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ENGR 3360U Winter 2014

Unit 5.6-7
Life Cycle Costs and Bonds
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-01

Unit 5 Present Worth Analysis

Change Record
2014-I-01 Initial Creation
Text Chapter 5

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2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

5.6 Life Cycle Costs


Another extension of present worth method
Applied to systems over their total estimated system
life span
Critical to estimate the system life span in years
Difficulties estimation of costs far removed from
time t = 0
The life cycle may be defined by two main time
phases

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Life Cycle Concept


Two main phases are:
Acquisition Phase
Operations Phase

Many cash flow estimates are

needed, thus making the analysis


less reliable as the life gets
longer

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

5.7 Present Worth of Bonds


Bond problems typical present worth application
Common analysis problem in the world of finance
Bond is basically an iou
Bond represent debt financing
Corporations sell bonds to raise capital
Bonds pay a stated rate of interest (bond dividend) to
the bond holder for a specified period of time

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Bonds Parameters and Examples


1.
2.
3.
4.

Face value, V = $1000


Life of the bond, n = 30 years
Coupon rate, b = 8% per year, paid quarterly
Number of dividend payments per year, c = 4
Bond dividend = I = Vb/c
I = 1000(.08)/4 = $20 per quarter

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Types of Bonds
Type

5-7

Issued By

Characteristics

Examples

Treasury
securities

Ottawa

Backed by
Canada

Bills
Marketable bond
Premium bonds
Savings bonds

Provincial

Provinces

May be
guaranteed

Bonds

Municipal

Local
governments

Issued against
taxes received

Bonds

Mortgage

Corporation

Backed by house

1st mortgage
2nd mortgage
Reverse mortgage

Debenture

Corporation

Backed by
reputation

Convertible

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Cash Flow Profile for Bond Purchase


Typical cash flow to bond buyer:

Repayment
of the face
value

Bond Purchase, V at t = 0

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Example 5.6
Loblaw Ltd. Has issued $5,000,000 worth of $5,000 ten-year
debenture bonds. Each bond pays interest quarterly at 6%.
(a) Determine the amount a purchaser will receive each 3 months
and after 10 years.
(b) Suppose a bond is purchased at a time when it is discounted
by 2% to $4900. What are the quarterly interest amounts and
the final payment at maturity date?

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Solution
(a) The quarterly interest is (5000)(0.06)/4 = $75 and $5000 is
repaid after 10 years
(b) The discount dos not change either the interest or the final
repayment amounts.

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Discounting a Bond
Bonds are seldom purchased for their face value
Most of the time a bond is discounted in the bond
market by a few percentage points
But the face value and the periodic dividend
payments remain unchanged
For example, V = $10,000 bond purchased for 98%
of V now, but repays full face value, V, in 10 years

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Bond Purchase: Example 5.7


$5,000 10-year bond that pays 4.5% semiannually is under consideration
As the potential buyer you require a rate of
return of 8% per year, compounded
quarterly on your purchase
What should you be willing to pay for this
bond now in order to receive at least the
required rate of return?

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2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Bond Purchase: Example


Draw the cash flow diagram using 6 month periods as the unit of time
Bond dividend = $5000(0.045)/2 = $112.50 every 6 months

$5,000

A = $112.50
0

PW = ? (willing to pay)

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18

19

20

n is 20 since bond dividend


payments are semi-annual

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Bond Purchase: Example


Investor requires 8% per year, compounded quarterly
i/qtr = 0.8/4 = 2% per quarter
Effective semiannual rate is (1.02)2 1 = 4.04% per 6 months

$5,000

Find the PW at 4.04% of this cash flow series


A = $112.50

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18

19

20

PW = max amount to pay for the bond


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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Bond Purchase: Example


P = 112.50(P/A,4.04%,20) + 5000(P/F,4.04%,20)
= $3788

If the bond can be purchased for $3788, or less,


the investor will make the required rate of
return
If the bond cost more than $3788, the
investment is not worth it financially

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Spreadsheet Applications PW
Analysis and Payback Period
Review the Excel financial functions
NPV and PV functions are useful analysis
tools built into Excel

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 5 Present Worth Analysis

Chapter Summary
PW method requires comparison over same number of
years equal service comparison
Alternative comparison using PW select the alternative
with the numerically larger PW value, that is, higher new
positive cash flow value, or lower net cost in PW terms
Extension of PW method are: capitalized cost, life-cycle
costs, payback period, bonds
Never use payback period as the primary selection
method; only as supplemental with other methods such
as PW, FW, AW or ROR (as covered in later chapters )

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco