You are on page 1of 102

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

ENGINEERING ECONOMY Fifth Edition


Blank and Tarquin

Mc

Graw
Hill

CHAPTER V

PRESENT WORTH
ANALYSIS

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

LEARNING OBJECTIVES
PURPOSE OF THIS CHAPTER

FORMULATION OF MUTUALLY EXCLUSIVE


ALTERNITIVES
PROPER COMPARISON/ANALYSIS OF
MUTUALLY EXCLUSIVE ALTERNATIVES
PRESENT WORTH METHOD
EXTENSIONS OF THE PRESENT WORTH
METHOD

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

CHAPTER TOPICS
Formulating Alternatives
PW of Equal-Life Alternatives
PW of Different-Life alternatives
Future Worth Analysis
Capitalized Cost Analysis
Payback Period
Life-Cycle Costs
PW of Bonds
Spreadsheet Applications

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.1 FORMULATING MUTUALLY EXCLUSIVE


ALTERNATIVES
Viable firms/organizations have the
capability to generate potential
beneficial projects for potential
investment
Two types of investment categories

Mutually Exclusive Set


Independent Project Set

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.1 FORMULATING MUTUALLY EXCLUSIVE


ALTERNATIVES
Mutually Exclusive set is where a
candidate set of alternatives exist
(more than one)
Objective: Pick one and only one from
the set.
Once selected, the remaining
alternatives are excluded.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.1 INDEPENDENT PROJECT SET


Given a set of alternatives (more than
one)
The objective is to:

Select the best possible combination of


projects from the set that will optimize a
given criteria.
Subjects to constraints
More difficult problem than the mutually
exclusive approach

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.1 FORMULATING MUTUALLY EXCLUSIVE


ALTERNATIVES
Mutually exclusive alternatives compete
with each other.
Independent alternatives may or may
not compete with each other
The independent project selection
problem deals with constraints and may
require a mathematical programming or
bundling technique to evaluate.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.1 Type of Alternatives


Revenue/Cost the alternatives consist
of cash inflow and cash outflows

Select the alternative with the maximum


economic value

Service the alternatives consist mainly


of cost elements

Select the alternative with the minimum


economic value (min. cost alternative)

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.1 Evaluating Alternatives

Part of Engineering Economy is the


selection and execution of the best
alternative from among a set of
feasible alternatives
Alternatives must be generated
from within the organization

One of the roles of engineers!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.1 Evaluating Alternatives

In part, the role of the engineer to


properly evaluate alternatives from
a technical and economic view
Must generate a set of feasible
alternatives to solve a specific
problem/concern

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

10

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.1 Alternatives

Do
Nothing

Analysis
Alt.
1

Problem

Alt.
2

Alt.
m

Selection

Execution

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

11

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.1 Alternatives: The Selected Alternative

Problem

Alt.
Selected

Execution

Audit and Track

Selection is dependent upon the data, life,


discount rate, and assumptions made.
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

12

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 Present Worth Approach Equal-Lifes


Simple Transform all of the current
and future estimated cash flow back to
a point in time (time t = 0)
Have to have a discount rate before the
analysis in started
Result is in equivalent dollars now!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

13

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 THE PRESENT WORTH METHOD


A process of obtaining the
equivalent worth of future cash
flows to some point in time

called the Present Worth


At an interest rate usually equal to or
greater than the Organizations
established MARR.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

14

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 THE PRESENT WORTH METHOD

P(i%) = P( + cash flows) +


P( - cash flows)
OR, . . .

P(i%) = P(+) P(-).

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

15

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 THE PRESENT WORTH METHOD

If P(i%) > 0 then the project is


deemed acceptable.
If P(i%) < 0 the project is usually
rejected.
If P(i%) = 0 Present worth of costs = Present
worth of revenues
Indifferent!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

16

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 THE PRESENT WORTH METHOD

If the present worth of a project turns out to =


0, that means the project earned exactly the
discount rate that was used to discount the cash
flows!
The interest rate that causes a cash flows NPV
to equal 0 is called the Rate of Return of the
cash flow!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

17

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 THE PRESENT WORTH METHOD

For P(i%) > 0, the following holds true:

A positive present worth is a dollar


amount of "profit" over the minimum
amount required by the investors
(owners).

