EE_Module_2

Engineering Economics
Module -2
Present Worth Comparisons
Present worth(PW)

In this method of comparison, the cash flows of each alternative will be reduced to
time zero by assuming an interest rate i. In most of the practical decision environments,
executives will be forced to select the best alternative from a set of competing alternatives.

There are 5 basic methods to have results of selected alternative or to be analysed

Equivalent worth :

i) Present worth (PW)

ii) Annual worth (AW)
iii) Future worth (FW)

Rate of returns

i) Internal rate of return(IRR)

ii) External rate of return(ERR)

Conditions for PW comparisions

1. Cash flows are known

2. Cash flows are in constant value Rs.
3. The interest rate is known
4. Comparisions are made with before-tax cash flows
5. Comparisions do not include intangible considerations
6. Comparisions do not include consideration of the availability of funds to implement
alternatives

REVENUE-DOMINATED CASH FLOW DIAGRAM

A generalized revenue-dominated cash flow diagram to demonstrate the present

worth method of comparison is presented in

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To find the present worth of the above cash flow diagram for a given interest rate,
the formula is

PW(i) = – P + R1[1/(1 + i)1] + R2[1/(1 + i)2] + .... + Rj[1/(1 + i) j] + Rn[1/(1 + i)n] + S[1/(1+
i)n]

In Fig. 4.1,

P represents an initial investment

Rj the net revenue at the end of the jth year. The interest rate is i, compounded annually.

S is the salvage value at the end of the nth year.

Expenditure is assigned a negative sign and revenues are assigned a positive sign.

If we have some more alternatives which are to be compared with this alternative,
then the corresponding present worth amounts are to be computed and compared.

Finally, the alternative with the maximum present worth amount should be selected as the
best alternative.

COST-DOMINATED CASH FLOW DIAGRAM

A generalized cost-dominated cash flow diagram to demonstrate the present worth

method of comparison is presented in Fig. 4.

To compute the present worth amount of the above cash flow diagram for a given interest
rate i, we have the formula

PW(i) = P + C1[1/(1 + i)1] + C2[1/(1 + i)2] + ... + Cj[1/(1 + i) j] + Cn[1/(1 + i)n] – S[1/(1 +
i)n]

In Fig,

P represents an initial investment

Cj the net cost of operation and maintenance at the end of the jth year

S the salvage value at the end of the nth year

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Expenditure is assigned a positive sign and the revenue a negative sign.

If we have some more alternatives which are to be compared with this alternative,
then the corresponding present worth amounts are to be computed and compared.

Finally, the alternative with the minimum present worth amount should be selected as
the best alternative.

Basic PW comparisions

The present worth of a cash flow overtime is its value today is represented as time ‘0’ in
a cash flow diagram.

Two general patterns are,

i) Present worth Equivalence

Example problem

1. The lease on a warehouse amounts to Rs.5000 per month for 5yrs. If payments are
made on the first of each month,what is the present worth of the agreement at a
nominal annual interest rate of 12% compounded annually.
A=5000
N=5*12=60months i=12%=12/12=1%
PW=A(P/A,1%,60)
= 5000(P/A,1%,60)
=5000 * 44.955
PW=2,24,775
ii) Net Present Worth

It has an initial outlay at time 0 followed by a series of receipts and disbursements.

Net present-worth = PW (benefits) – PW (costs)

Example problem

1. A piece of new equipments was proposed by engineers to increase the production of

a certain manual welding operation. The investment is Rs.25000 and the equivalent
will have salvage value of Rs.5000 at the end of 5yrs. Increased productivity will
gain Rs.8000 per year after extra operating costs have been subtracted from the
additional production, with rate of interest 20%.Use present worth method.
Ans:
Total PW=PW of cash receipts – PW of cash outlays
= 8000(P/A,20%,5)+5000(P/F,20%,5) - 25000

=8000(2.991) + 5000(0.4019) – 25000 using table

Total PW=934.5
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Problems based on the Concept of PW method of comparison applied to the selection of

best alternative.

