Present Worth Analysis

Same-Length Analysis Period

PW Formula
Different-Length Analysis Periods
Infinite-Length Analysis Period – Capitalized Costs
Comparing Alternatives
Concepts and Assumptions

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Present Worth Analysis
In the last two chapters we learned:
1. the idea of equivalence of various cash flows for the same interest rate
2. various compound interest factors.

Now we begin to make use of these subjects.

To choose among various feasible alternatives we employ the idea of economic efficiency.

Situation Criterion Example

Fixed input Maximize output Shop for clothes for the school
year given $200

Fixed output Minimize input Find a cheapest rental car

Free input & output Maximize Pick a best mutual fund

(output – input)

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Present Worth Analysis
Present worth analysis (PWA) can resolve alternatives into equivalent present
consequences.

“Present worth analysis is most frequently used to determine the present value
of future money receipts and disbursements.”
 We can restate the above three criteria in terms of PWA as follows:
Case Situation Criterion
 
Fixed input Amount of money or other input Maximize PW of benefits or
resources fixed other outputs.
 
Fixed output A fixed task, benefit, or other output Minimize PW of costs or other
must be accomplished. inputs
 
Free input & Amounts of money, other inputs, Maximize Net PW, which is PW
output amounts of benefits, other outputs of benefits less PW of costs.
can vary.

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Present Worth Analysis
“Careful consideration must be given to the time period covered by the
analysis.”

The time period is usually called the analysis period, or the planning
horizon.

Three different analysis-period situations occur:

1. The useful life of each alternative equals the analysis period.

2. The alternatives have useful lives different from the analysis
period (and from each other).
3. The analysis period is effectively infinite.

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Same-Length Analysis Periods

Example 5-1. GatorCo is considering buying device A or B. Each device can reduce costs. Each
device has a useful life of five years, and no salvage value. Device A saves $300 a year, device
B saves $400 the first year, but savings in later years decrease by $50 a year. Interest is 7%.
Which device should they choose?

Device A:
NPW = 300 (P/A,7%,5) = 300 (4.1000) = $1230

Device B:
NPW = 400 (P/A,7%,5) - 50 (P/G,7%,5) = 400(4.1000) - 50 (7.647) = $1257.65

Device B has the largest NPW of benefits.

Device B gives more of its benefits in the earlier years.

Note, If we ignore the time value of money (we should not), both devices have a NPW of benefits of $1500.

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Same-Length Analysis Periods

Example Wayne County plans to build an aqueduct to carry water. The county can:
a) spend $300 million now, and enlarge the aqueduct in 25 years for $350 million
more,
b) construct a full-size aqueduct now for $400 million.

The analysis period is 50 years. We ignore maintenance costs. Interest is 6%. There
is no salvage value.
a) NPW = $300 million + $350 million (P/F,6%,25) = $381.6 million
b)   NPW = $400 million
This is an example of stage construction. The two-stage construction appears
preferable.

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Same-Length Analysis Periods

Example The mailroom needs new equipment. Alternative choices are as below:
Either choice will provide the same desired level of (fixed) output.

Make Cost Useful life EOL salvage value

Speedy $1500 5 years $200
Allied $1600 5 years $325

Speedy: NPW = 1500 – 200 (P/F,7%,5) = 1500 – 200 (0.7130)

= 1500 – 143 = $1357.
Allied: NPW = 1600 – 325 (P/F,7%,5) = 1600 – 325 (0.7130)
= 1600 – 232 = $1368.
Remark. We have omitted maintenance costs from the analysis. Assuming both pieces
of equipment have the same annual maintenance costs, why is this omission justifiable?

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Same-Length Analysis Periods
Suppose each has a maintenance cost of C per year. Then each
would have a PW of maintenance costs of: C (P/A,7%,5).
 
The revised PW of the costs would be:
 
Speedy: $1358 + C (P/A,7%,5).
 
Allied: $1367 + C (P/A,7%,5).
 
The difference between the PW’s remains the same. Unless
other factors not considered above, we would still prefer Speedy.

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 PV Formula
Example
We must choose a weighing scale to install in a package filling operation in a
plant. Either scale will allow better control of the filling operation, and result in
less overfilling. Each scale has a life of 6 years. Interest is 6%.
 