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

18

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 THE PRESENT WORTH METHOD


Depends upon the Discount Rate Used

The present worth is purely a


function of the MARR (the
discount rate one uses).
If one changes the discount rate, a
different present worth will result.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

19

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 THE PRESENT WORTH METHOD

For P(i%) > 0, the following


holds true:
Acceptance or rejection of a
project is a function of the timing
and magnitude of the project's
cash flows, and the choice of the
discount rate.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

20

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 PRESENT WORTH: Special


Applications

Present Worth of Equal Lived


Alternatives
Alternatives with unequal lives: Beware
Capitalized Cost Analysis
Require knowledge of the discount rate
before we conduct the analysis

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

21

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 PRESENT WORTH: Equal Lives

Present Worth of Equal Lived


Alternatives straightforward
Compute the Present Worth of each
alternative and select the best, i.e.,
smallest if cost and largest if profit.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

22

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 Equal Lives Straightforward!


Given two or more alternatives with
equal lives.
Alt. 1

Alt. 2

N = for all
alternatives

Alt. N
Find PW(i%) for each alternative then compare

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

23

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 PRESENT WORTH: Example


Consider:
Machine A Machine B
First Cost
$2,500
$3,500
Annual Operating Cost
900
700
Salvage Value
200
350
Life
5 years
5 years
i = 10% per year
Which alternative should we select?

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

24

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 PRESENT WORTH: Cash Flow Diagram


F5=$200

MA
0

A = $900

$2,500

F5=$200

MB
0

$3,500

A = $700

Which alternative should we select?

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

25

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.2 PRESENT WORTH: Solving


PA = 2,500 + 900 (P|A, .10, 5)
200 (P|F, .01, 5)
= 2,500 + 900 (3.7908) - 200 (.6209)
= 2,500 + 3,411.72 - 124.18 = $5,788

PB = 3,500 + 700 (P|A, .10, 5)


350 (P|F, .10, 5)
= 3,500 + 2,653.56 - 217.31 = $5,936
SELECT MACHINE A: Lower PW cost!
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

26

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 PRESENT WORTH: Different Lives

Present Worth of Alternatives with


Different Lives
Comparison must be made over equal
time periods

Compare over the least common multiple,


LCM, for their lives

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

27

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 PRESENT WORTH: Unequal Lives

Present Worth of Alternatives with


Different Lives
Remember if the lives of the
alternatives are not equal, one must
create or force a study period where
the life is the same for all of the
alternatives

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

28

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 Present Worth with Unequal Lives: The Rule

In an analysis one cannot effectively

compare the PW of one alternative with


a study period different from another
alternative that does not have the same
study period.
This is a basic rule!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

29

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 PRESENT WORTH: Lowest Common


Multiple of Lives

If the alternatives have different study


periods, you find the lowest common
life for all of the alternatives in
question.
Example: {3,4, and 6} years. The
lowest common life is 12 years.
Evaluate all over 12 years for a PW
analysis.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

30

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 PRESENT WORTH: Example Unequal


Lives
EXAMPLE
Machine A Machine B
First Cost
$11,000
$18,000
Annual Operating Cost
3,500
3,100
Salvage Value
1,000
2,000
Life
6 years
9 years

i = 15% per year


Note: Where costs dominate a problem it is customary to assign a
positive value to cost and negative to inflows
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

31

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 PRESENT WORTH: Example Unequal


Lives

A common mistake is to
compute the present
worth of the 6-year
project and compare it to
the present worth of the
9-year project.
NO! NO! NO!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

32

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 PRESENT WORTH: Unequal Lives


Machine A
0

F6=$1,000

A 1-6

F6=$2,000

=$3,500

$11,000
2

Machine B

A 1-9
=$3,100

i = 15% per year


$18,000

LCM(6,9) = 18 year study period will apply for present worth


Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

33

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 Unequal Lives: 2 Alternatives


