Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Chapter 5
Present Worth Analysis

5.1. Formulating Alternatives

Mutually exclusive alternatives: Only one of the proposals can be selected. For

terminology purposes, each viable proposal is called an alternative.

Independent projects: More than one proposal can be selected. Each viable proposal is

called a project.

Do-nothing (DN) proposal: is usually understood to be an option when the evaluation is

performed.

5.2. Present Worth Analysis of Equal-Life Alternatives

If the alternatives have the same capacities for the same time period, the equal-service

requirement is met. Calculate the PW value at the stated MARR (Minimum Attractive

rate of Return) for each alternative.

One alternative: If PW ≥ 0, the requested MARR is met or exceeded and the alternative is

economically justified.

Two or more alternatives: Select the alternative with the PW that is numerically largest,

that is, less negative or more positive.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Example 5.1

A university lab is a research contractor to NASA for in-space fuel cell systems that are

hydrogen- and methanol-based. During lab research, three equal-service machines need to

be evaluated economically. Perform the present worth analysis with the costs shown

below. The MARR is 10% per year.

Solution

The solar-powered machine is selected since the PW of its costs is the lowest; it has the
numerically largest PW value.

5.3. Present Worth Analysis of Different-Life Alternatives

The PW of the alternatives must be compared over the same number of years and must
end at the same time to satisfy the equal-service requirement.

The equal-service requirement is satisfied by using either of two approaches:

LCM: Compare the PW of alternatives over a period of time equal to the least common
multiple (LCM) of their estimated lives.

Study period: Compare the PW of alternatives using a specified study period of n years.
This approach does not necessarily consider the useful life of an alternative. The study
period is also called the planning horizon.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Example 5.2

National Homebuilders, Inc., plans to purchase new cut-and-finish equipment. Two

manufacturers offered the estimates below.

Determine which vendor should be selected on the basis of a present worth comparison, if
the MARR is 15% per year.

Solution

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

5.4. Future Worth Analysis

The selection guidelines for FW analysis are the same as for PW analysis; FW ≥ 0 means
the MARR is met or exceeded. For two or more mutually exclusive alternatives, select the
one with the numerically largest FW value.

Example 5.3

A British food distribution conglomerate purchased a Canadian food store chain for £75

million 3 years ago. There was a net loss of £10 million at the end of year 1 of ownership.

Net cash flow is increasing with an arithmetic gradient of £5 million per year starting the

second year, and this pattern is expected to continue for the foreseeable future. This

means that breakeven net cash flow was achieved this year. Because of the heavy debt

financing used to purchase the Canadian chain, the international board of directors

expects a MARR of 25% per year from any sale.

(a) The British conglomerate has just been offered £159.5 million by a French company

wishing to get a foothold in Canada. Use FW analysis to determine if the MARR will be

realized at this selling price.

(b) If the British conglomerate continues to own the chain, what selling price must be

obtained at the end of 5 years of ownership to just make the MARR?

Solution

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

(a)

No, the MARR of 25% will not be realized if the £159.5 million offer is accepted.

(b)

The offer must be for at least £246.81 million to make the MARR.

5.5. Capitalized Cost Analysis

Capitalized Cost (CC) is the present worth of a project that has a very long life (n = ∞).

The procedure to determine the CC for an infinite sequence of cash flows is as follows:

1. Draw a cash flow diagram showing all nonrecurring (one-time) cash flows and at least
two cycles of all recurring (periodic) cash flows.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

2. Find the present worth of all nonrecurring amounts. This is their CC value.

3. Find the A value through one life cycle of all recurring amounts. (This is the same
value in all succeeding life cycles) Add this to all other uniform amounts (A) occurring in
years 1 through infinity. The result is the total equivalent uniform annual worth (AW).

4. Divide the AW obtained in step 3 by the interest rate i to obtain a CC value.

5. Add the CC values obtained in steps 2 and 4.

Example 5.4

The system has an installed cost of $150,000 and an additional cost of $50,000 after 10
years. The annual software maintenance contract cost is $5000 for the first 4 years and
$8000 thereafter. In addition, there is expected to be a recurring major upgrade cost of
$15,000 every 13 years. Assume that i = 5% per year. Find the equivalent cost (a) now, a
CC value, and (b) for each year hereafter, an AW value.

Solution

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

(b)

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Chapter 6
Annual Worth Analysis

6.1. Advantages and Uses of Annual Worth Analysis

The annual worth method offers a prime computational and interpretation advantage
because the AW value needs to be calculated for only one life cycle. The AW value
determined over one life cycle is the AW for all future life cycles. Therefore, it is not
necessary to use the LCM of lives to satisfy the equal-service requirement.

When alternatives being compared have different lives, the AW method makes the
assumptions that:

1. The services provided are needed for at least the LCM of the lives of the alternatives.

2. The selected alternative will be repeated for succeeding life cycles in exactly the same
manner as for the first life cycle.

