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Ch.

5 Present Worth
Analysis

5.2.1 Payback Period


Principle:
How fast can I recover my initial investment?
Method:
Based on the 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

$45,000

$45,000

Annual cash flow

$35,000

$35,000

$25,000
$15,000
0
1

2
Years

Cumulative cash flow ($)

$85,000
150,000
3.2 years
Payback period

100,000
50,000
0
-50,000
-100,000
0

6
Years (n)

5.2.2 Discounted Payback Period


Principle:
How fast can I recover my initial investment
plus interest?
Method:
Based on the cumulative discounted cash flow
Screening Guideline:
If the discounted payback period (DPP) is less
than or equal to some specified payback period,
the project would be considered for further
analysis.
Weakness:
Cash flows occurring after DPP are ignored

Discounted Payback Period Calculation


Period

Cash Flow

-$85,000

Cost of Funds
(15%)*

Cumulative
Cash Flow

-$85,000

15,000

-$85,000(0.15) = -$12,750

-82,750

25,000

-$82,750(0.15) = -12,413

-70,163

35,000

-$70,163(0.15) = -10,524

-45,687

45,000

-$45,687(0.15) =-6,853

-7,540

45,000

-$7,540(0.15) = -1,131

36,329

35,000

$36,329(0.15) = 5,449

76,778

Cost of funds = (Unrecovered beginning balance) X (interest r

Illustration of Discounted Payback


Period

Summary

Payback periods can be used as a screening


tool for liquidity, but we need a measure of
investment worth for profitability.

5.3.1 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 the net surplus is
positive.
Inflow
0

1
2

Outflow
PW(i)inflow

PW(i)outflow

5
Net surplus
PW(i) > 0

Example 5.3 - Tiger Machine Tool Company


inflow
0

$24,400

$27,340

$55,760

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

Future Worth Criterion

Given: Cash flows


and MARR (i)
Find: The net
equivalent worth at
the end of project
life

$24,400
0

$55,760

$27,340
2

$75,000

Project life

Future Worth Criterion


FW (15%) inflow $24,400( F / P,15%,2) $27,340( F / P,15%,1)
$55,760( F / P,15%,0)
$119,470
FW (15%)outflow $75,000( F / P,15%,3)
$114,066
FW (15%) $119,470 $114,066
$5,404 0, Accept

Investment Pool Concept

Suppose the company has $75,000. It has


two options. (1)Take the money out and
invest it in the project or (2) leave the money
in the company. Lets see what the
consequences are for each option.

Meaning of Net Future Worth


N=3
How much would you have if the
Investment is made?
Investment pool

$24,400(F/P,15%,2) = $32,269
$27,340(F/P,15%,1) = $31,441
$55,760(F/P,15%,0) = $55,760
$119,470

$75,000
l
poo
n
t
r
n
u
Ret vestme
$55,760
to i n

How much would you have if the


investment was not made?

$27,340

$75,000(F/P,15%,3) = $114,066

$24,400

Project

What is the net gain from the


investment?
0

$119,470 - $114,066 = $5,404

PW(15%) = $5,404(P/F,15%,3) = $3,553

What Factors Should the Company


Consider in Selecting a MARR in Project
Evaluation?

Risk-free return
Inflation factor
Risk premiums

Capitalized Equivalent Worth


Principle: PW for a project with an annual
receipt of A over infinite service life
Equation:
CE(i) = A(P/A, i,
A
0
P = CE(i)

) = A/i

Practice Problem
Given: i = 10%, N =
Find: P or CE (10%)

$2,000
$1,000
0

10

P = CE (10%) = ?

Solution
$2,000
$1,000
0

10

P = CE (10%) = ?
$1,000 $1,000

( P / F,10%,10)
0.10
0.10
$10,000(1 0.3855)

CE(10%)

$13,855

A Bridge Construction Project


Construction cost = $2,000,000

Annual Maintenance cost = $50,000


Renovation cost = $500,000 every 15 years
Planning horizon = infinite period
Interest rate = 5%

