FINACIAL MANAGEMENT

Part 2/4
Present Worth
Edited by

Ir. Dr. Salina Budin

Edit by Ir dr bulan on 28 may 2017

 There are many ways of judging proposed investments:
 All based on a minimum rate of return i*
 How to determine i*?
 At least as high as the interest rate
 Also based on other available opportunities
 Discussed in more detail in Chapter 18

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 Four different methods:
 Present worth
 Annual equivalent cash flow
 Internal rate of return
 Benefit/cost ratios
 All are mathematically equivalent:
 Slightly different pluses and minuses

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 One alternative might have:
 Higher initial cost, but
 Lower annual cost or longer life
 Must convert to comparable terms
 Alternatives may also have different income tax
implications:
 Compare based on after-tax performance!

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 Based on discounting!
 Future costs and benefits discounted to present
 Discount rate = minimum rate of return i*
 Tells us how much we care about the future
 Present worth is the most intuitive method:
 All costs and benefits are converted to year 0
 Easy to interpret
 But can be difficult to implement for projects with
different lives

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 Current labor cost is $9200/year
 Option to build new equipment:
 First cost $15,000
 Labor $3300/year
 Power $400/year
 Maintenance $1100/year
 Property tax and insurance $300/year
 Income tax $1040/year
 Total annual cost $6140/year > $3300!

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 Note:
 Only need to account for changes in property tax,
insurance, etc.
 Assumptions:
 Lifetime of equipment is 10 years
 Minimum rate of return i* = 9%

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 Present worth (cost) of current option:
 $9200 (P/A, 9%, 10) = $59,050
 Present worth (cost) of new equipment:
 $6140 (P/A, 9%, 10) = $39,407
 First cost = $15,000
 Total = $54,407
 Is the new equipment better?

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 Example Using
Formula
Alternative X has a first cost of $20,000, an operating cost of $9,000 per year,
and a $5,000 salvage value after 5 years. Alternative Y will cost $35,000
with an operating cost of $4,000 per year and a salvage value of $7,000
after 5 years. At an i of 12% per year, which should be selected?

DETERMINING THE NET PRESENT VALUE DETERMINING THE NET PRESENT VALUE
Firm's cost of capital 12% Firm's cost of capital 12%
machine A Year-End Cash Flow machine A Year-End Cash Flow
interest 0.12 interest 0.12
Year Project A using Formula Year Project A using Formula
0 (20,000) (20,000.00) first year cost 0 (35,000) (35,000.00)

5 (9,000) (32,442.99) operation cost 5 (4,000) (14,419.10)

5 7,000 3,971.99
5 5,000 2,837.13 salvarege

present value (45,447.12)

present value (49,605.85)

Select alternative Y
 Using table
Example
Alternative X has a first cost of $20,000, an operating cost
of $9,000 per year,
and a $5,000 salvage value after 5 years. Alternative Y will
cost $35,000
with an operating cost of $4,000 per year and a salvage
value of $7,000
after 5 years. At an i of 12% per year, which should be
selected?
PWX = -20,000 - 9000(P/A,12%,5) + 5000(P/F,12%,5)
= -$49,606

PWY = -35,000 - 4000(P/A,12%,5) + 7000(P/F,12%,5)

= -$45,447

Select alternative Y
 Cannot just bring back to present worth
 For example:
 20 years of service at a cost of $20,000
may (or may not) be worth more than
 10 years of service at a cost of $15,000
 When using present worth method:
 Must compare options with equivalent lives

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 Compare options A and B at i* = 11%:
A: First cost = $50,000
 Annual cost = $9,000/year for 20 years
 Salvage value = $10,000 in year 20
B:First cost = $120,000
 Annual cost = $7,000/year for 40 years
 Salvage value = $20,000 in year 40
 Salvage value should be subtracted from cost!

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 Present worth (cost) of option B:
 First cost = $120,000
 $7000 (P/A, 11%, 40) = $62,657
 -$20,000 (P/F, 11%, 40) = - $308
 Total = $182,349
 This option provides 40 years of service

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 Must convert option A to 40 years!
 First cost = $50,000
 $50,000 (P/F, 11%, 20) = $6201
 $9000 (P/A, 11%, 40) = $80,559
 -$10,000 (P/F, 11%, 20) = - $1240
 -$10,000 (P/F, 11%, 40) = - $154
 Total = $135,326
 First cost, salvage value appear twice!

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 Which option is better?
 Option B has:
 Longer lifetime
 Lower annual cost
 Higher salvage value at end of life
 But two copies of option A can provide 40 years of
service with lower present worth!

