EE_Module_2 Engineering Economics Module -2 Present Worth Comparisons Present worth(PW) In this method of comparison, the cash flows of each alternative will be reduced to time zero by assuming an interest rate i. In most of the practical decision environments, executives will be forced to select the best alternative from a set of competing alternatives. There are 5 basic methods to have results of selected alternative or to be analysed Equivalent worth : i) Present worth (PW) ii) Annual worth (AW) iii) Future worth (FW) Rate of returns i) Internal rate of return(IRR) ii) External rate of return(ERR) Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 Conditions for PW comparisions 1. Cash flows are known 2. Cash flows are in constant value Rs. 3. The interest rate is known 4. Comparisions are made with before- tax cash flows 5. | Comparisions do not include intangible considerations 6. Comparisions do not include consideration of the availability of funds to implement alternatives REVENUE-DOMINATED CASH FLOW DIAGRAM A generalized revenue-dominated cash flow diagram to demonstrate the present worth method of comparison is presented in Figure fit pee Fig. 4.1 Revenue dominated cashflow diagram In Fig. 4.1, Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 P represents an initial investment Rj the net revenue at the end of the jth year. The interest rate is i, compounded annually. S is the salvage value at the end of the nth year. Expenditure is assigned a negative sign and revenues are assigned a positive sign. If we have some more alternatives which are to be compared with this alternative, then the corresponding present worth amounts are to be computed and compared. Finally, the alternative with the maximum present worth amount should be selected as the best alternative. COST-DOMINATED CASH FLOW DIAGRAM A generalized cost-dominated cash flow diagram to demonstrate the present worth method of comparison is presented in Fig. 4.2. ° 1 2 jo: : ® Prepared by &EE_Module_2 In Fig. 4.2, P represents an initial investment Cj the net cost of operation and maintenance at the end of the jth year S the salvage value at the end of the nth year Expenditure is assigned a positive sign and the revenue a negative sign. If we have some more alternatives which are to be compared with this alternative, then the corresponding present worth amounts are to be computed and compared. Finally, the alternative with the minimum present worth amount should be selected as the best alternative. Basic PW comparisions The present worth of a cash flow overtime is its value today is represented as time ‘0’ ina cash flow diagram. Two general patterns are, Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 i) Present worth Equivalence Example problem 1. The lease on a warehouse amounts to Rs.5000 per month for 5yrs. If payments are made on the first of each month,what is the present worth of the agreement at a nominal annual interest rate of 12% compounded annually. A=5000 N=5*12=60months i=12%=12/12=1% PW=A(P/A,1%,60) = 5000(P/A,1%,60) =5000 * 44.955 PW=2,24,775 ii)Net Present Worth It has an initial outlay at time 0 followed by a series of receipts and disbursements. Net present-worth = PW (benefits) — PW (costs)_ Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 Example problem 1.A piece of new equipments was proposed by engineers to increase the production of a certain manual welding operation. The investment is Rs.25000 and the equivalent will have salvage value of Rs.5000 at the end of Syrs. Increased productivity will gain Rs.8000 per year after extra operating costs have been subtracted from