Machine A
6 years

6 years

Cycle 1 for A

Cycle 2 for A

6 years

Cycle 3 for A

Machine B
9 years

9 years

Cycle 1 for B

Cycle 2 for B

18 years

i = 15% per year


LCM(6,9) = 18 year study period will apply for present worth

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

34

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 Example: Unequal Lives Solving


LCM = 18 years
Calculate the present worth of a 6-year cycle
for A
PA = 11,000 + 3,500 (P|A, .15, 6)
1,000 (P|F, .15, 6)
= 11,000 + 3,500 (3.7845) 1,000 (.4323)
= $23,813, which occurs at time 0, 6 and 12

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

35

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 Example: Unequal Lives


Machine A
0

$23,813

12

$23,813

18

$23,813

PA= 23,813+23,813 (P|F, .15, 6)+


23,813 (P|F, .15, 12)
= 23,813 + 10,294 + 4,451 = 38,558

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

36

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 Unequal Lives Example: Machine B

Calculate the Present Worth of a 9-year


cycle for B
F6=$2,000

A 1-9
=$3,100

$18,000

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

37

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 9-Year Cycle for B


Calculate the Present Worth of a 9-year cycle
for B
PB = 18,000+3,100(P|A, .15, 9)
1,000(P|F, .15, 9)
= 18,000 + 3,100(4.7716) - 1,000(.2843)
= $32,508 which occurs at time 0 and 9

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

38

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 Alternative B 2 Cycles


Machine A: PW =$38,558
0

$32,508

18

$32,508

PB = 32,508 + 32,508 (P|F, .15, 9)


= 32,508 + 32,508(.2843)
PB = $41,750
Choose Machine A
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

39

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 Unequal Lives Assumed Study


Period
Study Period Approach

Assume alternative: 1 with a 5-year life


Alternative: 2 with a 7-year life

Alt-1: N = 5 yrs

LCM = 35 yrs

Alt-2: N= 7 yrs
Could assume a study period of, say, 5 years.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

40

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.3 Unequal Lives Assumed Study


Period
Assume a 5-yr. Study period
Estimate a salvage value for the 7-year
project at the end of t = 5
Truncate the 7-yr project to 5 years
Alt-1: N = 5 yrs
Alt-2: N= 7 yrs

Now, evaluate both


over 5 years using
the PW method!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

41

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.4 FUTURE WORTH APPROACH


FW(i%) is an extension of the present
worth method
Compound all cash flows forward in
time to some specified time period
using (F/P), (F/A), factors or,
Given P, the F = P(1+i)N

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

42

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.4 Applications of Future Worth


Projects that do not come on line until
the end of the investment period

Commercial Buildings
Marine Vessels
Power Generation Facilities
Public Works Projects

Key long time periods involving


construction activities

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

43

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.4 Future Worth Example (Figure 5.3)

See Example 5.3


Calculate the Future Worth of
determining the selling price in order to
earn exactly 25% on the investment
Draw the cash-flow diagram!!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

44

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 CAPITALIZED COST

CAPITALIZED COST- the present worth


of a project that lasts forever.
Government Projects
Roads, Dams, Bridges (projects that
possess perpetual life)
Infinite analysis period

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

45

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 Derivation for Capitalized Cost


Start with the closed form for the P/A factor

(1 i) 1
P A
N
i(1 i)
N

Next, let N approach infinity and divide the


numerator and denominator by (1+i)N

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

46

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 Derivation - Continued


Dividing by (1+i)N yields
1

1 (1 i ) N
P A

Now, let n approach infinity and the


right hand side reduces to.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

47

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 Derivation - Continued

1 A
P A
i i
Or,
CC(i%) = A/i

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

48

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 CAPITALIZED COST


Assume you are called on to maintain a
cemetery site forever if the interest rate
= 4% and $50/year is required to
maintain the site.
1

5 ..

..

N=inf.

A=$50/yr

P=?

Find the PW of an infinite annuity flow

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

49

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 CAPITALIZED COST


P0 = A[P/A,i%,N]
1

5 ..

..

N=inf.

A=$50/yr

P=?

