10/4/2024

MS-291: Engineering Economics

(3 Credit Hours)

Chapter 2
Factors: How Time and Interest
Affect Money

Engineering
Economics &
Management
(MS291)

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Content of the Chapter

❖ Single-Payment Compound Amount Factor (SPCAF)

❖ Single-Payment Present Worth Factor (SPPWF)

❖ Uniform Series Present Worth Factor (USPWF)

❖ Capital Recovery Factor (CRF)

❖ Uniform Series Compound Amount Factor

❖ Sinking Fund Factor (SFF)

❖ Arithmetic Gradient Factor

❖ Geometric Gradient Series Factor

Assignment No. 1
• Will be Shared Today via MS Teams

• Based on the course covered so far

• Submission date is within a week and on MS

TEAMS only
• Instructions → Handwritten, please.

• No submissions acceptable after the due date

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Join MS Team

Quiz No. 1
• Date: NEXT WEEK “THURSDAY”
• Time: 7:00 p.m.
• Course (Chapter 2 + 3)

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Chapter 3
Combining Factors
and Spreadsheet
Functions

Engineering
Economics &
Management
(MS291)

This Chapter Objectives

1. Shifted uniform series

2. Shifted series and single cash flows
3. Shifted gradients

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Example

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Year

P=? A = $50
F
P3 = ?

How can we get “Present value of this series” ?

• Use the P/F factor to find the present value of each disbursement at year 0 and add
them.
• Use the F/P factor to find the future value of each disbursement in year 13, add
them, and then find the present value of the total, using P/F= F( P/F, i ,13).
• Use the F/A factor to find the future amount F/A =A( F/A, i ,10), and then compute
the present value, using P/F=F(P/F, i ,13).
• Use the P/A factor to compute the “present value” P3 =A( P/A , i ,10) (which will be
located in year 3, not year 0), and then find the present value in year 0 by using the
(P/F , i ,3) factor.

Shifted Uniform Series

• Typically the last method is used for calculating the present value
of a uniform series that does not begin at the end of period 1.

• Note that a P value is always located 1 year or period prior to the

beginning of the first series amount. Why? Because the P/A factor
was derived with P in time period 0 and A beginning at the end of
period 1.

• The most common mistake made in working problems of this type

is improper placement of P .
Remember:
• When using P/A or A/P factor, PA is always one year ahead of first A
• When using F/A or A/F factor, FA is in same year as last A
• The number of periods n in the P/A or F/A factor is equal to the number of uniform
series values

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PA is always one year ahead

of first A

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Year

A = $50
P3 = ?

FA is in same year as last A

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Year

A = $50 F=?
The number of periods n in the P/A or
F/A factor is equal to the number of
uniform series values

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Steps for applying factors to

Shifted Cash Flows

1. Draw a diagram of the positive and negative cash flows.

2. Locate the present value or future value of each series on
the cash flow diagram.
3. Determine n for each series by renumbering the cash flow
diagram.
4. Draw another cash flow diagram representing the desired
equivalent cash flow. (Optional)
5. Set up and solve the equations.

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Example
The offshore design group at Bechtel just purchased
upgraded CAD software for $5000 now and annual
payments of $500 per year for 6 years starting 3 years
from now for annual upgrades. What is the present
value in year 0 of the payments if the interest rate is 8%
per year?
Solution 1. Draw a diagram of the positive and negative cash flows.
2. Locate the present
value or future value of
each series on the cash
i= 8% per year flow diagram.
0 1 2 3 4 5 6 7 8 Year
PA = ? 0 1 2 3 4 5 6 n

P’A = ?
PT = ? A = $500 3. Determine n for each
series by renumbering the
P0 = $5000 cash flow diagram.