the additional production, with rate of interest 20%.Use present worth method. Ans: Total PW=PW of cash receipts — PW of cash outlays = 8000(P/A,20%,5)+5000(P/F,20%,5) - 25000 =8000(2.991) + 5000(0.4019) — 25000 using table Total PW=934.5 Problems based on the Concept _of _PW method of comparison applied to the selection of best alternative. Problems 1.Alpha industry is planning to expand its production operation. It has identified three different technologies for meeting the goal. The initial outlay and annual revenues with respect to each of the technologies are summarized in Table Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 below. Suggest the best technology which is to be implemented based on the present worth method of comparison assuming 20% interest rate, compounded annually. Initial Annual Life outlay revenue (years) (Rs.) (Rs.) Technology | 12,00,000 | 4,00,000 | 10 1 Technology | 20,00,000 [6,00,000 | 10 2 Technology | 18,00,000 | 5,00,000 | 10 3 In all technologies, the initial outlay is assigned negative sign and annual revenues are assigned positive sign Technology 1 P=12,00,000 A=4,00,000 i=20% n=10 years The cas flow diagram of this technology isos shown ia Fig. 4.3. Aonge soy amen 5, 4cume sone Fig. 43. Cath low diagram for techusogy PW (20%) = -12,00,000 + 4,00,000(P/A,20%, 10) Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 = -12,00,000 + 4,00,000 * 4.192 PW(20%) = Rs. 4,76,800 Technology 2 P=20,00,000 , A=6,00,000 i=20% , n=10 The cath flow diagram of this technology iz shown in Fig. 4.1 600.000 6,00.000 6,00,000 ° r 2 - - 10 f= 20% 20.00.00 Fig. 44 Cash flow diagram for technology 2 PW(20%)= -20,00,000 + 6,00,000(P/A,20%, 10) =-20,00,000 + 600,000 * 4.192 PW(20%)=5,15,200 Technology 3 A=5,00,000 , i=20%, n=10 J tic technology ie shown in Fig. 45. 00,000 5,00,000 s,00,000 o 1 2 * 10. 15,0010 Fig. 45 Cach Slow diagram for technology 3 PW(20%)= -18,00,000 + 5,00,000(P/A,20%, 10) =+18,00,000 + 5,00,000 * 4.1925 PW(20%)=2,96,250 Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 Technology 2 should be considered. 2. An engineer has two bids for an elevator to be installed in a new building. The details of the bids for the elevators are as follows: Bid Engineers estimates Initial Service | Annual cost life operations and (Rs.) (years) | maintainance costs(Rs) Alpha 4,50,000 | 15 27000 elevator Beta 5,40,000 | 15 28500 elevator Determine wl Bid 1 : Alpha elevator ich bid should be accepted, based on the present worth method of comparison assuming 15% interest rate, compounded annually. P=4,50,000 A=27,000 n=15 i=15% PW(15%) = 4,50,000 + 27,000 (P/A,15%,15) PW(15%)=6,07,879.80 Prepared by Prof.Navyashree TM, CSE, DSCE =4,50,000 + 27000 * 5.8474EE_Module_2 ‘The cach flow diagram of bid 1 ie chowa ia Fig. 4.6 Fig. 46 Cosh How diagram for bid 1 Bid 2 : Beta elevator P=5,40,000 A=28,500 n=15 i=15% PW(15%)=5,40,000 + 28,500 (P/A,15%,15) =5,40,000 + 28,500 * 5.8474 PW(15%)=7,06,650.90 The cash flow diagram of bid 2 is shown in Fig. 4.7 ts I abe 0 1 2 a 4 Fig. 4.7 Cash flow diagram for bid 2. Alpha elevator should be implemented. 3. Investment proposals A and B have the net cash flows as follows: Proposals End of years 0 1 2 3 4 A(Rs.) =te000 3000 3000 7000 B(Rs.) 29.000 000 000 ~—~—=3000 Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 Compare the present worth of A with that of B at i = 18%. Which proposal should be selected? Proposal A Present worth of A af f— 18%, ‘The cash flow diagram of proposal A is shown in Fig. 4.8. 