Engineering Economics - Present Worth Analysis

Applied Software Project Management
Engineering Economics
Present-Worth Analysis
http://www.stellman-greene.com 1
Recap
PART 1 UNDERSTANDING MONEY AND ITS MANAGEMENT
Chapter 1 Engineering Economic Decisions
Chapter 2 Time Value of Money
Chapter 3 Understanding Money Management
Chapter 4 Equivalence Calculations under Inflation

PART 2 EVALUATING BUSINESS AND ENGINEERING ASSETS
Chapter 5 Present-Worth Analysis
Chapter 6 Annual Equivalence Analysis
Chapter 7 Rate-of-Return Analysis

www.hoasen.edu.vn 2
Road Map
Loan versus Project Cash Flows
Initial Project Screening Methods
Methods to Compare Mutually Exclusive Alternatives
3
Loan cash flow: future return in the form of interest plus
repayment of the principal in case of bank loan
Project cash flow: future return in the form of cash
generated by productive use of the fixed asset, along
with the capital expenditures and annual expenses (such
as wages, raw materials, operating costs, maintenance
costs, and income taxes)
4
Similarity between loan cash flow and project cash flow
future use the same equivalence techniques to
measure economic worth
5
Bank Loan

Bank
Loan

Repayment
Customer
Investment Project

Company
Investment

Return
Project
Road Map
6
One of the primary concerns of most businesspeople: whether and
when the money invested can be recovered
The payback method screens projects on the basis of how long it
takes for net receipts to equal investment outlays: cash inflows
exactly match or pay back the cash outflows
Conventional-payback method: ignore the time-value-of-money
Discounted-payback method: include the time-value-of-money
A common standard used to determine whether to pursue a project: a
project does not merit consideration unless its payback period is
shorter than some specified period of time
Payback screening: not an end in itself, but rather a method of
screening out certain obviously unacceptable investment alternatives
before progressing to an analysis of potentially acceptable ones
7
Benefits & Flaws of Payback Screening
Benefits:
Simplicity: one of its most appealing qualities.
focusing on that time at which the firm expects to
recover the initial investment.
Eliminate some alternatives: reducing a firm's need to
make further analysis efforts on those alternatives
Flaws:
fails to measure profitability
8
Benefits & Flaws of Payback Screening
n Project 1 Project 2
0 -10,000 -10,000
1 1,000 9,000
2 9,000 1,000
3 1,000 1,000
Payback Period 2 years 2 years
9
Discounted-Payback Period
Take into account the time value of money, i.e. the cost
of funds (interest) used to support the project

Payback-Period Calculation Considering the Cost of Funds
10
Period Cash Flow Cost of Funds (15%) Cumulative
Cash Flow
0 -85,000 0 -85,000
1 15,000 -85,000(0.15) = -12,750 -82,750
2 25,000 -82,750(0.15) = -12,413 -70,163
3 35,000 -70,163(015) = -10,524 -45,687
4 45,000 -45,687(0.15) = -6,853 -7,540
5 45,000 -7,540(0.15) = -1,131 36,329
6 45,000 36,329(0.15) = 5,449 76,778
Road Map
11
Net-Present-Worth Criterion
Basic procedure for applying the net-present-worth criterion
Evaluation of a Single Project
Step 1:
Determine the interest rate that the firm wishes to earn on its
investments.
This interest rate is often referred to as either a required rate of
return or a minimum attractive rate of return (MARR).
Step 2: Estimate the service life of the project
Step 3: Estimate the cash inflow for each period over the service life.
Step 4: Estimate the cash outflow for each period over the service life.
Step 5: Determine the net cash flows for each period
net cash flow = cash inflow - cash outflow
12
Step 6: Find the present worth of each net cash flow at the MARR. Add up
these present-worth figures; their sum is defined as the project's PW:

