CHAPTER 5

Present Worth Analysis

 Covered Topics

1. Formulating alternatives

2. Single and equal-life alternatives

3. Different-life alternatives

4. Capitalized cost alternative evaluation

5. Independent alternatives
 Formulating Alternatives
Types of alternatives
 Mutually exclusive (ME) - only one viable project can
be accepted. Do-nothing (DN) alternative is selected if
none are justified economically
• Single alternative
• Multiple alternatives

 Independent - more than one project can be selected.

DN is one of the projects
 PW of a Single Alternative
Example: MARR = 10%
Single project analysis First cost, P = $-2500
Annual revenue, R = $2000
• Calculate PW at stated Annual cost, AOC = $-900
Salvage value, S = $200
MARR Life, n = 5 years

PW = P +S(P/F,10%,5)
+ (R-AOC)(P/A,10%,5)
• Criterion: If PW ≥ 0, = -2500 + 200(P/F,10%,5)
+ (2000-900)(P/A,10%,5)
= $1794
project is economically
justified PW > 0; project is
economically justified
 Types of PW Analysis Problems

1. PW Analysis of Equal-Life Alternatives

2. PW Analysis of Different-Life Alternatives

 Equal-life ME Alternatives

• Calculate PW of each alternative at MARR

• Equal-service of alternatives is assumed

• Selection criterion: Select alternative with most favorable PW

value, that is,

numerically largest PW value

PW1 PW2 Select Note :

$-1,500 $-500 2 Not the
absolute
-2,500 500 2 value

2,500 1,500 1
 Equal-life ME Alternatives

• Example:
Two ME cost alternatives for traffic analysis. Revenues
are equal. MARR is 10% per year. Select one.

Estimate Electric-powered Solar-powered

P, $/unit -2,500 -6,000

Annual operating cost -900 -50
AOC, $/year
Salvage, $ 200 100

n, years 5 5
 Equal-life ME Alternatives
Determine PWE and PWS; select best PW

PWE = -2500-900(P/A,10%,5)+200(P/F,10%,5)
= $-5788

PWS = -6000-50(P/A,10%,5)+100(P/F,10%,5)
= $-6127

Conclusion: cost of the Electric is less than the cost

of Solar; select electric-powered.
 Equal-life ME Alternatives

Example:
Adam plans to buy a used car. He has two options as shown:

Escort Corolla
Purchase Cost $5000 $7500
Maintenance Cost / Year $900 $500
Salvage Value $2000 $3000
Life (years) 3 3

Which one should he buy at 10% interest?

 Equal-life ME Alternatives
$2,000
+
Option A

Cash
flow
0 1 2 3 Time

$900

$5,000

PWA = -5000 – 900(P/A,10%,3) +2000(P/F,10%,3)

= -5000 – 900(2.4869) + 2000(0.7513)

= -$5735.61
 Equal-life ME Alternatives
$3,000
+
Option B

Cash
flow
0 1 2 3 Time

$500

$7,500

PWB = -7500 – 500(P/A,10%,3) + 3000(P/F,10%,3)

= -7500 – 500(2.4869) + 3000(0.7513)

= -$6489.55

PWA is better than PWB

Adam should choose option A.
 Different-life Alternatives

• PW evaluation always requires equal-service between

all alternatives

• Two methods available:

o Study period (same period for all alternatives)

o Least common multiple (LCM) of lives for

alternatives

• Evaluation approach: Determine each PW at stated

MARR; select alternative with the best PW
 Different-life Alternatives
Example:

A company is planning to buy a welding machine. They

have two alternatives:

Machine A Machine B

Purchase Cost $13,000 $18,000

Annual Maintenance Cost $3,500 $3,100

Salvage Value $1,000 $2,000

Life (years) 6 9

Which one should they choose at 15% interest?

1- LCM Approach

Machine A

$1,000 $1,000 $1,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

$3,500

i=15%
$13,000

$13,000 $13,000
 Machine A

PWA = -13,000 – 3,500(P/A,15%,18)

–13,000[(P/F,15%,6) + (P/F,15%,12)] +
1,000[(P/F,15%,6) + (P/F,15%,12) + (P/F,15%,18)]

= -13,000 – 3,500(6.1280) – 13,000[0.4323 + 0.1869]

+ 1,000[0.4323 + 0.1869 + 0.0808]
= -$-41,798
 Another method

First calculate the PW of one life cycle:

PWA,6 = -$13K – 3.5K (P/A, 15%, 6)+$1K (P/F, 15%, 6)

= -$13K – 3.5K*(3.7845) +$1K*(0.4323)= -$25,813.45

Next, notice that this repeats every 6 years until the end of 18th
year.

0 6 12 18

i=15%

-$25,813.45

PWA = -$25,813.45[1 + (P/F, 15%, 6) + (P/F, 15%, 12)]

= -$25,813.45(1 + 0.4323 + 0.1869) = -$41,797
 Machine B

$2,000 $2,000

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18

$3,100

i=15%
$18,000

$18,000
 Machine B

PWB = -18,000 – 3,100(P/A,15%,18) –18,000 (P/F,15%,9)

+ 2,000[(P/F,15%,9) + (P/F,15%,18)]
= -18,000 – 3,100(6.1280) – 18,000(0.2843)
+ 2,000[0.2843 + 0.0808]
= -$41,384

You can work on the alternative method for

Machine B.