Find the PW of an infinite annuity flow

(1 i ) N 1
P A
, let N
N
i(1 i)
(1 i ) N 1 1
lim N

N
i(1 i) i

P0=A(1/i)

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

50

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 CAPITALIZED COST

P0 = $50[1/0.04]

P0 = $50[25] = $1,250.00
Invest $1,250 into an account that
earns 4% per year will yield $50 of
interest forever if the fund is not
touched and the i-rate stays constant.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

51

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 CAPITALIZED COST: Endowments


Assume a wealthy donor wants to endow a
chair in an engineering department.
The fund should supply the department with
$200,000 per year for a deserving faculty
member.
How much will the donor have to come up
with to fund this chair if the interest rate =
8%/yr.
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

52

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 CAPITALIZED COST: Endowed Chair


The department needs $200,000 per year.
P = $200,000/0.08 = $2,500,000
If $2,500,000 is invested at 8% then the
interest per year = $200,000

The $200,000 is transferred to the department,


but the principal sum stays in the investment to
continue to generate the required $200,000
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

53

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 Capitalized Cost Example

EXAMPLE
Calculate the Capitalized Cost of a
project that has an initial cost of
$150,000. The annual operating cost is
$8,000 for the first 4 years and $5000
thereafter. There is an recurring
$15,000 maintenance cost each 15
years. Interest is 15% per year.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

54

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 Cash Flow Diagram


i=15%/YR
0

15

30

$4,000
$8,000

$150,000

$15,000

$15,000

$15,000

$15,000

N=

How much $$ at t = 0 is required to fund this


project?
The capitalized cost is the total amount of $ at t
= 0, when invested at the interest rate, will
provide annual interest that covers the future
needs of the project.
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

55

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 CAPITALIZED COST - Example


Continued
1. Consider $4,000 of the $8,000 cost
for the first four years to be a one-time
cost, leaving a $4,000 annual operating
cost forever.
2.855
P0= 150,000 + 4,000 (P|A,
.15, 4) =
$161,420

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

56

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 CAPITALIZED COST - Continued


Recurring annual cost is $4,000 plus the
equivalent annual of the 15,000 end-ofcycle cost.
0

15

30

45

60 ..

Take any 15-year period and find the equivalent


annuity for that period using the F/A factor.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

57

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 CAPITALIZED COST: One Cycle


Take any 15-year period and find the equivalent
annuity for that period using the F/A factor

15

30

45

60 ..

$15,000

A for a 15-year period

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

58

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 CAPITALIZED COST


2. Recurring annual cost is $4,000 plus
the equivalent annual of the 15,000
end-of-cycle cost.
A= 4,000 + 15,000 (A|F, .15, 15)

= 4,000 + 15000 (.0210) = $5,315


Recurring costs = $5,315/i =
5,315/0.15 =$3,443/yr

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

59

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.5 CAPITALIZED COST


Capitalized Cost = 161,420 + 5315/.15
= $196,853
Thus, if one invests $196,853 at time t
= 0, then the interest at 15% will
supply the end-of-year cash flow to
fund the project so long as the principal
sum is not reduced or the interest rate
changes (drops).

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

60

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.6 Payback Period Analysis


Two forms for this method

Discounted Payback Period (uses an interest


rate)
Conventional Payback Period (does not use
an interest rate)

Payback is the period of time it takes for


the cash flows to recover the initial

investment.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

61

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.6 Payback Period Analysis


Discounted Payback Approach

Find the value of np such that:


t np

0 P NCFt ( P / F , i, t )
t 1

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

62

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.6 Payback Period Analysis - Example


Example 5.8

i = 15%

Machine 1: N=7

Machine 2: N=14

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

63

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.6 Payback Period Analysis - Example 5.8


Tabular Format: Machine 1

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

64

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.6 Payback Period Analysis- Machine A

Payback
is
between
6 and 7
yeas
(6.57 yrs)

PW(15%)= +$481.00
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

65

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.6 Non-Discounted Analysis Machine A


At a 0
interest rate
the PB time
is seen to
equal 4
years!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

66

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.6 Payback for Machine B at 15%, N = 14 yrs


Payback for B is
between 9 and
10 years!
Longer time
period to
recover the
investment.