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5. Set up P' A = $500( P /A ,8%,6)

and solve
the P = P' ( P /F ,8%, 2)
A A
equations.
P = $500( P /A ,8%,6) ( P /F ,8%, 2)
A

PT = P0 + PA
=5000 + 500( P /A ,8%,6)( P / F ,8%,2)
=5000 +500(4.6229)(0.8573)
$6981.60

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Class Practice 5 Minutes Time

Calculate the present value of the cash flow shown below at i = 10%

i = 10%
0 1 2 3 4 5 6 Actual year

A = $10,000

10% Single Payments Uniform Series Factors

n Compound Present Sinking Compound Capital Present

Amount Worth Fund Amount Recovery Worth
(F/P) (P/F) (A/F) (F/A) (A/P) (P/A)
1 1.1000 0.9091 1.00000 1.0000 1.10000 0.9091
5 1.6105 0.6209 0.16380 6.1051 0.26380 3.7908

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Class Practice 5 Minutes Time

Calculate the present value of the cash flow shown below at i = 10%

i = 10%
0 1 2 3 4 5 6 Actual year
0 1 2 3 4 5 Series year

P’A = ? A = $10,000
PT = ?
Solution
(1) Use P/A factor with n = 5 (for 5 arrows) to get P’A in year 1 ----→ A(P/A,10%, 5)

(2) Use P/F factor with n = 1 to move P’A back for PT in year 0 ----→ (P/F,10%, 1)

PT = A(P/A,10%, 5) (P/F,10%,1)
= 10,000(3.7908)(0.9091)
$34462
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Shifted Series and Random

Single Amounts
• For cash flows that include uniform series and randomly placed
single amounts:
Uniform series procedures are applied to the series amounts

Single amount formulas are applied to the one-time cash flows

• The resulting values are then combined per the problem statement

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Example
Find the present value in year 0 for the cash flows shown using an interest
rate of 10% per year.
i = 10%
0 1 2 3 4 5 6 7 8 9 10

A = $5000
Solution: $2000

i = 10%
Actual year
0 1 2 3 4 5 6 7 8 9 10
0 1 2 3 4 5 6 7 8
Series year
A = $5000
PT = ? $2000

• Find the cash flows both positive and negatives

• Locate the present value/ future value
• Determine the “n” by re-numbering the cash flows series
• Uniform series procedures are applied to the series amounts. Single amount
formulas are applied to the one-time cash flows
• The resulting values are then combined per the problem statement
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Example:

PT = ? PA = ?

Use P/A to get PA in year 2: PA = 5000(P/A,10%,8) = 5000(5.3349) = $26,675

Move PA back to year 0 using P/F: P0 = 26,675(P/F,10%,2) = 26,675(0.8264) = $22,044
Move $2000 single amount back to year 0: P2000 = 2000(P/F,10%,8) = 2000(0.4665) = $933
Now, add P0 and P2000 to get PT: PT = 22,044 + 933 = $22,977

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Class Practice: 8 Minutes

An engineering company lease the mineral rights to a mining
company on its land. The engineering company makes a
proposal to the mining company that it pay $20,000 per year for
20 years beginning 1 year from now, plus $10,000 six years from
now and $15,000 sixteen years from now. If the mining company
wants to pay off its lease immediately, how much should it pay
now if the investment is to make 16% per year?
16% Single Payments Uniform Series Factors

n Compound Present Worth Capital Present Worth

Amount (F/P) (P/F) Recovery (A/P) (P/A)
6 2.4364 0.4104 0.27139 3.6847
7 2.8262 0.3538 0.24761 4.0386
16 10.7480 0.0930 0.17641 5.6685
17 12.4677 0.0802 0.17395 5.7487
20 19.4608 0.0514 0.16867 5.9228

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Solution

0 1 2 3 4 5 6 7 16 17 18 19 20

A =$20,000

P=?
$10,000
$15,000

P = 20,000(P/A ,16%,20)+
10,000( P /F ,16%,6) +
15,000(P/F,16%,16)
P = $20,000(5.9288)+ $ 10,000( 0.4104) + $ 15,000(0.0930)
= $124,075

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This Chapter Objectives

1. Shifted uniform series

2. Shifted series and single cash flows
3. Shifted gradients

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Shifted Gradient Series

• We already learnt how to get P (Present

value) or A ( Annuity or a Uniform series)
from a Gradient Series

• We will now discuss how to calculate P or

A from “Shifted Gradient Series” … a
gradient series not starting from year 1.

