PROJECT COST ACCOUNTING AND ECONOMICS

Lecture 3. Present Worth Analysis

Qingbin Cui
 Review

1st Fundamental Concept: TIME VALUE OF VALUE

P F
2nd Fundamental Concept: EQUIVALENCE

Interest Formulas – standard Lego Pieces

G A

(n-1)G
F F

2G
G

0 1 n 0 1 n 0 1 2 3 n

P P= P=

Engineering Cash Flows – Determine Equivalent Value

Slide 2
1. Using an interest table gradient series factor, write
Yea
an equation to find the Present Worth (at year 0) of r
CF ($)

the series of payments on the right. Interest is 5%. 0 - 1,000

A. P = - 1,000 + 500 (P/F,5%,1) + 100 (P/G,5%,5) 1 500

2 600
B. P = - 1,000 + 500 (P/A,5%,5) + 100 (P/G,5%,4) 3 700
C. P = - 1,000 + 500 (P/G,5%,5) 4 800
5 900
D. P = - 1,000 + 500 (P/A,5%,5) + 100 (P/G,5%,5)
E. None of Above

Slide 3
2. At an interest rate of 12% per year, find the present worth (in year
0) of the annual savings in the cost of electricity due to the
installation of a more efficient pump. The cash flow is shown on the
right. 0 $50

A. P= 50 + 60(P/A,12%,6) + 10(P/G,12%,6) 1 $60

2 $70
B. P = 50(P/A,12%,7)*(F/P,12%,1) +10(P/G,12%,7)*(F/P,12%,1)
3 $80
C. P = 50+60(P/F,12%,1)+70(P/F,12%,2) +80(P/F,12%,3) + 4 $90
90(P/F,12%,4) +100((P/F,12%,5)+110(P/F,12%,6) 5 $100
D. All of Above 6 $110

E. None of Above

Slide 4
Learning Objectives
1. Systematic Economic Analysis
2. Economic Criteria
3. Applying Present Worth Techniques
• Useful Lives Equal the Analysis Period
• Useful Lives Different from the Analysis Period
• Infinite Analysis Period

Slide 5
SEAT

Systematic Economic Analysis Technique

• Identify the feasible alternatives
• Define the planning horizon
• Specify the discount rate
• Estimate the cash flows
• Compare the alternatives (criteria)
• Perform supplementary analysis
• Select the preferred alternative

Slide 6
Mutually Exclusive Alternatives

A firm is considering three investment proposals (A, B,

&C). A requires $1M investment, B requires $2.5M, and C
requires $3M. The firm has $4.5M to invest. C is contingent
on A; B and C are mutually exclusive. The “do nothing”
alternative is not feasible. Form the set of mutually
exclusive investment alternatives that exists.

Slide 7
Mutually Exclusive Alternatives

A firm is considering three investment proposals (A, B, &C). A requires $1M

investment, B requires $2.5M, and C requires $3M. The firm has $4.5M to invest. C is
contingent on A; B and C are mutually exclusive. The “do nothing” alternative is not
feasible. Form the set of mutually exclusive investment alternatives that exists.
ALT A B C Comments
1 0 0 0 Do nothing is not feasible
2 1 0 0 ok
3 0 1 0 ok
4 0 0 1 Violates contingency
5 1 1 0 ok
6 1 0 1 ok
7 0 1 1 Violates contingency
8 1 1 1 Violates budget constraint

Feasible ALTs: {A}, {B}, {A, B}, {A,

C}
Slide 8
Economic Criteria

Situation Criterion
Neither input nor output fixed Maximize (Output – Input)
Fixed input Maximize output
Fixed output Minimize input

Methods:
• Present worth (also called Present Value)
• Annual cash flow
• Rate of return

Slide 9
Applying Present Worth Techniques

Situation Criterion
Neither input nor output fixed: Maximize Net Present Worth
Typical cases (present worth of benefits minus
present worth of costs)
Fixed input: amount of money or Maximize present worth of
other input resources are fixed benefits or other outputs
Fixed output: fixed task, benefit, or Minimize present worth of costs
other outputs or other inputs

Slide 10
Example 5-1 Applying Present Worth when Useful Lives are Equal

A firm is considering which of two mechanical devices to install

to reduce costs. Both devices have useful lives of 5 years and no
salvage value. Device A costs $10,000 and can be expected to
result in $3,000 savings annually. Device B costs $13,500 and
will provide cost savings of $3,000 the first year but will
increase $500 annually, making the second-year savings $3,500,
the third-year savings $4,000, and so forth. With interest at 7%,
which device should the firm purchase?

Slide 11
Example 5-1 Applying Present Worth when Useful Lives are Equal

Device A Device B
5000
A=3000 3500 4000 4500
3000

0 1 2 3 4 5 0 1 2 3 4 5

P=10,000
P=13,500

Slide 12
Example 5-2 Applying Present Worth when Useful Lives are Equal

Build a full-sized facility for $400 million

now, or build a reduced-size facility now for
$300 million and expand it 25 years hence for
an additional $350 million, at 6% interest?

Slide 13
Example 5-2 Applying Present Worth when Useful Lives are Equal
Build a full-sized facility for $400 million now, or build a reduced-size
facility now for $300 million and expand it 25 years hence for an
additional $350 million, at 6% interest?