15

Years
30

45

60

$500,000

$500,000

$50,000

$500,000
$2,000,000

$500,000

Solution:
Construction Cost
P1 = $2,000,000
Maintenance Costs
P2 = $50,000/0.05 = $1,000,000
Renovation Costs
P3 = $500,000(P/F, 5%, 15)
+ $500,000(P/F, 5%, 30)
+ $500,000(P/F, 5%, 45)
+ $500,000(P/F, 5%, 60)
.
= {$500,000(A/F, 5%, 15)}/0.05
= $463,423
Total Present Worth
P = P1 + P2 + P3 = $3,463,423

Comparing Mutually
Exclusive Alternatives

Comparing Mutually Exclusive


Projects
Mutually Exclusive Projects

Alternative vs. Project

Do-Nothing Alternative

Revenue Projects
Projects whose revenues depend
on the choice of alternatives
(monitoring resolution)
Service Projects
Projects whose revenues do not
depend on the choice of
alternative ( Electric Company)

Analysis Period
The time span over which the
economic effects of an investment
will be evaluated (study period or
planning horizon).
Required Service Period
The time span over which the
service of an equipment (or
investment) will be needed.

Comparing Mutually Exclusive Projects

Principle: Projects must be


compared over an equal time span.
Rule of Thumb: If the required
service period is given, the analysis
period should be the same as the
required service period.

Case 1: Analysis Period Equals Project


Lives
Compute the PW for each project over its life
$600
$450

$2,075
$500

$1,400

$1,000

A
PW (10%)A= $283
PW (10%)B= $579

$4,000

$2,110

Case 2: Analysis Period Shorter than


Project Lives
Estimate the salvage value at the end
of the required service period.
Compute the PW for each project over
the required service period.

Example 5.6 - Comparison of unequal-lived service projects


when the required service period is shorter than the individual
project life

Required Service Period = 2 years

PW(15%)A =

PW(15%)B =

5.7 J&M Manufacturing plans on purchasing a new assembly machine for $32,000 to
automate one of its current manufacturing operations. It will cost an additional $3,500 to
have the new machine installed. With the new machine, J&M expects to save $12,000 in
annual operating and maintenance costs. The machine will last five years with an
expected salvage value of $5000.
(a) How long will it take to recover the investment (plus installation cost)?
(b) If J&M's interest rate is known to be 17%, determine the discounted payback period.
n

Inflow

Outflow

Net Cash Flow

Cumulative CF

$0

$35,500

$35,500-

$35,500-

$12,000

$0

$12,000

$23,500-

$12,000

$0

$12,000

$11,500-

$12,000

$0

$12,000

$500

$12,000

$0

$12,000

$12,500

$17,000

$0

$17,000

$29,500

Cash Flow

Cost of funds 17%

Cumulative CF

$35,500-

$0

$35,500-

$12,000

$6,035-

$29,535-

$12,000

$5,021-

$22,556-

$12,000

$3,835-

$14,391-

$12,000

$2,446-

$4,837-

$17,000

$822-

$11,341

5.10 The Northern Investment Group is considering investing $2.5 million in a new shopping plaza in
Atlanta. The company has estimated that the shopping plaza, once built, will generate $500,000 per
year for 10 years. If the firm is looking for a return of 12% on its investment, is it worth undertaking?
Assume that the shopping plaza will retain about 60% of its initial investment as salvage value.
5.17 You are in the mail-order business, selling computer peripherals, including high-speed Internet
cables, various storage devices such as memory sticks, and wireless networking devices. You are
considering upgrading your mail ordering system to make your operations more efficient and to
increase sales. The computerized ordering system will cost $250,000 to install and $50,000 to operate
each year. The system is expected to last eight years with no salvage value at the end of the service
period. The new order system will save $120,000 in operating costs (mainly, reduction in inventory
carrying cost) each year and bring in additional sales revenue in the amount of $40,000 per year for
the next eight years. If your interest rate is 12%,justify your investment using the NPW method.
5.18 A large food-processing corporation is considering using laser technology to speed up and
eliminate waste in the potato-peeling process. To implement the system, the company anticipates
needing $3 million to purchase the industrial-strength lasers. The system will save $1,200,000 per year
in labor and materials. However, it will incur an additional operating and maintenance cost of $250,000
per year. Annual income taxes will also increase by $150,000. The system is expected to have a 10year service life and a salvage value of about $200,000. If the company's MARR is 18%,justify the
economics of the project using the PW method.