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P from Arithmetic Shifted Gradient Series

P from Normal Arithmetic Gradient Series Shifted Arithmetic gradient Series
PT = ?
PA = A(P/A, i%, n)
PG = G(P/G, i%, n)

PA = ?

PG = ? P’G = ?

• Shifted gradient begins at a

time other than between periods • Present value PG is located 2
1 and 2 periods before gradient starts

P T =P A +P G
• Must use multiple factors to find PT
=100(P/A , i ,8) + 50(P/G, i ,5)(P/F, i ,3)
in actual year 0

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What will be the procedure for calculating “P” from

Shifted “Geometric” Gradient Series?

Lets discuss it directly from a Numerical Example

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Example:
Shifted Geometric Gradient
Weirton Steel signed a 5-year contract to purchase water treatment chemicals from a
local distributor for $7000 per year. When the contract ends, the cost of the chemicals
is expected to increase by 12% per year for the next 8 years. If an initial investment in
storage tanks is $35,000, determine the equivalent present value in year 0 of all of the
cash flows at i = 15% per year.

PT = ? Pg = ? i =15% per year

0 1 2 3 4 5 6 7 8 9 10 11 12 13 Year
0 1 2 3 4 5 6 7 8 9 Geometric
Gradient n
$7000 $7840

$35000

$17331
12% increase
per year

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P from Shifted Gradient Series

PT = 35,000 + A ( P /A ,15%, 4) + A1 ( Pg/A ,12%,15%,9) (P/F ,15%,4)

1− 1.12⁄1.15 9
PT = 35,000 + 7000 ( 2.8550) + 7000 (0.5718)
0.15−0.12

$83,232

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A from Shifted Gradient Series

Shifted gradient Series A (Annuity or Uniform Series)

0 1 2 3 4 5 6 7 8

• To calculate A for shifted Gradient Series (Arithmetic or

Geometric), there are several possibilities.

• The easiest way (and recommended also) is to get the “P” of

shifted Gradient Series first (procedure just explained in pervious slides) then
use A/P factor to get A for the shifted gradient series

• A, for above example will be: A = PT (A/PT, i%, n),

• where PT refers to the present value of the shifted gradient series that procedure is
already explained on pervious slide.

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Important Points for P and A

of Shifted Gradient Series
• Must use multiple factors to find P in actual year 0, for shifted
gradient series

• The present value (P) of an arithmetic gradient will always be

located two periods before the gradient starts.

• To find the equivalent A series of a shifted gradient through

all the n periods, first find the present value of the gradient at
actual time 0, then apply the (A/P, i, n) factor.

• F from gradient series can also be find by first calculating P

and then using F/P factor

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Example: Comparisons
For the cash flows shown, find the future value in year 7 at i = 10% per year

i = 10%
0 1 2 3 4 5 6 7
Actual years
Using
0 1 2 3 4 5 6 Gradient years
Multiple
Methods 450
500
550
PG = ? 600
650
P’G 700
F=?
G = $-50
Solution: PG is located in gradient year 0 (actual year 1); base amount of $700 is in gradient years 1-6
P’G = A(P/A,10%,6) – G(P/G,10%,6)
P’G = 700(P/A,10%,6) – 50(P/G,10%,6) = 700(4.3553) – 50(9.6842) = $2565
PG= P’G(P/F,10%,1) = 2565(0.9091) = $2331.84

F = P’G(F/P,10%,7) = 2331.84(1.9487) = $4544 Method 1

F = P’G(F/P,10%,6) = 2565(1.7716) = $4544 Method 2

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Using Single Amount factors (Correct

but not Standard methods)