Where: PW(i) = PW calculated at i,
A
n
= net cash flow at the end of period n
i = MARR (or cost of capital)
n = service life of the project
A
n
: positive if the corresponding period has a net cash inflow and
negative if the period has a net cash outflow.
13
N) i, (P/F, A PW(i)
i) (1
A
PW(i)
N
0 n
n
N
0 n
n
n
=
=
=
+
=
Step 7: a positive PW means that the equivalent worth of the inflows is
greater than the equivalent worth of the outflows, so the project makes
a profit.
If PW(i) > 0, accept the investment.
If PW(i) = 0, remain indifferent.
If PW(i) < 0, reject the investment.
14
Above rule for evaluation of a single project
Below guidelines for evaluating and comparing more than one project:
Comparing More Than One Alternative
1. To select the best alternative
Select the one with the highest PW (all the alternative have the
same service lives)
Comparison of alternatives with unequal service lives requires
special assumptions, as will be detailed in next Section.
2. Comparison of mutually exclusive alternatives with the same revenues
is performed on a cost-only basis.
accept the project that results in the smallest PW of costs,
or the least negative PW (because you are minimizing costs, rather
than maximizing profits).
15
Tiger Machine Tool Company is considering the acquisition of a new metal
cutting machine. The required initial investment of $75,000 and the
projected cash benefits over a three-year project life are as follows:

You have been asked by the president of the company to evaluate the
economic merit of the acquisition. The firm's MARR is known to be
15%.
Given: Cash flows as tabulated; MARR = 15% per year.
Find: PW.
16
End of Year Net Cash Flow
0 -75,000
1 24,000
2 27,340
3 55,760
To bring each flow to its equivalent at time zero as shown the table:

PW = -75,000 + 24,000(P/F,15%,1) + 27,000(P/F,15%,2) +
55,760(P/F,15%,3) = 3,553

Since the project results in a surplus of $3,553, the project is
acceptable. It is returning a profit greater than 15%.

17
1 2 3
75,000
24,000
27,000
55,760
outflow
inflow
Guidelines for Selecting a MARR
Return: one way to evaluate how your investments in financial
assets or projects are doing in relation to each other and to the
performance of investments in general.
Conceptually, the rate of return is a function of three components:
risk-free real return
inflation factor
risk premium(s)
Zero for safe or risk free (e.g. US Treasury Bills)
Increase risk premium for high risk investment (e.g. Internet
Stock?)
Expect return = risk-free real return + inflation factor + risk premium(s)
18
Meaning of Net Present Worth
In present-worth analysis, two sources to fund
investment:
Investment pool or
Borrowed money at the MARR from the capital
markets
Investment pool:
equivalent to a firm's treasury
left in pool to earn interest at the MARR
may withdraw funds from this investment pool for
other investment purposes
19
Meaning of Net Present Worth
Consider previous example which required an investment of $75,000
If the firm did not invest in the project and instead left the $75,000 in
the investment pool for three years to grow to:
75,000(F/P,15%,3) = 114,066
If the firm invest in the project, the return cash flow would also earn
interest:
24,400(F/P,15%,2) + 27,340(F/P,15%,1) + 55,760(F/P,15%,0) =
119,470
The additional cash accumulation at the end of three years from
investing in the project:
119,470 114,066 = 5,404 Net Future Worth of the Project
the equivalent present worth of this net cash surplus at time zero
$5,404(P/F, 15%. 3) = $3,553 same as in previous example
20
Capitalized-Equivalent Method
A special case of the PW criterion: when the life of a
proposed project is perpetual or the planning horizon is
extremely long
capitalized-equivalent [CE(i)] method for evaluating
such projects
PW(i) = A(P/A,i,N) with N

Same result shown in perpetuity (share of preferred
stock that pays a fixed cash dividend each period and
never matures)
21
i
A
i) i(1
1 i) (1
lim A N) i, (P/A, lim A PW(i)
N
N
N N
=
(
+
+
= =

Road Map
22
Methods to Compare Mutually
Exclusive Alternatives
Until now, considering situations involving only a single
project or projects that were independent of each other.
In both cases, the decision to reject or accept each
project individually, based on whether it met the MARR
requirements, evaluated using the PW.
In this section, evaluation techniques to consider multiple
projects that are mutually exclusive: the selection of
one alternative implies that the others will be excluded.
Consider two cases:
1. analysis period equals project lives and
2. analysis period differs from project lives.
23
Doing Nothing Is a Decision Option
When considering an investment, the project either:
aimed at replacing an existing asset or system
if the existing system still adequate and none of new
proposals economical replacements then do nothing
if the existing system terminally failed, the choice
among proposed alternatives is mandatory
new endeavor:
None of the proposed alternatives economically
sound, do nothing is an option