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 To evaluate based on present worth:
 Must convert lifetimes of all projects to their least
common multiple!
 In this example, that was easy:
 Least common multiple of 20 and 40 is 40
 In some problems, it can get complicated:
 Least common multiple of 7 and 12 is 84!
 Would need 12 copies of one, 7 of the other

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 Example: Different-Life
Alternatives
Compare the machines below using present worth analysis at i = 10% per year
Machine A Machine B
First cost, $ 20,000 30,000
Annual cost, $/year 9000 7000
Salvage value, $ 4000 6000
Life, years 3 6
Solution:

LCM = 6 years; repurchase A after 3 years

 Option 1
Solution Using Formula

DETERMINING THE NET PRESENT VALUE

Firm's cost of capital 10% DETERMINING THE NET PRESENT VALUE
Firm's cost
machine A Year-End Cash Flow
of capital 10%
interest 0.1
Year-End Cash Flow
Year Project A using Formula
machine B interest 0.1
0 (20,000) (20,000.00)
Year Project A using Formula
1 (9,000) (8,181.82)
0 (30,000) (30,000.00)
2 (9,000) (7,438.02)
1 (7,000) (6,363.64)
3 (9,000) (6,761.83)
2 (7,000) (5,785.12)
3 4,000 3,005.26
3 (7,000) (5,259.20)
3 (20,000) (15,026.30)
4 (7,000) (4,781.09)
4 (9,000) (6,147.12)
5 (7,000) (4,346.45)
5 (9,000) (5,588.29)
6 (7,000) (3,951.32)
6 (9,000) (5,080.27)
6 6,000 3,386.84
6 4,000 2,257.90
present value (57,099.98)
present value (68,960.49)
NPV (65,000) (87,099.98)
NPV (86,000) (88,960.49) Choice of
Choice of project #REF! project #REF!

LCM = 6 years; repurchase A after

3 years
Select alternative B 18
 Option 2
Solution Using Formula

DETERMINING THE NET PRESENT VALUE DETERMINING THE NET PRESENT VALUE
Firm's cost of capital 12% Firm's cost of capital 10%
machine A Year-End Cash Flow MACHINE B Year-End Cash Flow
interest 0.12 interest 0.1
Year Project A using Formula Year Project A using Formula
0 (20,000) (20,000.00) first year cost 0 (30,000) (30,000.00)
operation
c1 3 (9,000) (22,381.67) cost 6 (7,000) (30,486.82)
3 4,000 3,005.26 salvarege 6 6,000 3,386.84
present value (39,376.41)
present
3 (20,000) (15,026.30) value (57,099.98)
6 (9,000) (39,197.35)
6 4,000 2,257.90
c2 present value (51,965.75)

Total in 6 year (91,342.16) (68,960.49) C2-C1

(274,026.47)
NPV (50,000) (294,026.47)
Choice of project
LCM = 6 years; repurchase A after
3 years
Select alternative B 19
 Option 3
Solution Using table

3 6
Solution: LCM = 6 years; repurchase A after 3 years
PWA = -20,000 – 9000(P/A,10%,6) – 16,000(P/F,10%,3) + 4000(P/F,10%,6)
20,000 – 4,000
= $-68,961 in year 3
PWB = -30,000 – 7000(P/A,10%,6) + 6000(P/F,10%,6)
= $-57,100
Select alternative B
 Some projects may last so long that they can be
modeled as perpetual!
 Even projects with perpetual lives can have a finite
present worth:
 Why?
 General formula for perpetual lives:
 P = A/i*, or A = P i*

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 First cost = $50,000
 Annual cost = $9,000/year forever
 Interest rate i* = 11%
 Present worth:
 $50,000 + $9,000/.11 = $131,818

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 Some perpetual costs are not annual
 For example, every 20 years we may:
 Need to purchase new equipment ($50,000)
 Get salvage value of old equipment ($10,000)

 To convert perpetual recurrent costs to present worth:

 First convert to annual
 Then divide by i* to get present worth

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 Every 20 years we:
 Need to purchase new equipment
 $50,000
 Get salvage value of old equipment
 $10,000

 Annualized cost is:

 $40,000 (A/F, 11%, 20) = $623
 Present worth = $623/i* = $5664

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 Present worth of continuing project A in perpetuity:
 First cost in year 0 = $50,000
 Annual cost $9,000/i = $81,818
 $40,000 (A/F, 11%, 20)/i = $5664
 (Replacement cost minus salvage value)
 Total present worth = $137,482
 Only slightly greater than 2 copies ($135,326)

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 Why use perpetual lives?
 Avoids the need to analyze numerous copies of a
project:
 If least common multiple of lives is large
 Can simply convert all projects to their perpetual
equivalent
 (Assuming an infinite number of copies)

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 The comparison methods so far:
 Least common multiple of lifetimes
 Perpetual lifetimes
make sense if the best option would be used for an
extended period of time
 This may not always be the case:
 E.g., computers (due to rapid change)

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An industrial engineer is considering two robots for
purchase by a fiber-optic manufacturing company.
Robot X will have a first cost of $80,000, an annual
maintenance and operation (M&O) cost of $30,000
and a $40,ooo salvage value. Robot Y will have a first
cost of $97,ooo, an annual M&O cost of $27,000 and a
$50,000 salvage value. Which should be selected on
the basic of a future worth comparison at an interest
rate of 15% per year? Use a 3 year study period.

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 Robot X Robot Y First cost 80000 97000 M&O/year
30000 27000 Salvage 40000 50000

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Compare the alternatives shown on the basis of their
capitalized cost using an interest rate of 10% per year.

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