Problems
1. Alpha industry is planning to expand its production operation. It has identified
three different technologies for meeting the goal. The initial outlay and annual
revenues with respect to each of the technologies are summarized in Table below.
Suggest the best technology which is to be implemented based on the present
worth method of comparison assuming 20% interest rate, compounded annually.
Initial outlay Annual Life
(Rs.) revenue (years)
(Rs.)
Technology 1 12,00,000 4,00,000 10
Technology 2 20,00,000 6,00,000 10
Technology 3 18,00,000 5,00,000 10
In all technologies, the initial outlay is assigned negative sign and annual
revenues are assigned positive sign
Technology 1
P=12,00,000
A=4,00,000
i=20%
n=10 years

PW (20%) = -12,00,000 + 4,00,000(P/A,20%,10)

= -12,00,000 + 4,00,000 * 4.192
PW(20%) = Rs. 4,76,800
Technology 2
P=20,00,000 , A=6,00,000 i=20% , n=10

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PW(20%)= -20,00,000 + 6,00,000(P/A,20%,10)

=-20,00,000 + 6,00,000 * 4.192
PW(20%)=5,15,200
Technology 3
P=18,00,000 A=5,00,000 , i=20%, n=10

PW(20%)= -18,00,000 + 5,00,000(P/A,20%,10)

=-18,00,000 + 5,00,000 * 4.1925
PW(20%)=2,96,250

Technology 2 should be considered.

2. An engineer has two bids for an elevator to be installed in a new building. The
details of the bids for the elevators are as follows:
Bid Engineers estimates
Initial cost Service life Annual operations and
(Rs.) (years) maintainance costs(Rs)

Alpha elevator 4,50,000 15 27000

Beta elevator 5,40,000 15 28500
Determine which bid should be accepted, based on the present worth method of
comparison assuming 15% interest rate, compounded annually.

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Bid 1 : Alpha elevator

P=4,50,000 A=27,000 n=15 i=15%

PW(15%) = 4,50,000 + 27,000 (P/A,15%,15)

=4,50,000 + 27000 * 5.8474

PW(15%)=6,07,879.80

Bid 2 : Beta elevator

P=5,40,000 A=28,500 n=15 i=15%

PW(15%)=5,40,000 + 28,500 (P/A,15%,15)

=5,40,000 + 28,500 * 5.8474

PW(15%)=7,06,650.90

Alpha elevator should be implemented.

3. Investment proposals A and B have the net cash flows as follows:

Proposals End of years
0 1 2 3 4
A(Rs.) -10,000 3000 3000 7000
6000
B(Rs.) -10,000 6000 6000 3000
3000
Compare the present worth of A with that of B at i = 18%. Which proposal should be
selected?

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Proposal A

PW(18%)=-
10,000+3000(P/F,18%,1)+3000(P/F,18%,2)+7000(P/F,18%,3)+6000(P/F,18%,4)

=-10,000 + 3000 (0.8475) + 3000(0.7182) + 7000(0.6086) + 6000(0.5158)

PW(18%)= Rs. 2052

Proposal B

PW(18%)= -10,000 + 6000(P/F,18%,1) + 6000(P/F,18%,2) + 3000(P/F,18%,3) +

3000(P/F,18%,4)

= -10000 + 6000 (0.8475) + 6000 (0.7182) +3000(0.6086) + 3000(0.5158)

PW(18%) = Rs.2766.2

The PW of proposal B is higher than proposal A . so select proposal B.

4. A granite company is planning to buy a fully automated granite cutting machine.

If it is purchased under down payment, the cost of the machine is Rs. 16,00,000.
If it is purchased under installment basis, the company has to pay 25% of the cost
at the time of purchase and the remaining amount in 10 annual equal installments
of Rs. 2,00,000 each. Suggest the best alternative for the company using the
present worth basis at i = 18%, compounded annually.

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Two alternatives,
i) Down payment = Rs.16,00,000
ii) Down payment of Rs.4,00,000 and 10 annual equal installments of
2,00,000 each.

PW(18%)=4,00,000 + 2,00,000 (P/A,18%, 10)

=4,00,000 + 2,00,000 * 4.494
PW(18%)=12,98,800

Second alternative should be selected.

5. A small business with an initial outlay of Rs. 12,000 yields Rs. 10,000 during the
first year of its operation and the yield increases by Rs. 1,000 from its second
year of operation up to its 10th year of operation. At the end of the life of the
business, the salvage value is zero. Find the present worth of the business by
assuming an interest rate of 18%, compounded annually.

