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ENGINEERING ECONOMY Lecture 5

Present Worth

Judging proposed investments


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

Judging proposed investments


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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Judging proposed investments


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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Calculation of present worth


Based on discounting!
Based on the concept of equivalent worth of all cash flows relative to some base or beginning point 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

PRESENT WORTH METHOD ( PW )


Based on concept of equivalent worth of all cash flows relative to the present as a base All cash inflows and outflows discounted to present at interest PW is a measure of how much money can be afforded for investment in excess of cost PW is positive if dollar amount received for investment exceeds minimum required by investors

Discount future amounts to the present by using the interest rate over the appropriate study period
-k PW = k F ( 1 + i ) =0 k
N

FINDING PRESENT WORTH

i = effective interest rate, or MARR per compounding period k = index for each compounding period Fk = future cash flow at the end of period k N = number of compounding periods in study period interest rate is assumed constant through project The higher the interest rate and further into future a cash flow occurs, the lower its PW

Economic desirability of a project using PW


An investment of $ 10,000 can be made in a project that will produce a uniform annual revenue of $ 5,311for 5 years and then have a market (salvage) value of $ 2,000. annual expenses will be $ 3,000 per year. The company is willing to accept any project that will earn 10% per year or more on all invested capital. Show whether this is a desirable project using PW.

PW Cash outflows Annual revenue $ 5,311 (P/A, 10%, 5) Market (salvage) value: $ 2,000 (P/A, 10%, 5( Investment Annual expenses $ 3,000 (P/A, 10%, 5) TOTAL TOTAL PW $ $ 10,000 11,372 21,372 $ 21,375 3 $ Cash inflows 20, 133 1,242

Because total PW(10%) >0, the project is shown to be marginally acceptable.

Evaluation of new equipment purchase using PW


A price of new equipment has been proposed by engineers to increase productivity of certain manual welding operation. The investment cost is $ 25,000 and the equipment will have a market value of $ 5,000 at the end of study period 5 years. Increased productivity attributable to the equipment is $ 8,000 per year after extra operating costs has been subtracted from the revenue generated by additional production. If the firms minimal interest rate is 20% per year, is this proposal a sound one ?

Solution: PW = PW of cash inflows PW cash outflows Or

PW (20%)

= $ 8000 (P/A, 20%, 5) + $5000 (P/F, 20%,5) - $ 25,000 = $ 934.29

Because PW (20%) >0, this equipment is economically justified.

The value of a bond, at any time, is the present worth of future cash receipts from the bond The bond owner receives two types of payments from the borrower:
-- periodic interest payments until the bond is retired ( based on r ); -- redemption or disposal payment when the bond is retired ( based on i );

BOND AS EXAMPLE OF PRESENT WORTH

The present worth of the bond is the sum of the present values of these two payments at the bonds yield rate

For a bond, let Z = face, or par value C = redemption or disposal price (usually Z ) r = bond rate (nominal interest) per interest period N = number of periods before redemption i = bond yield (redemption ) rate per period VN = value (price) of the bond N interest periods prior to redemption -- PW measure of merit VN = C ( P / F, i%, N ) + rZ ( P / A, i%, N ) Periodic interest payments to owner = rZ for N periods -- an annuity of N payments When bond is sold, receive single payment (C), based on the price and the bond yield rate ( i )

PRESENT WORTH OF A BOND

Finding the Current Price of a Bond


Find the current price (PW) of a 10 year bond paying 6% per year (payable semiannually) that is redeemable at par value, if bought by the purchaser to yield10% per year. The face value of the bond is $1,000. N = 10 x 2 = 20 periods r = 6%/2 = 3% per period i = ((1.10) - 1) x 100% = 4.9% per semiannual period C = Z = $ 1000.

Solution:
VN = $1000(P/F,4.9%,20) + $1000 (0.03((P/A, 4.9%,20) = $ 384.10 + $ 377.06 = $ 761.16

Example4
Current labor cost is $9200/year Option to build new equipment:
First cost Labor Power Maintenance Property tax and insurance Income tax Total annual cost $15,000 $3300/year $400/year $1100/year $300/year $1040/year $6140/year > $3300!