For the single-stage construction

𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡=$ 400𝑚𝑖𝑙𝑙𝑖𝑜𝑛
For the two-stage construction

Slide 14
Example 5-3 Applying Present Worth when Useful Lives are Equal
End-of-Useful-Life
Manufacturer Cost Useful Life
Salvage Value
Speedy $1500 5 years $200
Allied $1600 5 years $325

The equipment of both manufacturers is expected to perform at the

desired level of (fixed) output. For a 5-year analysis period, which
manufacturer’s equipment should be selected? Assume 7% interest and
equal maintenance costs

Slide 15
Example 5-4 Applying Present Worth when Useful Lives are Equal

A firm is trying to decide which of two weighing scales it should

install to check a package filling operation in the plant. The ideal
scale would allow better control of the filling operation, hence
less overfilling. If both scales have lives equal to the 6-year
analysis period, which one should be selected? Assume an 8%
interest rate.
Uniform Annual End-of-Useful-Life
Alternatives Cost
Benefit Salvage Value
Atlas $2000 $450 $100
Tom Thumb $3000 $600 $700

Slide 16
Present Worth when Useful Lives are Different from
Analysis Period
• East Common Multiple of Useful Lives from Various
Alternatives
- Assuming service will be needed indefinitely
- Repeating same cash flows in each cycle for each alternative

• Analysis Period /Terminal Value Method

- Need to estimate the terminal values for all alternatives at the end of
the analysis period

Slide 17
Least Common Multiple of Useful Lives

Alternative (10% discount rate) A B

Initial cost $5,300 $10,700
Annual benefit 1,800 2,100
Useful life 4 years 8 years

Without Repeating A, NPWA = -5,300 + 1800*(P/A, 10%, 4) = -5,300 + 1800*3.17 = $406

NPWB = -10,700 + 2100*(P/A, 10%, 8) = -10,700 + 2100*5.335 = $503.5

$1800

0 1 2 3 4

P=5,300 $2100

0 1 2 3 4 5 6 7 8

P=10,700

Slide 18
Least Common Multiple of Useful Lives
Alternative (10% discount rate) A B
Initial cost $5,300 $10,700
Annual benefit 1,800 2,100
Useful life 4 years 8 years

Without Repeating A, NPWA = -5,300 + 1800*(P/A, 10%, 4) = -5,300 + 1800*3.17 = $406

NPWB = -10,700 + 2100*(P/A, 10%, 8) = -10,700 + 2100*5.335 = $503.5
NPWA = -5,300 + 1800*(P/A, 10%, 8) – 5300*(P/F, 10%, 4)
= -5,300 + 1800*5.335 – 5300*0.683 = $683.10
$1800 $1800

0 1 2 3 4 5 6 7 8

P=5,300 P=5,300

Slide 19
Example 5-5 Applying Present Worth using Analysis Period

Slide 20
Example 5-5 Applying Present Worth using Analysis Period

Alternatives Alt. 1 Alt. 2

Initial Cost $50,000 $75,000
Estimated salvage value at end of useful life $10,000 $12,000
Useful Life 7 years 13 years
Estimated market value, end of 10-year $20,000 $15,000

Slide 21
Present Worth with Infinite Analysis Period (Capitalized Cost)

𝐴
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃= (5-2)
𝑖

Slide 22
Example 5-6 Capitalized Cost

How much should one set aside to pay $50 per year for maintenance on a
gravesite if interest is assumed to be 4%?

𝐴 50
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃= = =$ 1250
𝑖 0.04

Slide 23
Example 5-7 Capitalized Cost

0 70 140 ∞

$8 million $8 million $8 million $8 million

n=70
0 70 =

A
$8 million

𝐴= 8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ¿
𝐴 4960
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃=8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛+ = =$ 8,071,000
𝑖 0.07

Slide 24
Example 5-7 Capitalized Cost (Alternate Solution 1)

0 70 140 ∞

$8 million $8 million $8 million $8 million

n=70
0 70 =

A
$8 million

𝐴= 8 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 ¿
𝐴 565000
𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑐𝑜𝑠𝑡 𝑃= = =$ 8,071,000
𝑖 0.07

Slide 25
Example 5-8 Multiple Alternatives

Slide 26
Example 5-8 Multiple Alternatives

Pipe Size (in.)

2 3 4 5
Initial Cost $22,000 $23,000 $25,000 $30,000
Cost of pumping ($/hr) $1.20 $0.65 $0.50 $0.40

Slide 27
Example 5-9 Multiple Alternatives

Slide 28
Example 5-9 Multiple Alternatives

Uniform Net
Alternatives Total Investment Terminal Value
Annual Benefit
A: Do Nothing $0 $0 $0
B: Vegetable market $50,000 $5,100 $30,000
C: Gas Station $95,000 $10,500 $30,000
D: Small motel $350,000 $36,000 $150,000

Slide 29
Example 5-10

Year Cash Flow

0 -$610
1-10 +200 per year
10 -1500

Slide 30
Example 5-11
1000 850
700 550 400 400 400 400

0 1 2 3 4 5 6 7 8

2000

700 600
400 500
300 300 300 300

0 1 2 3 4 5 6 7 8

1500

Slide 31
Example 5-11

Year Alt. B
0 -$1500 700 600
400 500
1 +700 300 300 300 300
2-5 +300
0 1 2 3 4 5 6 7 8
6 +400
7 +500
8 +600 1500

Slide 32
Example 5-11

Year Alt. A
1000 850
0 -$2000 700 550 400 400 400 400
1 +1000
2 +850 0 1 2 3 4 5 6 7 8
3 +700
4 +550
2000
5-8 +400

Slide 33
Example 5-13

A 15-yr municipal bond was issued 5 yrs ago. Its coupon interest rate is
8%, interest payments are made semi-annually, with face value of $1000.
What should be the bond’s price if market rate is 12.36%.

1000
40
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Slide 34
REVIEW
1. Systematic Economic Analysis
2. Economic Criteria
3. Applying Present Worth Techniques
• Useful Lives Equal the Analysis Period
• Useful Lives Different from the Analysis Period
• Infinite Analysis Period

Slide 35
Questions?

Thank You!