Engineering Economics

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PRESENT WORTH ANALYSIS

Engineering Management
Del Institute of Technology
 SUMMARY OF DISCRETE COMPOUNDING INTEREST FACTORS

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 Using Compound Interest Tables

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 Present Worth Analysis

Where we have been :

 Equivalence concept
 Cash flows
 Compound interest factors

Where we are going in this chapter :

 Understanding economic criteria
 Applying present worth techniques
 Assumptions in solving economic analysis
problems
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 Present Worth Analysis

• Problem solving tends to be complicated. The trick is to solve the

simplifying assumptions without compromising the applicability of
the solution in real life.

• Six assumptions in solving economic analysis problems :

 End of year convention

 Viewpoint of economic analysis studies
 Sunk costs
 Borrowed money viewpoint
 Effect of inflation and deflation
 Income taxes 21S3101
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Six Assumptions in Solving Economic Analysis Problems

 End of year convention

• We assume that all series of receipts or disbursements occur at
the end of the interest period
• P and F stay the same regardless of the convention
• Only A shifts
Year 0 End of Year 1 End of Year 2
Jan 1 Dec 31 Jan 1 Dec 31

A A
P F
Middle of Middle of
Year 0 Year 1 End of Year 1 Year 2 End of Year 2
Jan 1 Jun 30 Dec 31 Jan 1 Jun 30 Dec 31

A A
P F 21S3101
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Six Assumptions in Solving Economic Analysis Problems

 Viewpoint of economic analysis studies

Take the point of view of the total firm and avoid narrow viewpoint.

 Sunk costs
Sunk cost should be disregarded. Only the current and future differences
between alternatives should be considered.
 Borrowed money viewpoint
Distinguished between two aspects of money : financing and investment.

 Effect of inflation and deflation

Although inflation and deflation can be serious problems, we assume that
the prices are stable for now.

 Income taxes
Income taxes, like inflation and deflation, must be considered to find the
real payoff of a project.
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 Economic Criteria
• The economic criterion will be one of the following,
depending on the situation:

Situation Criterion
Neither input nor Maximize
output fixed (output - input)
For fixed input Maximize output

For fixed output Minimize input

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 Applying Present Worth Techniques

Situation Criterion
Neither input nor Typical, general case Maximize (present worth
output is fixed of benefits minus present
worth of costs), that is,
maximize net present
worth

Fixed input Amount of money or Maximize present worth of

other input resources are benefits or other outputs
fixed
Fixed output There is a fixed task, Minimize present worth of
benefit, or other output costs or other inputs
to be accomplished

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 Applying Present Worth Techniques

• The consequences of each alternative must be considered

for this period of time, which is usually called the analysis
period, planning horizon, or project life.

• Three different analysis period situations arencountered in

economic analysis problems with multiple alternatives:
1. Useful life of the alternatives equals the analysis period
2. Useful lives of the alternatives different from the analysis
period
3. The analysis period is infinite or long enough to be
treated as infinite, n = ¥
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 Useful Lives Equal the Analysis Period
• Straightforward
• All future costs and revenues are transformed to equivalent
monetary units now
• If the alternatives have the same capacities for the same
period (life), the equal-service requirement is met

Example 1 :
A firm is considering which of two mechanical devices to install to reduce
costs in particular situation. Both devices cost $1000 and have useful lives of
5 years and no salvage value. Device A can be expected to result in $300
savings annually. Device B will provide cost saving of $400 the first year but
will decline $50 annually, making the second year savings $350, the third
year savings $300 and so forth. With interest at 7% which device should the
firm purchase? 21S3101
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 Useful Lives Equal the Analysis Period
Device A Device B

PW of benefits A (PWA) = 300(P/A, 7%, 5) = 300(4.100)= $1230

PW of benefits B (PWB) = 400(P/A, 7%, 5) - 50(P/G, 7%, 5)
= 400(4.100) - 50(7.647) = $1257.65
Device B has the larger present worth of benefits and therefore is the
preferred alternative. 21S3101
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 Useful Lives Equal the Analysis Period

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 Useful Lives Equal the Analysis Period

Example 2 :
A purchasing agent is considering the purchase of some new equipment for the
mailroom. Two different manufacturers have provided quotations. An analysis of
the quotations indicates the following :

Manufacturer Cost Useful Life Salvage Value

(years)
A $1500 5 $200
B $1600 5 $325

The equipment of both manufacturers is expected to perform at the desired level

of (fixed) output. For a 5 year analysis period, which manufacturer’s equipment
should be selected? Assume 7% interest and equal maintenance costs.
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 Useful Lives Equal the Analysis Period
Solution :
For fixed output, the criterion is to minimize the present worth of cost.

PW of cost A (PWA) = 1500 – 200 (P/F, 7%,5)

= 1500 – 200 (0.7130)
= $ 1357
PW of cost B (PWB) = 1600 – 325 (P/F,7%,5)
= 1600 – 325 (0.7130)
= $ 1368
Since it is only the differences between alternatives that are relevant,
maintenance costs may be left out of the economic analysis. Although the PWs of
cost for the two alternatives are nearly identical, we would still choose the one
with minimum present worth of cost unless there were other tangible or
intangible differences that would change the decision. Buy the manufacturer
equipment A. 21S3101
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 Useful Lives Equal the Analysis Period

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 Useful Lives Equal the Analysis Period
• In example 1, we calculate present worth of benefits and in example 2,
we calculate present worth of costs.
• There are cases when we have to compare alternative and select the one
in which present worth of benefits minus present worth of cost was a
maximum.

