Module 4: Present Worth Analysis

SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Outline Module 4
    

Proposals for Investment Alternatives Selection of Alternatives Present-worth comparison Future Worth Analysis Capitalized-cost calculation

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Proposals for Investment Alternatives
  

An investment is usually established from (engineering) proposal. Every proposal can be considered as an investment alternatives, but An investment alternative can consist of a group or set of proposals, which in turn may include option to “do nothing”

 Independent Proposal  The condition at which the acceptance of a proposal from a set of proposals has not effect on the acceptance of any of the other proposals in the set.  Dependent Proposal  The condition at when the acceptance of a proposal from the set will influence the acceptance of the others  Mutually exclusive  the acceptance of a proposal from the set precludes the acceptance of any others


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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Selection of Alternatives

Decision criteria in an economic analysis can be done comparing mutually exclusive alternatives:
   

The differences between alternatives

highest inflow or lowest outflow highest rate of return shortest payback period

The minimum attractive rate of return

Payback period

Do nothing

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Selection of Alternatives
Selection of two or more (investment) alternatives by comparing their economic values.  Method for comparison of alternatives:

     

present values, future worth, capitalized cost, annual values, rate of returns, or payback period equal lives different lives
SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Conditions of comparison:
 

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MARR

Minimum Acceptable Rate of Return
    
R a n g e fo r RO R O n a cce p te d p ro p o sa l s A l ro p o sa l lp s m u st o ffe r a t Le a st M A R R to b e co n si e re d d MA RR

Minimum amount the investor is willing to accept for the use of money R a te o f Different from lending rates R e tu rn d More akin to Opportunity Cost of the moneyE xp e cteR e tu rn R a te o f on N ew Determined by Company Policy Pro p o sa l

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R O R on S a fe i ve stm e n t n SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Present-worth comparison
The comparison of alternatives is made by transforming all future receipts and expenditures into equivalent today’s rupiah

Example:
Two types of production systems are being considered based on MARR of 12% per year and the following characteristics: system A system B Initial cost Rp. 625.000.000,Rp. 570.000.000,Monthly Rp. 45.750.000,Rp. 55.750.000,expenses Receipts Rp. 152.000.000,- / Rp. 140.000.000,- / 4 months Salvage value quarter Rp. 225.000.000,Rp. 190.000.000,Life 3 tahun 3 tahun
7 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Present-worth comparison

System A:
R R R R
E

SV

R

R

R

R

R

R

R

R

I

0

1

2

3

?

Effective monthly interest rate, iA = i / 12 = 1% PA = -I - E(P/A, iA, 36) + R(P/F, iA, 3) + R(P/F, iA, 6) + … + R(P/F, iA, 36) + SV(P/F, iA, 36)

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Present-worth comparison

System B:
I
R R R
E

SV

R

R

R

R

R

R

0

1

2

3

PB = -I - E(P/A, iB, 36) + R(P/F, iB, 4) + R(P/F, iB, 8) + … + R(P/F, iB, 36) + SV(P/F, iB, 36)

Select System A if PA > PB

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Present-worth comparison
To have a fair comparison of alternatives with different lives, the time span over must made equal:
 a)

The time period of comparison is made equal to the least common multiple (LCM) for their lives.

Cash flows of the shorter period will be extended up to the remaining time period of comparison

b)

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At any time span to be considered (the study period approach or planning horizon approach),Ekonomi TeknikMuhamad Abduh, Ph.D. SI-4251 when LCM is

Present-worth comparison
Example:
Two types of production systems are being considered based on MARR of 12% per year and the following characteristics:

system A Initial cost Rp. 625.000.000,Monthly Rp. 45.750.000,expenses Monthly Rp. 32.000.000,receipts value Rp. 225.000.000,Salvage Life 2 tahun

system B Rp. 770.000.000,Rp. 55.750.000,Rp. 40.000.000,Rp. 110.000.000,4 tahun

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Present-worth comparison

System A:
I

R SV

E

0

1

2

System

B:
R SV E

I

0
12

1

2

3

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Present-worth comparison (LCM)

