Chapter 5

Present Worth Analysis

(Evaluating Business and Engineering Assets )
Present-Worth Analysis

 Loan versus Project Cash Flows

 Initial Project Screening Methods

 Present-Worth Analysis

 Methods to Compare Mutually Exclusive Alternatives

Types of question to address in evaluating and business investment decision
 Where the financial risk is by far the most critical element to consider
 determines its future success
 project ideas can originate from many different levels in an organization
 many companies have a specialized project analysis division, that actively searches for new
ideas, projects, ventures.
 The generation and evaluation of creative investment proposals is far too important a task to be left to just this project analysis group;
instead the task is the ongoing responsibility of all managers and engineers throughout the organization.

 key aspect of the process is the financial evaluation of investment proposals.

Payback period (chapter 5)
 Project screening tool,
 Cash flow equivalence technique of present worth(PW) analysis(discounted cash flow techniques) Annual cash flow analysis
(chapter 6)
 Present measures of investment worth based (rate of return analysis) on yield.(chapter 7)
 Benefit cost ratio. (chapter 8)
Chapter Opening Story – Federal Express

Nature of Project:

Equip 40,000 couriers with Power Pads

Save 10 seconds per pickup stop

Investment cost: $150 million

Expected savings: $20 million per year

Federal Express
 Ultimate Questions

Is it worth investing $150 million to save $20 million per year, say over 10 years?

How long does it take to recover the initial investment?

What kind of interest rate should be used in evaluating business investment

opportunities?
 Bank Loan vs. Investment Project

 Bank Loan (loan cash flow)

Loan
Bank Customer

Interest + Repayment
 Investment Project (project cash flow)
Investment

Company Project
Return
Loan versus project cash flows

• Fixed assets – similar to an investment made by a bank, when its lends money

• Loan cash flows - interest + loan repayment of the principle

• Fixed assets - future return takes the form of cash generated by productive use of the asset

• Future earnings along with the capital expenditure and annual expenses is the project cash flow

• Annual expenses : such as raw materials, operating costs, maintenance costs, income taxes.

Initial Project screening methods:

simple method that is commonly used to screen capital investment.

 Payback period - screens projects on the basis of how long it takes for net receipts to equal investment outlays

 The payback period is calculated by adding the expected cash flows for each year until the sum is equal to or greater than
zero.

 The cumulative cash flows equal zero at a point where cash inflows exactly match or payback, the cash outflows; thus the
project has reached the payback point.

 once the cumulative cash flows exceed zero, the project has begun to generate a profit.
 This calculation can take one of two forms by either ignoring time value of money consideration or including
them.

 The former(ignoring time value of money) case is usually designated – conventional pay back method

 Latter case is known as the discounted-payback method

 High-tech firm : such as computer chip manufacture would set a short time limit for any new investment,
because high-tech products rapidly become absolute.
Initial Project Screening Methods
When the money invested in a project can be
recovered ??

Investment or business depends on the answer

of this question!!

Initial screening of project through

Payback Period

Note: Public or Government projects like hospitals, universities, transportation,

etc., are normally don’t based on payback period
Payback Period
Payback Method screens projects on the basis of how long it takes for net receipts to
equal investment spending.

 Principle:
How fast can I recover my initial investment?(Once the cumulative cash flows exceed zero, the project has
begun to generate a profit)

 Method:
Based on cumulative cash flow (or accounting profit)

 Screening Guideline:
If the payback period is less than or equal to some specified payback period, the project would be
considered for further analysis.

 Weakness:
Does not consider the time value of money
Example 5.1 Conventional Payback Period with Salvage Value

N Cash Flow Cum. Flow

0 -$105,000+$20,000 -$85,000

1 $35,000 -$50,000

2 $45,000 -$5,000

3 $50,000 $45,000

4 $50,000 $95,000

5 $45,000 $140,000

6 $35,000 $175,000

Payback period should occurs somewhere

between N = 2 and N = 3.
 $45,000 $45,000
$35,000 $35,000

Annual cash flow

$25,000
$15,000
0
1 2 3 4 5 6
Years

$85,000

150,000
Cumulative cash flow ($)

100,000 3.2 years

Payback period
50,000

0
-50,000

-100,000

0 1 2 3 4 5 6
Years (n)
Example :
Machining and turning centre - Mazak multi tasking machine centre

Given : initial cost = $1,800,000 and find conventional payback period

Period Cash flow Cumulative cash flow

0 -$1800000 $1800000
1 $454,000 -$1,346,000
2 $681,000 $665,000
3 $908,000 $243,000
4 $908,000 $1,151,000
5 $908,000 $2,059,000
6 $908,000 $2,967,000
7 $1,268,000 $4,235,000

Draw backs of payback period :

 That it fails to measure profitability, it assumes that no profit is made during the payback period.
 Simply measuring how long it will take to recover the initial investment.( if you got money from bank as a loan, they will collect as
some interest amount also.)
 It fails to recognize the difference between the present and future value of money.
• Payback period calculation considering the cost of funds at 15%

Period Cash flow Cost of funds(15%) Cumulative cash flow

0 -$1800000 0 -$1800000

1 $454,000 -$1800000 * 0.15 = -270,000 (-$1800000 + 454,000 - 270,000) = -1,616,000

2 $681,000 -1,616,000 * 0.15 = -242,400 (-1,616,000 + 681,000 – 242400) = -1,177,400