3.000 e - “ ot 2 2 4 pany so600 iA CA SR a PW(18%)=- 10,000+3000(P/F, 18%, 1)+3000(P/F,18%,2)+7000(P/F,18%,3 )+6000(P/F,18%,4) =-10,000 + 3000 (0.8475) + 3000(0.7182) + 7000(0.6086) + 6000(0.5158) PW(18%)= Rs. 2052 Proposal B Present worth of B at i= 18%. The cash flow diagram of the proposal B is shown in Fig. 49. 6000 64 ©3000 3.000 10,000 Fig. 4.9 Cash flow diagram for proposal B PW(18%)= -10,000 + 6000(P/F,18%,1) + 6000(P/F,18%,2) + 3000(P/F,18%,3) + 3000(P/F,18%,4) Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 = -10000 + 6000 (0.8475) + 6000 (0.7182) +3000(0.6086) + 3000(0.5158) PW(18%) = Rs.2766.2 The PW of proposal B is higher than proposal A . so select proposal B. 4.A granite company is planning to buy a fully automated granite cutting machine. If it is purchased under down payment, the cost of the machine is Rs. 16,00,000. If it is purchased under installment basis, the company has to pay 25% of the cost at the time of purchase and the remaining amount in 10 annual equal installments of Rs. 2,00,000 each. Suggest the best alternative for the company using the present worth basis at i= 18%, compounded annually. Two alternatives, i) Down payment = Rs.16,00,000 ii) Down payment of Rs.4,00,000 and 10 annual equal installments of 2,00,000 each. PW(18%)=4,00,000 + 2,00,000 (P/A,18%, 10) =4,00,000 + 2,00,000 * 4.494 PW(18%)=12,98,800 2eBe00 202000 202000 200% 400,000 18% Fig, 410 Cash fow diagram fer the second stommtive Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 Second alternative should be selected. wn . A small business with an initial outlay of Rs. 12,000 yields Rs. 10,000 during the first year of its operation and the yield increases by Rs. 1,000 from its second year of operation up to its 10th year of operation. At the end of the life of the business, the salvage value is zero. Find the present worth of the business by assuming an interest rate of 18%, compounded annually. A= Al +G(A/G,18%,10) =10,000 + 1000 (3.194) A=13,194 PW(18%) = -12,000 +A (P/A,18%,10) = -12,000 + 13,194 (4.494) PW(18%) = 47,293 6.A company borrowed 1,00,000 to finance a new product the loan was for 20 years at a nominal interest rate of 8% compounded semiannually. It was to be repaid in 40 equal payments. After one half (1/2) the payments were made, the company decided to pay the remaining balance in one final payment at the end of the 10" year how much was owed? P=1,00,000 N=20years = 20 * 2 = 40 installments Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 i=8% Compounded semi-annually = 8/2=4% i) F20=P (FIP, 4%, 20) = 1,00,000 (2.19112) F20 = 2,19,112 P=50,000 — 2,19,112 P=1,69,112 ii) F30=P(F/P , 4%, 10) =1,69,112 * 1.4803 F30=2,50,336.49 The company owed to finance is 2,50,336.49 x . A proposed improvement in an assembly line will have an initial purchase and installation cost of Rs.1,75,000. The annual maintenance cost will be Rs.6000. Periodic overhauls once every 3yrs excluding the last year of use, will cost Rs.11,500 each. The improvement will have a usefull life of 9 years at which time it will have no salvage value, what is the Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 present worth of the 9 year costs of the improvement at i=8% ? PW= A(P/A,i%,N) + F(P/F,i%,N) + F(P/F,i%,N) + F(P/F,i%,N) =6000(P/A,8%,9) + 11500(P/E,8%,3) + 11500(P/F,8%,6) + 11500 (P/F,8%,9) + Initial investment = 6000 (6.247) + 11500(0.793) +11500 (0.630) +11500(0.5002) + 1,75,000 PW 2,34,598.8 Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 8. A bakery is thinking of purchasing a small delivery truck that has a first cost of Rs.18,000 and is to be kept in service for 6year. At what time the salvage value is expected to be 2500. Maintenance and operating costs are estimated at Rs.2500 the first year