3/15/2023

CHAPTER 5
Present Worth Analysis

March , 2023 Dr. Mansour Abou Gamila 1

Learning Objectives
• Use the Present Worth (PW) of equal life
alternatives, and (PW) of different life alternatives to
select the best alternatives.
• Select the best alternative using the future worth
analysis.
• Select the best alternative using the capitalized cost
calculations
• Perform the life cycle cost analysis for the
acquisition and operations phases of an alternative.

March , 2023 Dr. Mansour Abou Gamila 2

1
 3/15/2023

5. 1 Formulating Mutually Exclusive Alternatives

• Evaluation of alternatives is one of the important functions of
financial management and engineering.

The Economic Projects are classified to:

 Mutually exclusive alternatives
Only one of the viable projects can be selected by the
economic analysis. Each Viable project is an alternative. (e.g.
when an engineer must select the one best diesel powered engine
from several competing models)

 Independent projects
More than one viable project may be selected by the
economic analysis. (E.g. when an engineer has three diesel
engine models (A,B,and C) and may select any number of them
i.e DN, A, B, C,AB, AC, BC, or AB C)
Note: The “Do Nothing (DN)” alternative should always be considered
March , 2023 Dr. Mansour Abou Gamila 3

5. 1 Formulating Mutually Exclusive Alternatives

• All alternatives evaluated in one particular engineering economy
study must be of the same type.
• Given a set of “feasible” alternatives, engineering economy attempts
to identify the “best” economic approach to a given problem
• Types of Cash Flow for Projects:
 Revenue: Each alternative generates cost and revenue cash flow
estimates, and possibly savings. Revenues are dependent on
which alternative is selected (e.g. alternatives that require capital
investment to generate revenues/savings)
 Criteria: Select the alternative that maximizes the economic
measure of merit
 Services: Each alternative has only cost cash flow estimates.
Revenues or savings are not dependent upon the alternative
selected. So, these cash flows are assumed to be equal. (e.g public
sector, and safety improvement)
 Criteria: Select the alternative that minimizes the economic
measure of merit, which is a cost-based measure
March , 2023 Dr. Mansour Abou Gamila 4

2
 3/15/2023

5.2 Present Worth Analysis of Equal-Life Alternatives

In present worth analysis, the alternatives must be of equal service,
that is, evaluate all alternatives over the same number of years.
• The Present Worth Method is the process of calculating the equivalent worth of
future cash flows back to some specific points in time, that is all future cash
flows are converted to present.
• In present worth analysis, the “P” value now called “PW” is calculated at the
MARR for each alternative.
• MARR is the Minimum Attractive Rate of Return and is higher than the rate
expected from a bank or some safe investment
• The following guidelines are applied to select one alternative:
– One alternative: Calculate PW at the MARR. The alternative is
financially viable if PW ≥ 0.
– Two or more alternatives: Calculate the PW for each alternative. Select
the alternative with the PW value that is numerically largest (lowest
cost and highest income-least negative or highest positive).
– Independent projects: select all projects with PW ≥ 0 at the MARR.
March , 2023 Dr. Mansour Abou Gamila 5

Example 5-1, Page 132

 Perform a present worth analysis of equal-service
machines with the costs shown below, if the
MARR is 10% per year. Revenues for all the three
alternatives are expected to be the same

Electric Powered Gas Powered Solar Powered

First Cost, $ -4500 -3500 -6000
Annual operating cost, $ -900 -700 -50
Salvage value, $ 200 350 100
Life, years 8 8 8

March , 2023 Dr. Mansour Abou Gamila 6

3
 3/15/2023

Solution FSV = 200

AL.1: Electric
MARR = 10% per year
0 1 2 3 4 5 6 7 8
A = -900/Yr. FSV = 350
-4500

AL.2: Gas0 1 2 3 4 5 6 7 8
A = -700/Yr.
-3500 FSV = 100

AL.3:Solar 0 1 2 3 4 5 6 7 8
A = -50/Yr.
-6000

• PWElec. = -4500 - 900(P/A,10%,8) + 200(P/F,10%,8) = $-9208

• PWGas = -3500 - 700(P/A,10%,8) + 350(P/F,10%,8) = $-7071
• PWSolar = -6000 - 50(P/A,10%,8) + 100(P/F,10%,8) = $-6220
The solar powered machine is selected since the PW of its cost is the lowest.
March , 2023 Dr. Mansour Abou Gamila 7

5.3 Present Worth Analysis of Different-Life Alternatives

The equal service requirements can be satisfied by either of

two approaches:
 LCM : Compare the alternatives over a period of time
equal to the least common multiple of their lives. (e.g.
lives of 4 and 6, use n = 12 and assume re-investment at
same cash low estimates)

