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5 Present Worth

Analysis

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

$35,000

$35,000

$25,000

$15,000

0

1

2

Years

$85,000

150,000

3.2 years

Payback period

100,000

50,000

0

-50,000

-100,000

0

6

Years (n)

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

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

Period

Summary

tool for liquidity, but we need a measure of

investment worth for profitability.

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

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

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

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

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.

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

investment was not made?

$27,340

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

$24,400

Project

investment?

0

Consider in Selecting a MARR in Project

Evaluation?

Risk-free return

Inflation factor

Risk premiums

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

Construction cost = $2,000,000

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

Projects

Mutually Exclusive Projects

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.

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.

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

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.

when the required service period is shorter than the individual

project life

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

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

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.

i 10%

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

$1,000$900$500$0

$100$90

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

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.

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 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.

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