Method 3

Method 4

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So far ….
1. Introduction
➢ What is Economics? Economics for Engineers ?
➢ What is Engineering Economy ? Performing Engineering Economy
Study ?
➢ Some Basic Concepts Utility & Various cost concept, Time value of
money (TVM), Interest rate and Rate of Returns, Cash Flow, Economic
Equivalence, Minimum Attractive Rate of Return, Cost of Capital and
MARR, Simple and compound interest rates
2. Various Type of Factors
These were three
Factors Single payment Factors “Foundational Pillars”
➢ P/F, F/P we need for using
Uniform Series Factors
➢ P/A, A/P, F/A, A/F “various engineering
Gradient Series Factors economics measure
➢ Arithmetic Gradient and Geometric Gradient of worth criteria” for
decision making
3. Dealing with Shifted Series
➢ Shifted uniform series
➢ Shifted series and single cash flows
➢ Shifted gradients

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Lets go for the “Final

foundational pillar” before
studying formal engineering
economics measure of worth
EVAUALTING criteria of
decision making

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Chapter 4
Nominal and Effective
Interest Rates

Engineering
Economics &
Management
(MS291)

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Content of the Chapter

• Interest Rate: important terminologies
• Nominal and Effective Rate of Interest
• Effective Annual Interest Rate
• Converting Nominal rate into Effective Rate
• Calculating Effective Interest rates
• Equivalence Relations: PP and CP
• Continuous Compounding
• Varying Interest Rates

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Lets start with a

Simple Example

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15% per year

Compounded daily

But ..is Due amount

How much Paid $1000 from credit card
after a year is really
you going to $1150 ? Lets do
1000+150 = $1150 ?
pay after 1 check!!!
year ?

Rate is 15% per year but compounding is daily … so the rate at per day is 0.15/365 =
0.000411 per day or 0.0411% per day
Days Amount ($) Interest earned Total due ($) 1161.815863 …..
But this is around
1 1000 Amount x r =0.411 1000.411
16.81% rate … rather
2 1000.411 0.411169 1000. 82269 than 15% stated

3 1000. 82269 0.411169 1001.233507 Lets Continue on

- -------- ------ ------ next slide

365 1161.338553 0.47731 1161.815863

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Interest rate is same

for each period
But interest “due” is
1161.815863 …. But this is increasing in every
around 16.81% rate … rather period
than 15% stated

Nominal Interest Rate (15%) Effective Interest Rate (16.81%)

• denoted by (r) • Denoted by (i)
• does not include any consideration of • take accounts of the effect of the
the compounding of compounding period
interest(frequency) • commonly express on an annual
• It is given as: r = interest rate per basis (however any time maybe
period x number of compounding used)
periods

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Previous Learning
• Our learning so far is based “one” interest rate that’s
compounded annually

• Interest rates on loans, mortgages, bonds & stocks are

commonly based upon interest rates compounded more
frequently than annually

• When amount is compounded more than once annually,

distinction need to be made between nominal and
effective rate of interests

39

Interest Rate:
important terminologies

New time-based definitions to understand and remember

Interest period (t) – period of time over which interest is expressed.
Forexample, 1% per month.

Compounding period (CP) – The time unit over which interest is charged or earned.
Forexample,10% per year compounded yearly, here CP
is a year.

Compounding frequency (m) – Number of times compounding occurs within the

interest period t.
Forexample, at i = 10% per year, compounded monthly, interest would be
compounded 12 times during the one year interest period.

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Examples of interest rate

Statements

Annual interest rate of 8% compounded monthly …

interest period (t) = 1 year
compounding period (CP) = 1 month
compounding frequency (m) = 12

Annual interest rate of 6% compounded weekly …

interest period (t) = 1 year
compounding period (CP) = 1 Week
compounding frequency (m) = 52

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IMPORTANT: Compounding
Period and Interest Rate

• Some times, Compounding period is not mentioned in

Interest statement

• Forexample, an interest rate of “1.5% per month”

………..It means that interest is compounded each
month; i.e., Compounding Period is 1 month.

• REMEMBER: If the Compounding Period is not

mentioned it is understood to be the same as the time
period mentioned with the interest rate.

