10/11/2024

MS-291: Engineering Economics

(3 Credit Hours)

Chapter 2
Factors: How Time and Interest
Affect Money

Engineering
Economics &
Management
(MS291)

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Content of the Chapter

❖ Single-Payment Compound Amount Factor (SPCAF)

❖ Single-Payment Present Worth Factor (SPPWF)

❖ Uniform Series Present Worth Factor (USPWF)

❖ Capital Recovery Factor (CRF)

❖ Uniform Series Compound Amount Factor

❖ Sinking Fund Factor (SFF)

❖ Arithmetic Gradient Factor

❖ Geometric Gradient Series Factor

Join MS Team

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Chapter 5
Present Worth
Analysis

Content of the Chapter

1. Formulate Alternatives
2. Present Worth of equal-life alternatives
3. Present Worth of different-life alternatives
4. Future Worth analysis
5. Capitalized Cost analysis

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Previous Lecture
• Background
• Mutual Exclusive versus independent
Projects
• Revenue versus Cost Projects/Alternatives

PW Analysis Procedure

• The PW analysis is quite popular in industry because

all future costs and revenues are transformed to
equivalent monetary units NOW /Time “0”

This Criteria work as follows;

1. Convert all cash flows to Present Worth (same as
present value) using MARR
2. Precede costs by minus sign; receipts by plus sign
3. The numerical value obtain is called NPV/PW

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Present Worth Analysis

Evaluation
Mutually exclusive projects
• For one project, it is economically viable if PW ≥ 0.
• For 2 or more alternatives, select the one with the
(numerically) largest PW value.

Independent Projects
• Select all projects with PW ≥ 0
• However, in practice a budget limit exists (details in chapter 12)

REMEMBER: This Evaluation is for the case when

alternatives have equal life

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Example 1: Selection of Alternatives

by Present Worth Criteria
For the alternatives shown below, which should be selected if they
are (a) mutually exclusive; (b) independent?

Project ID Present Worth

A $ 30,000
B $ 12,500
C $ — 4,000
D $ 2,000

Solution: (a) Select numerically largest PW; alternative A

(b) Select all with PW > 0; projects A, B & D

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Example 2: PW evaluation of equal-life

Mutually Exclusive alternatives
• Alternative X has a first cost of $20,000, an operating cost of $9,000 per year, and a $5,000
salvage value after 5 years.
• Alternative Y has a first cost $35,000 with an operating cost of $4,000 per year and a
salvage value of $7,000 after 5 years.
• At a MARR of 12% per year, which should be selected based on PW?

Solution: Cash flow diagram ? Any one ?

Find PW at MARR and select numerically larger PW value
• Convert all cash flows
PWX = —20,000 — 9000(P/A,12%,5) + 5000(P/F,12%,5) to Present Worth
(same as present
= —$49,606 value) using MARR
PWY = —35,000 — 4000(P/A,12%,5) + 7000(P/F,12%,5)
• Precede costs by
= —$45,447 minus sign; receipts
by plus sign
Practice: Example
Select alternative Y 5.1

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Class Practice: PW Analysis

Electric Gas powered Solar
powered powered
First Cost($) ‒4500 ‒3500 ‒6000
Annual Operating Costs ‒900 ‒700 ‒50
($/year)
Salvage value S ($) 200 350 100
Life years 8 8 8
10% Single Payments Uniform Series Factors

n Compoun Present Sinking Compound Capital Present

d Amount Worth Fund (A/F) Amount Recovery Worth (P/A)
(F/P) (P/F) (F/A) (A/P)
8 2.1436 0.4665 0.08744 11.4359 0.18744 5.3349

PWE = ‒4500 ‒ 900( P/A ,10%,8) + 200( P/F ,10%,8) = ‒$9208

PWG = ‒3500 ‒ 700( P/A ,10%,8) + 350( P/F ,10%,8) =‒$7071
PWS = ‒6000 ‒ 50( P/A ,10%,8) + 100( P/F ,10%,8)= ‒$6220
‒$6220 Solar powered alternative should be selected
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PW of Different-Life
Alternatives
• For alternatives with unequal lives the rule is:
“PW must be compared over the same number of years”

• This is called “equal service alternatives”

requirement (i.e., alternatives must end at the same
time)… Why its important ?