3 $908,000 -1,177,400 * 0.15 = -176,610 (-1,177,400 + 908,000 – 176610) = -446,010

4 $908,000 -446,010 * 0.15 = -66901.5 (-446,010 + 908000 - -66901.5) = 395088.5

5 $908,000 395088.5 * 0.15 = 774,197 (395088.5 + 774,197 + 908,000) = 1,362,352

6 $908,000 1,362,352 * 0.15 = 204,352.8 (1,362,352 + 204,352.8+ $908,000) = 2,474,705

7 $1,268,000 2,474,705 * 0.15 = 371,205.72 (2,474,705 + 371,205.72 +1,268,00) = 4,113,911

 Example 5.2 Discounted Payback Period Calculation
Modify the procedure and consider time value of money, such as the cost of money
(interest) used to support the project.

Period Cash Flow Cost of Funds Cumulative

(15%)* Cash Flow
0 -$85,000 0 -$85,000

1 15,000 -$85,000(0.15) = -$12,750 -82,750

2 25,000 -$82,750(0.15) = -12,413 -70,163

3 35,000 -$70,163(0.15) = -10,524 -45,687

4 45,000 -$45,687(0.15) =-6,853 -7,540

5 45,000 -$7,540(0.15) = -1,131 36,329

6 35,000 $36,329(0.15) = 5,449 76,778

* Cost of funds = (Unrecovered beginning balance) X (interest rate)

Present Worth Analysis
Net Present Worth (NPW) Measure
 Principle: Compute the equivalent net surplus at n = 0 for
a given interest rate of i.
 Decision Rule: Accept the project if the net surplus is
positive.
Inflow
0 1
2 3 4 5
Outflow
Net surplus
PW(i)inflow
PW(i) > 0
0
PW(i)outflow
Present Worth Analysis
• Until 1950s, payback method (PM) widely used for investment decisions
• Due to flaws in PM, economists developed Discounted Cash Flow Techniques (DCFs)
• DCFs consider time value of money
• One of the DCFs techniques is net-present-worth (NPW)

Net-Present-Worth Criterion

Evaluating Single Project

Step 1: Determine interest rate (required rate of return or a minimum attractive rate
of return, MARR) that firm wishes to earn on investment
Step 2: Estimate the service life of the project
Step 3: Estimate cash inflow for each period over the service life
 Present Worth Analysis
Step 4: Estimate cash outflow for each period over the service life

Step 5: Determine net cash flows for each period

(Net cash flow = Cash inflow – Cash outflow)
Step 6: Find the present worth of each net cash flow at MARR as:

A0 A1 A2 AN
PW (i )     ... 
1  i  1  i  1  i  1  i 
0 1 2 N

N
An N
   An  P F , i, n 
1  i 
n
n 0 n 0
Present Worth Analysis
Step 7: Positive NPW means that the equivalent worth of the inflows is more than the
equivalent worth of the outflows, so project makes a profit. It means,
PW is positive Project is accepted
PW is negative Project is rejected

Decision Rule:
If PW(i) > 0, accept the investment
If PW(i) = 0, remain indifferent
If PW(i) < 0, reject the investment
 Example 5.3 - Tiger Machine Tool Company
Net Present Worth – Uneven Flows

inflow
$55,760
$24,400 $27,340

0
1 2 3
outflow
$75,000

PW (15%) inflow  $24,400( P / F ,15%,1)  $27,340( P / F ,15%,2)

$55,760( P / F ,15%,3)
 $78,553
PW (15%) outflow  $75,000
PW (15%)  $78,553  $75,000
 $3,553  0, Accept
Example : Net present worth uneven flows:

Consider the multi-tasking machine center investment project. Recall that the required initial investment of $1,800,000 and the projected cash
savings over a seven year project life are as follows. You have been asked by the president of the company to evaluate the economic merit of
the acquisition. The firms MARR is known to be 15% per year.
End of Cash flow
year Given: MARR = 15% per year
0 -$1800000
Find NPW?
1 $454,000

PW(15%) = -$1800000 +
2 $681,000
$454,000 (P/F, 15%, 1) +
3 $908,000
$681,000 (P/F, 15%, 2) +
4 $908,000
$908,000 (P/A, 15%, 4) (P/F, 15%, 2) +
5 $908,000
$1,268,000 (P/F, 15%, 7)
6 $908,000
= $1,546,571
7 $1,268,000
 $1,268,000

$908,000
$681,000
$454,000

0 1 2 3 4 5 6 7

$1,800,000 PW(15%) = $454,000 (P/F, 15%, 1) +

$681,000 (P/F, 15%, 2) +

$908,000 (P/A, 15%, 4) (P/F, 15%, 2) +

$1,268,000 (P/F, 15%, 7)

= $3,346,571

PW(15%) - investment = $1,800,000

= 3,346,571 - 1,800,000
= 1,546,571 > 0 ……………..accept
Future Worth Criterion
Given: Cash flows
and MARR (i)
Find: The net
equivalent worth at
the end of project $55,760
life $24,400 $27,340

0
1 2 3

$75,000

Project life
Future Worth Criterion

FW (15%) inflow  $24,400( F / P,15%,2)  $27,340( F / P,15%,1)

