Advanced Engineering Economics: Present Worth and Future Worth Analysis

Advanced Engineering
Economics
Lecture 2.3:
Present Worth and
Future Worth Analysis
(Blank & Tarquin Chapter 5)
J B Nel
Text Book:
Learning Stages and Chapters
Source: Blank & Tarquin

Online Videos/Presentations as
Preparation Work
Watch the following Online Videos/Presentations BEFORE

attending the lecture - copy and paste link into your Browser:
• Present Worth (PW) of Equal-Life Alternatives:

http://www.viddler.com/embed/24167f3a/?f=1&player=arpeggio&secret=59037080
• Present Worth (PW) of Different-Life Alternatives :

http://www.viddler.com/embed/6e319cf4/?f=1&player=arpeggio&secret=59037080
• Capitalized Cost Analysis:

http://www.viddler.com/embed/c78615e7/?f=1&player=arpeggio&secret=59037080
Main Subjects in Chapter
• Formulate Alternatives
• PW of equal-life alternatives
• PW of different-life alternatives
• Future Worth analysis
• Capitalized Cost analysis
5-4 Source: McGraw-Hill Resources

Formulating Alternatives
Two types of economic proposals
• Mutually Exclusive (ME) Alternatives:
• Only one can be selected;
• Compete against each other
• Independent Projects:
• More than one can be selected;
• Compete only against DN (do-nothing)
Do Nothing (DN) – The DN alternative or project means that the current approach is
maintained – nothing new is initiated => no new costs, revenues or savings

Formulating Alternatives
Two types of cash flow estimates

Revenue: Alternatives include estimates of costs
(cash outflows) and revenues (cash inflows), also
savings (considered as a cash inflow)
Cost: Alternatives include only costs;

revenues and savings assumed equal for all
alternatives;
also called service alternatives

PW Analysis of Alternatives
• Convert all cash flows to PW using MARR

• Precede costs by minus sign; receipts by plus sign
EVALUATION
• For one project, if PW > 0, it is justified
• For mutually exclusive alternatives, select one with
numerically largest PW
• For independent projects, select all with PW > 0

Selection of Alternatives by PW
For the alternatives shown below, which should be selected if

they are (a) mutually exclusive; (b) independent?
Project ID Present Worth
A R300,000
B R120,500
C -R40,000
D R 20,000
Solution: (a) Select numerically largest PW; alternative A
(b) Select all with PW > 0; projects A, B & D

Example: PW Evaluation of Equal-Life
Mutual Exclusive Alternatives
Alternative X has a first cost of R200,000, an operating cost of R90,000 per year,
and a R50,000 salvage value after 5 years. Alternative Y will cost R350,000 with an
operating cost of R40,000 per year and a salvage value of R70,000 after 5 years.
At an MARR of 12% per year, which should be selected?
Solution: Find PW at MARR and select numerically larger PW value
PWX = -200,000 – 90,000(P/A,12%,5) + 50,000(P/F,12%,5)

= -R496,060
PWY = -350,000 – 40,000(P/A,12%,5) + 70,000(P/F,12%,5)

= -R454,470
Select alternative Y

PW of Different-Life
Alternatives
Must compare alternatives for equal service
(i.e. compared over the same time period and alternatives
must end at the same time)
Two ways to compare equal service:
• Compare the PW over a period equal to the Least Common Multiple
(LCM) of their lives
• Compare the PW using a Specified Study Period – it does not
necessarily consider the useful life of an alternative (also called
planning horizon)
(The LCM procedure is used unless otherwise specified)
Assumptions of LCM approach
• Service provided is needed over the entire LCM years

or more
• Selected alternative can be repeated over each life

cycle of LCM in exactly the same manner
• Cash flow estimates are the same for each life cycle
(in Chapter 14 it will be explained that when taking inflation/
deflation into account, then any changes will be exactly by
the inflation or deflation rate)

Example: Different-Life
Alternatives
Compare the machines below using present worth analysis at i = 10% per year
Machine A Machine B
First cost, R 20,000 30,000
Annual cost, R/year 9000 7000
Salvage value, R 4000 6000
Life, years 3 6
Solution: LCM = 6 years; repurchase A after 3 years
PWA = -20,000 – 9000(P/A,10%,6) – 16,000(P/F,10%,3) + 4000(P/F,10%,6)

= R-68,961
-20,000 + 4,000
PWB = -30,000 – 7000(P/A,10%,6) + 6000(P/F,10%,6) in year 3
= R-57,100
Select alternative B
PW Evaluation Using
a Study Period
• Once a study period is specified, all cash flows
after this time are ignored
• Salvage value is the estimated market value at
the end of study period
Short study periods are often defined by

management when business goals are short-term
Study periods are commonly used in equipment

replacement analysis
Example: Study Period
PW Evaluation
Compare the alternatives below using present worth analysis at i = 10% per year
and a 3-year study period
Machine A Machine B
First cost, R -20,000 -30,000
Annual cost, R/year -9,000 -7,000
Salvage/market value, R 4,000 6,000 (after 6 years)
10,000 (after 3 years)
Life, years 3 6
Solution: Study period = 3 years; disregard all estimates after 3 years