Alternative Cost Uniform annual EOL salvage
benefit value
Atlas $2000 $450 $100

Tom Thumb $3000 $600 $700

 
We use the formula:

NPW = PW of benefits – PW of costs

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 PV Formula
Atlas:
NPW = 450 (P/A,8%,6) + 100 (P/F,8%,6) – 2000
= 450 (4.623) + 100 (0.6302) - 2000
= 2080 + 63 – 2000 = $143
  Tom Thumb:
NPW = 600 (P/A,8%,6) + 700 (P/F,8%,6) – 3000
= 600 (4.623) + 7700 (0.6302) – 3000
= 2774 + 441 – 3000 = $215
Tom Thumb looks preferable. 
Remark. The NPV formula is of fundamental importance. It
uses the fact that the PV formula is additive:
PW (benefits – costs) = PW (benefits) – PW (costs)

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Different-Length Analysis Periods
Sometimes the useful lives of projects differ from the analysis period.
 
Example The mailroom needs new equipment. Alternative choices are
as follows:
Make Cost Useful life EOL salvage value
Speedy $1500 5 years $200
Allied $1600 10 years $325

We no longer have a situation where either choice will provide the

same desired level of (fixed) output.
Speedy equipment for five years is not equivalent to Allied equipment
for ten years.

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 200 200 200

1500 1500 1500

325 325
5 years 5 years

1600 1600

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 Different-Length Analysis Periods
Allied for 10 years:
 
PW = 1600 – 325 (P/F,7%,10) = 1600 – 325 (0.5083)
 
= 1600 – 165 = $1435.
 
Speedy for 5 years:
 
PW = 1500 – 200 (P/F,7%,5) = 1500 – 200 (0.7130) = $1368.

 
We can no longer make a direct comparison:
APPLES AND ORANGES!

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Different-Length Analysis Periods
One possibility: Compare one Allied with two Speedy’s
We buy a Speedy for $1500, use it for 5 years, get $200 salvage, buy a second
Speedy for $1500, use it for the second 5 years, and again get $200 salvage.
 
Two Speedy’s:

PW
  = 1500 + (1500 – 200) (P/F,7%,5) – 200 (P/F,7%,10)
  = 1500 + 1300 (0.7130) – 200 (0.508)
= 1500 + 927 – 102 = $2325.

Allied for 10 years:

PW
  = 1600 – 325 (P/F,7%,10) = 1600 – 325 (0.5083)
= 1600 – 165 = $1435.

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Different-Length Analysis Periods
Generalization. “The analysis period for an economy study should be determined from the
situation.”
The period can be:
• short: PC manufacture,
• intermediate length: steel manufacture
• indefinite length: national government
 
“Least common multiple” idea.
In the above example, it made some sense to use 10 years as the analysis period.
 
If one piece of equipment had a life of 7 years, and the other a life of 13 years, and we followed
the same approach, we would need to use
7 (13) = 91 years. But an analysis period of 91 years is not too realistic.

Terminal Value Idea.

We estimate terminal values for the alternatives at some point prior to the end of their useful lives.

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 Different-Length Analysis Periods
 
Alternative 1 Alternative 2
C1 = initial cost C2 = initial cost
S1 = salvage value T2 = terminal value at the end of 10th year
R1 = replacement cost
T1 = terminal value at the end of 10th year

S1 T1 S1

C1 R1

T2 S2

C2
7 years 3 years 3 years 1 year

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 Infinite-Length Analysis Periods – Capitalized Cost
 
Present worth of costs with 10-yr. analysis period:
 
PW1 = C1 + (R1 – S1) (P/F,i%,7) – T1 (P/F,i%,10)

PW2 = C2 – T2 (P/F,i%, 10)

 
Infinite Analysis Period – Capitalized Cost.
 
Sometimes the analysis period is of indefinite length.
The need for roads, dams, pipelines, etc. is sometimes considered permanent.
The authors refer to this situation as an infinite analysis period.
Present worth analysis in this case is called capitalized cost.
 
Capitalized cost is the present sum of money that would need to be set aside now, at
some know interest rate, to yield the funds needed to provide a service indefinitely.

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 Infinite-Length Analysis Periods – Capitalized Cost

Motivating Example.
Ima Rich wants to set up a scholarship fund to provide $20,000 yearly to deserving
undergraduate women engineering students at UF. UF will invest her donation, and
expects it to earn 10% a year. How much will Ima need to donate in one lump sum
so that $20,000 is available every year?
 
