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

2 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


3 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
 The minimum attractive rate of return
 highest rate of return
 Payback period
 shortest payback period
 Do nothing


4 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
 Conditions of comparison:
 equal lives
 different lives
5 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
MARR
 Minimum Acceptable Rate of Return
 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
 More akin to Opportunity Cost of the moneyER xp e cte d
a te o f R e tu rn
on N ew
 Determined by Company Policy Pro p o sa l

R a n g e fo r
RO R
O n a cce p te d
p ro p o sa ls

A llp ro p o sa ls
m u st o ffe r a t MA
Le a st M A R R RR
to b e
R O R on
co n sid e re d
S a fe
in ve stm e n t
6 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
Salvage value quarter
Rp. 225.000.000,- months
Rp. 190.000.000,-
Life 3 tahun 3 tahun
7 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Present-worth comparison
SV
 System A:
R R R R R R R R R R R R
I
E

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)

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

Present-worth comparison
SV
 System B:

R R R R R R R R R
I
E

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

9 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) At any time span to be considered (the

study period approach or planning
10 horizon approach), when
SI-4251 Ekonomi LCM
Teknik is Abduh, Ph.D.
Muhamad
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 system B
Initial cost Rp. 625.000.000,- Rp. 770.000.000,-
Monthly Rp. 45.750.000,- Rp. 55.750.000,-
expenses
Monthly Rp. 32.000.000,- Rp. 40.000.000,-
receipts
Salvage value Rp. 225.000.000,- Rp. 110.000.000,-
Life 2 tahun 4 tahun

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

Present-worth comparison
 System A:
R
SV

I
E

0 1 2

System B:
R
SV
I
E

0 1 2 3 4

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

Present-worth comparison (LCM)
 System A:
R1 R2
SV SV2

I I2
E1 E2

0 1 2 3 4

System B:
R
SV
I
E

0 1 2 3 4

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

Present-worth comparison (Study Periods: 2
years)
 System A:
R
SV

I
E

0 1 2

System B:
R Estimated
SV
I
E

0 1 2 3 4

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

Example 1: Three Alternatives

 Assume i = 10% per year

A1 A2 A3
Electric Power Gas Power Solar Power
First Cost: First Cost: First Cost:
-2500 -3500 -6000
Ann. Op. Cost: -900 Ann. Op. Cost: -700 Ann. Op. Cost: -50
Sal. Value: Sal. Value: Sal. Value:
+200 +350 +100
Life: 5 Life: 5 Life: 5
years years 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 1 2 3 4 5
-2500 A = -900/Yr.
FSV = 350
A 2 : Gas

0 1 2 3 4 5
A = -700/Yr.
-3500
A 3 :Solar FSV = 100

0 1 2 3 4 5
A = -50/Yr.
-6000 i = 10 %/ yr and n = 5
16 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

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

Use LCM, where “n” = 18 yrs.
 The Cash Flow Diagrams are:

19 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 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

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.

23 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.

25 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.

26 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.

27 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.

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

P/A where “n” goes to infinity

 The P/A factor is:

 (1 + i ) − 1 
n
P = A n 
 i (1 + i ) 
On the right hand side, divide both
numerator and denominator by (1+i)n
 1 
1 − (1 + i ) n 
P = A 
 i 
 
29 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

CC =

i
 AW: annual worth

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

CC Problem: Public Works Example
 Problem Parameters
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 .
Two , Mutually Exclusive Alternatives : Select
the best alternative based upon a CC analysis
32 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Bridge Alternatives: Suspension

 Cash Flow Diagrams

Suspension Bridge
Alternative
0 1 2 3 4 . . . . .
9 10 11 ……..

$35,000/yr
i =
$50 Million
6 %/ year
$100 , 00
0
$2 Million

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

-25M +(-15M) Sandblast:

i = 6%/year -190,000

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

-25M +(-15M) Sandblast:

i = 6%/year -190,000

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

-25M +(-15M) Sandblast:

i = 6%/year -190,000

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

Truss Bridge Alternative
 3, A2: Annual Cost of Painting
i = 6%/year
Truss Design:
//////
0 1 2 3 4 5 6 7 8 9 10 11 …..
A. Maint. = $20,000/yr

Use A/F,6%,3 n = 
Paint: Paint: Paint:
-40,000 -40,000 -40,000
-25M +(-15M) Sandblast:
-190,000

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
Truss Design:
//////
0 1 2 3 4 5 6 7 8 9 10 11 …..
A. Maint. = $20,000/yr

Use The A/F,6%,10 to convert to an equivalent n = 

$/year amount
Paint: Paint: Paint:
-40,000 -40,000 -40,000
-25M +(-15M) Sandblast:
-190,000

For any given cycle of Sandblasting Compute

A3 = - $190 , 000 ( A / F , 6 %, 10 ) =- $14 , 421
39 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
CCTotal = CC1 + CC2 =-40.783 million
•CC Suspension = - $52 . 71 million
•CCT russ - - 40 . 783 million
•Select the Truss Design !

40 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
SI-4251 the
Ekonomi Teknik tollAbduh, Ph.D.
Muhamad
 Homework #4
1. A manufacturing company is trying to decide among three different pieces of equipment that have the
following characteristics:
equipment A equipment B equipment C
2. First cost Rp. 975.000.000,- Rp. 854.500.000,- Rp. 1.025.000.000,-
3. Annual M&O cost Rp. 89.700.000,- Rp. 95.000.000,- Rp. 75.000.000,-
Salvage value Rp. 161.000.000,- Rp. 205.000.000,- Rp. 321.000.000,-
4. Overhaul cost Rp. 175.000.000,- / 2 years Rp. 135.000.000,- / 3 years Rp. 175.000.000,- / 3
5. years

6.
 useful life = 6 years and interest rate of 12% per year.
2. 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
 First cost Rp. 3.800.000.000,- Rp. 1.675.000.000,-
Annual operating cost Rp. 289.700.000,- Rp. 315.000.000,-
2.
Salvage value Rp. 461.000.000,- Rp. 205.000.000,-
3. Life 5 years 3 years
4.


3. Ganeshaconsulting firm is considering to build or lease an office space. For interest rate of 6%
build own
compounded semiannualy compare and select alternative. lease
Construction cost Rp. 8.750.000.000,- -
Lease cost - Rp. 415.000.000,- / 3
Maintenance cost Rp. years
110.000.000,- / year Rp. 75.000.000,- / year
Period ∞ 3 years

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