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Calculating Effective
Interest Rate

• Effective interest rate per compounding

period can be calculated as follows:

𝑟% 𝑝𝑒𝑟 𝑡𝑖𝑚𝑒 𝑝𝑒𝑟𝑖𝑜𝑑 𝑡

𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑚 𝑓𝑟𝑒𝑞𝑢𝑒𝑛𝑐𝑦 𝑝𝑒𝑟 𝑐𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑝𝑒𝑟𝑖𝑜𝑑𝑠 𝑡

𝑟
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝑟𝑎𝑡𝑒 𝑝𝑒𝑟 𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑖𝑛𝑔 𝑃𝑒𝑟𝑖𝑜𝑑 =
𝑚

43

Example:

Three different bank loan rates for electric

generation equipment are listed below.
Determine the effective rate on the basis of the
compounding period for each rate
(a) 9% per year, compounded quarterly
(b) 9% per year, compounded monthly
(c) 4.5% per 6 months, compounded weekly

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Example: Calculating
Effective Interest rates per CP
a. 9% per year, compounded quarterly.
b. 9% per year, compounded monthly.
c. 4.5% per 6 months, compounded weekly.

45

Practice Exercise 1:
For nominal interest rate of 18% per year
calculate the effective interest rate
i. If compounding period is yearly 18%
ii. If compounding period is semi-annually 9%

iii. If compounding period is quarterly 4.5%

iv. If compounding period is monthly 1.5%
v. If compounding period is weekly 0.346%
vi. If compounding period is daily 0.0493 %

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Effective Annual Interest

Rates
• When we talk about “Annual” we consider year as the
interest period t , and the compounding period CP can be
any time unit less than 1 year

• Nominal rates are converted into Effective Annual Interest Rates (EAIR)
via the equation:

𝑟 𝑚
𝑖𝑎 = (1 + 𝑖)𝑚 −1 𝑖𝑎 = (1 + ) −1
𝑚

where Effective Interest Rate for any

ia = effective annual interest rate time period
i = effective rate for one compounding period (r/m)
m = number times interest is compounded per year
47

𝐂𝐚𝐧 𝐬𝐨𝐦𝐞 𝐨𝐧𝐞

r = 18% per year, 𝐜𝐨𝐧𝐬𝐢𝐝𝐞𝐫 𝐚 $𝟏𝟎𝟎𝟎
𝐚𝐧𝐝 𝐝𝐨 𝐜𝐚𝐥𝐜𝐮𝐚𝐭𝐢𝐨𝐧
compounded CP-ly 𝐰𝐭𝐢𝐡 𝐦𝐞

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Content of the Chapter

• Nominal and Effective Rate of Interest
• Interest Rate: important terminologies
• Effective Annual Interest Rate
• Converting Nominal rate into Effective Rate
• Calculating Effective Interest rates
• Equivalence Relations: PP and CP
• Continuous Compounding
• Varying Interest Rates

49

Continuous Compounding

• If we allow compounding to occur more and more frequently, the

compounding period becomes shorter and shorter and m , the
number of compounding periods per payment period, increases.

• Continuous compounding is present when the duration of the

compounding period (CP), becomes infinitely small and, the
number of times interest is compounded per period (m), becomes
infinite.

• Businesses with large numbers of cash flows each day consider

the interest to be continuously compounded for all transactions.

• As m approaches infinity, the effective interest rate

i = (1 + r/m)m – 1 must be written and use as; i = er – 1

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Example: Continuous
Compounding

Example: If a person deposits $500 into an account every 3 months

at an interest rate of 6% per year, compounded continuously, how
much will be in the account at the end of 5 years?

Solution: Payment Period: PP = 3 months

Nominal rate per three months: r = 6%/4 = 1.50%
Effective rate per 3 months: i = e0.015 – 1 = 1.51%
F = 500(F/A,1.51%,20) = $11,573

Practice:
Example 4.12 & 4.13

51

Content of the Chapter

• Nominal and Effective Rate of Interest
• Interest Rate: important terminologies
• Effective Annual Interest Rate
• Converting Nominal rate into Effective Rate
• Calculating Effective Interest rates
• Equivalence Relations: PP and CP
• Continuous Compounding
• Varying Interest Rates

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Varying Interest Rates

• Interest rate does not remain constant full life time of a
project

• In order to do incorporate varying interest rates in our

calculations, normally, engineering studies do consider
average values that do care of these variations.