• The criterion is called the net present worth criterion and written simply
as NPW:

Net Present Worth = Present worth of benefits - Present worth of cost

NPW = PW of benefits - PW of cost

• The field of engineering economy and this text often use Present Worth
(PW), Present Value (PV), Net Present Worth (NPW), and Net Present
Value (NPV) as synonyms. 21S3101
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Useful Lives Different from the Analysis Period

• 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 alternatives over a period of
time equal to the least common multiple 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.
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Useful Lives Different from the Analysis Period

LCM approach requires some assumptions be made about

subsequent life cycles :

1. The service provided will be needed over the entire

LCM years or more
2. The selected alternative can be repeated over each life
cycle of the LCM in exactly the same manner.
3. Cash flow estimates are the same for each life cycle.

Take a look at the next slides on how the assumptions are used
in solving the problem with LCM approach!
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Useful Lives Different from the Analysis Period

Example :
A purchasing agent is considering the purchase of some new equipment
for the mailroom. Two different manufactures have provided quotations.
An analysis of the quotations indicates the following :

Manufacturer Cost Useful Life Salvage Value

(years)
A $1500 5 $200
B $1600 5 $325

Suppose that the equipment B was expected to have 10 year useful-life,

or twice that of equipment A. Assuming the salvage value would still be
$325 in 10 years, which equipment should be purchased?
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Useful Lives Different from the Analysis Period

• Assuming the replacement equipment A after 5 years also cost $1500,

PW of cost = 1500 + (1500-200) (P/F,7%,5) - 200(P/F,7%,10)

= 1500 + 1300(0.7130) - 200(0.5083)
= 1500 + 927- 102 21S3101
= $ 2,325 Engineering Economics

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Useful Lives Different from the Analysis Period
• For the equipment B, on the other hand, we have the following results:

PW of cost = 1,600 - 325(P/F,7%,10)

= 1,600 - 325(0.5083)
= $ 1,435
• For the fixed output of 10 years of service in the mailroom, the
equipment B with its smaller present worth of cost, is preferred.
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Useful Lives Different from the Analysis Period
• Superimposing a 10-year analysis period on 7- and 13-year alternatives

As Figure shows, it is not necessary for the analysis period to equal the useful life of
an alternative or some multiple of the useful life. To properly reflect the situation at
the end of the analysis period, an estimate is required of the market value of the
equipment at that time.
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The calculations might be easier if everything came out
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Useful Lives Different from the Analysis Period

Example :
A diesel manufacturer is considering the two alternative production
machines with specific data are as follows :

Alternative 1 Alternative 2
Initial cost $50,000 $75,000
Estimated salvage value at end of useful life $10,000 $12,000
Useful life of equipment, in years 7 13

The manufacturer uses an interest rate of 8% and wants to use the PW method to
compare these alternatives over an analysis period of 10 years.

Estimated market value end of 10-year analysis period for alternative 1 is $20,000
and alternative 2 $15,000.
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Useful Lives Different from the Analysis Period
• Assume that Alternative 1 will be replaced by an identical machine after
its 7-year useful life. Alternative 2 has a 13-year useful life. The diesel
manufacturer has provided an estimated market value of the equipment
at the time of the analysis period. We can compare the two choices over
10 years as follows:
PW (Alt. 1) = −50,000 + (10,000 − 50,000)(P/F, 8%,7) + 20,000(P/F, 8%, 10)
= −50,000 − 40,000(0.5835) + 20,000(0.4632)
= −$64,076

PW (Alt. 2) = −75,000 + 15,000(P/F, 8%, 10)

= −75,000 + 15,000(0.4632)
= −$69,442

To minimize PW of costs the diesel manufacturer should select Alt. 1

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Useful Lives Different from the Analysis Period

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 Infinite Analysis Period-Capitalized Cost

• There are cases where present worth of cost analysis

would have an infinite analysis period, for example
maintenance for road, dams, or local infrastructure is
permanent. We call this particular analysis  capitalized
costs
• Capitalized costs is the present sum of money that would
need to be set aside now, at some interest rate, to yield
funds required to provide the service or (whatever)
indefinitely.
• Note : To able to analyze capitalized cost, the principal
money set aside for future expenditures must not
decline, only the interest can be spent.
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 Infinite Analysis Period-Capitalized Cost

For any initial sum P, there can be and end of period

withdrawal of A equal to iP each period, and these
withdrawals may continue forever without diminishing the
initial sum P. The equation :

Capitalized cost is therefore the P in the equation above. It

follows that :

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 Infinite Analysis Period-Capitalized Cost
Example :
A city plans a pipeline to transport water from a distant watershed area to
the city. The pipeline will cost $8 million and will have an expected life of 70
years. The city anticipates it will need to keep the water line in service
indefinitely. Compute the capitalized cost, assuming 7% interest.

Solution :
To compute the capitalized cost, it is necessary to first compute an end-of-
period disbursement A that is equivalent to $8 million every 70 years.

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 Infinite Analysis Period-Capitalized Cost

Solution :

We could find A, given a present $8 million disbursement.

A = P (A/P, i, n)
= $ 8,000,000 (A/P, 7%, 70)
= $ 8,000,000 (0.0706)
= $ 565,000

$ 565,000
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃 =
0.07

= $ 8,071,000 21S3101
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 Handbook

• Donald G. Newnan et al., Engineering Economic Analysis

Eleventh Edition, Oxford University Press: New York, 2012.

• Chan S. Park, Fundamentals of Engineering Economics,

Pearson Education Limited: Edinburgh Gate, 2013.

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