Chapter 5

Present-Worth Analysis
2
Chapter 5
Present-Worth Analysis
Loan versus Project Cash Flows
Initial Project Screening Methods
Present-Worth Analysis
Methods to Compare Mutually Exclusive
Alternatives

3
Bank Loan vs. Investment Project
Bank
Customer
Loan
Repayment
Company
Project
Investment
Return
Bank Loan
Investment Project
Payback Period
5
Federal Express: A Project Example
Nature of Project:
Equip 40,000 couriers
with PowerPads
Save 10 seconds per
pickup stop
Investment cost: $150
million
Expected savings: $20
million per year
Federal Express
6
Ultimate Questions
Is it worth investing $150 million to save $20
million per year, say over 10 years?
How long does it take to recover the initial
investment?
What kind of interest rate should be used in
evaluating business investment
opportunities?
7
Payback Period
Principle:
How fast can I recover my initial investment?
Method:
Based on cumulative cash flow (or accounting
profit)
Screening Guideline:
If the payback period is less than or equal to
some specified payback period, the project
would be considered for further analysis.
Weakness:
Does not consider the time value of money
8
Example: Conventional Payback
Period
N Cash Flow Cum. Flow
0
1
2
3
4
5
6

-$105,000+$10,000
$15,000
$25,000
$35,000
$45,000
$45,000
$35,000
-$95,000
-$80,000
-$55,000
-$20,000
$25,000
$65,000
$100,000
Payback period should occur
somewhere between N = 3 and N = 4.
9
Example: Conventional Payback
Period
N Cash Flow Cum. Flow
0
1
2
3
4
5
6

-$105,000+$10,000
$15,000
$25,000
$35,000
$45,000
$45,000
$35,000
-$95,000
-$80,000
-$55,000
-$20,000
$25,000
$65,000
$100,000
20,000/45,000= 0.44
Payback period occurs at N =3.44
10
-100,000
-50,000
0
50,000
100,000
150,000
0 1 2 3 4 5 6
Years (n)
~3.44 years
Payback period
$95,000
$15,000
$25,000
$35,000
$45,000 $45,000
$35,000
0
1 2 3 4 5 6
Years
A
n
n
u
a
l

c
a
s
h

f
l
o
w

C
u
m
u
l
a
t
i
v
e

c
a
s
h

f
l
o
w

(
$
)

11
Conventional Payback Period
Period 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
Although the payback periods are the same, Project 2 is better
because most investment is recovered at the end of year 1.
12
Discounted Payback Period
Principle:
How fast can I recover my initial investment
plus interest?
Method:
Based on cumulative discounted cash flow
Screening Guideline:
If the discounted payback period (DPP) is
less than or equal to some specified
payback period, the project would be
considered for further analysis.
Weakness:
Cash flows occurring after DPP are ignored
13
Example: Discounted Payback Period
Calculation
Period Cash Flow Cost of Funds
(15%)*
Cumulative
Cash Flow
0 -$95,000 0 -$95,000
1 15,000 -$95,000(0.15) = -$14,250
-94,250
2 25,000 -$94,250 (0.15) = -14,138
-83,388
3 35,000 -$83,387 (0.15) = -12,508
-60,896
4 45,000 -$60,895 (0.15) =-9,134
-25,030
5 45,000 -$25,030(0.15) = -3,754
16,216
6 35,000 $16,215 (0.15) = 2,432
53,648
* Cost of funds = (Unrecovered beginning balance) X (interest rate)
-95,000-14,250+15,000=
-94,250
Payback periods can be used as a screening
tool for liquidity, but we need a measure of
investment worth for profitability.
Present Worth Analysis
16
Net Present Worth Measure
Principle: Compute the equivalent net surplus at n
= 0 for a given interest rate of i.
Decision Rule: Accept the project if the net surplus
is positive.
2 3 4 5
0 1
Inflow
Outflow
0
PW(i)
inflow
PW(i)
outflow
Net surplus
PW(i) > 0
17
Evaluation of a Single Project
Step 1: Determine the interest rate that the firm wishes
to earn (Required rate of return or 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
Step 6: Find the present worth of each net cash flow,
add up these figures, find projects PW
Step 7: Accept the investment if PW>0, reject otherwise


