Engineering Economy

Chapter 4
Fall 2018

Dr. Ako Rashed Hama

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 Engineering Economy
Chap 4: Present Worth Analysis

Formulating Alternatives based on PW, FW & CC

Engineering alternatives are evaluated

upon the prognosis that a reasonable ROR can be expected

1. Capital (C):
the funds that finance engineering projects
2. Cost of Capital (COC):
the interest rate paid on capital funds
3. Minimum Attractive Rate of Return (MARR):
a reasonable ROR established for the evaluation/selection of alternatives
how much it costs to obtain the needed capital funds
for an accepted project: ROR ≥ MARR > COC
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MARR is same as the interest rate used for PW and AW analysis

Mutual Exclusive Alternatives

Economic Proposals:
Independent Projects
4. Mutual Exclusive (ME):
only one of the viable projects (compete against each other) can be selected
if no alternative >>> Do Nothing (DN) is the default selection
5. Independent Projects:
more than one of the viable projects (compete against DO) can be selected
Do Nothing (DN): an ME or Independent which maintain the current approach;
no new costs, revenues or savings
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Chap 4: Present Worth Analysis

Revenue
Cash Flow Estimates:
Cost
6. Revenue:
alternatives include estimates of costs (outflows) and revenues (inflows)
7. Cost:
alternatives include only costs
revenues and savings assumed equal for all alternatives
Costs are also called service alternatives
Present Worth (PW) Analysis of Alternatives:
 Using MARR for converting all cash flows to PW
 Preceding costs by minus sign; receipts by plus sign
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Chap 4: Present Worth Analysis

Progression
from Proposals
much of the emphasis
in professional
engineering practice is
on
Economic Evaluation
ME & cost alternatives

to selection
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Chap 4: Present Worth Analysis

8. PW Analysis of Equal-Life Alternatives:

for one project, if PW ≥ 0, it is economically justified
for ME projects, select one with numerically largest PW
for independent projects, select all with PW > 0
Example 1
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
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(a) ME; numerically largest PW;
alternative A
(b) Independent; all with PW > 0;
projects A, B & D
 Engineering Economy
Chap 4: Present Worth Analysis

Example 2
A project is defined by the following economical data:
MARR = 10%, first cost P = $-2500, Annual revenue A = $2000 per year
Annual cost AOC = $-900 per year, Salvage value S = $200, Life n = 6 years
Check whether this project is justified?
i = MARR = 0.1; 2 x P/A; 1 x P/F; n = 6
PW = P + A (P/A, 10%, 6) + AOC (P/A, 10%, 6) + S (P/F, 10%, 6)
= -2500 + 2000 (P/A, 10%, 6) – 900 (P/A, 10%, 6) + 200 (P/F, 10%, 6)
= -2500 + 8711 – 3920 + 113
= + $2,404
PW > 0; project is
economically justified

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Example 3

all are cost alternatives; i = MARR = 10% per year; n = 5

the Electric-powered machine, which has the largest PW is accepted

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Chap 4: Present Worth Analysis

9. PW Analysis of Different-Life Alternatives:

equal-service requirements must met
PW over same number of years & must end at the same time

Least Common Multiple (LCM)

ways of comparing equal-service:
Study Period

10. Least Common Multiple (LCM):

PW of alternatives over a period equal to the LCM of their lives
Assumptions for LCM method (may be unrealistic at times):
 Same service needed for LCM years (e.g. LCM of 5 and 9 is 45 years!),
 Alternatives available for multiple life cycles,
 Estimates are correct over all life cycles (some times not true).
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Evaluation of LCM approach:

 obtaining LCM,
 repeating purchase and life cycle for LCM years,
 calculating PW over LCM,
 selecting alternative with most favorable PW.

11. Study Period:

taking same period for all alternatives
all cash flows after this period are ignored

Evaluation of Study Period approach:

 determining each PW at stated MARR,
 select alternative with numerically largest PW.
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Chap 4: Present Worth Analysis

Example 4
The operations of two machines with following data must be compared.
Using Present Worth Analysis at an MARR of 10% per year find out which
machine is economically acceptable.
Machine A Machine B
1st cost $20,000 $30,000
Annual cost per year $9,000 $7,000
Salvage value $4,000 $6,000
Life, year 3 6

Machine A: 1 x P, 1 x A/P, 1 x P/F, n = 3

i = MARR = 0.1 / year (nA = 3) ≠ (nB = 6)
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Machine B: 1 x P, 1 x A/P, 1 x P/F, n = 6
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Chap 4: Present Worth Analysis

