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ENGINEERING ECONOMY
SESSION V
PRESENT WORTH
ANALYSIS
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University. 1
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LEARNING OBJECTIVES
PURPOSE OF THIS CHAPTER
FORMULATION OF MUTUALLY EXCLUSIVE
ALTERNITIVES
PROPER COMPARISON/ANALYSIS OF
MUTUALLY EXCLUSIVE ALTERNATIVES
PRESENT WORTH METHOD
EXTENSIONS OF THE PRESENT WORTH
METHOD
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CHAPTER TOPICS
Formulating Alternatives
PW of Equal-Life Alternatives
PW of Different-Life alternatives
Future Worth Analysis
Capitalized Cost Analysis
Payback Period
Life-Cycle Costs
PW of Bonds
Spreadsheet Applications
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5.1 Alternatives
Do
Nothing
Analysis
Alt.
1
Selection
Problem Alt.
2
Alt. Execution
m
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Problem Alt.
Execution
Selected
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Alt. N
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0 1 2 3 4 5
A = $900
$2,500
F5=$200
MB
0 1 2 3 4 5
$3,500 A = $700
Which alternative should we select?
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EXAMPLE
Machine A Machine B
First Cost $11,000 $18,000
Annual Operating Cost 3,500 3,100
Salvage Value 1,000 2,000
Life 6 years 9 years
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A common mistake is to
compute the present
worth of the 6-year
project and compare it to
the present worth of the
9-year project.
NO! NO! NO!
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don Smith, Texas A&M University. 32
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Machine A F6=$1,000
0 1 2 3 4 5 6
A 1-6
=$3,500 F6=$2,000
$11,000
0 1 2 3 4 5 6 7 8 9
A 1-9
Machine B
=$3,100
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Machine A
6 years 6 years 6 years
Machine B
9 years 9 years
18 years
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LCM = 18 years
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Machine A
0 6 12 18
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0 1 2 3 4 5 6 7 8 9
A 1-9
=$3,100
$18,000
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0 9 18
$32,508 $32,508
Alt-2: N= 7 yrs
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(1 i ) 1 N
P A N
i (1 i )
Next, let N approach infinity and divide the
numerator and denominator by (1+i)N
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1 A
P A
i i
Or,
CC(i%) = A/i
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1 2 3 4 5 .. ………………….. N=inf.
A=$50/yr
P=?
Find the PW of an infinite annuity flow
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1 2 3 4 5 ..
………………….. N=inf.
A=$50/yr
(1 i ) N 1
P A N
, let N
i (1 i )
P0=A(1/i)
(1 i ) 1 1 N
lim N N
i (1 i ) i
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P0 = $50[1/0.04]
P0 = $50[25] = $1,250.00
Invest $1,250 into an account that
earns 4% per year will yield $50 of
interest forever if the fund is not
touched and the i-rate stays constant.
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P = $200,000/0.08 = $2,500,000
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EXAMPLE
Calculate the Capitalized Cost of a
project that has an initial cost of
$150,000. The annual operating cost is
$8,000 for the first 4 years and $5000
thereafter. There is an recurring
$15,000 maintenance cost each 15
years. Interest is 15% per year.
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“i”=15%/YR
0 1 2 3 4 5 6 7 15 30 ………
$4,000
$8,000
$15,000 $15,000 $15,000 $15,000
$150,000
N=
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$161,420
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…….
0 15 30 45 60 ……..
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…….
0 15 30 45 60 ……..
$15,000
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Machine 1: N=7
Machine 2: N=14
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Payback
is
between
6 and 7
yeas
(6.57 yrs)
PW(15%)= +$481.00
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At a “0”
interest rate
the PB time
is seen to
equal 4
years!
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Payback for B is
between 9 and
10 years!
Longer time
period to
recover the
investment.
9.52 years
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Payback for B at
0% is 6 years!
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Discounted
Machine A: 6.57 years
Machine B: 9.52 years
Undiscounted
Machine A: 4.0 years
Machine B: 6.0 years
Go with Machine A – lower time period
payback to recover the original
investment
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Cost-$
Cumulative Life Cycle
Costs
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Costs - $
Acquisition Phase
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Treasury bonds
Issued by Federal Government
Full backing of the Government
1 year or less; 2-10 year issues; and 10-30
year issues
Conservative-type investment
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Mortgage Bonds
Issued by Corporations
Secured by the firm’s assets
Money received by the firm is used to fund
projects
Referred to a Debt Capital
Buyers of these bonds are not owners – they
are lenders to the firm
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Debenture Bond
Issued by Corporations
Not backed by specific assets
Backing – good faith of the firm
Pays higher interest rates
Higher risks involved
Bond interest rate may “float”
Could be convertible to common stock
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Investment Bankers
Proceeds from
The sale
Bondholders
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0.045
I $5, 000( ) $5, 000(0.0225)
2
I $112.50 every 6 months
The bondholder, buys the bond and will receive
$112.50 every 6 months for the life of the bond
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Given
V = $10,000 (Face value of the bond)
r = 4.5% paid semiannually
N = 10 years or 20 interest periods
$I/6 months = $5,000(0.045/2) = $112.50
paid to the current bondholder
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i=4.04%/6 months
A = 112.50/6 months
0 1 2 3 4 …. ….. 19 20
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P = $112.50(P/A,4.04%,20)
+ $5,000(P/F,2%,40)
P = $3,788
IF the buyer can buy this bond for
$3,788 or less, he/she will earn at least
the 8% c.q. rate.
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