1. www.izmirekonomi.edu.tr L15: Present Worth Analysis ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences

2. www.izmirekonomi.edu.tr Net Present Worth Measure  Principle: Compute the equivalent net surplus at n = 0 for a given interest rate of i.  Decision Rule: Accept the project if the net surplus is positive. 2 3 4 5 0 1 Inflow Outflow 0 PW(i) inflow PW(i) outflow Net surplus PW(i) > 0

3. www.izmirekonomi.edu.tr Example 5.3 - Tiger Machine Tool Company $75,000 $24,400 $27,340 $55,760 0 12 3 outflow inflow

4. www.izmirekonomi.edu.tr ABC 1PeriodCash Flow 20($75,000) 31$24,400 42$27,340 53$55,760 6 7PW(15%)$3,553.46 =NPV(15%,B3:B5)+B2 Excel Solution

5. www.izmirekonomi.edu.tr Present Worth Amounts at Varying Interest Rates i (%)PW(i)i(%)PW(i) 0$32,50020-$3,412 227,74322-5,924 423,30924-8,296 619,16926-10,539 815,29628-12,662 1011,67030-14,673 128,27032-16,580 145,07734-18,360 162,07636-20,110 17.45*038-21,745 18-75140-23,302 *Break even interest rate

6. www.izmirekonomi.edu.tr -30 -20 -10 0 10 20 30 40 0 510152025303540 PW (i) ($ thousands) i = MARR (%) $3553 17.45% Break even interest rate (or rate of return) Accept Reject Present Worth Profile

7. www.izmirekonomi.edu.tr Future Worth Criterion  Given: Cash flows and MARR (i)  Find: The net equivalent worth at the end of project life $75,000 $24,400 $27,340 $55,760 0 12 3 Project life

8. www.izmirekonomi.edu.tr Future Worth Criterion

9. www.izmirekonomi.edu.tr ABC 1PeriodCash Flow 20($75,000) 31$24,400 42$27,340 53$55,760 6PW(15%)$3553.46 7FW(15%)$5,404.38 =FV(15%,3,0,-B6) Excel Solution

10. www.izmirekonomi.edu.tr How To Use Cash Flow Analyzer Cash Flow Input Fields Output or Analysis results Graphical Plots

11. www.izmirekonomi.edu.tr Solving Example 5.3 with Cash Flow Analyzer Net Present Worth Net Future Worth Payback period Project Cash Flows

12. www.izmirekonomi.edu.tr Obtaining a NPW Plot Specify the Range of Interest Rate to plot NPW plot Between 0% and 100%

13. www.izmirekonomi.edu.tr Can you explain what $3,553 really means? 1.Project Balance Concept 2.Investment Pool Concept

14. www.izmirekonomi.edu.tr Project Balance Concept N0123N0123N0123N0123 Beginning Balance Interest Payment Project Balance -$75,000 -$11,250 +$24,400 -$61,850 -$9,278 +$27,340 -$43,788 -$6,568 +$55,760 +$5,404 Net future worth, FW(15%) PW(15%) = $5,404 (P/F, 15%, 3) = $3,553

15. www.izmirekonomi.edu.tr Project Balance Diagram 60,000 40,000 20,000 0 -20,000 -40,000 -60,000 -80,000 -100,000 -120,000 01230123 -$75,000 -$61,850 -$43,788 $5,404 Year(n) Terminal project balance (net future worth, or project surplus) Discounted payback period Project balance ($)

16. www.izmirekonomi.edu.tr Investment Pool Concept Suppose the company has $75,000. It has two options. (1)Take the money out and invest it in the project or (2) leave the money in the company. Let’s see what the consequences are for each option.

17. www.izmirekonomi.edu.tr $75,000 0 1 2 3 $24,400 $27,340 $55,760 Investment pool How much would you have if the Investment is made? $24,400(F/P,15%,2) = $32,269 $27,340(F/P,15%,1) = $31,441 $55,760(F/P,15%,0) = $55,760 $119,470 How much would you have if the investment was not made? $75,000(F/P,15%,3) = $114,066 What is the net gain from the investment? $119,470 - $114,066 = $5,404 Project Return to investment pool N = 3 Meaning of Net Present Worth PW(15%) = $5,404(P/F,15%,3) = $3,553

18. www.izmirekonomi.edu.tr What Factors Should the Company Consider in Selecting a MARR in Project Evaluation? Risk-free return Inflation factor Risk premiums

19. www.izmirekonomi.edu.tr Guideline for Selecting a MARR Real Return2% Inflation4% Risk premium0% Total expected return6% Real Return2% Inflation4% Risk premium20% Total expected return26% Risk-free real return Inflation Risk premium U.S. Treasury Bills Amazon.com Very safe Very risky

20. www.izmirekonomi.edu.tr Capitalized Equivalent Worth  Principle: PW for a project with an annual receipt of A over infinite service life  Equation: CE(i) = A(P/A, i, ) = A/i A 0 P = CE(i)

21. www.izmirekonomi.edu.tr Practice Problem 10 $1,000 $2,000 P = CE (10%) = ? 0 Given: i = 10%, N = ∞ Find: P or CE (10%) ∞

22. www.izmirekonomi.edu.tr Solution 10 $1,000 $2,000 P = CE (10%) = ? 0 ∞

23. www.izmirekonomi.edu.tr A Bridge Construction Project  Construction cost = $2,000,000  Annual Maintenance cost = $50,000  Renovation cost = $500,000 every 15 years  Planning horizon = infinite period  Interest rate = 5%

24. www.izmirekonomi.edu.tr $500,000 $2,000,000 $50,000 0 15 30 4560 Years

25. www.izmirekonomi.edu.tr Solution:  Construction Cost P 1 = $2,000,000  Maintenance Costs P 2 = $50,000/0.05 = $1,000,000  Renovation Costs P 3 = $500,000(P/F, 5%, 15) + $500,000(P/F, 5%, 30) + $500,000(P/F, 5%, 45) + $500,000(P/F, 5%, 60). = {$500,000(A/F, 5%, 15)}/0.05 = $463,423  Total Present Worth P = P 1 + P 2 + P 3 = $3,463,423

26. www.izmirekonomi.edu.tr Alternate way to calculate P 3  Concept: Find the effective interest rate per payment period  Effective interest rate for a 15-year cycle i = (1 + 0.05) 15 - 1 = 107.893%  Capitalized equivalent worth P 3 = $500,000/1.07893 = $463,423 15 304560 0 $500,000

27. www.izmirekonomi.edu.tr Practice Problem Want to purchase an electrical motor rated at 15HP for $1,000. The service life of the motor is known to be 10 years with negligible salvage value. Its full load efficiency is 85%. The cost of energy is $0.08 per kwh. The intended use of the motor is 4,000 hours per year. Find the total cost of owning and operating the motor at 10% interest.

28. www.izmirekonomi.edu.tr Solution

29. www.izmirekonomi.edu.tr 0 1 2 3 4 5 6 7 8 9 10 $4,211 $1,000