$55,760( F / P,15%,0)
 $119,470
FW (15%)outflow  $75,000( F / P,15%,3)
 $114,066
FW (15%)  $119,470  $114,066
 $5,404  0, Accept
 Present Worth Amounts at Varying Interest Rates
i (%) PW(i) i(%) PW(i)
0 $32,500 20 -$3,412
2 27,743 22 -5,924
4 23,309 24 -8,296
6 19,169 26 -10,539
8 15,296 28 -12,662
10 11,670 30 -14,673
12 8,270 32 -16,580
14 5,077 34 -18,360
16 2,076 36 -20,110
17.45* 0 38 -21,745
18 -751 40 -23,302

*Break even interest rate

Present Worth Profile
40
Accept Reject
30

20 Break even interest rate

(or rate of return)

PW (i) ($ thousands)
10
$3553 17.45%
0

-10

-20

-30
0 5 10 15 20 25 30 35 40
i = MARR (%)
 Investment Pool Concept
• Suppose the company has $75,000. It has two options.
(1)Take the money out and invest it in the project or
(2) leave the money in the company.

• Let’s see what the consequences are for each option.

Basics of Pooled Funds
Groups such as investment clubs, partnerships, and trusts use pooled funds to invest in stocks, bonds, and mutual funds. The
pooled investment account lets the investors be treated as a single account holder, enabling them to buy more shares collectively
than they could individually, and often for better—discounted—prices.

Mutual funds are among the best-known of pooled funds. Actively managed by professionals, unless they are index funds, they spread their
holdings across various investment vehicles, reducing the effect that any single or class of securities has on the overall portfolio.
Because mutual funds contain hundreds or thousands of securities, investors are less affected if one security underperforms.
Another type of pooled fund is the unit investment trust. These pooled funds take money from smaller investors to invest in stocks, bonds, and
other securities. However, unlike a mutual fund, the unit investment trust does not change its portfolio over the life of the fund and invests for
a fixed length of time.

Pros Diversification lowers risk.

Economies of scale enhance buying power.
Professional money management is available.
Minimum investments are low.
Cons
Commissions and annual fees are incurred.
Fund activities may have tax consequences.
Individual lacks control over investments.
Diversification can limit upside.
 Meaning of Net Present Worth N=3
How much would you have if the
Investment is made?

Investment pool $24,400(F/P,15%,2) = $32,269

$27,340(F/P,15%,1) = $31,441
$55,760(F/P,15%,0) = $55,760
$75,000 NFW of the project $119,470

ool How much would you have if the

u rn nt p
Ret vestme investment was not made?
to in $55,760
$27,340 $75,000(F/P,15%,3) = $114,066
$24,400
What is the net gain from the
investment?
Project
0 1 2 3
$119,470 - $114,066 = $5,404

PW(15%) = $5,404(P/F,15%,3) = $3,553

 Project Balance Concept (Bank loan)
N 0 1 2 3
Beginning
Balance -$75,000 -$61,850 -$43,788

Interest -$11,250 -$9,278 -$6,568

Payment -$75,000 +$24,400 +$27,340 +$55,760

Project
Balance -$75,000 -$61,850 -$43,788 +$5,404
Net future worth, FW(15%)
PW(15%) = $5,404 (P/F, 15%, 3) = $3,553
 Project Balance Diagram
60,000
Terminal project balance
40,000 (net future worth, or
project surplus)
20,000
Project balance ($) $5,404
0
Discounted
-20,000 payback period
-$43,788
-40,000

-60,000 -$61,850
-$75,000
-80,000

-100,000

-120,000
0 1 2 3
Year (n)
Guidelines for selecting a MARR :

How we may derive rates of return?

Conceptually, the rate of return that we realistically expect to earn on any investment is a function of three components.

Risk free real return,

Inflation factor,
Risk premium(s)

Meaning of Net present worth

Investment pool :

investments that yield a return equal to MARR, We may view these funds as an investment pool.

Alternatively, if no funds are available for investment, we assume that the firms can borrowed them at MARR from the capital markets.

Two views when explaining the meaning of MARR in PW calculations.

Investment pool concept:

An investment pool is equivalent to firms treasury. Its where all fund transaction are administered and managed by the firms controller or comptroller.

Example:

Option 1:
If the firm did not invest in the project and instead left the $1,800,000 in the investment pool for seven years, these funds would have grown as follows.
$1,800,000(F/P, 15%, 7) = 4,788,000
Suppose the company did decide to invest $1,800,000 in the project.

since, the funds that return to the investment pool earn interest at a rate of 15%, it
End of year (n) Cash flow()
would be helpful to see how much the would benefit from this investment.
1 $454,000
for this alternative, return after reinvestment are as follows:
2 $681,000
$454,000 (F/P, 15%, 6) + = $1,050,130 +
3 $908,000
$681,000 (F/P, 15%, 5) + = $1,369,734 +
4 $908,000
$908,000 (F/A, 15%, 4) (F/P, 15%, 1) + = $5,214,082 +
5 $908,000
$1,268,000 (F/P, 15%, 0) = $1,268,000
6 $908,000

7 $1,268,000 returns = 8,901,946 - 4,788,036 = $4,113,910

this $4,113,910 surplus is also known as net future worth of the project at the project termination.
If we compute the equivalent present worth of this net cash surplus at time “0”

We obtain, present worth from future value = $4,113,910(P/F, 15%, 7) = $1,546,571(NPW) ==

Tabular approach to determining the Project Balances(Excel)

End of year(n) 0 1 2 3 4 5 6 7

Beginning Project balance 1800000 1616000 1177400 446010 -395089 -1362352 -2474705

interest charges(15%) 270000 242400 176610 66901.5 -59263.3 -204353 -371206

payment received 1800000 454000 681000 908000 908000 908000 908000 1268000

project balance 1800000 1616000 1177400 446010 -395089 -1362352 -2474705 -4113910

Net present worth(15%) $1,546,571.23

=PV(15%,7,0,N9,0)
Net future worth(15%) -4113910.222 N9
Comparing Mutually
Exclusive Alternatives
 Comparing Mutually Exclusive Projects
 Mutually Exclusive Projects
When alternatives are mutually exclusive, any one if the alternatives will fulfill the same need, and the selection of
one alternative implies that the others will be excluded. Example of buying versus leasing car.

