Chapter 5

Present Worth Analysis

What we will cover

We will apply the P/F/A/G factors to project
analysis
Ch. 5 is Present Worth Analysis
Ch. 6 is Annual Cash Flow Analysis
Ch. 7 is Rate of Return Analysis
Ch. 8 Incremental Analysis

Chapter 5 Outline
Assumptions in Solving Economic Analysis
Problems
Economic Criteria
Applying Present Worth Techniques
Useful Lives Equal the Analysis Period
Useful Lives Different from the Analysis Period
Infinite Analysis Period

Assumptions in Solving
Economic Analysis Problems
End-of-Year Convention:

n-1

A
n

Viewpoint of Economic Analysis Studies

Generally, the point of view from the total firm is
taken
4

Economic Criteria
Situation
Neither input nor output
fixed
Fixed input
Fixed output

Criterion
Maximize (Output Input)
Maximize output
Minimize input

Methods:
Present worth
Annual cash flow
Rate of return
5

Applying Economics Criteria to

Present Worth Techniques
Situation

Criterion

Neither input nor output

fixed: Typical cases

Maximize Net Present Worth

(present worth of benefits
minus present worth of costs)

Fixed input: amount of

money or other input
resources are fixed
Fixed output: fixed task,
benefit, or other outputs

Maximize present worth of

benefits or other outputs

Minimize present worth of costs

or other inputs
6

Applying Present Worth when Useful

Lives are Equal
Device B

Device A

4500 5000
4000
3000 3500

A=3000
0

1
P=10,000

P=13,500

= 10,000 + 3000( , 7%, 5) = 10,000 + 3000 4.100 = $2300

= 13,500 + 3000( , 7%, 5) + 500( , 7%, 5)
= 13,500 + 3000 4.100 + 500 7.647
= $2624

PWProject = PW of Benefits PW of Costs

7

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
= $400
For the two-stage construction
= $300 + 350 ( , 6%, 25)
= $300 + 81.6
= $381.6

Applying Present Worth when Useful

Lives are Equal
Manufacturer

Cost

Useful Life

End-of-Useful-Life
Salvage Value

Speedy

$1500

5 years

$200

Allied

$1600

5 years

$325

Speedy
= 1500 200( , 7%, 5)
= 1500 200 0.7130 = $1357
Allied
= 1600 325( , 7%, 5)
= 1600 325 0.7130 = $1368
9

Applying Present Worth when Useful

Lives are Equal
Alternatives

Cost

Uniform Annual
Benefit

End-of-Useful-Life
Salvage Value

Atlas

$2000

$450

$100

Tom Thumb

$3000

$600

$700

Atlas = 450( , 8%, 6) + 100( , 8%, 6) 2000

= 450 4.623 + 100 0.6302 2000
= $143
Tom Thumb

= 600( , 8%, 6) + 700( , 8%, 6) 3000

= 600 4.623 + 700 0.6302 3000
= $215
10

Present Worth when Useful Lives are

Different from Analysis Period
Least 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
Need to estimate the terminal values for all
alternatives at the end of the analysis period
11

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

.1 = 50,000 + (10,000 50,000)( , 8%, 7) + 20,000( , 8%, 10)

= 50,000 40,000 0.5835 + 20,000 0.4632
= $64,076
.2 = 75,000 + 15,000( , 8%, 10)
= 75,000 + 15,000 0.5835
= $68,052

12

Present Worth with Infinite Analysis

Period (Capitalized Cost)

13

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%?

50
= =
= $1250
0.04

14

Capitalized Cost
0
$8 million
0

70

140
$8 million

$8 million
70 =

$8 million

n=70
A

$8 million

= 8 ( , 7%, 70) = $4960

4960
= 8 + =
= $8,071,000

0.07
15

Capitalized Cost
(Alternate Solution 1)
0
$8 million
0

70

140
$8 million

$8 million
70 =

$8 million

n=70
A

$8 million

= 8 ( , 7%, 70) = $565,000

565000
= =
= $8,071,000

0.07

16

Capitalized Cost
(Alternate Solution 2)
0
$8 million

70

140

$8 million

$8 million

$8 million

70 = (1 + 7%)70 = 113.989

8
= 8 + =
= $8,071,000

113.989

17

Multiple Alternatives
Pipe Size (in.)
2
Initial Cost

$22,000 $23,000 $25,000 $30,000

Cost of pumping ($/hr)

2"
3"
4"
5"

$1.20

$0.65

= 22,000 + 1.20 2000(

= 23,000 + 0.65 2000(
= 25,000 + 0.50 2000(
= 30,000 + 0.40 2000(

$0.50

$0.40

, 7%, 5) = $31,840
, 7%, 5) = $28,330
, 7%, 5) = $29,100
, 7%, 5) = $33,280

18

Multiple Alternatives
Total
Investment

Uniform Net
Annual Benefit

Terminal
Value

$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

Alternatives
A: Do Nothing

= $0
= 50,000 + 5,100( , 10%, 20) + 30,000( , 10%, 20) = $2,120
= 95,000 + 10,500( , 10%, 20) + 30,000( , 10%, 20) = $1,140
= 350,000 + 36,000( , 10%, 20) + 150,000( , 10%, 20) = $21,210

19

Year
0
1-10
10

Cash Flow
-$610
+200 per year
-1500

= 610 + 200( , 10%, 10) 1500( , 10%, 10)

= 610 + 200 6.145 1500 0.3855
= $41

20

Example 5-10
Year
0
1
2-5
6
7
8

Alt. B
-$1500
+700
+300
+400
+500
+600

700
300 300
1

300

300

400
6

500 600
7

1500

= 1500 + 300( , 8%, 8) + 400( , 8%, 1) + 100( , 8%, 4) ( , 8%, 4)

= 1500 + 300 5.747 + 400 0.9259 + 100 4.650 (0.7350)
= $936.24
21

Example 5-11
Year
0
1
2
3
4
5-8

Alt. A
-$2000
+1000
+850
+700
+550
+400

1000 850

700 550
3

400 400
5

400 400
7

2000

= 2000 + 400( , 8%, 8) + 600( , 8%, 4) 150( , 8%, 4)

= 2000 + 400 5.747 + 600(3.312) 150 4.650
= $1588.50

22

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 bonds 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

(1 + )2 = 1 + 0.1236
= 6%
= 40 , 6%, 20 + 1000 , 6%, 20 = $770.60
23

Problem 5-2
1. What variables do
we have?
2. What do we have a
time = 0?

24

Problem 5-2
Identify variables
Do we have an A?
Do we have a P?
Do we have an G?
When do they
start?
What are the possible
solutions?

25

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