• Because if this condition is not meet, For COST

ALTERNATIVES (which involves only cost) will always
favor the shorter-lived mutually exclusive alternative,
even if it is not the more economical choice, because
fewer periods of costs are involved

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PW of Different-Life
Alternatives
The following are two equal ways of “meeting the
equal service” requirements:
1. Least Common Multiple (LCM) of alternative
lives
Compare the PW of alternatives over a period of time
equal to the least common multiple (LCM) of their
estimated lives
2. Study Period Approach
Compare the PW of alternatives using a specified
study period of n years. This approach does not
necessarily consider the useful life of an alternative.
The study period is also called the planning horizon.
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LCM of Alternative Lives

Approach
• This approach compare the PW of alternatives
over a period of time equal to the least common
multiple (LCM) of their estimated lives
Three assumptions of LCM Approach
1. The service provided is needed for LCM years or
more.
2. The selected alternative is repeated over each
life cycle of the LCM in exactly the same manner.
3. Cash flow estimates are the same in every life
cycle (i.e., change are exactly by the inflation or deflation
rate only)

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Evaluation of Present Worth

Using a LCM Approach
1. First, find the LCM for the life of alternatives
2. Second, expand the cash flows for each
alternatives till the LCM period …thus meeting
the equal service requirement
3. Calculate the present worth for all the
alternatives
4. Use the criteria used for “Equal Life Alternatives”
to evaluate the alternatives

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Study Period Approach

• Compare the PW of alternatives using a

specified study period of n years. This
approach does not necessarily consider the
useful life of an alternative. The study period
is also called the planning horizon.

• A study period analysis is necessary if the

first assumption of LCM approach (i.e., The
service provided is needed for LCM years or more )
cannot be made.

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Evaluation of Present Worth

Using a Study Period

• For the study period approach, a time horizon is chosen

over which the economic analysis is conducted, and only
those cash flows which occur during that time period are
considered relevant to the analysis

• Once a study period is specified, all cash flows after this time
are ignored

• Salvage value is the estimated market value at the end of

study period (at this stage we will just use Salvage value as it is)

• Short study periods are often defined by management when

business goals are short-term
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Example:
Use of PW criteria for Different-Life
Alternatives

National Homebuilders, Inc., plans to purchase new cut-and-finish

equipment. Two manufacturers offered the estimates below.
Vendor A Vendor B
First cost, $ 15,000 18,000
Annual cost, $/year 3,500 3,100
Salvage value, $ 1,000 2,000
Life, years 6 9

(a) Determine which vendor should be selected on the basis of a

present worth comparison, if the MARR is 15% per year.

(b) National Homebuilders has a standard practice of evaluating all

options over a 5-year period. If a study period of 5 years is used
and the salvage values are not expected to change, which vendor
should be selected?
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(a) Determine which vendor should be selected on the basis of a present worth
comparison, if the MARR is 15% per year.
What is LCM of 6 and 9 ?
Solution: LCM = 18 years; We draw its cash flows to make things easy
To meet the criteria of equal service
alternatives …we extended the
project life from 6 years to 18
years for the first alternative (& 9 to
18 for 2nd alternative)

NOW You have equal life two

alternatives(equal service
condition meet) with cash
flows…you can use standard
procedure to obtain the present
value of both and compare it.

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PW Calculations
PWA = -15,000 ―15,000(P/F,15%,6) +1000(P/F,15%,6) ―15,000(P/F,15%,12)
+1000(P/F,15%,12) + 1000(P/F,15%,18) ― 3,500(P/A,15%,18)
= $ ― 45,036
PWB = -18,000 ― 18,000(P/F,15%,9)+ 2000(P/F,15%,9)+ 2000(P/F,15%,18)
― 3100(P/A,15%,18)
= $ – 41,384
Which one to select ? … A or B ? Select vender B
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Use of Study Period Approach

Solution (b): Now
comparison is required for
5 years. Since cash flows
are of 6 years …no cycle
repeat is required

Salvage value is the

estimated market
value at the end of
study period

We r told here…to
PWA = -15,000 ― 3,500(P/A,15%,5) +1000(P/F,15%,5) that salvage value is
= $ ― 26, 236 not expected to
change
PWB = -18,000 ― 3100(PA,15%,5) + 2000(P/F,15%,5)
= $ – 27,397

Which one to select ? … A or B ? Select vender A

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PW of Different-Life Alternatives
for independent alternatives

• Can we use LCM approach for Independent projects ?

• For independent projects , use of the LCM approach is

unnecessary since each project is compared to the do-nothing
alternative, not to each other

• Equal-service requirement is not a problem

• Use the MARR to determine the PW over the respective life of

each project, and select all projects with a PW 0

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Future Worth Analysis

• Future Worth is exactly like PW analysis, except
“Future Worth Must compare alternatives for equal
service (i.e. alternatives must end at the same time)”

• The selection guidelines for FW analysis are the

same as for PW analysis; FW ≥ 0 means the MARR
is met or exceeded

• For two or more mutually exclusive alternatives,

select the one with the numerically largest FW
value.

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Future Worth Analysis

• If life of two alternatives are not equal, one need to fulfill

the equal service requirement for using FW criteria.