Decision: Choose Machine B, because

PWB is better than PWA

 Different-life Alternatives

Study Period of length n years (periods)

• n is same for each alternative

• If life > n, use market value estimate in year n for

salvage value

• If life < n, estimate costs for remaining years

Estimates outside time frame of the study period are

ignored
 Different-life Alternatives
Example:

Solve the same problem using a study period of:

a- 5 years. Assume the market values remain the same.

b- 6 years. Assume the market value of Machine B at the end of

6th year is $4,000.

Machine A Machine B

Purchase Cost $13,000 $18,000

Annual Maintenance Cost $3,500 $3,100

Salvage Value $1,000 $2,000

Life (years) 6 9
Part a – 5 years study period:

Machine A

$1,000

0 1 2 3 4 5 i=15%

$3,500

$13,000
Part a – 5 years study period:

Machine A

PWA = -$13,000 - $3,500(P/A,15%,5)

+ $1,000(P/F,15%,5)

= -$13,000 - $3,500(3.3522)
+ $1,000(0.4972)

= -$24,236
Part a – 5 years study period:

Machine B
$2,000

0 1 2 3 4 5 i=15%

$3,100

$18,000
Part a – 5 years study period:

Machine B

PWB = -$18,000 - $3,100(P/A,15%,5)

+ $2,000(P/F,15%,5)

= -$18,000 - $3,100(3.3522)
+ $2,000(0.4972)

= -$27,397
Decision: Choose Machine A, because

PWA > PWB

Part b – 6 years study period:

Machine A
$1,000

0 1 2 3 4 5 6

$3,500
i=15%
$13,000
 Part b - 6 years study period:

Machine A

PWA = -$13,000 - $3,500(P/A,15%,6)

+ $1,000(P/F,15%,6)

= -$13,000 - $3,500(3.7845)
+ $1,000(0.4323)

= -$25,813
Part b – 6 years study period:

Machine B
$4,000

0 1 2 3 4 5 6

$3,100
i=15%
$18,000
 Part b – 6 years study period:

Machine B

PWB = -$18,000 - $3,100(P/A,15%,6) + $4,000(P/F,15%,6)

= -$18,000 - $3,100(3.7845) + $4,000(0.4323)

= -$28,003

Decision: Choose Machine A, because

PWA > PWB

 Capitalized Cost (CC)
• PW of alternatives that last ‘forever’

• Especially applicable to public project evaluation (dams,

bridges, irrigation, hospitals, police, etc.)

• CC relation is derived using the limit as n → ∞ for the P/A

factor

PW = A(P/A,i%,n) =

A
n→∞ PW =
i
 Capitalized Cost (CC)
A
CC = PW =
i

• Refer to PW as CC when n is large (n → ∞). Then:

AW = CC × i

• Cash flows for CC computations are of two types:

• Recurring; and

• Non-recurring
 Capitalized Cost (CC)
Recurring Costs: Costs that repeat forever with a
constant frequency; every year, every 10 years.

Nonrecurring Costs: One time Costs, or costs that

do not repeat forever.
 Capitalized Cost (CC)

Procedure of finding CC

1. Draw cash flow diagram for 2 cycles of recurring cash

flows and any nonrecurring amounts
2. Calculate PW (CC) for all nonrecurring amounts
3. Find AW for 1 cycle of recurring amounts; then add
these to all A series applicable for all years 1 to ∞ (or
long life) A
4. Find CC for amount above using: CC =
i
5. Add all CC values (steps 2 and 4)
 Capitalized Cost (CC)

Example:

Find CC and A values at i = 5% of long-term public project

with cash flows below. Cycle time is 13 years.

Nonrecurring costs: first $150,000; one-time of $50,000 in

year 10

Recurring costs: annual maintenance of $5000 (years 1-4)

and $8000 thereafter; upgrade costs $15,000 each 13
years
Step 1

Nonrecurring
recurring
costs
costs
It repeats
every 13 years

This cash flow can be simplified by dividing it into 4 different

cash flows as following:
 $50,000
$150,000
+

+ $15,000

$5,000
+

$3,000
Step 2

$50,000
$150,000

CC of nonrecurring costs:

CC1 = ‐150,000 – 50,000(P/F,5%,10) = $‐180,695

Step 3

$15,000

$5,000

AW of recurring $15,000 upgrade:

AW = ‐15,000(A/F,5%,13) = $‐847 per year

AW of recurring maintenance costs years 1 to ∞:

AW = $‐5000 per year forever

CC for recurring upgrade and maintenance costs:

CC2 = AW/i = (‐847‐5000)/0.05 = $‐116,940
Step 4:

$3,000

CC of extra $3000 maintenance for years 5 to ∞:

CC3 =[‐3000/0.05](P/F,5%,4)= $‐49,362

A
CC =
i
Step 5:

Total CC obtained by adding all three CC components

CCT = -180,695 –116,940 –49,362= $-346,997

The AW value is the annual cost forever:

AW = CC × i = -346,997(0.05) = $-17,350
 CC Evaluation of Alternatives

• For two long-life or infinite-life alternatives:

Select alternative with lower CC

• For one infinite life and one finite life:

Determine CC for finite life alternative using

AW of 1 life cycle and relation CC = AW/i

Select alternative with lower CC

 CC Evaluation of Alternatives
Example:
Long-term alternative (LT): $8 million now; $25,000 renewal annual
contract .