and will increase at a rate of Rs.200/year. Determine the PW of. this vehicle using interest rate of 12%. A= Al1+G (A/G,12%,6) A=2500 + 200 (2.17205) A=2934.4 PW= A(P/A,i%,N) — F(P/F,i%,N) =2934.4 (P/A,12%,6) — 2500 (P/F,12%,6) =2934.4 (4.111) — 2500 (0.5066) PW=10,797.9 PW of the vehicle = 10,797.9 + 18,000 =28,797.9 Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 9. A small dam and an irrigation system are exclusive to cost Rs.3,00,000. Annual maintenance and operating costs are executed to be Rs.40000 the first year and will increase at a rate of 10% per year. Determine the equivalent PW of building and operating the system with interest of 10% over a 30 year life. i=10% N=30 A= A1 + G (A/G,i%,N) =40000 + 4000 (A/G,10%,30) A=72,704.9 PW= A(P/A,i%,N) =72,704.9 * (P/A,10%,30) =72,704.9 * 9.427 PW=6,85,389.1 + Initial investment Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 PW=6,85,389 + 3,00,000 PW=9,85,389 10. A newly developed electric car will cost 21000 to purchase. Operating and maintaenance costs is Rs.350 for the first year with annual increase of Rs.50 per year. Salvage value after Syears is Rs.6500. A new gasoline run will cost Rs.16,000 with average 30 miles per gallon. Gasoline costs Rs.1.26 per gallon is expected to increase at a rate of Rs. 0.05 per year each of the next 4years maintaenance costs are estimated to be Rs.300 per year.Salvage value is Rs.1500 after Prepared by Prof. Navyashree TM, CSE, DSCEEE_Module_2 Syears of service.If the vehicles are expected to be driven for 20,000 miles per year, determine which option will have the lower cost over 5 years. Use PW. analysis with 10% rate of interest. Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 Electric car is having lowest cost. 11. A company is considering constructing a plant to manufacture a proposed new product. The land costs 3,00,000 the building costs 6,00,000. The equipment costs 2,50,000 and 1,00,000 working capital is required. It is expected that the product will result in sales of 7,50,000 per Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 year for 10 years at which time the land can be sold for 4,00,000 the building for 3,50,000 the equipment for 50,000 and all of the working capital recovered. The annual out-of- pocket expenses for labour.materials and all other items are estimated to be total 4,75,000. If the company requires a minimum return of 25% on projects of comparable risk, determine if it should invert in the new product line use PW methods. Ans: Investment = 3,00,000 + 6,00,000 + 2,50,000 + 1,00,000=12.5 lakhs Profit (A)= 7,50,000 / year for 10 years Salvage value = 4,00,000 + 3,50,000+50,000+100000=9,00,000 Annual expenses = 4,75,000 / year for 10 years i=25% ,N=10 years PW= -P +A (P/A,i%,N) — A (P/A,i%,N) + F (P/F,i%,N) ~ 12,50,000 + 7,50,000 (P/A,25%,10) - 4,75,000 (P/A,25%,10) + 9,00,000 (P/F,25%,10) = -12,50,000 + 750,000 ( 3.571) — 4,75,00 (3.571) + 9,00,000 (0.108) PW= -1,70,775 12. Determine the PW of the following proposal when MARR is 15%. Proposal A First cost (P) 10,000 Expected lift(N) [5 years Salvage value(F) _|-1000 Annual 8000 receipts(+A) ‘Annual expenses(- [4000 Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 A) PW= - P+ A(P/A,i%,N) ~ A (P/A,i%,N) - F(P/F,i%,N) = -10,000 + 8000(P/A,15%,5) — 4000(P/A,15%,5) — 1000(P/F,15%,5) = -10,000 + 8000(3.352) — 4000(3.352) — 1000(0.497) PW=2910.8 13. Evaluate machine XYZ on the basis of the present worth method when MARR is 12% pertinent cost data is as follows: Machine XYZ First cost 13,000 Useful life 15 years Salvage value 3000 Annual operating cost 100 Overhaul end of 5® year 200 Overhaul