9.52 years

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

67

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.6 Payback at 0% for Machine B

Payback for B at
0% is 6 years!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

68

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.6 Payback for Example 5.8


Discounted

Machine A: 6.57 years


Machine B: 9.52 years

Undiscounted

Machine A: 4.0 years


Machine B: 6.0 years

Go with Machine A lower time period


payback to recover the original
investment

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

69

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.6 Payback Method Summarized


Payback is only a rough estimator of
desirability
Use as an initial screening method
Avoid using this method as a primary
analysis technique for selection projects
Totally avoid the no-return payback
period

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

70

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.6 Payback Method Summarized


The No-return method

Does not employ the time value of money


Disregards all cash flows past the payback
time period
If used, can lead to conflicting selections
when compared to more technically correct
methods like present worth!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

71

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.7 Life Cycle Costs (LCC)


Extension of the Present Worth method
Used for projects over their entire life
span where cost estimates are
employed
Used for:

Military/Defense Projects
New Product Lines
Large construction projects

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

72

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.7 Life Cycle Defined Detailed Phases


Needs Assessment Phase
Conceptual Design Phase
Detailed Design Phase
Production/Construction Phase
Operation (upgrading to extend)
Phase
Retirement/Disposal Phase
The life can be for years into the future

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

73

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.7 Life Cycle: Two General Phases

Cost-$
Cumulative Life Cycle
Costs

Acquisition Phase

Operation Phase

TIME

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

74

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.7 Life-Cycle Costs: Impact of Design


Changes
Cost of a design change tends to
multiply by 10 with each phase
Any design changes that might occur
late in the life cycle drastically increase
the total life cycle costs!

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

75

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.7 Life-Cycle Costs: Acquisition Phase


Rule: About 80% of LCC are locked in
by the end of the Acquisition Phase.
Emphasis is on good design!
Costs - $

Needs Assessment

Conceptual Design

Detailed Design

Acquisition Phase

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

76

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.7 Life-Cycle Costs Purpose


Make explicit as possible the
relationship of costs over the total life
span of a product/system
Design Process Objective

Minimize the life-cycle costs


And meet other performance requirements
By making correct trade-offs between costs
in the acquisition phase and costs during
the operations phase

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

77

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.7 Life-Cycle Costs Warning


Beware of introducing certain costcutting measures in the acquisition
phase and early production phase
Such cost-cutting measures could
impact the future operations and
degrade safety or require modifications
later on
These cost-cutting measures can be
misleading and dangerous!
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

78

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.7 Life-Cycle Costs Warning


Engineers have a ethical and moral
responsibility to ensure that designs
are:

Economically sound
Functional
Safe
Perform as expected

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

79

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Present Worth of Bonds


Bonds represent a source of funds for
the firm.
Bonds are sold (floated) by investment
banks for firms in order to raise
additional debt capital
A bond is similar to an IOU
Bonds are evidence of Debt

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

80

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bond Types Treasury Bonds


Treasury bonds

Issued by Federal Government


Full backing of the Government
1 year or less; 2-10 year issues; and 10-30
year issues
Conservative-type investment

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

81

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bond Types Municipal Bonds


State and Municipal Bonds

Issued by states and local governments


Generally tax-exempt by the Federal
Government
Used to finance state and local projects
Backed by future tax and user fees to pay
the interest and face value

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

82

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bond Types Mortgage Bonds


Mortgage Bonds

Issued by Corporations
Secured by the firms assets
Money received by the firm is used to fund
projects
Referred to a Debt Capital
Buyers of these bonds are not owners they
are lenders to the firm

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

83

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bond Types Debentures


Debenture Bond

Issued by Corporations
Not backed by specific assets
Backing good faith of the firm
Pays higher interest rates
Higher risks involved
Bond interest rate may float
Could be convertible to common stock

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

84

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Present Worth of Bonds Overview

Investment Bankers

The Firm

Sell the Bonds to


The lending public

Proceeds from
The sale

Commissions/Fees

Bondholders

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

85

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bonds Basics


Bonds are negotiable instruments
Can be traded by the current
bondholder
Source of funds to the firm
Debt capital
Bondholders are loaning $$ to the firm
Earn periodic interest
Sell the bonds at any time