 Alternative vs. Project

When we use terms alternative and project interchangeably to mean decision option.

 Do-Nothing Alternative
When considering an investment, we are in one of two situations: Either the project is aimed at replacing an existing
asset or system, or it is a new attempt. If a process or system already in place to accomplish our business objectives is
adequate, then we must determine which, if any, new proposals are economical replacement. If none are feasible, then
we do nothing. If the existing system has failed, then the choice among proposed alternatives is mandatory (i.e., do
nothing is not an option).
 Revenue Projects
are projects that generate revenues that depend on the choice of alternative that we want to select the alternative with the
largest net gains
 Service Projects
are projects that generate revenues that do not depend on the choice of project, but must produce the same amount of
output (revenue) with lower production cost.

Analysis Period is the time span over which the economic effects of an investment will be evaluated.
 The study (analysis) period, sometimes called the planning horizon, is the selected time period over which Mutually
Exclusive alternatives are compared.

 Factors influence the decision are; the required service period, the useful life of the shorter lived alternative, the useful lived
of the longer lived alternative, company policy and so on.

 Consider Analysis period to be Required Service Period.

 One convenient choice of analysis is the period of the useful life of the investment project.
Comparing Mutually Exclusive Projects

• Case 1: Project lives longer than the

analysis period (Example 5.6)

• Case 2: Project lives shorter than the

analysis period (Example 5.7)
Case 1: Project lives longer than the
analysis period (Example 5.6)

 Estimate the salvage value at the end of

required service period.

 Compute the PW for each project over

the required service period.
Example 5.6 - Comparison of unequal-lived service projects when the
required service period is shorter than the individual project life

Required Service Period = 2 years

PW(15%)A = -$362,000 PW(15%)B = -$364,000
= -$300,000 - $80,000(P/A, 15%, 2) + $90,000 (P/F, 15%, 2)

= - 300,000 - 130,056 + 68,049

= -362,007

= -$480,000 - $45,000(P/A, 15%, 2) + $250,000 (P/F, 15%, 2)

= -$480,000 - 553,156.5 - 189,025

= -364,131
Case 2: Project lives shorter than the
analysis period (Example 5.7)

 Come up with replacement projects that

match or exceed the required service period.

 Compute the PW for each project over the

required service period.
 Example 5.7 - Comparison for Service Projects with Unequal
Lives when the required service period is longer than the
individual project life

$2,000

0 1 2
3 4 5

Model A
$5,000 $5,500
$6,000 Required Service
$1,500 Period = 5 years
$12,500
1 2 3
0 4 5

Model B $4,000 $4,500 $5,000

$5,500

$15,000
PW(15%)A = -$35.929

PW(15%)B = -$33,173
= -$12,500 - $5,000(F/P, 15%, 4) …….F=P(1+i)^N = 1.749
- $5,000(F/P, 15%, 3) …………………….= 1.521
- $6,000(F/P, 15%, 2) ……………….. = 1.322
+$2,000 (F/P, 15%, 2) …………………= 1.322
= - 34,898

= -$15,000 - $4,000(F/P, 15%, 4)

- $4,500(F/P, 15%, 3)
- $5,000(F/P, 15%, 2)
- $5,500(F/P, 15%, 1) ……………F=P(1+i)^N….= 1.150
+$1,500 (F/P, 15%, 1)
= -33,173
Analysis period Equals Project lives:

Ansell , Inc., a medical device manufacturer, uses compressed air in solenoids and pressure switches in its machines to control various
mechanical movements. Over the years, the manufacturing floor layout has changed numerous times. With each new layout, more piping was
added to the compressed air delivery system in order to accommodate new locations of manufacturing machines. None of the extra unused old
piping was capped or removed; thus the current compressed air delivery system is inefficient and fraught with leaks. Because of the leaks in the
current system, the compressor is expected to run 70% of the time that the plant will be in operation during the upcoming year. The compressor
will require 260kw of electricity at a rate of $0.05/kwh. The plant runs 250 days a year, 24 hours per day. Ansell may address this issue in one of
two ways.
Option 1: Continue current operation. If Ansell continues to operate the current air delivery system, the compressors run time will increase by
7% per year for the next five years because of ever-worsening leaks.(After five years, the current system will not be able to meet the plants
compressed air requirement so it will have to be replaced)
Option 2: Replace old piping now. If Ansell decides to replace all of the old piping now, new piping will cost $28,570. The compressor will still run
for the same number of days; however, it will run 23% less(or will incur 70%(1-.23)=53.9% usage per day) because of the reduced air-pressure
loss.
If Ansell's interest rate is 12% compounded annually, is it worth fixing the air delivery system now?