18
Example - Tiger Machine Tool Company
$75,000
$24,400
$27,340
$55,760
0
1 2
3
outflow
inflow
19
Solution
$75,000
$24,400
$27,340
$55,760
0
1 2
3
outflow
inflow
inflow
outflow
(15%) $24,400( / ,15%,1) $27,340( / ,15%,2)
$55,760( / ,15%,3)
$78,553
(15%) $75,000
(15%) $78,553 $75,000
$3,553 0, Accept
PW P F P F
P F
PW
PW

20
Present Worth Amounts at Varying Interest Rates
i (%) PW(i) i(%) PW(i)
0 $32,500 20 -$3,412
2 27,743 22 -5,924
4 23,309 24 -8,296
6 19,169 26 -10,539
8 15,296 28 -12,662
10 11,670 30 -14,673
12 8,270 32 -16,580
14 5,077 34 -18,360
16 2,076 36 -20,110
17.45* 0 38 -21,745
18 -751 40 -23,302
*Break even interest rate OR the internal rate of return
21
-30
-20
-10
0
10
20
30
40
0
5 10 15 20 25 30 35 40
P
W

(
i
)

(
$

t
h
o
u
s
a
n
d
s
)

i = MARR (%)

$3553
17.45%
Break even interest rate
(or rate of return)
Accept Reject
Present Worth Profile
22
Future Worth Criterion
Given: Cash flows
and MARR (i)
Find: The net
equivalent worth
at the end of
project life
$75,000
$24,400
$27,340
$55,760
0
1 2
3
Project life
23
Future Worth Criterion
inflow
outflow
(15%) $24, 400( / ,15%, 2) $27, 340( / ,15%,1)
$55, 760( / ,15%, 0)
$119, 470
(15%) $75, 000( / ,15%, 3)
$114, 066
(15%) $119, 470 $114, 066
$5, 404 0, Accept
FW F P F P
F P
FW F P
FW

24
What factors should the company
consider in selecting a MARR in
project evaluation?
Rate of return that we expect to earn on an
investment is a function of three components:

to be rewarded for not being able to use our money
inflation factor (decrease in purchasing power)
risk premiums
25
Guideline for Selecting a MARR
Real Return 2%
Inflation 4%
Risk premium 0%
Total expected
return
6%
Real Return 2%
Inflation 4%
Risk premium 20%
Total expected
return
26%
Risk-free
real return
Inflation
Risk
premium
Treasury Bills
Amazon.com
Very safe
Very risky
Can you explain what
$3,553 really means?
Meaning of Net Present Worth
1. Investment Pool Concept
2. Borrowed Funds Concept
27
Investment-Pool Concept
There is an investment pool where the money
earns MARR. The money can be taken from
the pool for other investments.

Suppose the company has $75,000. It has
two options. (1)Take the money out and
invest it in the project or (2) leave the
money in the company. Lets see what the
consequences are for each option.

28
$75,000
0 1 2 3
$24,400
$27,340
$55,760
Investment pool
How much would you have if the
Investment is made?

$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

How much would you have if the
investment was not made?

$75,000(F/P,15%,3) = $114,066

What is the net gain from the
investment?

$119,470 - $114,066 = $5,404
Project
N = 3, MARR = 15%
Meaning of Net Present Worth
PW(MARR) = $5,404(P/F,15%,3) = $3,553
29
Borrowed-Funds Concept
The firm does not have the money required
for investment
Suppose that the firm borrows the required
money from a bank at an interest rate of
MARR

30
Borrowed-Funds and Project
Balance Concepts
N 0 1 2 3

Beginning
Balance

Interest

Payment

Project
Balance
-$75,000


-$75,000
-$75,000

-$11,250

+$24,400


-$61,850
-$61,850

-$9,278

+$27,340


-$43,788
-$43,788

-$6,568

+$55,760


+$5,404
Net future worth, FW(15%)
PW(15%) = $5,404 (P/F, 15%, 3) = $3,553
31
Project Balance Diagram

60,000

40,000

20,000

0

-20,000

-40,000

-60,000

-80,000

-100,000

-120,000


0 1 2 3
-$75,000
-$61,850
-$43,788
$5,404
Year(n)
Terminal project balance
(net future worth, or
project surplus)
Discounted
payback
period
P
r
o
j
e
c
t

b
a
l
a
n
c
e

(
$
)

32
Capitalized-Equivalent Method
Principle: PW for a project with an annual receipt
of A over infinite service life

Example: Public projects such as bridges,
waterway constructions, hydroelectric dams.

