Chapter 5

Present Worth
Analysis
Lecture slides to accompany

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

5-1
 LEARNING OUTCOMES
1. Formulate Alternatives
2. PW of equal-life alternatives
3. PW of different-life alternatives
4. Future Worth analysis
5. Capitalized Cost analysis

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5-2
 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 (DN) – An ME alternative or independent project to

maintain the current approach; no new costs, revenues or savings
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 Formulating Alternatives

Two types of cash flow estimates

Revenue: Alternatives include estimates of costs

(cash outflows) and revenues (cash inflows)

Cost: Alternatives include only costs; revenues and savings

assumed equal for all alternatives;
also called service alternatives

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 PW Analysis of Alternatives
Convert all cash flows to PW using MARR
Precede costs by minus sign; receipts by
plus sign

EVALUATI
ON
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

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Selection of Alternatives by PW

Project ID Present Worth

A $30,000
B $12,500
C $-4,000
D $ 2,000
Solution: (a) Select numerically largest PW; alternative A
(b) Select all with PW > 0; projects A, B & D
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 Example: PW Evaluation of Equal-Life ME Alts.

Alternative X has a first cost of $20,000, an operating cost of $9,000 per year,
and a $5,000 salvage value after 5 years. Alternative Y will cost $35,000
with an operating cost of $4,000 per year and a salvage value of $7,000
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 = -20,000 - 9000(P/A,12%,5) + 5000(P/F,12%,5)

= -$49,606

PWY = -35,000 - 4000(P/A,12%,5) + 7000(P/F,12%,5)

= -$45,447

Select alternative Y
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PW of Different-Life Alternatives
Must compare alternatives for equal service
(i.e., alternatives must end at the same time)

Two ways to compare equal service:

Least common multiple (LCM) of lives

Specified study period

(The LCM procedure is used unless otherwise specified)

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 Assumptions of LCM approach
 Service provided is needed over the LCM or
more years

 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 (i.e., change in exact accord with the
inflation or deflation rate)

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 Example: Different-Life Alternatives
Compare the machines below using present worth analysis at i = 10% per year

Machine A Machine B
First cost, $ 20,000 30,000
Annual cost, $/year 9000 7000
Salvage value, $ 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)

= $-68,961
20,000 – 4,000 in
PWB = -30,000 – 7000(P/A,10%,6) + 6000(P/F,10%,6) year 3
= $-57,100

Select alternative B
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5-10
 Example: Different-Life Alternatives
Compare the machines below using present worth analysis at i = 10% per year

Machine A Machine B
Year 0 First cost, $ 20,000 30,000
Year 1 Cost, $ 9,000 7,000
Year 2 Cost, $ 9,000 7,000
Year 3 Cost+Salvage value+ 9,000+4,000+20,000 7,000
First cost, $
Year 4 Cost, $ 9,000 7,000
Year 5 Cost. $ 9,000 7,000
Year 6 Cost+Salvage value,$ 9,000+4,000 7,000+6,000

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)

= $-68,961 20,000 – 4,000 in
PWB = -30,000 – 7000(P/A,10%,6) + 6000(P/F,10%,6) year 3
= $-57,100 © 2012 by McGraw-Hill All Rights Reserved

Select alternative B 5-11

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
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1-12
 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, $ -20,000 -30,000
Annual cost, $/year -9,000 -7,000
Salvage/market value, $ 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) = $-39,376

PWB = -30,000 – 7000(P/A,10%,3) + 10,000(P/F,10%,3)= $-39,895
Marginally, select A; different selection than for LCM = 6 years
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 Future Worth Analysis
FW exactly like PW analysis, except calculate FW

Must compare alternatives for equal service

(i.e. alternatives must end at the same time)

Two ways to compare equal service:

Least common multiple (LCM) of lives

Specified study period

(The LCM procedure is used unless otherwise specified)
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5-14
 FW of Different-Life Alternatives
Compare the machines below using future worth analysis at i = 10% per year

Machine A Machine B
First cost, $ -20,000 -30,000
Annual cost, $/year -9000 -7000
Salvage value, $ 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
= $-122,168
FWB = -30,000(F/P,10%.6) – 7000(F/A,10%,6) + 6000
= $-101,157
Select B (Note: PW and FW methods will always result in same selection)
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5-15
 Payback Period Analysis
Payback period: Estimated amount of time (np) for cash inflows to recover an
initial investment (P) plus a stated return of return (i%)

Types of payback analysis: No-return and discounted payback

1. No-return payback means rate of return is ZERO (i = 0%)

2. Discounted payback considers time value of money (i > 0%)

Caution: Payback period analysis is a good initial screening

tool, rather than the primary method to justify a project or
select an alternative (Discussed later)
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 Payback Period Computation
Formula to determine payback period (np)
varies with type of analysis.
NCF = Net Cash Flow per period t

Eqn. 1

Eqn. 2

Eqn. 3

Eqn. 4

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 Points to Remember About Payback Analysis
• No-return payback neglects time value of money, so no
return is expected for the investment made
• No cash flows after the payback period are considered
in the analysis. Return may be higher if these cash flows
are expected to be positive.

• Approach of payback analysis is different from PW, AW, ROR

and B/C analysis. A different alternative may be selected using
payback.
• Rely on payback as a supplemental tool; use PW or AW at the
MARR for a reliable decision
• Discounted payback (i > 0%) gives a good sense of the risk
involved
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 Example: Payback Analysis
System 1 System 2
First cost, $ 12,000 8,000
NCF, $ per year 3,000 1,000 (year 1-5)
3,000 (year 6-14)
Maximum life, years 7 14
Problem: Use (a) no-return payback, (b) discounted payback at
15%, and (c) PW analysis at 15% to select a system. Comment on
the results.

Solution: (a) Use Eqns. 1 and 2

np1 = 12,000 / 3,000 = 4 years
np2 = -8,000 + 5(1,000) + 1(3,000) = 6 years

Select system 1
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13-19
 Example: Payback Analysis
(continued)
First cost, $ System
12,0001 System 2 8,000
NCF, $ per year 3,000 1,000 (year 1-5)
3,000 (year 6-14)
Maximum life, years 7 14

Solution: (b) Use Eqns. 3 and 4

System 1:0 = -12,000 + 3,000(P/A,15%,np1)
np1 = 6.6 years

System 2: 0 = -8,000 + 1,000(P/A,15%,5)

+ 3,000(P/A,15%,np2 - 5)(P/F,15%,5)
np1 = 9.5 years
Select system 1
(c) Find PW over LCM of 14 years PW1 = $663
PW2 = $2470
Select system 2
Comment: PW method considers cash flows after payback
period. © 2012 by McGraw-Hill All Rights
Reserved
Selection changes from system 1 to 2
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Example: Payback Analysis – Using Payback Period Calculator

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Example: Payback Analysis – Using Payback Period Calculator

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Reserved

13-22
 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

Basic equation is: CC = P = A

i
“A” essentially represents the interest on a perpetual investment

For example, in order to be able to withdraw $50,000 per year forever

at i = 10% per year, the amount of capital required is 50,000/0.10 = $500,000

For finite life alternatives, convert all cash flows into

an A value over one life cycle and then divide by i
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5-23
 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,$ -20,000 -100,000
Annual cost,$/year -9000 -7000
Salvage value, $ 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) = $-15,834
CC1 = -15,834 / 0.10 = $-158,340

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

Select machine 1
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 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

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