Given: 260 kw of electricity

rate of $0.05/kwhr.,
Plant runs = 250days/year
24 hrs per day
The compressor is expected to run 70% of the time
Option 1 : continue the current operation

Cost of power consumption = % of day operating * days operating per year * hours per day * kw * $/kwh.,

= 70% * 250 days/year * 24 hrs./day * 260kw * 0.05/kwh.,

Annual power cost = $54600

Each year, if the current piping system is left in place, the annual power cost will increase at the rate of 7% over the previous cost.

P1 = $54600(P/A, 7%, 12%, 5)

= $54600 [

= $222,937

Option 2:

If Ansell replaces the current compressed air delivery system with the new one(23% less during the first year, will remain at that level over
the next five year)

P2 = $54,600(1-0.23) (P/A, 12% , 5)

= $151,553

Net cost of not replacing the old system now is

$71,384 === ($222,937 - $151,553)

Comparing two mutually exclusive revenue projects:
Monroe Manufacturing owns a warehouse that has been used for storing finished goods for electro pump products. As the company is phasing out the
electro pump product line, the company is considering modifying the existing structure to use for manufacturing a new product line. Monroes production
engineer feels that the warehouse could be modified to handle one of two new product lines. The cost and revenue data for the two product alternatives are
as follows: Product A Product B
Initial cash expenditure:
 Warehouse modification $115,000 $189,000
 Equipment $250,000 $315,000
Annual revenues $215,000 $289,000
Annual O&M costs $126,000 $168,000
Product life 8years 8years
Salvage value(equipment) $25,000 $35,000

After eight years the converted building will be too small for efficient production of either product line. At that time, Monroe's plans to use it as a warehouse
for storing raw materials as before. Monroe's required return on investment is 15%. Which product should be manufactured?

= -$365,000 + $89,000 (P/A, 15%, 8) + $25,000 (P/F, 15%, 8)

= $42,544

= -$504,000 + $121,000 (P/A, 15%, 8) + $35,000 (P/F, 15%, 8)

= $50,407.
Project lives longer than the Analysis period:

Allen company got permission to harvest southern pines from one of its timber land tracts. Its considering purchasing a feller buncher, which has the ability to
hold saw, and place trees in bunches to be skidded to the log landing. The logging operation on this timberland track must be completed in three years. Allen
could speed up the logging operation but doing so is not desirable because the market demand of the timber does not warrant such haste. Because the logging
operation is to be done in wet conditions, this task requires a specially made feller-buncher with high-flotation tires and other devices designed to reduce site
impact. There are two possible models of feller-buncher that Allen could purchase for this job. Model A is a two year old used piece of equipment where as
Model B is a brand-new machine.

Model A costs $205,000 and has a life of 10,000 hours before it will require any major overhaul. The operating cost will run $50000 per year for 2000 hours of
operation. At this operational rate, the unit will be operable for five years, and at the end of that time, its estimated that the salvage value will be $75000.
The more efficient model B costs $275000 has a life of 14000 hours before requiring any major overhaul and costs $32500 to operate for 2000 hours per year in
order to complete the job within three years. The estimated salvage value of model B at the end of seven years is $95000.

Since, the life time of either model exceeds the required service period of three years, Allan company has to assume some things about the used equipment at the
end of that time. Therefore, the engineers at Allen estimate that after three years, the model A unit could be sold for $130000 and the model B unit for $180,000.
After considering all tax effects, Allan summarized the resulting cash flows for the projects as follows.
 Period Model A Model B
0 -$205,000 -$275,000
1 -50,000 -32,500
2 50,000- -32,500
3 130,000 50,000- 180,000 -32,500
4 50,000- -32,500
5 75000 50,000- -32,500
6 -32,500
7 95,000 -32,500

Here, the figures in the boxes represent the estimated salvage values at the end of the analysis period(end of year 3). Assuming that the firms MARR is 15%,
which option is more acceptable?

Given: i = 15% per year,

Find PW for each alternative and preferred alternative
= - $205,000 - $50,000(P/A, 15%, 3) + 130,000(P/F, 15%, 3)
= -$233,684

= - $275,000 - $32,500(P/A, 15%, 3) + 180,000(P/F, 15%, 3)

= -$230,852
Model A = -$233,000
Model B = -$230,852(less compare with model A, that’s why, we can choose Model B)
Phoenix Manufacturing Company is planning to modernize one of its distribution centers located outside Denver, Colorado. Two options to move goods in the distribution center have been
under consideration: a conveyor system and forklift trucks. The firm expects that the distribution center will be operational for the next 10 years, and then it will be converted into a factory
outlet. The conveyor system would last eight years whereas the forklift trucks would last only six years. The two options will be designed differently but will have identical capacities and
will do exactly the same job. The expected cash flows for the two options, including maintenance costs, salvage values, and tax effects are as follows.
Period Conveyor system Lift trucks
0 -$205,000 -$275,000
1 -15,000 -13,000
2 -15,000 -13,000
3 -15,000 -13,000
4 -15,000 -13,000
5 -15,000 -13,000
6 -15,000 -13,000 + 4000
7 -15,000
8 -15,000 +5000

With this scenario, which option should the firm select at MARR = 12%?
Since each option has a shorter life than the required service period (10Years), we need to make an explicit assumption of how the service requirement is to be met.
If the company goes with the conveyor system, it will spend $18,000 to overhaul system to extend its service life beyond eight years. The expected salvage
value of the system at the end of the required service period (10 years) will be $6000. The annual operating and maintenance cost will be $15,000.
If the company goes with the Lift truck option, the company will consider leasing a comparable lift truck that has an annual lease payment of $8000, payable at the
beginning of each year, with an annual operating cost of $13,000 for the remaining required service period.