Observation. If Ima donates $200,000, 10% of it is $20,000. The money grows in
one year to $220,000, a scholarship is funded, $200,000 remains, and grows in
another year again to $220,000, another scholarship is funded, etc.
With P = $200,000, i = 10%, A = $20,000, we see that:
 
P=A/iA=Pi
 
In fact this approach works generally. To make an amount A available every year
beginning with an initial present sum P and given an interest rate i, just take P = A/i.
P is called the capitalized cost.

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Infinite-Length Analysis Periods – Capitalized Cost
Example LA plans a pipeline to transport water from a distant watershed area to the city. The
pipeline will cost $8 million and have an expected life of 70 years. The water line needs to be kept in
service indefinitely. We estimate we need $8 million every 70 years. Compute capitalized cost
(compounding 7% yearly).
 
8M 8M 8M

P=?
To find the capitalized cost, we first compute an annual disbursement A that is equivalent to $8
million every seventy years.
8M
A A A A A A

A = F (A/F,i,n) = 8 million (A/F,7%,70) = 8 million (0.00062) = $4960

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Infinite-Length Analysis Periods – Capitalized Cost
8M A A A A A A A A

P
Capitalized cost P = $8 million +A/i = $8 million +4960/0.07 =$8 million+$71,000 = $8,071,000.
 
We spend $8 million initially, and are left with $71,000.
From the $71,000 we get $4,960 yearly for 70 years.
The amounts of $4,960 grow over 70 years at 7% interest to $8 million.
At the end of 70 years we then have $8,071,000.
We spend the $8 million for a second pipeline, are left with $71,00, etc.
 
Another approach. We can assume the interest is for 70 years, and compute an equivalent interest
rate for the 70-year period. Then we compute the capitalized cost. We use the effective interest
rate per year formula 0.07
 
i70 years = (1 + i1-year)70 – 1 = 112.989.
 
P = $8 million + $8 million/112.989 = $8,071,000.

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Comparing Alternatives
WARNING. Infinite period analysis is VERY approximate. There is little likelihood that the
problem or the data will remain the same indefinitely.
 
Multiple Alternatives. The above approach generalizes to more than two alternatives. Just compute
the NPV of each alternative, and then pick the one with the best NPV.
 
Example A contractor must build a six-miles-long tunnel. During the five-year construction
period, the contractor will need water from a nearby stream. He will construct a pipeline to carry the
water to the main construction yard. Various pipe diameters are being considered.
  Pipe diameter
  2” 3” 4” 6”
Installed cost of pipeline & pump $22,000 $23,000 $25,000 $30,000
Pumping Cost per hour. $1.20 $0.65 $0.50 $0.40

The salvage value of the pipe and the cost to remove them may be ignored.
The pump will operate 2,000 hours per year.
The lowest interest rate at which the contractor is willing to invest money is 7%.
(This is called the minimum attractive rate of return, abbreviated as MARR.)

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Comparing Alternatives
We compute the present worth of the cost for each alternative. This cost is equal to the
installed cost of the pipeline and pump, plus the present worth of five years of pumping
costs.
Pumping costs:
2” pipe: 1.2 (2000) (P/A,7%,5) = 1.2 (2000) (4.100) = $9,840.
 3” pipe: 0.65 (2000) (4.100) = $5,330
 4” pipe: 0.50 (2000) (4.100) = $4,100.
 6” pipe: 0.40 (2000) (4.100) = $3,280.
 PW of all costs:
2” pipe: $22,000 + $9,840 = $31,840
3” pipe: $23,000 + $5,330 = $28,330
4” pipe: $25,000 + $4,100 = $29,100 
6” pipe: $30,000 + $3,280 = $33,280.
 
Question: Which pipe size would you choose?

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Comparing Alternatives
Example An investor paid $8,000 to a consulting firm to analyze what to do with a
parcel of land on the edge of town he bought for $30,0000.
The consultants suggest four alternatives.
An investor always has the alternative to do nothing. It is not too exciting, but may be
better than other choices. (Assume he can sell the land for $30,0000)

We maximize the net present worth.