A= A1 + G (A/G,18%,10)
=10,000 + 1000 (3.194)
A=13,194
PW(18%) = -12,000 +A (P/A,18%,10)
= -12,000 + 13,194 (4.494)
PW(18%) = 47,293
6. A company borrowed 1,00,000 to finance a new product the loan was for 20 years
at a nominal interest rate of 8% compounded semiannually. It was to be repaid in
40 equal payments. After one half (1/2) the payments were made, the company
decided to pay the remaining balance in one final payment at the end of the 10 th
year how much was owed?
P=1,00,000 N=20years = 20 * 2 = 40 installments
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i=8% Compounded semi-annually = 8/2=4%

i) F20 = P (F/P, 4% , 20 )
= 1,00,000 ( 2.19112)
F20 = 2,19,112

P=50,000 – 2,19,112
P=1,69,112

ii) F30=P( F/P , 4% , 10)

=1,69,112 * 1.4803
F30=2,50,336.49
The company owed to finance is 2,50,336.49

7. A proposed improvement in an assembly line will have an initial purchase and

installation cost of Rs.1,75,000. The annual maintenance cost will be Rs.6000.
Periodic overhauls once every 3yrs excluding the last year of use, will cost
Rs.11,500 each. The improvement will have a usefull life of 9 years at which time
it will have no salvage value, what is the present worth of the 9 year costs of the
improvement at i=8% ?
PW= A(P/A,i%,N) + F(P/F,i%,N) + F(P/F,i%,N) + F(P/F,i%,N)
=6000(P/A,8%,9) + 11500(P/F,8%,3) + 11500(P/F,8%,6) + 11500 (P/F,8%,9) +
Initial investment
= 6000 (6.247) + 11500(0.793) +11500 (0.630) +11500(0.5002) + 1,75,000
PW= 2,34,598.8

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8. A bakery is thinking of purchasing a small delivery truck that has a first cost of
Rs.18,000 and is to be kept in service for 6year. At what time the salvage value
is expected to be 2500. Maintenance and operating costs are estimated at Rs.2500
the first year and will increase at a rate of Rs.200/year. Determine the PW of this
vehicle using interest rate of 12%.

A= A1 + G (A/G,12%,6)

A=2500 + 200 (2.17205)

A=2934.4

PW= A(P/A,i%,N) – F(P/F,i%,N)

=2934.4 (P/A,12%,6) – 2500 (P/F,12%,6)

=2934.4 (4.111) – 2500 (0.5066)

PW=10,797.9

PW of the vehicle = 10,797.9 + 18,000

=28,797.9

9. A small dam and an irrigation system are exclusive to cost Rs.3,00,000. Annual
maintenance and operating costs are executed to be Rs.40000 the first year and
will increase at a rate of 10% per year. Determine the equivalent PW of building
and operating the system with interest of 10% over a 30 year life.
i=10% N=30
A= A1 + G (A/G,i%,N)
=40000 + 4000 (A/G,10%,30)
A=72,704.9
PW= A(P/A,i%,N)
=72,704.9 * (P/A,10%,30)
=72,704.9 * 9.427

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PW=6,85,389.1 + Initial investment

PW=6,85,389 + 3,00,000
PW=9,85,389

10. A newly developed electric car will cost 21000 to purchase. Operating and
maintaenance costs is Rs.350 for the first year with annual increase of Rs.50 per
year. Salvage value after 5years is Rs.6500. A new gasoline run will cost
Rs.16,000 with average 30 miles per gallon. Gasoline costs Rs.1.26 per gallon is
expected to increase at a rate of Rs. 0.05 per year each of the next 4years
maintaenance costs are estimated to be Rs.300 per [Link] value is Rs.1500
after 5years of [Link] the vehicles are expected to be driven for 20,000 miles
per year, determine which option will have the lower cost over 5 years. Use PW
analysis with 10% rate of interest.

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Electric car is having lowest cost.

11. A company is considering constructing a plant to manufacture a proposed new
product. The land costs 3,00,000 the building costs 6,00,000. The equipment
costs 2,50,000 and 1,00,000 working capital is required. It is expected that the
product will result in sales of 7,50,000 per year for 10 years at which time the
land can be sold for 4,00,000 the building for 3,50,000 the equipment for 50,000
and all of the working capital recovered. The annual out-of-pocket expenses for

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labour,materials and all other items are estimated to be total 4,75,000. If the
company requires a minimum return of 25% on projects of comparable risk,
determine if it should invert in the new product line use PW methods.
Ans :
Investment = 3,00,000 + 6,00,000 + 2,50,000 + 1,00,000=12.5 lakhs
Profit (A)= 7,50,000 / year for 10 years
Salvage value = 4,00,000 + 3,50,000+50,000+100000=9,00,000
Annual expenses = 4,75,000 / year for 10 years
i=25% , N=10 years

PW= -P + A (P/A,i%,N) – A (P/A,i%,N) + F (P/F,i%,N)