= -$205,000 -$15,000 (P/A, 12%, 10) -$18,000 (P/F, 12%, 8) + $6,000 (P/F, 12%, 10)
= -$205,000 -$15,000 [ - 1)/ -$18,000 + $6,000
= -$295,088
 = -$275,000 -$13,000 (P/A, 12%, 10) -$8,000 (P/A, 12%, 4) (P/F, 12%, 5) + $4,000 (P/F, 12%, 6)
= -$275,000 -$13,000 [ - 1)/
-$8,000 + $6,000
= -$347,800.710
Since, these projects are service projects, the conveyor option is the better choice.
5:14: You have been asked to evaluate the profitability of building a new distribution center under the following conditions:
# The proposal is for a distribution center costing $1,500,000. The facility has an expected useful life of 35 years and a net salvage value(net proceeds from its
sale after tax adjustments) of $225,000.
# Annual savings(due to a better strategic location) of $227,000 are expected, annual maintenance and administrative costs will be $114, 000 and annual income
taxes are $43,000.
Suppose that firms MARR is 12%. Determine the net present worth of the investment.
Given:
Center costing = $1500,000
Life 35 years
Salvage value = $225,000
Maintenance and operating cost = $114,000
Annual savings = $227,000
Income tax = $43,000
MARR = 12%
NPW ==?
PW(12%) = -$1,500,000 + $70,000(P/A, 12%, 34) + $295,000(P/F, 12%, 35)
= -$1,500,000 +
$70,000[

= -923,443.2434
5:15: You are considering the purchase of a parking deck close to your office building. The parking deck is a 15 year old structure with an estimated remaining
service life of 25 years. The tenants have recently signed long term leases, which leads you to believe that the current rental income of $250,000 per year will
remain constant for the first five years. Then the rental income will increase by 10% for every five year interval over the remaining asset life. Thus the annual
rental income would be $275,000 for years 6 through 10, $302,500 for years 11 through 15, $332,750 for years 16 through 20, and $336,025 for years 21 through
25. You estimate that operating expenses, including income taxes, will be $65000 for the first year and that they will increase by $6000 each year thereafter. You
estimate that razing the building and selling the lot on which it stands will realize a net amount of $200,000 at the end of the 25 year period. If you had the
opportunity to invest your money elsewhere and thereby earn interest at the rate of 15% per annum, what would be the maximum amount you would be willing
to pay for the parking deck and lot at the present time?
Given :
Estimated remaining service life = 25 years,
Current rental income = $250,000 per year,
Operating and maintenance costs = $65,000 for the first year increasing by $6000 thereafter,
Salvage value = $200,000
MARR = 15%
PW(15%) = $250,000(P/A, 15%, 5) +
$275,000(P/A, 15%, 5) (P/F, 15%, 5) +
$302,500(P/A, 15%, 5) (P/F, 15%, 10) +
$332,750(P/A, 15%, 5) (P/F, 15%, 15) +
$366,025(P/A, 15%, 5) (P/F, 15%, 20) +
$65,000(P/A, 15%, 25) - $6000(P/G, 15%, 25) + $200,000(P/F, 15%,25) = $1,116,775
5: 20: Consider the following sets of investment projects, each of which has a three year investment life:

Compute the net future worth of each project at i = 16%.

Period Project Cash Flows = -$6000 + $5,800(P/F, 13%, 1) +

$12,400(P/F, 13%, 2) + $8,200(P/F, 13%, 3)
n A B C D = $15, 526.86
FW(13%) = $15,526.86 (F/P, 13% , 3) = $22,403.88
0 -$6000 -$2,500 -$4,800 -$4,100

1 $5,800 -$4,400 -$6000 -$1000 = -$2500 + $4,400(P/F, 13%, 1) +

$7000(P/F, 13%, 2) + $3000(P/F, 13%, 3)
2 $12,000 $7,000 $2,000 $5,000 = $1,667
3 $8,200 $3,000 $4,000 $6000 FW(13%) = $1,667(F/P, 13% , 3) = $2,405.85

= -$4800 + $6,000(P/F, 13%, 1) +

$2,000(P/F, 13%, 2) + $4000(P/F, 13%, 3)
= $3,528.6
FW(13%) = $3,528.6 (F/P, 13% , 3) = $5,091.42

= -$4,100 + $1,000(P/F, 13%, 1) +

$5,000(P/F, 13%, 2) + $6,000(P/F, 13%, 3)
= $5, 458.99
FW(13%) = $5,458.99(F/P, 13% , 3) = $7,876.76
5:45: Consider the following two mutually exclusive investment projects:
A B
Salvage values represent the net proceeds(after tax) from the disposal of assets if n Cash flow Salvage value Cash flow Salvage value
They are sold at the end of the year listed. Both projects will be available (and can be 0 -$12,000 -$10,000
repeated) with the same costs and salvage values for an indefinite period. 1 -$2000 -$6000 -$2,100 $6,000
a. With an infinite planning horizon, which project is a better choice at MARR=12%? 2 -$2000 -$4000 -$2,100 $3,000
b. With a 10 year planning horizon, which project is a better choice at MARR=12%? 3 -$2000 -$3000 -$2,100 $1,000