System A:
I

R1 SV

R2 SV2 E2

E1

I2

0

1

2

3

4

System

B:
R SV E

I

0
13

1

2

3

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Present-worth comparison (Study Periods: 2 years)

System A:
I

R SV

E

0

1

2

System

B:
R Estimated SV E

I

0
14

1

2

3

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Example 1: Three Alternatives

Assume i = 10% per year
A2 Gas Power First Cost: -3500 Ann. Op. Cost: -700 Sal. Value: +350 Life: 5 years A3 Solar Power First Cost: -6000 Ann. Op. Cost: -50 Sal. Value: +100 Life: 5 years

A1 Electric Power First Cost: -2500 Ann. Op. Cost: -900 Sal. Value: +200 Life: 5 years

Which Alternative – if any , should be selected based upon a present worth analysis?
15 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Example 1: Cash Flow Diagrams
FSV = 200

A 1: Electric

0
-2500

1

2

3
A = -900/Yr.

4

5
FSV = 350

A 2 : Gas

0
-3500

1

2

3
A = -700/Yr.

4

5
FSV = 100

A 3 :Solar

0
-6000
16

1

2

3
A = -50/Yr.

4

5

i = 10 %/ yr and n = 5
SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Calculate the Present Worth's

Present Worth's are:

1. P W Elec. = -2500 - 900 ( P / A , 10 % , 5 ) + 2 0 0 (P /F , 1 0 % , 5 ) = $ -5 7 8 8 2. P W Gas = -3500 - 700(P/A,10%,5) + 350(P/F,10%,5) = $-5936 3.PWSolar = -6000 - 50(P/A,10%,5) + 100(P/F,10%,5) = $-6127
Select “ Electric ” which has the min . PW Cost !
17 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Example 2:
Two Location Alternatives, A and B where one can lease one of two locations.  Which option is preferred if the interest rate is 15%/year?
 

Location A Location B First cost , $ - 15 , 000 - 18 , 000 Annual lease cost , $ per year - 3 , 500 - 3 , 100 Deposit return , $ 1 , 000 2 , 000 Le ase term , years 6 9

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Use LCM, where “n” = 18 yrs.

The Cash Flow Diagrams are:

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Unequal Lives: 2 Alternatives
A
6 years 6 years 6 years

Cycle 1 for A

Cycle 2 for A

Cycle 3 for A

B
9 years Cycle 1 for B 9 years Cycle 2 for B

18 years

i = 15% per year
LCM(6,9) = 18 year study period will apply for present worth
20 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

LCM Present Worth's
Since the leases have different terms (lives), compare them over the LCM of 18 years.  For life cycles after the first, the first cost is repeated in year 0 of the new cycle, which is the last year of the previous cycle.  These are years 6 and 12 for location A and year 9 for B.  Calculate PW at 15% over 18 years.

21 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

PW Calculation for A and B -18 yrs

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) 3500(P/A,15%,18)= $-45,036

PWB = -18,000 - 18,000(P/F,15%,9) + 2000(P/F,15%,9) + 2000(P/F,15%,18) 3100(P/A,15 %,18)Select “ B ”: Lowest PW Cost @ 15 %  = $-41,384

22 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Use The Study Period Approach
An alternative method; Impress a study period (SP) on all of the alternatives;  A time horizon is selected in advance;  Only the cash flows occurring within that time span are considered relevant;  May require assumptions concerning some of the cash flows.  Common approach and simplifies the analysis somewhat.