(b)

5.26 Consider the following project balances for a typical investment project with a service life of five
years:
N
An
Project Balance
------------------------------------------------------------------------0
-$1000
-1000
1
(
)
-900
2
490
-500
3
(
)
0
4
(
)
-100
5
200
( )

0
1
2
3
4
5

$1,000$200
$490
$550
$100$200

(a) Fill in the blanks by constructing the original cash flows of the project and
determining the terminal balance.
(b) Determine the interest rate used in the project-balance calculation, and
compute the present worth of this project at the computed interest rate.

PB(i) 2 $900(1 i) $490 $500


i 10%
PW(10%) $90( P / F ,10%,5) $55.88

$1,000$900$500$0
$100$90

5.28 Consider the following set of independent investment projects:


N
A
B
C
------------------------------------------------------------------------0
-$200
-100
120
1
50
40
-40
2
50
40
-40
3
50
40
-40
4
-100
10
5
400
10
6
400
(a) For a MARR of 10%, compute the net present worth for each project, and
determine the acceptability of each project.
(b) For a MARR of 10%, compute the net future worth of each project at the
end of each project period, and determine the acceptability of each project.
(c) Compute the future worth of each project at the end of six years with variable
MARRs as follows: 10% for n = 0 to n = 3 and 15% for n = 4 to n = 6.

5.32 A group of concerned citizens has established a trust fund that pays 6% interest
compounded monthly to preserve a historical building by providing annual maintenance
funds of $25,000 forever. Compute the capitalized-equivalent amount for these building
maintenance expenses.
5.33 A newly constructed bridge costs $10,000,000. The same bridge is estimated to need
renovation every 10 years at a cost of $1,000,000. Annual repairs and maintenance are
estimated to be $100,000 per year.
(a) If the interest rate is 5%, determine the capitalized-equivalent cost of the bridge.
(b) Suppose that the bridge must be renovated every 15 years, not every 10 years. What is
the capitalized cost of the bridge if the interest rate is the same as in (a)?
5.34 To decrease the costs of operating a lock in a large river, a new system of operation is
proposed. The system will cost $650,000 to design and build. It is estimated that it will have
to be reworked every 10 years at a cost of $100,000. In addition, an expenditure of $50,000
will have to be made at the end of the fifth year for a new type of gear that will not be
available until then. Annual operating costs are expected to be $30,000 for the first 15 years
and $35,000 a year thereafter. Compute the capitalized cost of perpetual service at i = 8%.

5.47 A local car dealer is advertising a standard 24-month lease of $1,150 per month for its
new XT 3000 series sports car. The standard lease requires a down payment of $4,500 plus
a $1,000 refundable initial deposit now. The first lease payment is due at the end of month
1. Alternatively, the dealer offers a 24-month lease plan that has a single up-front payment
of $30,500 plus a refundable initial deposit of $1,000. Under both options, the initial deposit
will be refunded at the end of month 24. Assume an interest rate of 6% compounded
monthly. With the present-worth criterion, which option is preferred?
5.48 Two alternative machines are being considered for a manufacturing process. Machine
A has an initial cost of $75,200, and its estimated salvage value at the end of its six years of
service life is $21,000. The operating costs of this machine are estimated to be $6,800 per
year. Extra income taxes are estimated at $2,400 per year. Machine B has an initial cost of
$44,000, and its salvage value at the end of its six years of service life is estimated to be
negligible. Its annual operating costs will be $11,500. Compare these two alternatives by the
present-worth method at i = 13%.

Summary

Present worth is an equivalence method of analysis in which


a projects cash flows are discounted to a lump sum amount
at present time.
The MARR or minimum attractive rate of return is the interest
rate at which a firm can always earn or borrow money.
MARR is generally dictated by management and is the rate
at which NPW analysis should be conducted.
Two measures of investment, the net future worth and the
capitalized equivalent worth, are variations to the NPW
criterion.

The term mutually exclusive means that, when one of several


alternatives that meet the same need is selected, the others
will be rejected.
Revenue projects are those for which the income generated
depends on the choice of project.
Service projects are those for which income remains the
same, regardless of which project is selected.
The analysis period (study period) is the time span over
which the economic effects of an investment will be
evaluated.
The required service period is the time span over which the
service of an equipment (or investment) will be needed.

The analysis period should be chosen to cover


the required service period.
When not specified by management or company
policy, the analysis period to use in a comparison
of mutually exclusive projects may be chosen by
an individual analyst.