4 -$2000 -$2000
Assuming a common service period of 15 years 5 -$2000 -$2000
Project A:

PW(12%) cycle  $12, 000  $2, 000( P / A,12%, 5)

$2, 000( P / F ,12%, 5)
 $18, 075
PW(12%) total  $18, 075[1  ( P / A, 76.23%, 2)] Note : (1.12)5  1  76.23%

 $34,151

Project B: PW(12%) cycle  $10, 000  $2,100( P / A,12%, 3)

$1, 000( P / F ,12%, 3)
 $14, 332
PW(12%) total  $14, 332[1  ( P / A, 40.49%, 4)]
 $40, 642 Note : (1.12)3  1  40.49%
Select project A
 Project A with 2 replacement cycles:

PW(12%)  $18, 074  $18, 074( P / F ,12%, 5)

 $28, 329.67

Project B with 4 replacement cycles where the 4 th replacement cycle ends at the end of first operating year:

PW(12%)  $14, 332[1  ( P / F ,12%, 3)  ( P / F ,12%, 6)]

[$10, 000  ($2,100  $6, 000)( P / F ,12%,1)]
( P / F ,12%, 9)
 $34,144.73

Project A is still a better choice.

The analysis period differ from the project lives.
You are running a small machine shop where you need to replace a worn-out sanding machine. Two different models have been proposed.
Model A. is semi automated, requires an initial investment of $150,000 and has an annual operating cost of $55,000 for each of three years, at which time it will
have to be replaced. The expected salvage value of the machine is just $15,000.
Model B. is an automated machine with a five year life and requires an initial investment of $230,000 with an estimated salvage value of #35,000. Expected annual
operating and maintenance cost of the B machine is $30,000.
Suppose, that the current mode of operation is expected to continue for an indefinite period . You also think that these two models will be available in the future
without significant changes in price and operating costs. At MARR = 15% which model should you select?. Apply the annual equivalence approach to select the
most economical machine.

n Model A Model B

0 -$150,000 -$230,000

Given :
1 -$55,000 -$30,000
Cash flow for Model A, Model B
2 -$55,000 -$30,000
i=15% compounded annually

3 -$55,000 +$15,000 -$30,000 Find AE cost and which model is the preferred alternative.

4 -$30,000

5 -$30,000 +$35,000
Model A: for a three year period (first cycle)
PW(15%) = -$150,000 - $55,000 (P/A, 15%, 3) + $15,000 (P/F, 15%, 3)
= -$265,715
AEC(15%) first cycle = -$265,715 (A/P, 15%, 3) = $116,377
for 15 year period (five replacement cycle)
PW(15%) = -$265,715 [1 + (P/F, 15%, 3) + (P/F, 15%, 6) + (P/F, 15%, 9) + (P/F, 15%, 12)]
=-$680,499

AEC(15%) 15 year period = -$680,499 (A/P, 15%, 15) = $116,377

Model B:
for a five year period (first cycle)
PW(15%) = -$230,000 - $30,000 (P/A, 15%, 5) + $35,000 (P/F, 15%, 5)
= -$313,163
AEC(15%) first cycle = -$313,163 (A/P, 15%, 5) = $93,422

for 15 year period (three replacement cycle)

PW(15%) = -$313,163 [1 + (P/F, 15%, 5) + (P/F, 15%, 10) ]
=-$546,270
AEC(15%) 15 year period = -$546,270 (A/P, 15%, 15) = $93,422
AE cost of model A is higher value than model B, thus we select B. ($116,377 > $93,422)
Mutually Exclusive Alternatives with Unequal Project Lives

Model A: Required service Period = Indefinite

0 1 2 3

$3,000 Analysis period = LCM (3,4) = 12 years

$5,000 $5,000
$12,500

Model B:
0 1 2 3 4

$2,500
$4,000 $4,000 $4,000
$15,000
 Model A:
0 1 2 3

$3,000
$5,000 $5,000
$12,500

• First Cycle:
PW(15%) = -$12,500 - $5,000 (P/A, 15%, 2) - $3,000 (P/F, 15%, 3)
= -$22,601
AE(15%) = -$22,601(A/P, 15%, 3) = -$9,899
• With 4 replacement cycles:
PW(15%) = -$22,601 [1 + (P/F, 15%, 3) + (P/F, 15%, 6) + (P/F, 15%, 9)]
= -$53,657
AE(15%) = -$53,657(A/P, 15%, 12) = -$9,899
 Model B:
0 1 2 3 4

$2,500

$4,000 $4,000 $4,000

$15,000

• First Cycle:
PW(15%) = - $15,000 - $4,000 (P/A, 15%, 3) - $2,500 (P/F, 15%, 4)
= -$25,562
AE(15%) = -$25,562(A/P, 15%, 4) = -$8,954
• With 3 replacement cycles:
PW(15%) = -$25,562 [1 + (P/F, 15%, 4) + (P/F, 15%, 8)]
= -$48,534
AE(15%) = -$48,534(A/P, 15%, 12) = -$8,954
 0 1 2 3

$4,000
4 5 6
$5,000
$5,500
$12,500
$4,000 7 8 9
$5,000
$5,500
$12,500
Model A $4,000
10 11 12
$5,000
$5,500
$12,500
$4,000
$5,000
$5,500
0 1 2 3 4
$12,500