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Example Problem with a 5-yr SP

Assume a 5- year Study Period for both options:

For a 5 - year study period no cycle repeats are necessary . PW A = - 15 , 000 - 3500 ( P / A , 15 %, 5 ) + 1000 ( P / F , 15 %, 5 ) = $ - 26 , 236 PW B = - 18 , 000 - 3100 ( P / A , 15 %, 5 ) + 2000 ( P / F , 15 %, 5 ) = $ - 27 , 397 Location A is now the better choice .
Note : The assumptions made for the A and B alternatives ! Do not expect the same result with a study period approach vs . the LCM approach !
24 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Future Worth Analysis
In some applications, management may prefer a future worth analysis;  Analysis is straight forward:

 

Find P0 of each alternative: Then compute Fn at the same interest rate used to find P0 of each alternative. For a study period approach, use the appropriate value of “n” to take forward.

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Future Worth Approach (FW)

Applications for the FW approach:  Wealth maximization approaches;  Projects that do not come on line until the end of the investment (construction) period:
Power Generation Facilities  Toll Roads  Large building projects  Etc.

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Capitalized Cost Calculations

CAPITALIZED COST- the present worth of a project which lasts forever.
   

Government Projects; Roads, Dams, Bridges, project that possess perpetual life; Infinite analysis period; “n” in the problem is either very long, indefinite, or infinity.

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Derivation of Capitalized Cost

We start with the relationship:
 

P = A[P/A,i%,n] Next, what happens to the P/A factor when we let n approach infinity. Some “math” follows.

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

P/A where “n” goes to infinity

The P/A factor is:

On the right hand side, divide both numerator and denominator by (1+i)n

 (1 + i ) − 1  P = A n   i (1 + i ) 
n

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1  1 − (1 + i ) n P = A i   

     

SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

CC Derivation…

Repeating:

1  1 − (1 + i ) n P = A i   

     

If “n” approaches  the above reduces to:

A P= i
30 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

CC Explained
For this class of problems, we can use the term “CC” in place of P.  Restate: A
     

CC =

i

Or,

AW: annual worth

AW CC = i
SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

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CC Problem: Public Works Example

Problem Parameters

Two , Mutually Exclusive Alternatives : Select the best alternative based upon a CC analysis
32 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

The suspension bridge will cost $50 million with annual inspection and maintenance - costs of $35 , 000 . In addition , the concrete deck would have to be resurfaced every 10 years at a cost of $100 , 000 . The truss bridge and 'approach roads' are expected to cost $25 million and have annual maintenance costs of $20 , 000 . The bridge would have to be painted every 3 years at a cost of $40 , 000 . In addition , the bridge would have to be sandblasted every 10 years at a cost of $190 , 000 . The cost of purchasing right - of - way is expected to be $2 million for the suspension bridge and $15 million for the truss bridge . Compare the alternatives on the basis of their capitalized cost if the interest rate is 6 % per , year .

Bridge Alternatives: Suspension

Cash Flow Diagrams

Suspension Bridge Alternative
0 1 9 $35,000/yr $50 Million $2 Million 2 10 3 11 …….. 4 . . . . .

i = 6 %/ year
$100 , 00 0

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Suspension Bridge Analysis

CC1= -52 million at t = 0.

A1 = −$35, 000 A 2 = −100, 000( A / F , 6%,10) = −$7,587 A1 + A2 −35, 000 + ( −7,587) CC2 = = = −$709, 783. i 0.06

Total CC – suspension bridge is : - 52 million + (- 709 , 783 ) = - $52 . 71 million
34 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Truss Bridge Alternative

For the Truss Bridge Alternative: Cash Flow Diagram:

Truss Design:
0 1 2 3 4 5 6 7 ////// 8 9 10 11 …..

A. Maint. = $20,000/yr

n = 
Paint: -40,000
-25M +(-15M)

Paint: -40,000 Paint: -40,000

i = 6%/year

Sandblast: -190,000

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Truss Bridge Alternative
1.CC1 Initial Cost:  -$25M + (-15M) = -$40M
Truss Design:
0 1 2 3 4 5 6 7 ////// 8 9 10 11 …..