Short-term alternative (ST): $2.75 million now; $120,000 AOC; life is n =

5 years.
Select best one at MARR = 15% per year

CCLT = -8,000,000 – 25,000/0.15 = $-8.17 million

CCST = AW/0.15
= [-2,750,000(A/P,15%,5) – 120,000]/0.15
= $-6.27 million
Select ST with lower CC of costs
 CC Evaluation of Alternatives

Example:
Two sites are currently under consideration for a
bridge construction in New York City. The projected
expenses for each bridge are provided in the
following table. Compare both alternatives under a
6% interest and decide which bridge should be
chosen?
 Suspension Bridge Truss Bridge

Initial Cost $30M $12M

Annual Maint. Cost $15K $8K

Resurfacing Cost every 10 $10K -

years
Painting Cost every 3 - $10K
years
Sandblast every 10 years - $45K

Purchasing right of way $2M $10.3M

 Suspension Bridge

0 10 20

$15K $15K $15K

$10K $10K
$32M
 CC of Nonrecurring Costs:

1. Initial investment and right-of-way cost:

-$30M initial investment

-$2M right-of-way

Both are at time 0, hence the CC of NR costs:

CCNR = -$32M

CC of Recurring Costs:

1. Annual maintenance cost:

-$15K for each year

2. Resurfacing cost every 10 years:

-$10K (A/F,6%,10)= -$3,793.5
Total Annual Equivalent of Recurring Costs:

-$15,000 -$3,793.5 = -$18,793.5

CC of the recurring costs:

CCRC = -$18,793.5 / i = -$18,793.5 / 0.06 = -$313,225

Capitalized Cost of the suspension bridge:

CCS = CCNR + CCRC

= -$32M - $313,225 = -$32,313,225

 Truss Bridge

0 3 9 10 12 20

$8K

$10K $10K $10K

$45K $45K
$22.3M
 CC of Nonrecurring Costs:

1. Initial investment and right-of-way cost:

-$12M initial investment
-$10.3M right-of-way

Both are at time 0, hence the CC of NR costs:

CCNR = -$22.3M

CC of Recurring Costs:

1. Annual maintenance cost:

-$8K for each year

2. Painting cost every 3 years:

-$10K (A/F,6%,3)= -$3,141.1

3. Sandblast every 10 years:

-$45K (A/F,6%,10) = -$3,414.15
Total Annual Equivalent of Recurring Costs:

-$8,000 -$3,141.1 - $3,414.15 = -$14,555.25

CC of the recurring costs:

CCRC = -$14,555.25 / i = -$ 14,555.25 / 0.06 = -$242,587.50

Capitalized Cost of the truss bridge:

CCT = CCNR + CCRC = -$22.3M - $242,587.50 = -$22,542,587.5

CCT > CCS, so choose the truss bridge.

 Solved Example on capitalized cost:

Calculate the capitalized cost of a project that has an

initial cost of $150,000 and an additional investment
cost of $50,000 after 10 years. The annual operating
cost will be $5000 for the first 4 years and $8000
thereafter. In addition, there is a recurring major
rework cost of $15,000 every 13 years. Assume that
i = 5% per year.
 1 4 7 10 13 16 19 22 26

$5K
$8K

$15K $15K

$50K
$150K
Nonrecurring Costs: (find CCNR)

1. -$150K at time 0

2. -$50K at the end of year 10:

PW50 = -$50K (P/F, 5%, 10) = -$30,695

The PW of the nonrecurring costs is:

CCNR = - $180,695
Recurring Costs: (find CC)

1. -$5K annuity starts at the end of 1st yr:

CC5K = -$5K/i = -$5K/0.05 = -$100K

2. -$3K annuity starts at the end of 5th yr:

CC’3K = -$3K/i = -$60K

But CC’3K is in fact at the end of 4th yr. So,

CC3K = -$60K(P/F,5%,4)=-$49,362
Recurring Costs: (find CC)

3. -$15K repeats every 13 years:

For one cycle, the annual worth of it:

AW15= -$15K(A/F,5%,13)=$-847

Then, the CC of -$15K is:

CC15 = -$847/0.05 = -$16,940

The total CC of all recurring costs is:

CCRC= -($100,000 + $49,362 + $16,940)

= -$166,302

The total CC of the project is:

CCT = CCNR + CCRC

= -$180,695 - $166,302

= - $346,997