$4,000
5 6 7 8
$4,000
$4,500
$5,000
$4,000
$15,000
9 10 11 12
$4,000
$4,500
$5,000
$15,000 $4,000

Model B $4,000
$4,500
$5,000
$15,000
5:51: An electric utility company is taking bids on the purchase, installation, Cost per Tower
and operation of microwave towers:
Bid A Bid B

Which is the most economical bid if the interest rate is 11%? Both towers will have no salvage Equipment cost $65000 $58,000
value after 20 years of use. Installation cost $15,000 $20,000
Annual maintenance and inspection fee $1,000 $1,250

Since either tower will have no salvage value after 20 years, we may select the analysis Annual extra income taxes $500
period of 35 years: Life 40 years 35 years
Salvage value $0 $0
PW(11%) Bid A  $80, 000  $1, 000( P / A,11%,35)
 $88,855
PW(11%) Bid B  $78, 000  $1, 750( P / A,11%,35)
 $93, 497
Bid A is a better choice.

 If we assume an infinite analysis period, the present worth of each bid will be
[$80,000  $1,000( P / A,11%, 40)]( A / P,11%, 40)
PW(11%)Bid A 
0.11
 $90,341
$93, 497( A / P,11%,35)
PW(11%)Bid B 
0.11
What is a Bid.  $95,985
Bid A is still preferred.

The term bid refers to an offer made by an individual or corporation to purchase an asset. Buyers commonly make bids at auctions and in various markets, such as the stock
market. Bids may also be made by companies that compete for project contracts. When a buyer makes a bid, they stipulate how much they're willing to pay for the asset along with
how much they are willing to purchase. 1
A bid also refers to the price at which a market maker is willing to buy a security. But unlike retail buyers, market makers must also display an ask price.
Multiple Alternatives. The approach we discussed earlier to compare between two alternatives can be extended to more than two alternatives. Just compute the
NPW of each alternative, and then pick the one with the best NPW. Comparing Alternatives

Example. A contractor must build a six-miles-long tunnel. During the five-year construction period, the contractor will need water from a nearby stream. He
will construct a pipeline to carry the water to the main construction yard. Various pipe diameters are being considered.

Pipe diameter

Installed cost $22,000 $23,000 $25,000 $30,000

of pipeline
and pump

Pumping cost $1.20 $0.65 $0.50 $0.40

per hour

The salvage value of the pipe and the cost to remove them may be ignored.
The pump will operate 2,000 hours per year.
The lowest interest rate at which the contractor is willing to invest money is 7%.
(This is called the minimum attractive rate of return, abbreviated as MARR.)
We compute the present worth of the cost for each alternative.
This cost is equal to the installed cost of the pipeline and pump, plus the present worth of five years of pumping costs.

Pumping costs:
2” pipe: 1.2 (2000) (P/A,7%,5) = 1.2 (2000) (4.100) = $9,840.
3” pipe: 0.65 (2000) (4.100) = $5,330
4” pipe: 0.50 (2000) (4.100) = $4,100.
6” pipe: 0.40 (2000) (4.100) = $3,280.

PW of all costs:
2” pipe: $22,000 + $9,840 = $31,840 30
3” pipe: $23,000 + $5,330 = $28,330
4” pipe: $25,000 + $4,100 = $29,100
6” pipe: $30,000 + $3,280 = $33,280.
Select the 3 in. pipe size since it the alternative with the least present worth of cost.
Example
An investor paid $8,000 to a consulting firm to analyze what to do with a parcel of land on the edge of town that can be bought for $30,0000. The consultants
suggest four alternatives (shown in the following table) An investor always has the alternative to do nothing. It is not too exciting, but may be better than other
choices.

Alternative Total investment Uniform net annual Terminal value at end

including land benefit of 20yr.,

A Do nothing $0 $0 $0
B Vegetable market $50,000 $5,100 $30,000

C $95,000 $10,500 $30,000

D Small motel $350,000 $36,000 $150,000

The problem is one of neither fixed input nor fixed output. So, our criterion will be to maximize the present worth of benefits minus the present worth of cost; i.e.
maximize the net present worth (NPW)
Alternative A: do nothing, NPW = 0
Alternative B: Vegetable market
NPW = -50,000 + 5,100 (P/A,10%,20) + 30000 (P/F,10%,20)
= -50,000 + 5,100 (8.514) + 30000(0.1486) = - 50,000 + 43,420 + 4,460 = - $2,120.
Alternative C: Gas station
NPW = -95000 + 10500 (P/A,10%,20) + 30000 (P/F,10%,20)
= -95,000 + 10500 (8.514) + 30000(0.1486) = - 95,000 + 9,400 + 4,460 = - $1,140.
Alternative D: Small motel
NPW = -350,000 + 36000 (P/A,10%,20) + 150000 (P/F,10%,20)
= -350,000 + 36000 (8.514) + 150000(0.1486) = - 350,000 + 306,500 + 23,290 = - $21,210

Important note. The $8,000 the investor spent for consulting services is a past cost, and is called a sunk cost. The only relevant costs in the economic analysis are
present and future costs. Past events and past costs are gone and cannot be allowed to affect future planning.
The authors do not mention it, but the sort of analysis the consultants did to provide the table was probably very approximate. Predicting the future is always
very tricky