Equation: CE(i) = A(P/A, i,) = A/i
A
0
P = CE(i) : Capitalized-equivalent worth
N
33
Practice Problem
10
$1,000
$2,000
P = CE (10%) = ?
0
Given: i = 10%, N =
Find: P or CE (10%)

34
Solution

$2, 000
(10%) $1, 000( / ,10%,10) ( / ,10%,10)
0.10
$13, 855
CE P A P F
10
$1,000
$2,000
P = CE (10%) = ?
0

$1, 000 $1, 000
(10%) ( / ,10%,10)
0.10 0.10
$10, 000(1 0.3855)
$13, 855
CE P F

OR
35
A Bridge Construction Project
Construction cost = $2,000,000

Annual Maintenance cost = $50,000

Renovation cost = $500,000 every 15 years

Planning horizon = infinite period

Interest rate = 5%
36
$500,000 $500,000 $500,000 $500,000
$2,000,000
$50,000
0
15
30
45 60
Years
37
Solution:
Construction Cost
P
1
= $2,000,000
Maintenance Costs
P
2
= $50,000/0.05 = $1,000,000
Renovation Costs
P
3
= $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 (Capitalized-Equivalent)
P = P
1
+ P
2
+ P
3
= $3,463,423
38
Alternate way to calculate P
3
Concept: Find the effective interest rate per payment period
Effective interest rate for a 15-year cycle

i = (1 + 0.05)
15
- 1 = 107.893%

Capitalized equivalent worth
P
3
= $500,000/1.07893
= $463,423
15 30 45 60 0
$500,000 $500,000 $500,000 $500,000
39
Practice Problem
Want to purchase an electrical motor rated at 15HP
for $1,000. (1HP=0.7457kW)
The service life of the motor is known to be 10
years with negligible salvage value.
Its full load efficiency is 85%.
The cost of energy is $0.08 per kwh.
The intended use of the motor is 4,000 hours per
year.
Find the total cost of owning and operating the
motor at 10% interest.

40
Solution

1HP=0.7457kW
15HP = 15 0.7457 = 11.1855kW
Required input power at 85% efficiency rating:
11.1855
13.1594
0.85
Required total kWh per year
13.1594kW 4,000 hours/year =52,638
kW
kW

kWh/yr
Total annual energy cost to operate the motor
52,638kWh $0.08/kWh =$4,211/yr
The total cost of owning and operating the motor for 10 years
(10%) $1,000 $4,211( / ,10% PW P A ,10)
= $26,875
41
0 1 2 3 4 5 6 7 8 9 10
$4,211
$1,000

(10%) $1,000 $4,211( / ,10%,10)

$26,875
PW P A
Comparing Mutually
Exclusive Alternatives
43
Comparing Mutually Exclusive
Projects
Any one of the alternatives will fulfill the
need, others will be excluded.
Mutually exclusive alternatives must be
compared over an equal time span.
If the existing system still works, do-
nothing may also be an alternative.
Cash flows of the new proposals are
generated relative to those of do-nothing:
Incremental costs and returns will be used.
44
Revenue Projects
Projects whose revenues depend on the
choice of alternatives
Alternative with the largest net gains
(output-input) is selected (largest net
present value)
Service Projects
Projects whose revenues do not depend on
the choice of alternative, they must
produce the same amount of output
Alternative with the least cost (lower
present value) is selected

45
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.
46
Comparing Mutually Exclusive Projects
Principle: Projects must be compared
over an equal time span.