A. Maint. = $20,000/yr

n = 
Paint: -40,000
-25M +(-15M)

Paint: -40,000 Paint: -40,000

i = 6%/year

Sandblast: -190,000

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Truss Bridge Alternative

2. Annual Maintenance is already an “A” amount so: A1 = -$20,000/year

Truss Design:
0 1 2 3 4 5 6 7 ////// 8 9 10 11 …..

A. Maint. = $20,000/yr

n = 
Paint: -40,000
-25M +(-15M)

Paint: -40,000 Paint: -40,000

i = 6%/year

Sandblast: -190,000

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Truss Bridge Alternative

3, A2: Annual Cost of Painting
i = 6%/year
3 4 5 6 7 ////// 8 9 10 11 …..

Truss Design:
0 1 2

A. Maint. = $20,000/yr

Use A/F,6%,3 Paint: -40,000
-25M +(-15M)

n = 
Paint: -40,000 Sandblast: -190,000

Paint: -40,000

For any given cycle of painting compute :

A 2 = - $40 , 000 ( A / F , 6 %, 3 ) = - $12 , 564 / year
38 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Truss Bridge Alternative

3, A3 Annual Cost of Sandblasting
i = 6%/year
3 4 5 6 7 ////// 8 9 10 11 …..

Truss Design:
0 1 2

A. Maint. = $20,000/yr

Use The A/F,6%,10 to convert to an equivalent $/year amount Paint: Paint: Paint: -40,000 -40,000 -40,000 Sandblast: -25M +(-15M) -190,000

n = 

For any given cycle of Sandblasting Compute A3
39

= - $190 , 000 ( A / F , 6 %, 10 ) =- $14 , 421
SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Bridge Summary for CC(6%)
   

CC2 = (A1+A2+A3)/i CC2 = -(20,000+12,564+14,421)/0.06 CC2 – $783,083

CCT otal = CC1 + CC2 =-40.783 million = - $52 . 71 million •CC Suspension •CCT russ - - 40 . 783 million •Select the Truss Design !

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Exercise:

The municipal government of Bandung is considering two proposals to build new toll highway system.

The first alternative calls for upgrading the existing system, which would cost Rp. 225,75 B for construction and additional Rp 210 M and Rp 250 M per year for maintenance and operation cost The other option is to build a new elevated highway that is estimated to cost Rp. 885 B for construction and annual maintenance cost of Rp 325 M

If either alternatives would yield Rp 815 M revenue per year, and the interest rate is set at 8% p.a., which alternative should the 41 government go about realizing the tollAbduh, Ph.D. SI-4251 Ekonomi TeknikMuhamad

Homework #4
1. 2. 3. 4. 5. 6.

A manufacturing company is trying to decide among three different pieces of equipment that have the following characteristics:
First cost Annual M&O cost Salvage value Overhaul cost equipment A equipment B equipment C Rp. 975.000.000,Rp. 854.500.000,Rp. 1.025.000.000,Rp. 89.700.000,Rp. 95.000.000,Rp. 75.000.000,Rp. 161.000.000,Rp. 205.000.000,Rp. 321.000.000,Rp. 175.000.000,- / 2 years Rp. 135.000.000,- / 3 years Rp. 175.000.000,- / 3 years

useful life = 6 years and interest rate of 12% per year. Which of these two machines that have the following costs is to be selected for a continuous production process, if the i = 15% p.a: machine X machine Y

2.

2. 3. 4.

First cost Annual operating cost Salvage value Life

Rp. 3.800.000.000,Rp. 289.700.000,Rp. 461.000.000,5 years

Rp. 1.675.000.000,Rp. 315.000.000,Rp. 205.000.000,3 years

3.

Ganeshaconsulting firm is considering to build or lease an office space. For interest rate of 6% build own lease compounded semiannualy compare and select alternative.
Construction cost Lease cost Maintenance cost Period

Rp. 8.750.000.000,Rp. 415.000.000,- / 3 years 75.000.000,- / year Rp. 110.000.000,- / year Rp. ∞ 3 years

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SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

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