 Compare the alternatives using a Study period of length

n yeas, which does not necessary take into consideration
the useful lives of alternatives. This is called the planning
horizon approach. (e.g. alternatives with expected lives of 6
and 8 years are compared over a 5 year period. Only the
cash flows which occur during the 5 years are considered)
March , 2023 Dr. Mansour Abou Gamila 8

4
 3/15/2023

5.3 Present Worth Analysis of Different-Life Alternatives

The PW of the alternatives must be compared over the same
number of years and end at the same time

The assumption of a PW analysis of different life

alternatives for the LCM method are as follows:
1. The service provided by the alternatives will be
needed for the LCM of years or more.
2. The selected alternatives will be repeated over
each life cycle of the LCM in exactly the same
manner.
3. The cash flow estimates will be the same in every
life cycle.

March , 2023 Dr. Mansour Abou Gamila 9

Example 5.3, Page 134

a. Which lease option should be selected on the basis of PW
comparison, if the MARR is 15%/year?
b. If a study period of 5 years is used and the deposit returns
are not expected to change, which location should be
selected?
c. Which location should be selected over a 6-years study
period if the deposit return at location B is estimated to be
$6000 after 6 years.

Location A Location B
First Cost, $ -15,000 -18,000
Annual lease cost, $ per year -3,500 -3,100
Deposit return,$ 1,000 2,000
Lease term, years 6 9

March , 2023 Dr. Mansour Abou Gamila 10

5
 3/15/2023

Example 5.3, Page 134

• Using LCM approach: use n = 18, because lives of

alternatives are 6 and 9, and assume re-investment at same
cash low estimates, at MARR =15%.

March , 2023 Dr. Mansour Abou Gamila 11

Example 5.3, Page 134

a. PW Calculation for A and B:
 PWA = -15,000 - 15,000(P/F,15%,6) + 1000(P/F,15%,6)
- 15,000(P/F,15%,12) + 1000(P/F,15%,12)
+1000(P/F,15%,18) - 3500(P/A,15%,18) = $-45,036

 PWB = -18,000 - 18,000(P/F,15%,9) + 2000(P/F,15%,9)

+2000(P/F,15%,18) - 3100(P/A,15 %,18) = $-41,384
Location B is selected, since it costs less in PW.

b. Using the study period approach: a 5 year Study Period no cycle

repeats are necessary.
 PWA = -15,000 - 3500(P/A,15%,5) + 1000(P/F,15%,5) = $-26,236
 PWB = -18,000- 3100(P/A,15%,5) + 2000(P/F,15%,5) = $-27,397
Location A is better
Note: The result with a study period approach vs. the LCM approach is
not the same.
March , 2023 Dr. Mansour Abou Gamila 12

6
 3/15/2023

Example 5.3, Page 134

c. For a 6 year study period, the deposit return for B is

$6000 in year 6:

PWA = -15000-3500(P/A,15%,6)+1000(P/F,15%,6)=$-27,813
PWB=-18,000-3100(P/A,15%,6)+6000(P/F,15%,6) = $-27,138
Location B is selected

March , 2023 Dr. Mansour Abou Gamila 13

5.4 Future Worth Analysis

• Future worth analysis is often utilized if the asset “equipment,
a corporation, a building, etc.) might be sold or traded at some
time after its start up or acquisition, but before the expected
life is reached.
• In some applications, a future worth analysis is preferred.
(E.g. an entrepreneur is planning to buy a company and
expects to trade it within 3 years)
• Alternatives as electric generation facilities, toll roads, hotels
can be analyzed using the FW.
• Analysis is straight forward:
– Multiplying the PW value by the F/P factor

• The selection guidelines for the best FW value is the same

as PW analysis selection guidelines

March , 2023 Dr. Mansour Abou Gamila 14

7
 3/15/2023

5.4 Future Worth Analysis

Example
 A small strip-mining coal company is trying to decide
whether it should purchase or lease a new clamshell. If
purchased, the shell will cost $150,000 and is expected to
have a $65,000 salvage value in 6 years. Alternatively, the
company can lease a clamshell for $30,000 per year. If the
clam shell is purchased, it will be leased to other strip-
mining companies whenever possible, an activity that is
expected to yield revenues of $12,000 per year. If the
company’s minimum attractive rate of return is 15% per
year, should the clamshell be purchased or leased on the
basis of a future worth analysis?