• Two ways to compare equal service:

1. Least common multiple (LCM) of lives
2. Specified study period

• Same way as used for Present Worth Analysis expect

once life of alternatives are equal for cash flows, one
need to compare the Future Worth instead of Present
Worth

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Example: Future Worth Analysis

(Problem 5.26)
An industrial engineer is considering two robots
for purchase by a fiber-optic manufacturing
company. Robot X will have a first cost of
$80,000, an annual maintenance and operation
(M&O) cost of $30,000, and a $40,000 salvage
value.
Robot Y will have a first cost of $97,000, an annual
M&O cost of $27,000, and a $50,000 salvage
value. Which should be selected on the basis of a
future worth comparison at an interest rate of 15%
per year? Use a 3-year study period.
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Future Worth Analysis

(Problem 5.26)
$40,000 $50,000

F=? i = 15%
i = 15%
F=?
0 1 2 3
0 1 2 3
A = $30,000 A = $27,000

$80,000 $97,000 Robot Y CF

Robot X CF

FWX = – 80,000(F/P,15%,3) – 30,000(F/A,15%,3) + 40,000

= – 80,000(1.5209) – 30,000(3.4725) + 40,000
= $-185,847
FWY = – 97,000(F/P,15%,3) – 27,000(F/A,15%,3) + 50,000
= – 97,000(1.5209) – 27,000(3.4725) + 50,000
= $ – 191,285 Select robot X
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Capitalized Worth Analysis

• The capitalized worth method is especially useful in

problems involving public projects with indefinite
lives, or permanent endowments(or donations) for
charitable organizations and universities

• Capitalized worth is the present worth of all

revenues or expenses over an infinite length of
time

• If only expenses(cost alternative) are considered this

is referred as capitalized cost

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Capitalized Worth Analysis

• The Capitalized Worth of a series of end-of-period
uniform payments A, with interest at i% per period, is
CW (or CC) = A(P/A, i%, n) where n→∞
As N becomes very large (if the A are perpetual payments)
1
1−
(1+𝑖)𝑛
• We already know that P/A is given as P/A= 𝐴
𝑖
1
• The term in the bracket becomes as n tends to infinity
𝑖
• So, the above equations become as:
1
Capitaized Worth (or Capitalized Costs) = 𝐴
𝑖
𝐴 𝐴𝑊
CW or CC = or
𝑖 𝑖

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Capitalized Worth Analysis

• The equation can be understood by “thinking” of …..

“ What present amount invested today at “i” will enable an
investor to periodically withdraw an amount A forever”

• If investor withdraw more than amount A each period,

he/she will be withdrawing a portion of the initial
principle and eventually it will exhaust

• If amount being withdrawn each period is equals the

interest earned on the principal for that period, the
principal remains intact, thus series of withdraw will continue
forever

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Example: Capitalized Worth

(Costs) Problems

• Capitalized worth (or costs) type problems vary

from very simple to somewhat complex

• Consider a “simple” Capitalized Cost type

problem

• A person want to donate $100, 000 for

scholarships in a university. Consider, 20%
per year interest rate; How much money can
be withdrawn forever from this account?

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Example: Capitalized Worth

(Costs) Problems
• Draw a Cash Flow Diagram
$ A per year = ?

1 2 3 - - - - - - ∞

Solution: CC= A (or AW)

$100,000
i
Or AW= CC (i)

A = $100,000(0.20) = $20,000 per period

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Capitalized Worth (Costs)

―Recurring and Non-recurring
More complex problems will have two types of costs
associated;
1. Recurring – Periodic and repeat
2. Non-recurring– One-time present or future cash flows

• For more complex CC problems one must separate the

recurring from the non-recurring

• You will not just face problems calculating Capital

Costs of a single amount (like the previous
example) but you confronts situations in which you
have to make selection among alternatives using CC
criteria

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Capitalized Cost Analysis

• For the comparison of two alternatives on the basis
of capitalized cost, you will use formula (CC = A/i)

• So find the A value & CCT (the sum of recurring and

non-recurring costs) for each alternative and select
the one which has lowest present worth of costs
(or equal to say… Lowest capitalized costs).

• Alternatives are automatically compared for

same life period because CCT represents the total
present worth of financing and maintaining a given
alternative forever (i.e., infinity).
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Summary: How to calculate CC and A and how to use

CC criteria to select an alternative
Cost (cash flows) Recurring
(Step 1) Periodic and repeated

Non-recurring A in only one cost Uniform Equal

One time present or future Cycle: e.g., cash
cash flows (e.g., first cost, Recurring
cost once in 25th year etc)
flow every 5th year or Amounts: e.g.,
every 20th year Annuity Series (say
A2)
Non-recurring Convert this to a Uniform
Convert it to PW (will be PW Series (say A1)
of all non-recurring costs
for whole life)
(Step 2) Add A1 and A2 to
get one Uniform
Series (Annuity
Divide the value of Uniform
Annuity Series by “i" Series) starting
Add values of step 4 and
Step 2 to obtain CC of (using CC= A/i) to get the from time 0 and
overall cash flows value of “Capitalized worth” continue till infinity
(Step 5) for uniform series (Step 3)
(Step 4)
Select the alternative
with lowest capitalized Step 3 can be skipped if you convert both recurring costs
costs directly to present worth

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Thank You

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