Present Worth Analysis

1
Present Worth Analysis

• Chapter 5

2
Types of Economic Alternatives

• Mutually Exclusive Alternatives
• Only one of the viable projects can be selected.
• The viable projects compete against one another.
• Independent Alternatives
• More than one viable project may be selected.
• There may be dependent projects requiring a
  particular project to be selected before another.
• Contingent projects where one project may be
  substituted for another.

3
Types of Economic Alternatives

• Do Nothing Alternative
• If none of the mutually exclusive alternatives
  are considered economically viable the Do
  Nothing alternative is accepted by default.
• New alternatives should be developed and the
  analysis should continue until an economically
  viable alternative is available.
• Most of the problems we will study in this class
  will involve the analysis of mutually exclusive
  alternatives.

4
Independent Projects

• Each project is evaluated separately.
• Comparison is between one project at a time and
  the do-nothing alternative.
• One or more of the projects can be selected on
  the basis of an economic evaluation.
• Budgets may limit the implementation of one or
  more of the selected alternatives.

5
Present Worth Analysis of Equal-Life Alternatives

• One alternative
• Calculate the PW using the MARR. If PW gt or
  0, the MARR is met or exceeded and the
  alternative is financially viable.
• Two or more alternatives
• Calculate the PW of each alternative using the
  MARR. Select the alternative with the PW value
  that is numerically largest, that is, less
  negative and more positive, indicating a lower PW
  of cost cash flows or larger PW of net cash flows
  of receipts minus disbursements.

6
Present Worth Analysis of Equal-Life Alternatives

• For one of more independent projects, select all
  projects with PW gt or 0 using the MARR value.
• This compares each project with the do-nothing
  alternative.
• The projects must have positive and negative
  cash flows to obtain a PW value that exceeds
  zero. They must be revenue projects.

7
Present Worth Analysis of Different-Life
Alternatives

• THE PRESENT WORTH OF THE ALTERNATIVES MUST BE
  COMPARED OVER THE SAME NUMBER OF YEARS!

8
Present Worth Analysis of Different-Life
Alternatives

• In order to compare the alternatives over the
  same number of years, two approaches are used
• Compare the alternatives over a period of time
  equal to the least common multiple (LCM) of their
  lives.
• or
• Compare the alternatives using a study period of
  length n years, which does not necessarily take
  into consideration the useful lives of the
  alternatives. This is also called the planning
  horizon approach.

9
Assumptions of a PW Analysis of Different-Life
Alternatives

• The service provided by the alternatives will be
  needed for the LCM of years or more.
• The selected alternative will be repeated over
  each life cycle of the LCM in exactly the same
  manner.
• The cash flow estimates will be the same in
  every life cycle.
• (Valid only when the cash flows are expected to
  change by exactly the inflation (or deflation)
  rate that is applicable through the LCM time
  period)
• If these assumptions cannot be applied to your
  particular analysis, then you should compare the
  alternatives using a planning horizon approach.

10
Analysis period implied in comparing mutually
exclusive alternatives

11
Future Worth (FW) Analysis

• Used to determine when to sell an asset before
  the expected life is reached.
• Used for projects that will not come online
  until the end of the investment period. Electric
  generation facilities, toll roads and hotels are
  prime examples of this types of projects.
• FW gt or 0 indicates that the MARR has been met
  or exceeded for one alternative.
• For two or more mutually exclusive alternatives,
  select the one with the numerically largest FW
  value.

12
Capitalized Cost (CC) Analysis

• Capitalized Cost (CC) is the present worth of an
  alternative that is assumed to have a perpetual
  life. Public sector projects such as bridges,
  dams, irrigation systems, and railroads fall into
  this category. In addition, charitable
  organization endowments are evaluated using
  capitalized cost methods.
• CC AW
• i
• The application of this equation can become
  complicated with the presence of nonrecurring
  cash flows.
• It is very important for you to know how to
  apply this equation.