March , 2023 Dr. Mansour Abou Gamila 15

5.4 Future Worth Analysis

Solution
FWpurchase = -150,000(F/P,15%,6) + 12,000(F/A,15%,6) +65,000
= -150,000(2.313)+12,000(8.754)+65,000
=$-176,902

FWlease = -30,000(F/A,15%,6)
=-30,000(8.754) = $-262,620
Purchase the clamshell

March , 2023 Dr. Mansour Abou Gamila 16

8
 3/15/2023

Example 5.5, Page 137

• ABritish food distribution conglomerate purchased a Canadian food
store chain for $75 million (U.S.) three years ago. There was a net
loss of $10 million at the end of year 1 of ownership. Net cash flow
is increasing with an arithmetic gradient of $5 million per year
starting the second year, and this pattern is expected to continue for
the foreseeable future. This means that breakeven net cash flow was
achieved this year. Because of the heavy debt financing used to
purchase the Canadian chain, the international board of directors
expects a MARR of 25% per year from any sale.
a. The British conglomerate has just been offered $159.5 million
(U.S.) by a French company wishing to get a foothold in Canada.
Use FW analysis to determine if the MARR will be realized at this
selling price.
b. If the British conglomerate continues to own the chain, what
selling price must be obtained at the end of 5 years of ownership to
make the MARR?
March , 2023 Dr. Mansour Abou Gamila 17

Example 5.5, Page 137

a. FW3=-75(F/P,25%,3)-10(F/P,25%,2)-5(F/P,25%,1)+159.5
= -168.36+159.5 = $-8.86 millions
No, the MARR of 25% will not be realized if the $159.5 million
offer is accepted.

b. FW5=-75(F/P,25%,5) – 10(F/A,25%,5)
+5(A/G,25%,5)(F/A,25%,5) = $-246.81 millions
The offer must be for at least $246.81 millions to make the
MARR .
March , 2023 Dr. Mansour Abou Gamila 18

9
 3/15/2023

5.5 Capitalized Cost Calculations and Analysis

CAPITALIZED COST ”CC”: is the present worth of an
alternative that will last forever.

CC is used for public projects; such as bridges, dams,

roads, and irrigation systems, and all projects that
basically possess infinite life;

• Infinite analysis period:

“n” is either very long, indefinite, or infinity ”∞”.

March , 2023 Dr. Mansour Abou Gamila 19

5.5 Capitalized Cost Calculations and Analysis

 (1  i ) n  1 
 The equation for P using the P  A n 
P/A factor formula is:  i (1  i ) 
 1 
 Divide both numerator and  1  (1  i ) n 
denominator by (1+i)n P  A 
 i 
 
 If “n” approaches  and CC
“capitalized cost” replaces PW A
and P ; the above reduces to: A CC 
P
i i
 If A value is an annual worth
“AW” determined through AW
equivalence calculations of cash
CC 
i
flows over n years

 The amount of “A” for an A = Pi = (CC)i

infinite number of periods is
March , 2023 Dr. Mansour Abou Gamila 20

10
 3/15/2023

Example 5.6, Page 139

The Haverty County Transportation Authority (HCTA) has just
installed new software to charge and track toll fees. The director
wants to know the total equivalent cost of all future costs incurred
to purchase the software system. If the new system will be used for
the indefinite future, find the equivalent value (a) now ”CC” value,
and (b) for each year thereafter ”AW”. The system has an installed
cost of $150,000 and an additional cost of $50,000 after 10 years.
The annual software maintenance contract cost is $5000 for the first
4 years and $8000 thereafter. In addition, there is expected to be a
recurring major upgrade cost of $15,000 every 13 years. Assume
that i = 5% per year for county funds.

i = 5%
March , 2023 Dr. Mansour Abou Gamila 21

Example 5.6, Page 139

a. Find the present worth of all non-recurring costs of $150,000 now and
$50,000 in year 10 at i=5%. Label this “CC1”.
CC1 = -150,000 - 50,000(P/F,5%,10) = $-180,695
• Convert the recurring costs of $15,000 every 13 years into an annual worth
“A1” for the first 13 years.
A1 = -15,000(A/F,5%,13) = $-847
• The capitalized cost for the two annual maintenance cost series:
The annual software maintenance contract cost is $5000 for the first 4 years and
$8000 thereafter.
The annual cost A 2 = $-5000,
The capitalized cost of $-3000 from 5 to infinity is:
 3000
CC 2   P / F ,5 %, 4   $  49 ,362
0 . 05
A  A2  847  (  5000 )
CC 3  1   $  116 ,940
i 0 .05
CC T   180 , 695  49 ,362  116 ,940  $  346 ,997
b. The equivalent value of “A” per year forever is
A=Pi = CCT (i) =$346,997(0.05) = $17,350/Yr.
March , 2023 Dr. Mansour Abou Gamila 22

11