= - 12,50,000 + 7,50,000 (P/A,25%,10) – 4,75,000 (P/A,25%,10) + 9,00,000
(P/F,25%,10)
= -12,50,000 + 7,50,000 ( 3.571) – 4,75,00 (3.571) + 9,00,000 (0.108)
PW= -1,70,775

12. Determine the PW of the following proposal when MARR is 15%.

Proposal A
First cost (P) 10,000
Expected lift(N) 5 years
Salvage value(F) -1000
Annual receipts(+A) 8000
Annual expenses(-A) 4000
PW= - P + A(P/A,i%,N) – A (P/A,i%,N) – F(P/F,i%,N)
= -10,000 + 8000(P/A,15%,5) – 4000(P/A,15%,5) – 1000(P/F,15%,5)
= -10,000 + 8000(3.352) – 4000(3.352) – 1000(0.497)
PW=2910.8
13. Evaluate machine XYZ on the basis of the present worth method when MARR is
12% pertinent cost data is as follows:
Machine XYZ
First cost 13,000
Useful life 15 years
Salvage value 3000
Annual operating cost 100
th
Overhaul end of 5 year 200
Overhaul end of 10th year 550
PW= -P –A(P/A,i%,N) – F(P/F,i%,N) – F(P/F,i%,N) +F(P/F,i%,N)
= -13,000 – 100 (P/A,12%,15) – 200 (P/F,12%,5) – 550(P/F,12%,10) +
3000(P/F,12%,15)
= -13,000 – 100 (6.811) – 200 (0.567) – 550 (0.322) + 3000(0.1827)
PW= -13,422

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Assests with Unequal Lives (Present Worth Comparisions with Unequal

lives)
1. Repeatability assumptions(LCM method)
2. Co-terminated assumptions/Study period method

Problems

1. Two holidays cottages are under consideration. Compare the present worth of the
cost of 24 years service, at an interest rate of 5% when no salvage value.
Cottage 1 Cottage 2
First cost Rs. 4500 Rs. 10,000
Estimated life 12 years 24 years
Annual maintenance Rs. 1000 Rs. 720
cost

LCM of 12 and 24 = 24
Cottage 1
N=12
24/12 = 2
PW = P + A (P/A,i%,N) + F1(P/F,i%,N)
= 4500 + 1000 (P/A,5%,24) + 4500(P/F,5%,12)
=4500 + 1000 (13.79864) + 4500 (0.55684)
PW=20,804.42

Cottage 2
PW= P + A(P/A,i%,N)
=10,000 + 720 (P/A,5%,24)
=10,000 + 720 (13.79864)
PW=19,935.02
Cottage 2 is selected.

2. Two types of trucks are available for transportation use. They are needed for 10 years.
i=7% , PW=?
Truck A Truck B
First cost Rs. 10,00,000 Rs. 15,00,000
Estimated annual Rs. 20,000 Rs. 15,000
maintenance cost
Estimated life 5 years 10 years
Estimated salvage value Rs. 2,00,000 Rs. 5,00,000

LCM of 5 and 10 = 10

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Truck A
10/5 = 2
PW = -P – A (P/A,i%,N) + S1(P/F,i%,N) – F1(P/F,i%,N + S2(P/F,i%,N)
= -10,00,000 – 20,000 (P/A,7%,10) + 2,00,000(P/F,7%,5) – 10,00,000
(P/F,7%,5) + 2,00,000 (P/F,7%,10)
= -10,00,000 – 20,000 (7.024) + 2,00,000(0.7130)- 10,00,000(0.7130) +
2,00,000(0.5083)
PW= -16,09,220
Truck B
PW = - P – A (P/A,i%,N) + F (P/F,i%,N)
= -15,00,000 – 15,000 (P/A,7%,10) + 5,00,000 (P/F,7%,10)
= -15,00,000 – 15,000 (7.024) + 5,00,000 (0.5083)
PW = -13,51,210
Truck B will be selected.

