CHAPTER 4: Present Worth Analysis

FORMULATING ALTERNATIVES

PW EVALUATION USING A STUDY PERIOD

Capitalized Cost (CC) ANALYSIS

PRESENT WORTH ANALYSIS OF EQUAL LIFE ALTERNATIVES

SELECTION OF ALTERNATIVES BY PW

FUTURE WORTH ANALYSIS
FW

PRESENT WORTH ANALYSIS OF
DIFFERENT LIFE ALTERNATIVES

Two types of economic proposals

Two types of cash flow estimates

  1. Mutually Exclusive (ME) Alternatives: Only one can be selected; Compete against each other
  1. Independent Projects: More than one
    can be selected; Compete only against DN
  1. Cost: Alternatives include only costs; revenues and savings assumed equal for all alternatives; also called service alternatives
  1. Revenue: Alternatives include estimates of costs (cash outflows) and revenues (cash inflows)

MUTUALLY EXCLUSIVE

INDEPENDENT

Select numerically largest PW; alternative A

Select all with PW > 0; projects A, B & D

For one project, if PW > 0, it is justified

For mutually exclusive alternatives, select
one with numerically largest PW

Precede costs by minus sign; receipts by p lus sign

For independent projects, select all with
PW > 0

Convert all cash flows to PW using
MARR

Two ways to compare equal service:

Assumptions of LCM approach

  1. LCM (least common multiple) : Compare the PW of alternatives over a period of time equal to the (LCM) of their estimated lives.
  1. Study period: Compare the PW of alternatives using a specified study period of n years.
  1. Selected alternative can be repeated over each life cycle of LCM in exactly the same manner
  1. Cash flow estimates are the same for each life cycle
    (i.e., change in exact accord with the inflation or deflation rate)
  1. Service provided is needed over the LCM or more years

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

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.

FW exactly like PW analysis, except calculate FW

DEFINATION

BASIC EQUATION

PW of project with
infinite life

CC = P = A/i