3. All cash flows will have the same estimated values in every life cycle.

Example 6.1

In Example 5.2, National Homebuilders, Inc. evaluated cut-and-finish equipment from

vendor A (6-year life) and vendor B (9-year life). The PW analysis used the LCM of 18
years. Consider only the vendor A option now. The following diagram shows the cash
flows for all three life cycles (first cost $-15,000; annual M&O costs $-3500; salvage
value $1000). Demonstrate the equivalence at i = 15% of PW over three life cycles and
AW over one cycle. In Example 5.2, present worth for vendor A was calculated as PW =
$-45,036.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Solution

6.2. Calculation of Capital Recovery and AW Values

An alternative should have the following cash flow estimates:

Initial investment P: This is the total first cost of all assets and services required to
initiate the alternative.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Salvage value S: This is the terminal estimated value of assets at the end of their useful
life. The S is zero if no salvage is anticipated; S is negative when it will cost money to
dispose of the assets.

Annual amount A: This is the equivalent annual amount. Often this is the annual
operating cost (AOC) or M&O cost.

The annual worth (AW) value for an alternative is comprised of two components: capital
recovery for the initial investment P at a stated interest rate (usually the MARR) and the
equivalent annual amount A. The symbol CR is used for the capital recovery component.
In equation form,

AW = CR + A

Capital recovery (CR) is the equivalent annual amount that the asset, process, or system
must earn (new revenue) each year to just recover the initial investment plus a stated
rate of return over its expected life. Any expected salvage value is considered in the
computation of CR.

CR = -P(A/P,i,n) + S(A/F,i,n)

Example 6.2

Lockheed Martin is increasing its booster thrust power in order to win more satellite
launch contracts from European companies interested in opening up new global
communications markets. A piece of earth-based tracking equipment is expected to
require an investment of $13 million, with $8 million committed now and the remaining
$5 million expended at the end of year 1 of the project. Annual operating costs for the
system are expected to start the first year and continue at $0.9 million per year. The useful
life of the tracker is 8 years with a salvage value of $0.5 million. Calculate the CR and
AW values for the system, if the corporate MARR is 12% per year.

Solution

P = 8 + 5(P/F,12%,1) = $12.46

CR = -12.46(A/P,12%,8) + 0.5( A/F ,12%,8) = -12.46(0.20130) + 0.5(0.08130) = $ - 2.47

AW = - 2.47 - 0.9 = $ - 3.37

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

6.3. Evaluating Alternatives by Annual Worth Analysis

One alternative: If AW ≥ 0, the requested MARR is met or exceeded and the alternative
is economically justified.

Two or more alternatives: Select the alternative with the AW that is numerically largest,
less negative or more positive.

Example 6.3

Heavenly Pizza, which is located in Toronto, fares very well with its competition in
offering fast delivery. Many students at the area universities and community colleges
work part-time delivering orders made via the web. The owner, Jerry, a software
engineering graduate, plans to purchase and install five portable, in-car systems to
increase delivery speed and accuracy. The systems provide a link between the web order-
placement software and the On-Star system for satellite-generated directions to any
address in the area. The expected result is faster, friendlier service to customers and larger
income.

Each system costs $4600, has a 5-year useful life, and may be salvaged for an estimated
$300. Total operating cost for all systems is $1000 for the first year, increasing by $100
per year thereafter. The MARR is 10%. The net income is $6000 per year for all five
systems from the first year to the end. Perform an annual worth evaluation for the owner
that answers the following questions.

(a) Is this project financially viable at the MARR?

(b) Based on the answer in part (a), determine how much new net income Heavenly Pizza
must have to economically justify the project. Operating costs remain as estimated.

Solution

(a) CR = -5[4600(A/P,10%,5)] + 5[300(A/F ,10%,5)]

= -5[4600(0.26380)] + 5[300(0.16380)]

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

= $ -5822
AW = CR + A = -5822 + 5000 - 100(A/G,10%,5)
= $ -1003

(b) 0 = -5822 + (R - 1000) - 100(A/G ,10%,5)

R = -5822 - 1000 - 100(1.8101)
= $7003 per year

Example 6.4

Luby’s Cafeterias is in the process of forming a separate business unit that provides meals
to facilities for the elderly, such as assisted care and long-term care centers. Since the
meals are prepared in one central location and distributed by trucks throughout the city,
the equipment that keeps food and drink cold and hot is very important. Michele is the
general manager of this unit, and she wishes to choose between two manufacturers of
temperature retention units that are mobile and easy to sterilize after each use. Use the
cost estimates below to select the more economic unit at a MARR of 8% per year.

Solution

The Hamilton unit is considerably less costly on an annual equivalent basis.

6.4. AW of a Permanent Investment

This section discusses the annual worth equivalent of the capitalized cost.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Example 6.4

At the end of each year, all owners and employees at Bell County Utility Cooperative are
given a bonus check based on the net profit of the Coop for the previous year. Bart just
received his bonus in the amount of $8530. He plans to invest it in an annuity program
that returns 7% per year. Bart’s long-term plans are to quit the Coop job some years in the
future when he is still young enough to start his own business. Part of his future living
expenses will be paid from the proceeds that this year’s bonus accumulates over his
remaining years at the Coop. Determine the amount of annual year-end withdrawal that
he can anticipate (starting 1 year after he quits) that will continue forever.

Solution