BMFG 4623

Engineering Economy
and Management
Present Worth Analysis &
Future Worth Analysis
References:
1. Blank, L and Tarquin, A. Engineering Economy,8thEdition,McGraw Hill, 2017.
2. Sullivan, W.G., Wicks,E.M., and Koelling,C.P., Engineering Economy,17th Edition, Pearson, 2018
3. Park C.S., Contemporary Engineering Economics, Pearson, 5th Edition, 2011

Nor Akramin Mohamad

Faculty of Manufacturing Engineering
Universiti Teknikal Malaysia Melaka
LEARNING OUTCOMES
Utilize different present/future worth techniques to evaluate
and select alternatives.
1. Formulate alternatives : Identify mutually exclusive and independent
projects; define revenue and cost alternatives.
2. PW of equal-life alternatives: Select the best of equal-life alternatives
using present worth analysis.
3. PW of different-life alternatives: Select the best of different-life
alternatives using present worth analysis.
4. FW analysis: Select the best alternative using future worth analysis.
5. CC analysis: Select the best alternative using capitalized cost (CC)
analysis.
INTRODUCTION
An engineering project or alternative is formulated
1. to make or purchase a product,
2. to develop a process, or
3. to provide a service with specified results.
An engineering economic analysis evaluates cash flow
estimates for parameters such as initial cost, annual costs and
revenues, nonrecurring costs, and possible salvage value over
an estimated useful life of the product; process, or service.
The chapters in this Learning Stage develop and demonstrate
the basic tools and techniques to evaluate one or more
alternatives using the factors, and formulas learned in
previous discussion.
FORMULATING ALTERNATIVES
To understand how to organize an economic analysis, this chapter begins
with a description of independent and mutually exclusive projects as well as
revenue and cost alternatives.
Two types of economic proposals
1. Mutually Exclusive (ME) Alternatives:
Only one can be selected; Compete against each other
2. Independent Projects:
More than one can be selected; Compete only against DN
Two types of cash flow estimates
1. Revenue: Alternatives include estimates of costs (cash outflows)
and revenues (cash inflows)
2. Cost: Alternatives include only costs; revenues and savings assumed
equal for all alternatives; also called service alternatives
Do Nothing (DN) – An ME alternative or independent project to maintain the current
approach; no new costs, revenues or savings
FORMULATING ALTERNATIVES
SELECTION OF ALTERNATIVES BY PW

For the alternatives shown below, which should be selected

if they are (a) mutually exclusive; (b) independent?

Project ID Present Worth

A RM30,000
B RM12,500
C -RM4,000
D RM2,000
Solution: (a) Select numerically largest PW; alternative A
(b) Select all with PW > 0; projects A, B & D
PRESENT WORTH ANALYSIS OF
EQUAL-LIFE ALTERNATIVES
The present worth P is renamed PW of the alternative. The present worth method
is quite popular in industry because all future costs and revenues are transformed
to equivalent monetary units NOW; that is, all future cash flows are converted
(discounted) to present amounts at a specific rate of return, which is the MARR.
This makes it very simple to determine which alternative has the best economic
advantage.
> Convert all cash flows to PW using MARR
> Precede costs by minus sign; receipts by plus sign

EVALUATION
> For one project, if PW > 0, it is justified
> For mutually exclusive alternatives, select one with numerically largest PW
> For independent projects, select all with PW > 0
Example: PW Evaluation of Equal-Life
Alternative X has a first cost of RM20,000, an operating cost of RM9,000 per
year, and a RM5,000 salvage value after 5 years. Alternative Y will cost
RM35,000 with an operating cost of RM4,000 per year and a salvage value of
RM7,000 after 5 years. At an MARR of 12% per year, select the best
alternative.
Solution: Find PW at MARR and select numerically larger PW value

PWX = -20,000 - 9000(P/A,12%,5) + 5000(P/F,12%,5)

= - RM 49,606
Example: PW Evaluation of Equal-Life
Solution: Find PW at MARR and select numerically larger PW value