24
Service Projects vs. Revenue Projects
Service projects: generate revenues that do not depend
on the choice of project, but must produce the same
amount of output( revenue)
PW criterion used to compare alternatives to minimize
expenditures, e.g. choose the alternative with the lower
present-value production cost over the service life
Revenue projects: generate revenues that depend on the
choice of alternative.
Not limiting the amount of input to the project or the
amount of output that the project would generate
Select the alternative with the largest net gains (output -
input).
25
Analysis Period Equals Project Lives
Ansell, Inc., a medical-device manufacturer uses compressed
air in solenoids and pressure switches in its machines to
control various mechanical movements. Over the years,
the manufacturing floor has changed layouts numerous
times. With each new layout, more piping was added to the
compressed-air delivery system in order to accommodate
new locations of manufacturing machines. None of the
extra, unused old piping was capped or removed; thus, the
current compressed-air delivery system is inefficient and
fraught with leaks. Because of the leaks in the current
system, the compressor is expected to run 70% of the time
that the plant will be in operation during the upcoming year.

26
This excessive usage will require 260 kWh of electricity at a
rate of $O.O5/kWh. (The plant runs 250 days a year, 24
hours per day.) Ansell may address this issue in one of two
ways:
Option 1 - Continue current operation: If AnseIl continues
to operate the current air delivery system, the compressor's
run time will increase by 7% per year for the next five
years. because of ever-worsening leaks. (After five years,
the current system will not be able to meet the plant's
compressed-air requirement, so it will have to be replaced.)
27
Option 2 - Replace old piping now: If Ansell decides to
replace all of the old piping now, it will cost $28,570. The
compressor will still run for the same number of days;
however, it will run 23% less (or will incur 70%(1 - 0.23)
= 53.9% usage per day) because of the reduced air-
pressure loss.
If Ansell's interest rate is 12% compounded annually, is it
worth fixing the air delivery system now?
Given: Current power consumption, g = 7%, i = 12%,
and N = 5 years.
Find: A
1
and P.
28
Step 1: We need to calculate the cost of power consumption
of the current piping system during the first year
Power cost = (% of day operating) x (days operating per year) x
(hours per day) x (kWh) x ($/kWh)
Power cost = (70%) x (250 days/years) x (24 hours/days) x
(260kWh) x ($0.05/kWh) = $54,600

PW = 54,600(P/F,12%,1) + 54,600(1+7%)(P/F,12%,2) +
54,600(1+7%)
2
(P/F,12%,3) + 54,600(1+7%)
3
(P/F,12%,4)
29
Step 2: Each year, if the current piping system is left in
place, the annual power cost will increase at the rate of 7%
over the previous year's cost. The anticipated power cost
over the five-year period is summarized in Figure 5.10. The
equivalent present lump-sum cost at 12% interest for this
geometric gradient series is:

P
Option1
= 54,600(P/A
1
,7%,12%,5)

30
222,936 P
7% 12%
12%) (1 7%) (1 1
54,600 P
Option1
5 5
Option1
=
(
+ +
=

Step 3: If Ansell replaces the current compressed-air
delivery system with the new one, the annual power cost will
be 23% less during the first year and will remain at that level
over the next five years. The equivalent present lump-sum
cost at 12% interest is

P
Option2
= 54,600(1 - 23%)(P/A,12%,5)
P
Option2
= 54,600(1 - 23%)(P/A,12%,5)
P
Option2
= 151,553
Step 4: The net cost of not replacing the old system now is
$71,383 (= $222,936 - $ 151,553). Since the new system
costs only $28,570, the replacement should be made now.