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Example4
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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Example4--results
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 5
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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Example 5
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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Example 5
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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Example 5
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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Projects with different lives


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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Projects with different lives


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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Projects with perpetual lives


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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Example 3
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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Example 6
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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Perpetual lives
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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Example 7
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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Review
What is the single most important pitfall to avoid when using present worth to compare projects?

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More Sample Problems

EX1] A new dam project will require $48,000 a year in maintenance costs after it is complete. These maintenance costs will continue forever. Assume that the funding can be set aside in an account that earns 5% interest per year. What is the lump sum to be set aside now in order to cover the $48,000 in annual maintenance costs? Solution: This is a capitalized cost problem with an infinite analysis period. Capitalized cost, P=A/I
where A is the annual disbursement and i is the interest rate.

P=$48,0000/.05= $960,000. So, $960,000 must be set aside in this account in order to pay for annual maintenance costs.

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Your grandfather deposits $50,000 into your savings account that pays 6% interest compounded quarterly. Equal annual withdrawals are to be made from the account beginning 1 year from now and continuing forever. The maximum amount of equal annual withdrawals is approximately Solution: First we need to find the effective annual interest rate because our interest is compounded quarterly instead of annually. We then use the effective annual interest in the infinite life formula, P = A/i Ie= (1+0.015)4 1 = 0.06136 The maximum annual withdrawal is approximately A = Pi = 50,000(0.06136) = $3,068

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EXAMPLE 2
The amount of money deposited 25 years ago at 5% interest that would now provide a perpetual payment of $15,000 per year is closest to Solution: The amount of money needed now to begin the perpetual payments is P" = A/I = 15,000/0.05 = 300,000. The amount that would need to have been deposited 25 years ago is: P = 300,000(P/F, 5%, 25) P = 300,000(1+0.05)-25 = 88,590 Or from the 5% interest table P = 300,000(0.2953) = $88,590

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EXAMPLE 3
The amount of money deposited 10 years ago at 8% interest that would now provide a perpetual payment of $15,000 per year is approximately Solution: The amount of money needed now to generate a perpetual payment of $15,000 annually is P"=A/I = 15,000/0.08 = 187,500 Now, we can compute the amount that would need to have been deposited 10 years ago. Letting 10 years ago be the present, P = 187,500(P/F, 8%, 10) = 187,500(0.4632 ) = $86,850

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EXAMPLE 4
Machine A has an initial cost of $6,000 with total annual maintenance costs of $750. Machine B has an initial cost of $8,500 with total annual maintenance costs of $405. At a 10% interest rate, in approximately how many years do the two machines have the same present worth? Solution: PW of cost A = PW of cost B 6,000 + 750(P/A, 10%, n) = 8,500 + 405(P/A, 10%, n) 8,500 6,000 = 750 405(P/A, 10%, n) (2,500/345) = (P/A, 10%, n) (P/A, 10%, n) = 7.25 So, from the 10% interest table, this equates to about 10 years.

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EXAMPLE 5
You borrow $10,000 from your parents at an interest rate of 12% compounded monthly. You agree to pay your parents $300 per month. Approximately how long will it take for you to pay off your loan assuming that you pay exactly $300 per month? Solution: PW of benefits = PW of costs 10,000 = 300(P/A, 1%, n) 10,000/300 = (P/A, 1%, n) 33.33 = (P/A, 1%, n)

n is approximately 41 months

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EXAMPLE 6
A project has an initial cost of $100,000 and uniform annual benefits of $12,500. At the end of its 8-year useful life, its salvage value is $30,000. At a 10% interest rate, the net present worth of the project is approximately Solution: NPW = PW of benefits PW of costs =12,500(P/A, 10%, 8) + 30,000(P/F, 10%, 8) 100,000 =12,500(5.335) + 30,000(0.4665) 100,000 = $19,317.50. Thus, this project has an overall cost of $19,317.50

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Assignments
A company is considering constructing a plant manufacture a proposed new costs $ 250,000 and $ 100,000 additional working capital is required. It is expected that the product will result in a sales of $ 750,000 per year for 10 years, at which the time the land can be sold for $ 400,000, the building for $ 300,000 and the equipment for $ 50,000. all of the working capital could be recovered at the end of 10 year. The annual expenses for labor, materials and all other items are estimated total of $ 475,000. if the company requires MARR of % per year on projects at comparable risks determine if it should invest in the new product line.