PWY = -35,000 - 4000(P/A,12%,5) + 7000(P/F,12%,5)

= - RM 45,447

Select alternative Y
Example: PW Evaluation of Equal-Life
A university lab is a research contractor for in-space fuel cell systems that are
hydrogen and methanol-based. During lab research, three equal-service
machines need to be evaluated economically. Perform the present worth
analysis with the costs shown below. The MARR is 10% per year.
Electric-Powered Gas-Powered Solar-Powered

First cost, RM 4500 3500 6000

Annual operating cost (AOC), RM/year 900 700 50
Salvage value S, RM 200 350 100
Life, years 8 8 8

Answer:
PWelectrical = RM -9208 The solar-powered machine is selected since
PWgas = RM -7071 the PW of its costs is the lowest; it has the
PWsolar = RM -6220 numerically largest PW value.
Example: PW Evaluation of Equal-Life
Example of electric – powered Electric-
Powered
cash flow diagram First cost, RM 4500
Annual operating cost (AOC), 900
RM/year
Salvage value S, RM 200
Life, years 8
PRESENT WORTH ANALYSIS OF
DIFFERENT-LIFE ALTERNATIVES
The PW of the alternatives must be compared over the
same number of years and must end at the same time to satisfy
the equal-service requirement.

Two ways to compare equal service:

1. LCM (least common multiple) : Compare the PW of alternatives over
a period of time equal to the (LCM) of their estimated lives.

2. Study period: 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.
(The LCM procedure is used unless otherwise specified)
Assumptions of LCM approach
1. Service provided is needed over the LCM or more years
2. Selected alternative can be repeated over each life cycle of LCM in
exactly the same manner
3. Cash flow estimates are the same for each life cycle (i.e., change in
exact accord with the inflation or deflation rate)

> LCM approach makes the cash flow estimates extend to the same period,
as required. For example, lives of 3 and 4 years are compared over a 12-
year period.
> The first cost of an alternative is reinvested at the beginning of each life
cycle, and the estimated salvage value is accounted for at the end of each
life cycle when calculating the PW values over the LCM period.
Example: Different-Life Alternatives
Compare the machines below using present worth analysis at i = 10% per year

Machine A Machine B
First cost, RM 20,000 30,000
Annual cost, RM/year 9000 7000
Salvage value, RM 4000 6000
Life, years 3 6

Solution: LCM = 6 years; repurchase A after 3 years

PWA = -20,000 – 9000(P/A,10%,6) – 16,000(P/F,10%,3) + 4000(P/F,10%,6)

= -RM 68,961
20,000 – 4,000 in
PWB = -30,000 – 7000(P/A,10%,6) + 6000(P/F,10%,6) year 3
= -RM57,100

Select alternative B
Example: Different-Life Alternatives
Red color
line is the
2nd life cycle
PW EVALUATION USING A STUDY PERIOD
 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

Short study periods are often defined by management when

business goals are short-term

Study periods are commonly used in equipment replacement

analysis
Example: Study Period PW Evaluation
Compare the alternatives below using present worth analysis at i = 10% per year
and a 3-year study period
Machine A Machine B
First cost, RM -20,000 -30,000
Annual cost, RM/year -9,000 -7,000
Salvage/market value, RM 4,000 6,000 (after 6 years)
10,000 (after 3 years)
Life, years 3 6
Solution: Study period = 3 years; disregard all estimates after 3 years

PWA = -20,000 – 9000(P/A,10%,3) + 4000(P/F,10%,3) = -RM 39,376

PWB = -30,000 – 7000(P/A,10%,3) + 10,000(P/F,10%,3) = -RM 39,895
Marginally, select A; different selection than for LCM = 6 years
Example: Study Period PW Evaluation

Cash flow
after year 3
are ignored
Example: Different-Life Alternatives
FKP Homebuilders Sdn Bhd, plans to purchase new cut-and-finish equipment.
Two manufacturers offered the estimates below.