31
Analysis Period Differs from Project Lives
Present-Worth Comparison: Project Lives Longer Than
the Analysis Period
Waste Management Company (WMC) has won a contract that requires
the firm to remove radioactive material from government-owned
property and transport it to a designated dumping site. This task
requires a specially made ripper-bulldozer to dig and load the
material onto a transportation vehicle. Approximately 400,000 tons
of waste must be moved in a period of two years. There are two
possible models of ripper-bulldozer that WMC could purchase for
this job:
Model A costs $150,000 and has a life of 6.000 hours before it will
require any major overhaul. Two units of model A will be required in
order to remove the material within two years, and the operating
cost for each unit will run $40,000 per year for 2,000 hours of
operation. At this operational rate, each unit will be operable for
32
Present-Worth Comparison: Project
Lives Longer Than the Analysis Period
for three years, and at the end of that time, it is estimated that the
salvage value will be $25,000 for each machine.

The more efficient model B costs $240,000 each, has a life of 12,000
hours before requiring any major overhaul, and costs $22,500 to
operate for 2,000 hours per year in order to complete the job within
two years. The estimated salvage value of model B at the end of six
years is $30,000. Once again, two units of model B will be required.

Since the lifetime of either model exceeds the required service period
of two years, WMC has to assume some things about the used
equipment at the end of that time. Therefore, the engineers at WMC
estimate that, after two years, the model A units could be sold for
$45,000 each and the model B units for $125,000 each.
33
After considering all tax effects. WMC summarized the resulting cash
flows (in thousands of dollars) for each project as follows:

34
Period Model A (thousand) Model B (thousand)
0 -300 -480
1 -80 -45
2 -80 + 90 -45 + 250
3 -80 + 50 -45
4 -45
5 -45
6 -45 + 60
Given: Cash flows for the two alternatives as shown in table;
i = 15% per year.
Find: PW for each alternative: the preferred alternative.

PW(15%)
A
= -$300 - $80(P/A, 15%. 2) + $90(P/F, 15%, 2) = -$362;
PW(15%)
B
= -$480 - $45(P/A, 15%, 2) + $250(P/F, 15%, 2) = -$364.
Model A has the least negative PW costs and thus would be preferred.
35
Lives Shorter Than the Analysis Period
The Smith Novelty Company, a mail-order firm, wants to install an
automatic mailing system to handle product announcements and
invoices. The firm has a choice between two different types of
machines. The two machines are designed differently, but have
identical capacities and do exactly the same job. The $12,500
semiautomatic model A will last three years, while the fully automatic
model B will cost $15,000 and last four years. The expected cash
flows for the two machines, including maintenance costs, salvage
values, and tax effects, are as follows:
36
Period Model A Model B
0 -12,500 -15,000
1 -5,000 -4,000
2 -5,500 -4,500
3 -6,000 + 2,000 -5,000
4 -5,500 + 1,500
5
Once again, as business grows to a certain level, neither of the models
may be able to handle the expanded volume at the end of year 5. If
that happens, a fully computerized mail-order system will need to be
installed to handle the increased business volume. With this
scenario, which model should the firm select at MARR = 15%?

Given: Cash flows for the two alternatives as shown in Figure 5.12,
analysis period of five years. and i = 15%.
Find: PW for each alternative: the preferred alternative.
37
Since both models have a shorter life than the required service period
(five years), we need to make an explicit assumption of how the
service requirement is to be met. Suppose that the company
considers leasing comparable equipment (Model A) that has an
annual lease payment of $5,000 (after taxes). With an annual
operating cost of $6,500 for the remaining required service period.
The anticipated cash flows for both models under this scenario are
as follows:
38
Period Model A Model B
0 -12,500 -15,000
1 -5,000 -4,000
2 -5,500 -4,500
3 -6,000 + 2,000 -5,000
4 -6,500 5,000 -5,500 + 1,500
5 -6,500 5,000 -6,500 5,000
PW(15%)
A
= -12,500 5,000(P/F,15%,1) -
5,500(P/F,15%,2) - 6,000(P/F,15%,3) -
11,500(P/A,15%,2)(P/F,15%,3) + 2,000(P/F,15%,3)

PW(15%)
B
= -15,000 4,000(P/A,15%,4) 500[(1+15%)
3

i3 1]/[(15%)
2
(1+15%)
3
] - 11,500(P/F,15%,5) +
1,500(P/F,15%,4)

39
Tutorial
Do end chapter problems: 5.1, 5.3, 5.7, 5.8, 5.16, 5.18,
5.30, 5.33, 5.47, 5.49
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Engineering Economics - Present Worth Analysis

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