Example 4

PWA=? $4000 $4000

LCM of 3 & 6 = 6 years
0 1 2 3 4 5 6 repurchasing A after 3 years
$9000 / year $9000 / year PWA = -20,000 – 9000 (P/A, 10%, 6) –
$20000 $20000 (20000 – 4000) (P/F, 10%, 3) +
Machine A 4000 (P/F, 10%, 6) = $-68,961
PWB=? $6000

0 1 2 3 4 5 6
PWB = -30,000 – 7000 (P/A, 10%, 6) +
6000 (P/F, 10%, 6)
$7000 / year = $-57,100
$30000 Machine B machine B would be selected
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Example 5

Vendor A: 1 x P, 1 x A/P, 1 x P/F, n = 6

i = MARR = 0.15 / year (nA = 6) ≠ (nB = 9)
10/23/2018 Vendor B: 1 x P, 1 x A/P, 1 x P/F, n = 9
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Chap 4: Present Worth Analysis

Example 5
LCM of 6 & 9 = 18 years

Vendor A repurchasing A for 12 years

10/23/2018 Vendor B repurchasing B for 9 years

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Chap 4: Present Worth Analysis

Example 5
(a) with an LCM = 18:

vendor B would be selected

(b) for a 5 year study period, i.e. PW < 6 & 9:

vendor A would be CARFULLY selected!

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12. Future Worth (FW) Analysis:

especially applicable for LARGE capital investment situations
when maximizing the future worth of a corporation is important
e.g. Building, Power Generation, Refinery, …

FW analysis exactly like PW analysis, except calculate FW

PW and FW methods will always result in same selection; FW ≥ 0

Evaluation approach:
determining FW value from cash flows or PW with an n value in F/P factor
Least Common Multiple (LCM)
ways of comparing equal-service:
Study Period
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13. Capitalized Cost (CC) Analysis:

refers to the Present Worth of an alternative with a very long life
project will last forever, i.e. n becomes infinite
especially applicable to public project evaluation
e.g. Dams, Bridges, Irrigation, Hospitals, Police, ...

CC is derived using the PW=A(P/A,i,n) or P/A factor where n approaches ∞

1
1− 𝑛 𝐴 𝐴𝐴
1+𝑖
lim 𝑃𝑃 = lim 𝐴 = = = 𝐶𝐶
𝑛→∞ 𝑛→∞ 𝑖 𝑖 𝑖

AW = CC x i for an infinite number of time period

e.g. $20,000 invested now (PW = CC) at 10% per year ≡ max $2,000
could be withdrawn at the end of each for eternity
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Example 6
Compare the machines shown below on the basis of their capitalized cost.
Use i = 10% per year.
Machine 1 Machine 2
1st cost $20,000 $100,000
Annual cost per year $9,000 $7,000
Salvage value $4,000 -------------
Life, year 3 ∞
Converting machine 1 cash flows into A and then divide by i:
A1 = -20,000 (A/P, 10%, 3) – 9000 + 4000 (A/F, 10%, 3) = $-15,834
CC1 = A1 / i = -15,834 / 0.1 = $-158,340 machine 1 is selected
n2→∞, CC2 = -100,000 – (7000) / 0.1 = $-170,000
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13. Procedure to find CC for an infinite sequence of cash flows:
1. Draw diagram for 2 cycles of recurring (periodic) cash flows and any
nonrecurring (one-time) cash flows,
2. Calculate PW (or CC) for all nonrecurring amounts,
3. Find AW for 1 cycle of recurring amounts; then add these to all A
series applicable for all years 1 to ∞ (or long life),
4. Find CC for amount above using CC = AW / i,
5. Add all CC values (steps 2 and 4).
Example 7
Find CC and A values at i = 5% of long-term public project with cash flows
below. Cycle time is 13 years.
Nonrecurring costs: first $150,000; then one-time of $50,000 in year 10
Recurring costs: annual maintenance of $5000 (years 1-4) and $8000
thereafter; upgrade costs $15,000 each 13 years
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Example 7
Step 1

recurring

nonrecurring
cycle time
Step 2
nonrecurring costs CC1 = -150,000 – 50,000 (P/F, 5%, 10) = $-180,695
Step 3
recurring $15,000 upgrade AW = -15,000 (A/F, 5%, 13) = $-847 / year
recurring maintenance costs years 1 to ∞ AW = $-5000 / year forever
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Example 7

Step 4
CC of extra $3000 (=8000-5000) maintenance for years 5 to ∞:
CC2 = -3000 (P/F, 5%, 4) / 0.05 = $-49,362
CC for recurring upgrade and maintenance costs:
CC3 = (-847-5000) / 0.05 = $-116,940
Step 5
Total CC obtained by adding all three CC components:
CCT = -180,695 – 49,362 – 116,940 = $-346,997
The AW value is the annual cost forever:
AW = CC × i = -346,997 (0.05) = $-17,350
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