PWA = -20,000 – 9000(P/A,10%,3) + 4000(P/F,10%,3) = R-39,376
PWB = -30,000 – 7000(P/A,10%,3) + 10,000(P/F,10%,3) = R-39,895
Marginally, select A; different selection than for LCM = 6 years
Future Worth Analysis
FW exactly like PW analysis, except calculate FW
• FW can be calculated using cash flows or from PW using

the F/P factor at the established MARR – the n value to be
used is either the LCM value or the specified study period
• FW typically used in large capital investment decisions with
the prime goal to maximize future wealth of stockholders
• The selection guidelines are the same as for PW analysis:
• FW >= 0 means the MARR met or exceeded
• For two or more mutually exclusive alternatives, select the one
with numerically largest FW
5-15 Source: Blank & Tarquin

FW of Different-Life
Alternatives
Compare the machines below using future worth analysis at i = 10% per year
Machine A Machine B
First cost, R -20,000 -30,000
Annual cost, R/year -9000 -7000
Salvage value, R 4000 6000
Life, years 3 6
Solution: LCM = 6 years; repurchase A after 3 years
FWA = -20,000(F/P,10%,6) – 9000(F/A,10%,6) – 16,000(F/P,10%,3) + 4000
= R-122,168
-20,000 + 4,000
FWB = -30,000(F/P,10%.6) – 7000(F/A,10%,6) + 6000 in year 3
= R-101,157
Select B (Note: PW and FW methods will result in same selection)
Capitalized Cost (CC) Analysis
CC refers to the present worth of a project with a
very long life, that is, PW as n becomes infinite
A
Basic equation is: CC = P =
i
“A” essentially represents the interest on a perpetual investment
For example, in order to be able to withdraw R50,000 per year forever

at i = 10% per year, the amount of capital required is 50,000/0.10 = R500,000
For finite life alternatives, convert all cash flows into

an A value over one life cycle and then divide by i
Example: Capitalized Cost
Compare the machines shown below on the basis of their
capitalized cost. Use i = 10% per year
Machine 1 Machine 2
First cost,R -20,000 -100,000
Annual cost,R/year -9000 -7000
Salvage value, R 4000 -----
Life, years 3 ∞
Solution: Convert machine 1 cash flows into A and then divide by i
A1 = -20,000(A/P,10%,3) – 9000 + 4000(A/F,10%,3) = R-15,834
CC1 = -15,834 / 0.10 = R-158,340
CC2 = -100,000 – 7000 / 0.10 = R-170,000

Select machine 1
5-18
Source: McGraw-Hill Resources
Summary of Important Points
• PW method converts all cash flows to present value at MARR

• Alternatives can be mutually exclusive or independent
• Cash flow estimates can be for revenue or cost alternatives
• PW comparison must always be made for equal service
• Equal service is achieved by using LCM or study period
• Capitalized cost is PW of project with infinite life; CC = P = A/i

Questions

Advanced Engineering Economics: Present Worth and Future Worth Analysis

Uploaded by

Copyright:

Available Formats

Advanced Engineering Economics: Present Worth and Future Worth Analysis

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Advanced Engineering Economics: Present Worth and Future Worth Analysis

Uploaded by

Copyright:

Available Formats

Advanced Engineering

Source: Blank & Tarquin

Watch the following Online Videos/Presentations BEFORE

• Present Worth (PW) of Equal-Life Alternatives:

• Present Worth (PW) of Different-Life Alternatives :

• Capitalized Cost Analysis:

5-4 Source: McGraw-Hill Resources

5-5 Source: McGraw-Hill Resources

Two types of cash flow estimates

Cost: Alternatives include only costs;

5-6 Source: McGraw-Hill Resources

• Convert all cash flows to PW using MARR

5-7 Source: McGraw-Hill Resources

For the alternatives shown below, which should be selected if

5-8 Source: McGraw-Hill Resources

Solution: Find PW at MARR and select numerically larger PW value

PWX = -200,000 – 90,000(P/A,12%,5) + 50,000(P/F,12%,5)

PWY = -350,000 – 40,000(P/A,12%,5) + 70,000(P/F,12%,5)

5-9 Source: McGraw-Hill Resources

• Service provided is needed over the entire LCM years

• Selected alternative can be repeated over each life

5-11 Source: McGraw-Hill Resources

Solution: LCM = 6 years; repurchase A after 3 years

PWA = -20,000 – 9000(P/A,10%,6) – 16,000(P/F,10%,3) + 4000(P/F,10%,6)

Short study periods are often defined by

Study periods are commonly used in equipment

Solution: Study period = 3 years; disregard all estimates after 3 years

• FW can be calculated using cash flows or from PW using

5-15 Source: Blank & Tarquin

For example, in order to be able to withdraw R50,000 per year forever

For finite life alternatives, convert all cash flows into

CC1 = -15,834 / 0.10 = R-158,340

CC2 = -100,000 – 7000 / 0.10 = R-170,000

• PW method converts all cash flows to present value at MARR

5-19 Source: McGraw-Hill Resources

You might also like