• But sometimes variation can be large and having significant

effects on Present or future values calculated via using
average values

• Mathematically, varying interest rates can be

accommodated in engineering studies

53

Example: Varying Interest Rates

Given below the cash flow calculate the Present value.
$70,000

i=7% i=7%
$35,000
$25,000
i=9%
i=10%
Year
0 1 2 3 4

P=?

P = 70,000(P/A, 7%, 2) + 35,000 (P/F, 9%, 1) (P/F, 7%, 2)

+ 25000(P/F, 10%, 1) (P/F, 9%, 1) (P/F, 7%, 2)
= 70,000 (1.8080) + 35,000 (0.9174)(0.8734) + 25,000(0.9091)(0.8734)(0.0.9174)
= $172,816

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Varying Interest Rates

• When interest rates vary over time, use the interest

rates associated with their respective time periods to
find P

• The general formula for varying interest rate is given as:

P = F1(P/F, i1, 1) + F2(P/F, i1, 1)(P/F, i2, 1) + …..

+ Fn (P/F, i1, 1)(P/F, i2, 1) …(P/F, in, 1)

• For single F or P only the last term of the equation can

be used.
• For uniform series replace “F” with “A”
55

Syllabus & Study Plan

Week Contents Reading Materials
Week 1 Foundation of Engineering Economy, Chapter 1: (B&T 2012)
to various cost concepts
Week 4 Factors: How time and Interest Affect Money Chapter 2: (B&T 2012)

Combining Factors and Spread Sheets Chapter 3: (B&T 2012)

Nominal and Effective Interest Rates Chapter 4: (B&T 2012)

Week Contents Reading Materials

Week 5 Present Worth Analysis, Annual Worth Chapter 5 & Chapter 6:
to Analysis (B&T 2012)
Week 8 Rate of Return Analysis: Single Alternative Chapter 7 & Chapter 8:
and Multiple Alternatives (B&T 2012)

Benefit/Cost Analysis and Public Sector Chapter 9: (B&T 2012)

Economics

Week 9 Mid-Term

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Chapter 5
Present Worth
Analysis

58

Background
• An engineering project or alternative is formulated to make or purchase a
product, develop a process, or provide a service with specified results

• An engineering economic analysis evaluates cash flow estimates for

parameters such as initial cost, annual costs and revenues, etc., over an
estimated useful life of the product; process, or service

• We have learned some basic tools in previous chapters

• In this chapter (and the next few chapters….Stage 2) we are going to use the
basic tools (we learnt already) with some more techniques to evaluate one or
more alternatives using the factors and formulas learned in Stage 1

• After completing these chapters, you will be able to evaluate most engineering
project proposals using a well-accepted economic analysis technique, such
as present worth, future worth, capitalized cost, life-cycle costing, annual
worth, rate of return, or benefit /cost analysis

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Background
• A future amount of money converted to its equivalent value now has
a present worth (PW) that is always less than that of the future cash
flow, because all P/F factors have a value less than 1.0 for any interest
rate greater than zero

• For this reason, present worth values are often referred to as

discounted cash flows (DCF), and the interest rate is referred to as
the discount rate

• Up to this point, present worth computations have been made for

one project or alternative

• In this chapter, techniques for comparing two or more mutually

exclusive alternatives by the present worth method. Full details of the
contents of the chapter are on next slide

60

Content of the Chapter

1. Formulate Alternatives
2. Present Worth of equal-life alternatives
3. Present Worth of different-life alternatives
4. Future Worth analysis
5. Capitalized Cost analysis

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From Chapter 1:
Steps in an Engineering Economy Study
Step 1 in Problem description
Study Objective statement

Available data One or more approaches

Step 2
Alternatives for solution to meet objectives

Cash flows and other • Expected life

Step 3
estimates • Revenues
• Costs
Measure of worth • Taxes
Step 4 criterion • Project Financing
(PW, B/C, IRR etc)

Engineering Economic Tools u will be learning

Step 5
Analysis in this course are used
here
Best alternative
Step 6
Selection
Time Passes
Implementation and
Step 7
Monitoring