  Alternative Tot. Invest. Uniform net annual Terminal value,

benefit yr. 20.
A Do nothing $0 $0 $0
B Vegetable $50,000 $5,100 $30,000
market
C Gas station $95,000 $10,500 $30,000
D Small motel $350,000 $36,000 $150,000

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 Comparing Alternatives
30K
Example
5.1K
Project B cash flow chart

50K
Alternative A: do nothing, NPW = 0
Alternative B: Vegetable market
NPW = -50,000 + 5,100 (P/A,10%,20) + 30000 (P/F,10%,20)
= -50,000 + 5,100 (8.514) + 30000(0.1486) = - 50,000 + 43,420 + 4,460 = - $2,120.
Alternative C: Gas station
NPW = -95000 + 10500 (P/A,10%,20) + 30000 (P/F,10%,20)
= -95,000 + 10500 (8.514) + 30000(0.1486) = - 95,000 + 9,400 + 4,460 = - $1,140.
Alternative D: Small motel
NPW = -350,000 + 36000 (P/A,10%,20) + 150000 (P/F,10%,20)
= -350,000 + 36000 (8.514) + 150000(0.1486) = - 350,000 + 306,500 + 23,290 = - $21,210.
In this case it is best to do nothing.

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Comparing Alternatives
Important note.
The $8,000 the investor spent for consulting services is a past cost, and is called a sunk
cost. The only relevant costs in the economic analysis are present and future costs.
Past events and past costs are gone and cannot be allowed to affect future planning.
The only exceptions occur in computing depreciation charges and income taxes.
 
If the investor decides to gamble on one of the above alternatives to try to recover the
sunk cost it would not be a good risk.
 
The authors do not mention it, but the sort of analysis the consultants did to provide the
table was probably very approximate. Predicting the future is always very tricky.

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 Comparing Alternatives
  Example Strip Mining. Land can be purchased for $610,000 to be strip-mined for
coal. Annual net income will be $200,000 per year for ten years. At the end of ten
years, the surface of the land must be restored according to federal law. The cost of
reclamation will be $1,500,000 in excess of the resale value of the land after it is
restored. The interest rate is 10%. Is the project economically justifiable?

NPW = -610 + 200 (P/A,10%,10) – 1500 (P/F,10%,10)

= - 610 + 200 (6.145) + 1500 (0.3855)
= - 610 + 1229 – 578 = +$41 ($41,000)

The NPW is positive, so the answer is “yes”.

 
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  Concepts and Assumptions
End-of-Year Convention
 
Textbooks in this area usually follow an end-of-year convention. For each time period, all the series of receipts
and disbursements occur at the end of the time period. If, in fact, they do not, you can replace them by their
equivalent values at the end of the year. Multiply each by the appropriate factor (F/P,i %,n) to move it to the end
of the year.
 
Viewpoint of Economic Analysis Studies.
 
Usually we take the point of view of an entire firm when doing an industrial economic analysis. What is best for
the entire firm may not be best for smaller groups in the firm. It is easy to make a bad decision if we ignore part of
the problem.

Sunk Costs

It is the differences between alternatives that are relevant to economic analysis. Events that have occurred in the
past have no bearing on what we should do in the future. What is important are the current and future differences
between alternatives. Past costs, like past events, have no bearing on deciding between alternatives unless the past
costs somehow actually affect the present or future costs. Usually, past costs do not affect the present or the future
costs, so we call them sunk costs and disregard them.

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Concepts and Assumptions

Borrowed Money Viewpoint

Economic analyses involve spending money. It is thus natural to ask the
source of the money. There are two aspects of money to determine: 

Financing – obtaining the money

 
Investment – spending the money 

Experience shows it is important to distinguish between these two aspects.

Failure to separate them sometimes leads to confusing results and poor decision
making. The conventional assumption in economic analysis is that the money
required to finance alternatives and/or solutions in problem solving is considered to
be borrowed at interest rate i.

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Concepts and Assumptions

Effect of Inflation and Deflation
  For the time being we assume prices are stable. We deal with inflation and
deflation later in the course.

Income Taxes
We defer our introduction of income taxes into economic analyses until later.

Stability
The economic situation is stable.

  Determinism This is a strong assumption.

It is almost never satisfied.
All data of interest are known
deterministically (no randomness)
and can be accurately predicted.

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