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5 Present Worth
Analysis
$45,000
$45,000
$35,000
$35,000
$25,000
$15,000
0
1
2
Years
$85,000
150,000
3.2 years
Payback period
100,000
50,000
0
-50,000
-100,000
0
6
Years (n)
Cash Flow
-$85,000
Cost of Funds
(15%)*
Cumulative
Cash Flow
-$85,000
15,000
-$85,000(0.15) = -$12,750
-82,750
25,000
-$82,750(0.15) = -12,413
-70,163
35,000
-$70,163(0.15) = -10,524
-45,687
45,000
-$45,687(0.15) =-6,853
-7,540
45,000
-$7,540(0.15) = -1,131
36,329
35,000
$36,329(0.15) = 5,449
76,778
Summary
1
2
Outflow
PW(i)inflow
PW(i)outflow
5
Net surplus
PW(i) > 0
$24,400
$27,340
$55,760
outflow
$75,000
PW (15%) inflow $24,400( P / F ,15%,1) $27,340( P / F ,15%,2)
$55,760( P / F ,15%,3)
$78,553
PW (15%) outflow $75,000
PW (15%) $78,553 $75,000
$3,553 0, Accept
$24,400
0
$55,760
$27,340
2
$75,000
Project life
$24,400(F/P,15%,2) = $32,269
$27,340(F/P,15%,1) = $31,441
$55,760(F/P,15%,0) = $55,760
$119,470
$75,000
l
poo
n
t
r
n
u
Ret vestme
$55,760
to i n
$27,340
$75,000(F/P,15%,3) = $114,066
$24,400
Project
Risk-free return
Inflation factor
Risk premiums
) = A/i
Practice Problem
Given: i = 10%, N =
Find: P or CE (10%)
$2,000
$1,000
0
10
P = CE (10%) = ?
Solution
$2,000
$1,000
0
10
P = CE (10%) = ?
$1,000 $1,000
( P / F,10%,10)
0.10
0.10
$10,000(1 0.3855)
CE(10%)
$13,855
15
Years
30
45
60
$500,000
$500,000
$50,000
$500,000
$2,000,000
$500,000
Solution:
Construction Cost
P1 = $2,000,000
Maintenance Costs
P2 = $50,000/0.05 = $1,000,000
Renovation Costs
P3 = $500,000(P/F, 5%, 15)
+ $500,000(P/F, 5%, 30)
+ $500,000(P/F, 5%, 45)
+ $500,000(P/F, 5%, 60)
.
= {$500,000(A/F, 5%, 15)}/0.05
= $463,423
Total Present Worth
P = P1 + P2 + P3 = $3,463,423
Comparing Mutually
Exclusive Alternatives
Do-Nothing Alternative
Revenue Projects
Projects whose revenues depend
on the choice of alternatives
(monitoring resolution)
Service Projects
Projects whose revenues do not
depend on the choice of
alternative ( Electric Company)
Analysis Period
The time span over which the
economic effects of an investment
will be evaluated (study period or
planning horizon).
Required Service Period
The time span over which the
service of an equipment (or
investment) will be needed.
$2,075
$500
$1,400
$1,000
A
PW (10%)A= $283
PW (10%)B= $579
$4,000
$2,110
PW(15%)A =
PW(15%)B =
5.7 J&M Manufacturing plans on purchasing a new assembly machine for $32,000 to
automate one of its current manufacturing operations. It will cost an additional $3,500 to
have the new machine installed. With the new machine, J&M expects to save $12,000 in
annual operating and maintenance costs. The machine will last five years with an
expected salvage value of $5000.
(a) How long will it take to recover the investment (plus installation cost)?
(b) If J&M's interest rate is known to be 17%, determine the discounted payback period.
n
Inflow
Outflow
Cumulative CF
$0
$35,500
$35,500-
$35,500-
$12,000
$0
$12,000
$23,500-
$12,000
$0
$12,000
$11,500-
$12,000
$0
$12,000
$500
$12,000
$0
$12,000
$12,500
$17,000
$0
$17,000
$29,500
Cash Flow
Cumulative CF
$35,500-
$0
$35,500-
$12,000
$6,035-
$29,535-
$12,000
$5,021-
$22,556-
$12,000
$3,835-
$14,391-
$12,000
$2,446-
$4,837-
$17,000
$822-
$11,341
5.10 The Northern Investment Group is considering investing $2.5 million in a new shopping plaza in
Atlanta. The company has estimated that the shopping plaza, once built, will generate $500,000 per
year for 10 years. If the firm is looking for a return of 12% on its investment, is it worth undertaking?
