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ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007

Chapter 7 Present Worth AnalysisDescribing Project Cash Flows Initial Project Screening Method Present Worth Analysis

Describing Project Cash Flows Initial Project Screening Method Present Worth Analysis

7 Present Worth Analysis Describing Project Cash Flows Initial Project Screening Method Present Worth Analysis

Bank Loan vs. Investment ProjectBank Loan Loan Bank Repayment Investment Project Customer Company Investment Return Project

Bank Loan

Loan Bank Repayment Investment Project
Loan
Bank
Repayment
Investment Project

Customer

Company
Company

Investment

vs. Investment Project Bank Loan Loan Bank Repayment Investment Project Customer Company Investment Return Project
vs. Investment Project Bank Loan Loan Bank Repayment Investment Project Customer Company Investment Return Project

Return

Project

ENGR 390 Lecture 11: Present Worth Analysis

Winter 2007

  Describing Project Cash Flows
 

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

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

5 $45,000 $140,000 6 $35,000 $175,000 Payback period should occurs somewhere between N = 2 and
Payback period should occurs somewhere between N = 2 and N = 3.

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
$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

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
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

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
0
1
2
3
4
5
PW( i) inflow
0
PW( i) outflow

Inflow

Outflow

Net surplus PW( i) > 0
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

Example - Tiger Machine Tool Company

inflow $55,760 $27,340 $24,400 0 1 2 3 $75,000 i = 15%
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
$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

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

Present Worth Profile

40 Accept Reject 30 20 Break even interest rate (or rate of return) 10 $3553
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 AnalysisAnalysisNet Present Worth of initial and future cash flows can be used to select among

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

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

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

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
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

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
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

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 ∴

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

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

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

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 consideri ng the purchase of a new piece of testing

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 S T COST = $20,000 ANNUAL COST: $500/YR (LINEAR GRADIENT)

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 = -
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

(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

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 ($)
10 000
NPW ($)

2 289

0

Plotting NPW vs. i

IRR 10% 15.1%
IRR
10%
15.1%

i (%)

Why does NPW decrease as i increases?