Step 1 in New Problem New engineering

Study description economic study begins

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Two types of the Events:

basic concept from probability theory

Mutually Exclusive events Independent Events

• If two events cannot occur at • One event is independent of
the same time, it is called the other event
mutually exclusive events

• In this case the occurrence of

• Mutually exclusive means two
outcomes cannot happen
one event is independent of
simultaneously another event
• E.g., the government has to
• An example is tossing a coin spend money on several
once, which can result in either projects. For instance, roads,
heads or tails, but not both. health, education, social safety
• In the current context, we can say net etc
a solution to a problem. As only
one can be picked

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Formulating Alternatives
Two types of economic proposals:
1. Mutually Exclusive (ME) Alternatives: Only one proposal
can be selected; Compete against each other and are
compared pairwise. These proposals are normally called
alternatives
e.g., A selection of the BEST diesel-powered engines among the
available models

2. Independent Projects: More than one can be selected, these

proposals are called projects; they compete only against DN

Do Nothing (DN) – An ME alternative or independent project to

maintain the current approach; no new costs, revenues or savings
In this chapter, we will learn “Present Worth Method” to evaluate either type
of proposal ..in next chapters we will learn some more such techniques.

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Project or alternatives types

based on Cash flows
There are two types of alternatives based on Cash flows
1. Revenue – each alternative project being evaluated generates
costs and revenues over the life period of the alternative.
• E.g., new systems, products/services that involve capital costs
Criteria of selection is to maximize the economic measure (e.g.,
profit in case of introducing a new product).

2. Cost ( or service-based) – Each alternative has only cost cash

flow estimates (revenues are the same for all alternatives)
• E.g., which 100-seat plane to buy?
• Criteria of selection is to minimize the economic measures (e.g.,
in this case, cost of buying a 100-seat plane)

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Mandates, Ideas, identifications,

experience, Plans, Estimates

Not viable viable Not viable

A B 1 2
D
C 3 E

Mutually
Either of Independent
Exclusive
these projects
Alternatives

Formulating 1
1
2
Alternatives Select
only
3
.
Select
all
2
3
.
. justifi
one .
. ed
.
m
DN

Type of Cash flow Estimates

- Revenue Alternatives - Cost Alternatives
Revenues and costs Costs only

Performance evaluation and make

selection

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Content of the Chapter

1. Formulate Alternatives
2. Present Worth of equal-life alternatives
3. Present Worth of different-life alternatives
4. Future Worth analysis
5. Capitalized Cost analysis

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Present Worth (PW)

analysis

• Present Worth is also called “Net Present Value/NPV

• It is a process of obtaining the equivalent worth of future cash

flows at present time

• That is, finding PW of cash flows

• We say that future cash flows are “discounted” to time 0

• The higher the PW, the better PW is…… evaluate based on an

interest rate, which is equal to the organization’s MARR

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PW Analysis Procedure

• The PW analysis is quite popular in industry because

all future costs and revenues are transformed to
equivalent monetary units NOW /Time “0”

This Criteria work as follows;

1. Convert all cash flows to Present Worth (same as
present value) using MARR
2. Precede costs by minus sign; receipts by plus sign
3. The numerical value obtain is called NPV/PW

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Present Worth Analysis

Evaluation
Mutually exclusive projects
• For one project, it is economically viable if PW ≥ 0.
• For 2 or more alternatives, select the one with the
(numerically) largest PW value.

Independent Projects
• Select all projects with PW ≥ 0
• However, in practice a budget limit exists (details in chapter 12)

REMEMBER: This Evaluation is for the case when

alternatives have equal life

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Example 1: Selection of Alternatives

by Present Worth Criteria
For the alternatives shown below, which should be selected if they
are (a) mutually exclusive; (b) independent?

Project ID Present Worth

A $ 30,000
B $ 12,500
C $ — 4,000
D $ 2,000

Solution: (a) Select numerically largest PW; alternative A

(b) Select all with PW > 0; projects A, B & D

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Thank You

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