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Evaluate machine XYZ on the basis of PW method when the MARR is 12% oer year. Pertinent costs are as follows: Investement cost $ 13,000 Useful life 15 years Market value $ 3,000 Annual operating expense $100 Overhaul expense-at the end of 5 years $ 200 Overhaul expense-at the end 10yr $ 550

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FUTURE WORTH METHOD (FW )


FW is based on the equivalent worth of all cash inflows and outflows at the end of the planning horizon at an interest rate that is generally MARR The FW of a project is equivalent to PW FW = PW ( F / P, i%, N ) If FW > 0, it is economically justified
N-k FW ( i % ) =k F ( 1 + i ) =0 k
N

i = effective interest rate k = index for each compounding period Fk = future cash flow at the end of period k N = number of compounding periods in study period

Evaluation of new equipment purchase using FW


A price of new equipment has been proposed by engineers to increase productivity of certain manual welding operation. The investment cost is $ 25,000 and the equipment will have a market value of $ 5,000 at the end of study period 5 years. Increased productivity attributable to the equipment is $ 8,000 per year after extra operating costs has been subtracted from the revenue generated by additional production. If the firms minimal interest rate is 20% per year, is this proposal a sound one ?

Solution:
FW (20%) = -$ 25,000 (F/P, 20%,5) + $ 8.000 (F/A, 20%, 5%) + $ 5,000 = $ 2,324.80 Again the project is shown to be a good investment (FW >0). The present worth is the multiple of the equivalent FW value: PW (20%) = $ 2,324.80 (/f, 20%, 5) = $ 934.29

Suppose that a firm wishes to endow an advanced biological at a university. The ebdowment principal will earn interest that will earn 8% per year, which will be sufficient to cover all expenditures incurred in the establishement and maintenance of the laboratory for indefinite long period of time (forever). Cash requirements of the laboratory are estimated to be $ 100,000 now (to establish it), $ 30,000 per year indefinitely, and $ 20,000 at the end of every 4th yr (forever) for equipment replacement. A. For this type of problem, what

Problems on AW
A piece of construction equipment has an initial cost of $80,000, a salvage value of $10,000, and annual operating costs of $13,000. Assuming a 15year useful life and a 10% interest rate, the equivalent uniform annual cost of the equipment is approximately Solution: EUAC = 80,000(A/P, 10% 15) B 10,000(A/F, 10%, 15) + 13,000 = 80,000(0.1315) B 10,000(0.0315) + 13,000 =$23,205

A factory purchased a new tooling machine for $20,500. It is projected that it will have a useful life of 9 years with a $5,000 salvage value at the end of the 9 years. Assuming a 10% interest rate, the equivalent uniform annual cost is approximately The correct answer was: c. $3,191. References: Solution: EUAC = 20,500(A/P, 10%, 9) B 5,000(A/F, 10%, 9) = 20,500(0.1736) B 5,000(0.0736) = $3190.80

Maintenance costs for a backhoe were $1,200 in year 1, $1500 in year 2, $1650 in year 3, and $1700 in year 4. If the interest rate is 7%, the equivalent uniform annual maintenance cost for the 4 years is approximately The correct answer was: b. $1,498. References: Solution: EUAC = [1,200(P/F, 7%, 1) + 1,500(P/F, 7%, 2) + 1,650(P/F, 7%, 3) + 1,700(P/F, 7%, 4)](A/P, 7%, 4) = [(1,200)(0.9346) + (1,500)(0.8734) + (1,650)(0.8163) + (1,700)(0.7629)](0.2952) = (5,075.45)(0.2952) = $1,498.27

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