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

86

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bonds Firms View


Firm authorizes a bond sale
Bonds are sold by an outside agency
Firm pays a commission to the selling
agency
The firm receives the proceeds from the
sale
This is now DEBT capital to the firm

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

87

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bond Basics Continued


The bondholders are not owners
They are lendors
The firm pays periodic interest
payments to the current bond holders
At the end of the bonds life, the bonds
are redeemed (bought back) from the
current bond holder

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

88

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bond Basics - Continued


The bond itself is just a piece of paper
Evidence of the debt the firm has
incurred
The firm may be able to call the bonds
back by paying the current bondholder a
calculated sum

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

89

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bonds Notation


P0 The time t = 0 selling price of the
bond the cost to the buyer of the bond
V The face value of the bond

The value printed on the bond

Face values are usually:


$100, $1,000, $5,000, $10,000 increments

N The life of the bond in years


r The nominal annual bond interest
rate
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

90

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bonds Notation and Example


Given the nominal annual bond interest
rate, the payment frequency of the
interest (monthly, quarterly semiannually, etc.) is also stated
Example:

V = $5,000 (face value)


r = 4.5% per year paid semiannually
N = 10 years

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

91

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bonds Example Continued


The interest the firm would pay to the
current bondholder is calculated as:

0.045
I $5, 000(
) $5, 000(0.0225)
2
I $112.50 every 6 months
The bondholder, buys the bond and will receive
$112.50 every 6 months for the life of the bond

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

92

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Bonds Example 5.11


Given

V = $10,000 (Face value of the bond)


r = 4.5% paid semiannually
N = 10 years or 20 interest periods
$I/6 months = $5,000(0.045/2) = $112.50
paid to the current bondholder

Bonds are bought at sold in a bond market. Thus


the price of the bond is subject to the pressures of
the bond market.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

93

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Example 5.11


Key Point The purchase price of the
bond can be considered a value that is
determined by a willing buyer and a
willing seller.
Assume the potential buyer of this bond
requires a interest rate of no less than
8%/year compounded quarterly.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

94

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Example 5.11 Continued


The purchaser will consider this bond if
he/she can earn 8%/yr c.q.
What is fixed?

The future interest payments are fixed


The future face value of the bond in fixed

What can vary?

The purchase price such that the buyer can


earn at least the 8%/yr c.q.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

95

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Example 5.1 Continued

8% c.q is the same as

0.08/4 = 0.02 = 2% per quarter.


Bond interest flows every 6 months
Need an effective 6-month rate
The effective 6-month rate is then
(1.02)2 1 0.0404 = 4.04%/6 months
This is the potential buyers required

interest rate

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

96

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Example 5.11 Solving


The objective is to determine the
purchase price of this bond discounted
at the buyers required rate of 4.04%
per 6 months
Draw the cash-flow diagram
Work the problem with N = 20 (not 10)

We have 20 interest payments (every 6


months) = 10 years

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

97

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Example 5.11 Cash-Flow Diagram

$5,000

i=4.04%/6 months

A = 112.50/6 months
0

P=??

..

19

20

Find the PW(4.04%) of the future cash


flows to the potential bond buyer

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

98

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

5.8 Example 5.11 Solving


P = $112.50(P/A,4.04%,20)
+ $5,000(P/F,2%,40)
P = $3,788
IF the buyer can buy this bond for
$3,788 or less, he/she will earn at least
the 8% c.q. rate.

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

99

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Summary: Present Worth


Present Worth is the basic analysis approach for
most engineering economy studies.
It also forms a basis for the Internal Rate of
Return method to be presented later
Requires knowledge of the discount rate as part
of the analysis

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

100

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

Summary: Present Worth


PW represents a family of methods
Annual worth
Future Worth

Capitalized Cost
Life-cycle cost analysis application

Bond Problems application

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

101

Copyright The McGraw-Hill Companies, Inc. Permission required for reproduction or display.

End of Chapter 5 Lecture Set

Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University.

102