Rule of Thumb: If the required
service period is given, the analysis
period should be the same as the
required service period.
47
Case 1: Analysis Period Equals
Project Lives
Compute the PW for each project over its life
$450
$600
$500 $1,400
$2,075
$2,110
0
$1,000 $4,000
A
B
PW (10%) = $283
PW (10%) = $579
A
B
48
Example: Buying versus Lease Decision
Option 1
Debt Financing

Option 2
Lease Financing
Price $14,695 $14,695
Down payment $2,000 $731.45
APR (%) 3.6%
compounded
monthly
Monthly payment $372.55 $236.45
Length 36 months 36 months
Cash due at lease end $300
Selling Price at lease end $8.673.10
49
Which Interest Rate to Use to Compare These Options?
APR = 3.6 % vs. Your Earning Rate at 6%
(both compounded monthly) ?
50
Your Earning Interest Rate = 6%
Effective Monthly Interest Rate =0.5%
Debt Financing:
P
debt
= $2,000 + $372.55(P/A, 0.5%, 36)
- $8,673.10(P/F, 0.5%, 36)
= $6,998.47
Lease Financing:
P
lease
= $731.45 + $236.45(P/A, 0.5%, 35)
+ $300(P/F, 0.5%, 36)
= $8,556.90
51
Case 2: Analysis Period Shorter
than Project Lives
Ex: In the construction industry, the
building project has a shorter completion
time than the useful time of equipment
purchased.

Estimate the salvage value at the end of
the required service period.
Compute the PW for each project over
the required service period.
52
Example - Comparison of unequal-lived service projects
when the required service period is shorter than the
individual project life
Required Service Period = 2 years
53
PW(15%)B = -$364,000
PW(15%)A = -$362,000
54
Case 3: Analysis Period Longer
than Project Lives
Come up with replacement projects
that match or exceed the required service
period
We may assume that the replacement
project will be same as the initial project
Compute the PW for each project over
the required service period
If the analysis period is not given: Select
it as the LCM (lowest common multiple) of
project lives.
55
Example - Comparison for Service Projects with Unequal
Lives when the required service period is longer than
the individual project life
Required
Service
Period
= 5 years
Model A
Model B
$15,000
$12,500
$4,000
$4,500
$5,000
$5,500
$1,500
$5,000
$5,500
$6,000
$2,000
4
5
5
0
0
1
2
3
1
2 3
4
56
Lease Model A to serve the
remaining service life
PW(15%)A = -$35.929
PW(15%)B = -$33,173
57
Example
Machine A Machine B
Purchase cost $6,000 $10,000
Operating cost/year $5,000 $3,000
Estimated life 15 years 10 years
Salvage value $1,000 -
MARR=6%
58
Solution
Analysis period LCM(15,10)=30 years

P
A
=6,000+(6,000-1,000)(P/F,6%,15)+5,000(P/A,6%,30)-
1,000(P/F,6%,30)
=6,000+2,086.5+68,824-174.1=76,736.4

P
B
=10,000+10,000(P/F,6%,10)+10,000(P/F,6%,20)+3,000(P/A,6%,30)
=10,000+5,584+3,118+41,294.4=59,996.4

Choose B
59
Solution
Suppose the required service period is 10 years and salvage value of
machine A is $1,500 at the end of 10
th
year

P
A
=6,000+5,000(P/A,6%,10)-1,500(P/F,6%,10)=41,962.9

P
B
=10,000+3,000(P/A,6%,10)=32,080.3

Choose B
60
Solution
Over an infinite horizon

i
15
=(1+0.06)
15
-1=139.656% per 15 years

P
A
=6,000+(6,000-1,000)/1.39656+5,000/0.06=92,913.559

i
10
=(1+0.06)
10
-1=79.085% per 10 years

P
B
=10,000+(10,000-0)/0.79085+3,000/0.06=72,644.623

Choose B
61
Summary
Present worth is an equivalence method of analysis in which
a projects cash flows are discounted to a lump sum amount
at present time.
The MARR or minimum attractive rate of return is the
interest rate at which a firm can always earn or borrow
money.
MARR is generally dictated by management and is the rate
at which NPW analysis should be conducted.
Two measures of investment, the net future worth and the
capitalized equivalent worth, are variations to the NPW
criterion.

62
The term mutually exclusive means that, when one of
several alternatives that meet the same need is selected,
the others will be rejected.
Revenue projects are those for which the income generated
depends on the choice of project.
Service projects are those for which income remains the
same, regardless of which project is selected.
The analysis period (study period) is the time span over
which the economic effects of an investment will be
evaluated.
The required service period is the time span over which the
service of an equipment (or investment) will be needed.


63

The analysis period should be chosen to cover
the required service period.
When not specified by management or company
policy, the analysis period to use in a
comparison of mutually exclusive projects may
be chosen by an individual analyst (as the
lowest common multiple of project lives).