) – \$10,000 = \$2,289 ExampleExample ProblemProblem

Project B costs \$10,000 and will also last for 10 years. Annual revenues will be \$3,000 with annual expenses of \$1,500. Salvage value is \$5,000.

GIVEN:

LIFETIME = 10 YRS MARR = 10%/YR, CPD ANNUALLY FIRST COST = \$10,000 ANNUAL REVENUES = \$3,000/YR ANNUAL COSTS = \$1,500/YR SALVAGE VALUE = \$5,000 FIND NPW B :

DIAGRAM: NPW B ?
0
123 4
\$10,000

\$5,000

\$3,000

10

\$1,500

NET ANNUAL = ANNUAL REVENUES – ANNUAL COSTS

= \$3,000/YR – \$1,500/YR = \$1,500/YR

NPW B = A(P|A,i,N) + SALVAGE(P|F,i,N) – 1 ST COST

= \$1,500(P|A,10%,10) + \$5,000(P|F,10%,10) – \$10,000

= \$1,500(6.1446) + \$5,000(0.3855) – \$10,000 = \$1,144

PREFER A

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 What does this mean?

NPW A = \$2,289 NPW B = \$1,144

We prefer project A over project B.

Does NOT mean \$2289 profit!

Concept:

We favor Project A by \$2,289 over taking \$10,000 and putting it in an account earning 10%. In other words…

With expenses and revenues known, select the largest NPW > 0

Select Project A

What does this mean? At i = 10%, \$2,000 at the end of each of the next 10 years is worth, today, \$2,289 more than the initial cost of

\$10,000.

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 Further…

You would be willing to pay as much as \$10,000 + \$2,289 = \$12,289 for the project.

At that price and at i = 10%, you are indifferent between:

1. Investing \$12,289 for 10 years at i = 10%.

2. Obtaining \$2000 at the end of each of the next 10 years (and reinvesting each receipt at 10%). Illustrating…

F 10 = (\$10,000 + \$2,289) (F | P, 10%, 10)

= (\$10,000 + \$2,289) (2.594)

= \$31,875

F 10 = \$2000 (F | A, 10%, 10)

= \$2000 (15.937)

= \$31,875

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 Thus…

The project only costs \$10 000, but at i = 10% it is equivalent to investing \$10 000 + 2 289 for 10 years.

Since PW > 0, you are actually earning more than 10% on investment. ProblemProblem 11

A company is considering the purchase of a new piece of testing equipment that is expected to produce \$8,000 additional income during the first year of operation. This amount will decrease by \$500 per year for each subsequent year of ownership.

The equipment costs \$20,000 and will have an estimated salvage value of \$3,000 after 8 years of use.

For a MARR of 15% compounded annually, determine the net present worth of this investment.

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 ProblemProblem 11

GIVEN: 1 ST COST = \$20,000 ANNUAL COST: \$500/YR (LINEAR GRADIENT) STARTING AT YR 2 ANNUAL REVENUE: \$8,000 SALVAGE VALUE: \$3,000 LIFE TIME: 8 YEARS MARR = 15%/YR, CPD ANNUALLY FIND: NPW DIAGRAM:
NPW =
- \$20,000 - \$500(P|G,15%,8)
\$3,000
+ \$8,000(P|A,15%,8) + \$3,000(P|F,15%,8)
\$8,000
= - \$20,000 - \$500(12.4807)
+ \$8,000(4.4873) + \$3,000(0.3269)
0
123
8
= - \$20,000 - \$6,240 + \$35,898 + \$981
NPW = \$10,639
\$500
\$1,000
\$3,500
Worth investing in !
\$20,000 (Net) Present Worth Analysis

When comparing projects, it is necessary to compare alternatives with the same project life (i.e., over the same period of time).

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007 Present Worth Analysis

When applied correctly, NPW can be used to select among various alternative projects.

The larger the NPW the better.

Requires establishing MARR.

MARR is used as the (i) in the equations. 10 000
NPW (\$)

2 289

0

Plotting NPW vs. i IRR
10%
15.1%

i (%)

Why does NPW decrease as i increases?