Chapter 5 - Present Worth Analysis

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EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz

Industrial & Manufacturing Engineering Department Cal Poly Pomona

EGR 403 - The Big Picture

Framework: Accounting & Breakeven Analysis Time-value of money concepts - Ch. 3, 4 Analysis methods
Ch. 5 - Present Worth Ch. 6 - Annual Worth Ch. 7, 8 - Rate of Return (incremental analysis) Ch. 9 - Benefit Cost Ratio & other techniques

Refining the analysis

Ch. 10, 11 - Depreciation & Taxes Ch. 12 - Replacement Analysis
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Where we have been: Equivalence concept Cash flows Compound interest factors

Where we are going in this chapter:

Understanding economic criteria. Applying present worth techniques. Assumptions in solving economic analysis problems.

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Economic Decision Making Problems Fall Into Three Categories

Three criteria that apply to all of our analysis techniques:
1. For fixed input situations, maximize the benefits or other outputs. 2. For fixed output situations, minimize the costs or other inputs. 3. Where inputs and outputs vary, maximize = benefits costs.

First step is to decide which category applies. See the back inside cover of the text.
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Economic Criteria Restated Present Worth Techniques

Fixed input

Situation Criterion Amount of capital Maximize present available fixed worth of benefits
$ amount of benefit is fixed or fixed outcome Neither capital nor $ benefits are fixed Minimize present worth of costs Maximize net present worth (NPW)
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Fixed output

Neither fixed

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Economic Criteria - Examples

Alt A Situation Fixed input Fixed output Example $150,000 budgeted for raw materials Criterion Purchase the most you can for the money. Maximize output.

20,000 sq ft Negotiate for minimum building needed cost/sq ft. Minimize input Maximize the profit - The biggest margin between benefit & cost. Maximize PWB - PWC
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Neither fixed

Purchasing rental property

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Applying Present Worth Techniques

With PW analysis the analysis period used is a major consideration. Several cases:
Useful life of the alternative(s) equals the analysis period. Alternatives have useful lives different from the analysis period. The analysis period is infinite or long enough to be treated as infinite, n =
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Useful Lives Equal the Analysis Period

1. Example 5-1: Require a project to last five years. 2. The equipment and tooling will last five years. 3. Calculate the PW or NPW over a five year span and junk the equipment at the end of the five years (salvage value = 0). 4. Two alternatives with cost of $1000 and useful live of 5 years. Assume i = 7%.
Year 0 1 2 3 4 5 A -1000 300 300 300 300 300 B -1000 400 350 300 250 200
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Example 5-1: Fixed input, therefore maximize PW of Benefits.

Alternative A
Find the PW of all cash flows related to benefits of Alternative A. Also include additional costs that come later. PW of Benefits = 300 (P/A, 7%, 5) = 300 (4.100) = $1230

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Example 5-1: Fixed input, therefore maximize PW of Benefits (contd)

Alternative B - Here we have a combination of a uniform series (A = 400) and a negative gradient (G = 50). Decompose to use the factors available.
PW of Benefits = 400 (P/A, 7%, 5) - 50 (P/G, 7%, 5) = 400 (4.100) - 50 (7.647) = $1257.65

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Example 5-1 Contd

PWB Alternative A = $1230.00 PWB Alternative B = $1257.65 Since our criteria was to maximize PW of Benefits, Alternative B is preferred. Notice that each alternative provided the same total cash flow, but alternative B provided it sooner so that it was available sooner to the company to use.

MONEY NOW IS BETTER THAN MONEY LATER

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More Examples
Example 5-2: Two stage construction. Fixed output so Minimize PW of Cost Use PW factors to find PW of second stage costs and benefits at time 0. Example 5-3: Salvage value included Fixed output, so Minimize PW of Cost Use PW factors to find PW of salvage value. Operating & maintenance costs were assumed equal. Example 5-4: Neither input nor output fixed Maximize (PWB - PWC) or Maximize NPW Salvage value treated as a negative cost ( a benefit)
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Useful Lives Different From the Analysis Period

Consider (based on Example 5-3):
Speedy: Useful life = 5 years. P = 1500, S = 200, PWC = $1357 Allied: Suppose useful life = 10 years instead of 5 years. P = 1600, Salvage value = 325. PWC = $1435.

If we have two alternatives with different useful lives, is it proper to compare PWB and/or PWC directly?

Solution: Require the project to last 10 years.

Answer: No, because we have 5 additional years of benefits for Allied that would be ignored

For Speedy assume that you will purchase new equipment and tooling twice: At the beginning of year one and six. Junk the equipment and tooling at the end of each five year period and replace with the same equipment.
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Useful Lives Different From the Analysis Period

Calculate the PW or NPW over a 10 year span.
Now Allied is the preferred choice since PWC is less than for Speedy
Speedy: PWC = $2325

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Techniques for Dealing with Unequal Useful Lives

Repeated Project Policy - We will assume the same costs and benefits and repeat a project all the way to the end of the analysis period. This is a major part of PW analysis. Least Common Multiple - Find useful life that coincides with multiple lives of each alternative under consideration: e.g. If useful lives are 3 years and 4 years, then the least common multiple is 12 years.
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Techniques for Dealing with Unequal Useful Lives

Terminal year
Sometimes the least common multiple method (LCM) creates an unrealistic useful life (e.g., 13 years and 7 years = LCM of 91 years). Instead, pick a terminal year and repeat all projects up until the terminal year. Truncate all costs and benefits after the terminal year (See Figure 5-1 on page 175 for an illustration)
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Infinite Analysis Period

For n = infinity, A = i P Therefore:
P=A/i i=A/P

When you have a very long analysis period, use the infinity assumption to simplify problems. Example 5-6: If we can resolve our desired task or service into an equivalent A, then we can use P = A / i to simplify the process of finding P.
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Assumptions in Solving Economic Analysis Problems

End-of-year (or period) convention (simplifies calculations) Viewpoint (generally the firm) Sunk costs (past has no bearing) Borrowed money (consider investing only) Effect of inflation (prices are not stable) Income taxes (must be considered for realism)
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