Vendor A Vendor B
First cost, RM 15 000 18 000
Annual operating cost (AOC), RM/year 3 500 3 100
Salvage value S, RM 1 000 2 000
Life, years 6 9

(a) Analyse which vendor should be selected on the basis of a present worth
comparison, if the MARR is 15% per year.

(b) FKP Homebuilders Sdn Bhd 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, analyse which vendor should be selected.
(a) Answer:
Vendor B is selected, since it costs less in PW terms;
PWvendor A = - RM 45 036
that is, the PW B value is numerically larger than PW A .
PWvendor B = - RM 41 384
 1000

2000

Vendor A is now selected based on its smaller PW value. This

(b) Answer:
means that the shortened study period of 5 years has caused a
PWvendor A = - RM 26 236
switch in the economic decision. In situations such as this, the
PWvendor B = - RM 27 397
standard practice of using a fixed study period should be
carefully examined to ensure that the appropriate approach, that
is, LCM or fixed study period, is used to satisfy the equal-service
requirement.
FUTURE WORTH ANALYSIS
FW exactly like PW analysis, except calculate FW

Analysis of alternatives using FW values is especially applicable to

large capital investment decisions when a prime goal is to maximize
the future wealth of a corporation’s stockholders.

Future worth analysis over a specified study period is often utilized if

the asset (equipment, a building, etc.) might be sold or traded at some
time before the expected life is reached. Suppose an entrepreneur is
planning to buy a company and expects to trade it within 3 years. FW
analysis is the best method to help with the decision to sell or keep it 3
years.
FW of Different-Life Alternatives
Compare the machines below using future worth analysis at i = 10% per year

Machine A Machine B
First cost, RM -20,000 -30,000
Annual cost, RM/year -9000 -7000
Salvage value, RM 4000 6000
Life, years 3 6

Solution: LCM = 6 years; repurchase A after 3 years

FWA = -20,000(F/P,10%,6) – 9000(F/A,10%,6) – 16,000(F/P,10%,3) + 4000
= -RM 122,168
FWB = -30,000(F/P,10%.6) – 7000(F/A,10%,6) + 6000
= -RM 101,157
Select B (Note: PW and FW methods will always result in same selection)
FW of Different-Life Alternatives
CAPITALIZED COST (CC) ANALYSIS
Many public sector projects such as bridges, dams, highways and toll roads,
railroads, and hydroelectric and other power generation facilities have very long
expected useful lives. A perpetual or infinite life is the effective planning horizon.
Permanent endowments for charitable organizations and universities also have
perpetual lives. The economic worth of these types of projects or endowments is
evaluated using the present worth of the cash flows.

Basic equation is: CC = P = A

i
“A” essentially represents the interest on a perpetual investment
For example, in order to be able to withdraw RM50,000 per year forever
at i = 10% per year, the amount of capital required is 50,000/0.10 = $500,000

For finite life alternatives, convert all cash flows into an A value over one life
cycle and then divide by i
Example: Capitalized Cost
Compare the machines shown below on the basis of their
capitalized cost. Use i = 10% per year
Machine 1 Machine 2
First cost,$ -20,000 -100,000
Annual cost,$/year -9000 -7000
Salvage value, $ 4000 -----
Life, years 3 ∞

Solution: Convert machine 1 cash flows into A and then divide by i

A1 = -20,000(A/P,10%,3) – 9000 + 4000(A/F,10%,3) = $-15,834
CC1 = -15,834 / 0.10 = - RM 158,340

CC2 = -100,000 – 7000/ 0.10 = - RM 170,000

Select machine 1
SUMMARY OF IMPORTANT POINTS

1. PW method converts all cash flows to present value at MARR

2. Alternatives can be mutually exclusive or independent

3. Cash flow estimates can be for revenue or cost alternatives

4. PW comparison must always be made for equal service

5. Equal service is achieved by using LCM or study period

6. Capitalized cost is PW of project with infinite life; CC = P = A/i