Assume that the shopping plaza will retain about 60% of its initial investment as salvage value.
5.17 You are in the mail-order business, selling computer peripherals, including high-speed Internet
cables, various storage devices such as memory sticks, and wireless networking devices. You are
considering upgrading your mail ordering system to make your operations more efficient and to
increase sales. The computerized ordering system will cost $250,000 to install and $50,000 to operate
each year. The system is expected to last eight years with no salvage value at the end of the service
period. The new order system will save $120,000 in operating costs (mainly, reduction in inventory
carrying cost) each year and bring in additional sales revenue in the amount of $40,000 per year for
the next eight years. If your interest rate is 12%,justify your investment using the NPW method.
5.18 A large food-processing corporation is considering using laser technology to speed up and
eliminate waste in the potato-peeling process. To implement the system, the company anticipates
needing $3 million to purchase the industrial-strength lasers. The system will save $1,200,000 per year
in labor and materials. However, it will incur an additional operating and maintenance cost of $250,000
per year. Annual income taxes will also increase by $150,000. The system is expected to have a 10year service life and a salvage value of about $200,000. If the company's MARR is 18%,justify the
economics of the project using the PW method.
(b)
5.26 Consider the following project balances for a typical investment project with a service life of five
years:
N
An
Project Balance
------------------------------------------------------------------------0
-$1000
-1000
1
(
)
-900
2
490
-500
3
(
)
0
4
(
)
-100
5
200
( )
0
1
2
3
4
5
$1,000$200
$490
$550
$100$200
(a) Fill in the blanks by constructing the original cash flows of the project and
determining the terminal balance.
(b) Determine the interest rate used in the project-balance calculation, and
compute the present worth of this project at the computed interest rate.
$1,000$900$500$0
$100$90
5.32 A group of concerned citizens has established a trust fund that pays 6% interest
compounded monthly to preserve a historical building by providing annual maintenance
funds of $25,000 forever. Compute the capitalized-equivalent amount for these building
maintenance expenses.
5.33 A newly constructed bridge costs $10,000,000. The same bridge is estimated to need
renovation every 10 years at a cost of $1,000,000. Annual repairs and maintenance are
estimated to be $100,000 per year.
(a) If the interest rate is 5%, determine the capitalized-equivalent cost of the bridge.
(b) Suppose that the bridge must be renovated every 15 years, not every 10 years. What is
the capitalized cost of the bridge if the interest rate is the same as in (a)?
5.34 To decrease the costs of operating a lock in a large river, a new system of operation is
proposed. The system will cost $650,000 to design and build. It is estimated that it will have
to be reworked every 10 years at a cost of $100,000. In addition, an expenditure of $50,000
will have to be made at the end of the fifth year for a new type of gear that will not be
available until then. Annual operating costs are expected to be $30,000 for the first 15 years
and $35,000 a year thereafter. Compute the capitalized cost of perpetual service at i = 8%.
5.47 A local car dealer is advertising a standard 24-month lease of $1,150 per month for its
new XT 3000 series sports car. The standard lease requires a down payment of $4,500 plus
a $1,000 refundable initial deposit now. The first lease payment is due at the end of month
1. Alternatively, the dealer offers a 24-month lease plan that has a single up-front payment
of $30,500 plus a refundable initial deposit of $1,000. Under both options, the initial deposit
will be refunded at the end of month 24. Assume an interest rate of 6% compounded
monthly. With the present-worth criterion, which option is preferred?
5.48 Two alternative machines are being considered for a manufacturing process. Machine
A has an initial cost of $75,200, and its estimated salvage value at the end of its six years of
service life is $21,000. The operating costs of this machine are estimated to be $6,800 per
year. Extra income taxes are estimated at $2,400 per year. Machine B has an initial cost of
$44,000, and its salvage value at the end of its six years of service life is estimated to be
negligible. Its annual operating costs will be $11,500. Compare these two alternatives by the
present-worth method at i = 13%.
Summary