Lesson Four Present Worth Analysis

One of the things to keep in mind is that when we invest a given amount of money, That
money, as you know, is called the Principle and is represented in equations as P.
However, when we take some future amount and evaluate it as to what it would be
worth today, this is called Present Worth (PW).

In this chapter we will be evaluating Mutually exclusive and independent projects. We

will be evaluating a single alternative and we will be able to select the best of
alternatives with equal life. We will use the PW analysis to evaluate different life
alternatives. We will also begin to select an alternative using capital cost calculations.
We will than be examining various ways the best independent projects, with and without
budget limits. Finally we will look at spreadsheets to select an alternative PW analysis.

Formulating Alternatives.

Projects are either mutually exclusive (ME) or independent.

Mutually exclusive projects are a scenario where only one of the projects
can be selected. Independent Projects are such that one or more of the
projects can be selected. In this case we can evaluate each project and
compare to select, or rank the projects in order of ROI. An example a
mutually exclusive event we could be looking at building ships or planes.
For an independent event we could be evaluating several models of aircraft
to purpose to the government.

Terms for this chapter

1. Salvage value value of any material at the end of a project. Salvage

may be estimated ats a percentage of first cost or an actual monetary
amount. Most often this is either nil or zero value.
2. Annual costs are either named maintenance an operating (M&O)
annual operating costs (AOC)They may be uniform over the life of a
project, or they may decline or increase each year based on a
percentage of an arithmetic series or gradient series.
3. Do nothing is the (DN) alternative selection when none of the options
are attractive.
4. A mutually exclave alternative is the most common in engineering.
 For instance we may be asked to select the best starter for vehicle. It
is simply a choice of one or the other.Mutually exclusive events
compete with each other.
5. Independent projects are usually designed to accomplish different
purposes. Project do not compete with each other. Each project is
evaluated separately and the comparison is the MARR.
6. Savings are treated are treated like revenues.

Present Worth Analysis of Equal life Alternatives

For mutually exclusive projects the following guidelines are applied

1. One alternative is to calculate the PW (present worth) at the MARR.

If PW 0. The alternative is viable.
2. Two or more alternatives: Calculate the PW of each alternative at the
MARR. Select the the alternative with the PW value that is the
largest, that is less negative or more positive.

The calculations for example 4.1 are very straight forward. The only
consideration is what factors to use. P/A is used in annual costs bringing
the value back to present worth. P/F is used because the salvage value is
is a future cost and it s factor P/F brings this to present worth. The tree
numbers derived are than added together to get the PW. The PW for all
three alternatives are than looked at and the numerically largest is
selected.

Evaluation of Bond Purchases

Bond information:

1. A bond is a note for a loan. The investor lends the money to the
corporation, Therefore they are IOUs for the corporation.
2. Each bond is for a specified number of years, 1, 5, 10 or more years
3. Each bond has a face value V of $100, $1000, $5000. This loan is
repaid at maturity (the end life of the bond)
4. Bonds pay interest (i) (dividends)( each period to the lender. As a
 side note should a corporation go belly up (go bankrupt) bond holders
are paid by the liquidation of assets ahead of stockholders. For this
reason they are more secure than stock.
(bond face value)(Bond rate) Vb
Formula I= Nuber of payments (didvidens)per year = c At the time of the sale of
the bond it may sell at more or less than its face value, depending on the
how solid the corporation is financially. A purchase discount is more
attractive financially to the purchaser, a premium is better for the issuer.
Bonds at a premium means that a $1000 bond (face value) might sell for
$1050. Discounted means that a $1000 bond (face value) might sell for
$950. A good example of this is written on page 89 under 4.2.2 Secdond
paragraph. To evaluate a bond purchase, determine the PW at the MARR
of all cash flows. Basically these are the purchase price of the bond, each
didvidends and the period used, and the bond price at maturity. Lokk at
problem 4.2 page 100.

I = 5000(.06) / 2 = $150 every 6 months n= 20 payments (semi annual for

10 years The semi annual MARR is 6.7/2 = 3.35% and the purchase price
is = PW = -4750 (computed as (.05 )(5000) for a % discount) + 150(P/A,
3.35%,20) dont forget that the period is semiannual so n =20) + (P/F,
3.35% 20) (P/F because we are looking at the principal in the future)

Present Worth Analysis of Different life Alternatives

When you evaluate Present Worth the life cycles must be equal. If you not
do this shorter service comparisons will almost always win. There are two
ways to compute PW analysis when there are unequal life services.

1. Evaluate over a specific study period.

2. Use the least common multiple lives for each pair of alternatives.

Study Period. This is the most common way used to approach the problem
of unequal service periods. Once a study period is selected, only cash
flows during this time frame is considered. If an expected life is longer than
this period, the estimated market value is considered the salvage value in
the last year of the study period.

Future Worth

Sometimes we can look at FW to select an alternative. The FW is

determined directly from the cash flows, or by multiplying the PW value by
the FP value for the MARR

Life-cycle costs (LCC)

This section is very well covered in your book on page 103

Capitalized Cost Analysis (CC)

Capital costs are costs that last forever. This includes such public projects
like Railroads, Bridges and dams, to name a few. It is because thes
projects maintain lives of 30, 40, or more years. Look at how long the
Washington Bridge has been collecting tolls or the Lincoln and Holland
tunnels.
A AW
The Formulas CC = i = i PW = A(P/A,I,n) A = CC(i)

Recurring Costs Those costs that repeat year after year such as annual
maintenance

Non Recurring Costs Are one-time costs such as purchase price.

The following procedure will assist you in calculating CC for an infinite

sequence of cash flows.

1. Draw a cash flow (very Important) for all non recurring and at least
two cycles of recurring costs.(Cash flows are most important in CC
calculations more than in other forms of project evaluation)
2. Find the PW of all non recurring costs this is their CC value
3. Find the equivalent uniform annual worth (A value) through o ne life
 cycle of all recurring amounts. This is the same value for all
succeeding life cycles. Add this to all other uniform amounts
occurring in year 1 through infinity. The result is the total equivalent
uniform annual worth, (AW)
4. Divide the AW by the interest rate I to obtain CC value
5. Add the CC values in step 2 and 4

Problem 4.4

This takes quite a bit of calculation, but the example is very well done.
Follow the steps shown above along with the example. The final answer is
A = C + C + C

This took a full page of calculations to follow the steps outlined above.
Howver, I think it is important to this chapter that you do at least this sample
problem.

Also review the section on using spreadsheets for PW analysis