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
Customer
Investment
Return
Project
S.V. Atre
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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.
S.V. Atre
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ENGR 390 Lecture 11: Present Worth Analysis
Winter 2007
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
S.V. Atre
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ENGR 390 Lecture 11: Present Worth Analysis
Winter 2007
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
Inflow
Outflow
Gives a measure of profitability of the project
S.V. Atre
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ENGR 390 Lecture 11: Present Worth Analysis
Winter 2007
Example  Tiger Machine Tool Company
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
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ENGR 390 Lecture 11: Present Worth Analysis
Winter 2007
Present Worth Profile
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.
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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.
S.V. Atre
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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:
$3,000
10
$1,000
NET ANNUAL = ANNUAL REVENUES – ANNUAL COSTS
= $3,000/YR – $1,000/YR = $2,000/YR NPW _{A} = A(PA,i,N) – 1 ^{S}^{T} COST
= $2,000(PA,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:
$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(PA,i,N) + SALVAGE(PF,i,N) – 1 ^{S}^{T} COST
= $1,500(PA,10%,10) + $5,000(PF,10%,10) – $10,000
= $1,500(6.1446) + $5,000(0.3855) – $10,000 = $1,144
►PREFER A
S.V. Atre
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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.
S.V. Atre
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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 _{1}_{0} = ($10,000 + $2,289) (F  P, 10%, 10)
= ($10,000 + $2,289) (2.594)
= $31,875
F _{1}_{0} = $2000 (F  A, 10%, 10)
= $2000 (15.937)
= $31,875
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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.
S.V. Atre
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ENGR 390 Lecture 11: Present Worth Analysis
Winter 2007
ProblemProblem 11
GIVEN: 1 ^{S}^{T} 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
(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).
S.V. Atre
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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.
2 289
0
Plotting NPW vs. i
i (%)
Why does NPW decrease as i increases?
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