3. The following alternatives are available to accomplish an objective of 12 years

duration. Compare the PW of the alternatives using i=7% per year.
Plan A Plan B Plan C
Life cycle (in yrs) 6 3 4
First cost ($) 2000 8000 10,000
Annual cost ($) 3200 700 500
LCM of 6,3,4 = 12
Plan A
12/6=2
PW = P + A(P/A,i%,N) + F(P/F,i%,N)
=2000 + 3200 (P/A,7%,12) + 2000(P/F,7%,6)
=2000 + 3200 (7.943) + 2000 (0.6663)
PW= 28,750.2
Plan B
12/3 = 4
PW = P +A(P/A,i%,N) + F1(P/F,7%,3) + F2(P/F,7%,6) + F3(P/F,7%,9)
= 8000 + 700 (P/A,7%,12) + 8000(P/F,7%,3) + 8000(P/F,7%,6) + 8000
(P/F,7%,9)
= 8000 + 700 (7.943) + 8000 (0.8163) + 8000(0.6663) + 8000(0.5439)
PW = 29772.4
Plan C
12/4=3
PW= P + A(P/A,i%,N) + F1(P/F,i%,N) + F2(P/F,i%,N)
= 10,000 + 500(P/A,7%,12) + 10,000(P/F,7%,4) + 10,000(P/F,7%,8)
= 10,000 + 500(7.943) + 10,000(0.7629) + 10,000(0.5820)
PW= 27420.4
Plan C will be selected.

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4.
LCM of 6 and 9 is 18

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PW= - P – A(P/A, 15%,18) + S1 (P/F,15%,6) + S2(P/F,15%,12) + S3(P/F,15%,18)

– F1 (P/F,15%,6) – F2(P/F,15%,12)

Proposal B (Vendor B) will be selected.

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Vendor A will be selected

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Problems on PW comparisions of Infinite lives / Comparison of assets

having Infinite lives

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Capitalized cost = 2,00,000 + [12,000 +1,00,000(A/F,6%,10) /0.06]

=2,00,000 + [12,000 + 1,00,000 (0.07587) / 0.06]

Capitalized cost = 5,26,500

Problem 2 : Capitalised cost = 5 crore

Annual M C = 10 lakhs

Additional maintenance cost every 10 yrs = 8 lakhs

i=9%

First cost (P) =?

Capitalised cost = first cost (P) +[ disbursement(A) / i]

First cost= capitalised cost – Total annual costs / i

= 50000000 – 10,00,000 + [8,00,000 (A/F,9%,10)]/0.09

First cost= 3,83,03,822.22

Future Worth method [Refer Paneerselvam text book pg. No. 55 to 66]
And Naidu text book pg.53 to 60 (includes Pay back comparison method)
[both the documents are shared in GCR]

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Problems to be solved
1. A finance company advertises two investment plans. In plan 1, the company
pays Rs. 12,000 after 15 years for every Rs. 1,000 invested now. In plan 2,
for every Rs. 1,000 invested, the company pays Rs. 4,000 at the end of the
10th year and Rs. 4,000 at the end of 15th year. Select the best investment
plan from the investor’s point of view at i = 12%, compounded annually.
Ans : Plan 1 PW=1,192 Plan 2 PW=1018 Plan 1 is the best one.
2. Novel Investment Ltd. accepts Rs. 10,000 at the end of every year for 20 years
and pays the investor Rs. 8,00,000 at the end of the 20th year. Innovative
Investment Ltd. accepts Rs. 10,000 at the end of every year for 20 years and
pays the investor Rs. 15,00,000 at the end of the 25th year. Which is the best
investment alternative? Use present worth base with i = 12%.
Ans: Novel investment ltd. PW(12%)=Rs.8266 Innovative Investment
ltd. PW(12%) = Rs.13,506 . Innovative investment ltd plan is the best one
for the investor.

3. Autocon company is evaluating three robots for possible use in its assembly
operations (only one robot will be purchased). Data associated with these
robots are as follows,

Robot A Robot B Robot C

First cost Rs. 55,000 58,000 53,000
Operating & 3000/year 4500/year 4000/year
maintenance
costs Rs.
Expected 40,000/year 44,000/year 38,000/year
income
Estimated 4000 6000 4000
salvage value
Rs.
Assuming a technological life of 3 years and a desired interest rate of 12% ,
which robot seems to be preferable assuming all other factors are equal. Use
a net PW evaluation.
PW(Robot A) = 36,721 PW(Robot B)=41,149 PW(Robot C) = 31,515

4. The following data presents for two feasible alternatives A and B for which
revenues and costs are known and which have different lives. If the minimum
alternative rate of return is 10% , show which feasible alternative is more
desirable by using PW.
A B
Investment (first) cost 3500 5000
Annual revenue 1900 2500
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Annual cost 645 1383

Useful life 4 8

5.
PW(location A) = -45,036.36
PW(location B) = -41,383.28

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Prepared by [Link] M, CSE, DSCE