end of 10" year 550 PW= -P -A(P/A%.N) — F(P/EA%N) — F(P/F,i%,N) +F(PIF,1%,N) -13,000 - 100 (P/A,12%,15) — 200 (P/F,12%,5) — 550(P/F,12%,10) + 3000(P/F,12%,15) = -13,000 — 100 (6,811) — 200 (0.567) - 550 (0.322) + 3000(0.1827) PW -13,422 Assests with Unequal Liv with Unequal lives) 1, Repeatability assumptions(LCM method) 2. Co-terminated assumptions/Study period method Problems Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 1. Two holidays cottages are under cor sideration. Compare the present worth of the cost of 24 years service, at an interest rate of 5% when no salvage value. Cottage | Cottage 2 First cost Rs. 4500 Rs. 10,000 Estimated life 12 years 24 years Annual Rs. 1000 Rs. 720 maintenance cost LCM of 12 and 24 = 24 Cottage 1 N=12 24/12 =2 PW=P+A (P/A,i%,N) + F1(P/F,i%,N) = 4500 + 1000 (P/A,5%,24) + 4500(P/F,5%,12) =4500 + 1000 (13.79864) + 4500 (0.55684) PW=20,804.42 Cottage 2 PW= P + A(PYA,i%,N) =10,000 + 720 (P/A,5%,24) 10,000 + 720 (13.79864) PW=19,935.02 Cottage 2 is selected. Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 2. Two types of trucks are available for transportation use. They are needed for 10 years. Truck A Truck B First cost Rs. 10,00,000 Rs. 15,00,000 Estimated annual | Rs. 20,000 Rs. 15,000 maintenance cost Estimated life S years 10 years Estimated _ salvage | Rs. 2,00,000 Rs. 5,00,000 value 3. The following alternatives are available to accomplish an objective of 12 years duration. Plan A Plan B Plan C Life cycle (in| 6 3 4 13) First cost ($)_| 2000 3000 10,000 Annual cost | 3200 700 500 ($) Problems to be solved 1. A finance company advertises two investment plans. In plan 1, the company pays Rs. 12,000 after 15 years for every Rs. 1,000 invested now. In plan 2, for every Rs. 1,000 invested, the company pays Rs. 4,000 at the end of the 10th year and Rs. 4,000 at the end of 15th year. Select Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 the best investment plan from the investor's point of view at i= 12%, compounded annually. Ans : Plan 1 PW=1,192 Plan 2 PW=1018 Plan 1 is the best one. 2. Novel Investment Ltd. accepts Rs. 10,000 at the end of every year for 20 years and pays the investor Rs. 8,00,000 at the end of the 20th year. Innovative Investment Ltd. accepts Rs. 10,000 at the end of every year for 20 years and pays the investor Rs. 15,00,000 at the end of the 25th year. Which is the best investment alternative? Use present worth base with i = 12%. Ans: Novel investment Itd. PW(12%)=Rs.8266 Innovative Investment Itd. PW(12%) = Rs.13,506 . Innovative investment Itd plan is the best one for the investor. 3. Autocon company is evaluating three robots for possible use in its assembly operations (only one robot will be purchased). Data associated with these robots are as follows, RobotA [RobotB | Robot C First cost Rs. | 55,000 58,000 53,000 Operating &[3000/year | 4500/year | 4000/year maintenance costs Rs. Expected | 40,000/year | 44,000/year | 38,000/year income Estimated | 4000 6000 4000 salvage value Rs. Assuming a technological life of 3 years and a desired interest rate of 12% , which robot seems to be preferable Prepared by Prof.Navyashree TM, CSE, DSCEEE_Module_2 assuming all other factors are equal. Use a net PW evaluation. 4, The following data presents for two feasible alternatives A and B for which revenues and costs are known and which have different lives. If the minimum alternative rate of return is 10% , show which feasible alternative is more desirable by using PW. A B Investment (first) | 3500 5000 cost ‘Annual revenue | 1900 2500 Annual cost 645 1383 Useful life 4 8 Prepared by Prof.Navyashree TM, CSE, DSCE