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Lecture 7

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Lecture 7

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nouman215988
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APPLICATION OF MONEY-TIME

RELATIONSHIP IN ENGINEERING
ECONOMY STUDIES

By
Engr. Hiba Arshad
Lecture 7

APPLICATION OF MONEY TIME


RELATIONSHIP
METHODS FOR ECONOMIC
ANALYSIS
1. Present Worth Method
2. Future Worth Method
3. Annual Worth Method
4. Internal Rate of Return
Method
5. External Rate of Return
Method
6. Payback Period Method
Example-1 [PW (NPV)
Method]
A piece of new equipment has been proposed by engineers to
increase the productivity of a certain manual welding operation.
The investment cost is $25,000, and equipment will be a market
value of $5,000 at the end of a study period of five years.
Increased productivity attributable to the equipment will amount
to $8,000 per year after extra operating costs have been
subtracted from the revenue generated by the additional
production. A cash flow diagram for this investment opportunity
is given below. If the firm’s MARR (before income taxes) is 20%
per year, is this proposal a sound one? Use the PW method.
Solution:
PW = PW of cash flow - PW of cash flow
or
PW(20%) = $8,000(P/A, 20%,5) + $5,000(P/F,20%,5) - $25,000
= $934.29
Because PW(20%) > 0, this equipment is economically justified.
Example-2 [PW (NPV)
Method]
The estimated construction cost of a residential
building is Rs. 4, 000,000. The land cost for this project
Rs. 2, 000,000. Owner is planning to rent this building
just after its construction. The building is located in an
area, where owner expects annual rent of Rs. 580,000.
The Owner intends to keep this building for 15 years
after that building can be sold in Rs. 12,000,000. The
Owner will have to spend annually Rs. 50,000 for repair
and maintenance of the building. Moreover, he has to
pay annual property tax at a rate 2% of rental value.
Evaluate the project by using Present Worth method.
Consider Owner’s MARR equal to 12% per year for
analysis. Also make a cash flow diagram for the
situation.
2. ANALYZING PROJECTS WITH FUTURE WORTH
METHOD (NET FUTURE WORTH, FW)

Because a primary objective of all time value of


money methods is to maximize the future wealth of
the owners of a firm, the economics information
provided by the Future Worth (FW) method is very
useful in capital investment decision situations. The
future worth is based on the equivalent worth of all
cash inflows and outflows at the end of the planning
horizon (study period) at an interest rate that is
generally the MARR.
Example-2 (FW Method)
A company is considering constructing a plant to
manufacture a proposed new product. The land costs
$300,000, the building costs $ 600,000, the equipment costs
$ 2500,000 additional working capital is required. It is
expected that the product will result in sales of $ 750,000
per year for 10 years, at which time the land can be sold for
$400,000, the building for $350,000, and the equipment for
$50,000. All of the working capital would be recovered. The
annual expenses for labor, materials, and all other items are
estimated to total $475,000. If the company requires a
MARR of 25% per year on projects of comparable risk,
Determine if company should invest in the new product line.
Use the FW method for analysis.
3. ANALYZING PROJECTS WITH ANNUAL WORTH
METHOD (NET ANNUAL WORTH, AW)
The Annual Worth (AW) of a project is an equal annual series
of dollar amounts for a stated study period, that is equivalent
to the cash inflows and outflows at an interest rate that is
generally the MARR. Hence, the AW of a project is annual
equivalent revenues or savings (R) minus annual equivalent
expenses (E), less its annual equivalent Capital Recovery (CR)
amount, which is defined below.
An annual equivalent value R, E and CR is computed for the
study period, N, which is usually in years. In equation form
the AW, which is a function of i% is
AW(i%) = R – E – CR (i%)
Also, we need to notice that the AW of a project is equivalent
to its PW and FW.
AW = PW (A/P, i%, N) and AW = FW (A/F, i%, N).
Hence, it can be easily computed for a project from these
other equivalent values.
Example-3 (Annual Worth
Method)
An investment company is considering building a 25-unit
apartment complex in a growing town. Because of the
long-term growth potential of the town, it is felt that the
company could average 90% of full occupancy for the
complex each year. If the following items are reasonably
accurate estimates, what is the minimum monthly rent
that should be charged if a 12% MARR (per year) is
desired? Use the AW method.

Data
Land investment cost = $50,000
Building investment cost = $225,000
Study period, N = 20 years
Rent per unit per month = ?
Upkeep expense per unit per month = $35
Solution
The procedure for solving this problem is first to determine
the equivalent AW of all costs at the MARR of 12% per year.
To earn exactly 12% on this project, the annual rental
income, adjusted for 90% occupancy, must equal the AW of
costs:

Initial investment cost = $50,000 + $225,000 =


$275,000
Taxes and insurance / year = 0.1 ($275,000) = $27,500
Upkeep / year = $35(12 x 25) (0.9) = $9,450
CR cost / year = $275,000 (A/P, 12%, 20) - $50,000
(A/F,12%,20)
= $36,123
(We assume that investment in land is recovered at the end
of year 20 and that annual upkeep is directly proportional to
the occupancy rate.)
Equivalent AW (of costs) = -$27,500 – $9,450 - $36,123 = -
$73,073
Example-4
Maintenance costs for a small bridge with an expected 60
year life are estimated to be $1000 each year for the first
5 years, followed by a $10,000 expenditure in the year 15
and a $10,000 expenditure in year 30. If i = 10% per year,
what is the equivalent uniform annual cost over the entire
60-year-period?
Thank you

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