Topic 1: Financial Management
Present Worth Comparison
Judging proposed investments
• There are many ways of judging proposed
investments:
– All based on a minimum rate of return i*
• How to determine i*?
– At least as not lower than the interest rate
– Also based on other available opportunities
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Judging proposed investments
• Four different methods:
– Present worth
– Annual equivalent cash flow
– Internal rate of return
– Benefit/cost ratios
• All are mathematically equivalent:
– Slightly different pluses and minuses
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Judging proposed investments
• One alternative might have:
– Higher initial cost, but
– Lower annual cost or longer life
• Must convert to comparable terms
• Alternatives may also have different
income tax implications:
– Compare based on after-tax performance!
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Calculation of present worth
• Based on discounting!
– Future costs and benefits discounted to present
– Discount rate = minimum rate of return i*
– Tells us how much we care about the future
• Present worth is the most intuitive method:
– All costs and benefits are converted to year 0
– Easy to interpret
• But can be difficult to implement for projects with
different lives
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Example
• Current labor cost is $9200/year
• Option to build new equipment:
– First cost $15,000
– Labor $3300/year
– Power $400/year
– Maintenance $1100/year
– Property tax and insurance $300/year
– Income tax $1040/year
– Total annual cost $6140/year > $3300!
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Example
• Note:
– Only need to account for changes in property
tax, insurance, etc.
• Assumptions:
– Lifetime of equipment is 10 years
– Minimum rate of return i* = 9%
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Example--results
• Present worth (cost) of current option:
– $9200 (P/A, 9%, 10) = $59,050
• Present worth (cost) of new equipment:
– $6140 (P/A, 9%, 10) = $39,407
– First cost = $15,000
– Total = $54,407
• Is the new equipment better?
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Projects with different lives
• Cannot just bring back to present worth
• For example:
– 20 years of service at a cost of $20,000
may (or may not) be worth more than
– 10 years of service at a cost of $15,000
• When using present worth method:
– Must compare options with equivalent lives
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Example
• Compare options A and B at i* = 11%:
A: First cost = $50,000
– Annual cost = $9,000/year for 20 years
– Salvage value = $10,000 in year 20
B: First cost = $120,000
– Annual cost = $7,000/year for 40 years
– Salvage value = $20,000 in year 40
• Salvage value should be subtracted from cost!
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Example
• Present worth (cost) of option B:
– First cost = $120,000
– $7000 (P/A, 11%, 40) = $62,657
– -$20,000 (P/F, 11%, 40) = - $308
– Total = $182,349
• This option provides 40 years of service
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Example
• Must convert option A to 40 years!
– First cost = $50,000
– $50,000 (P/F, 11%, 20) = $6201
– $9000 (P/A, 11%, 40) = $80,559
– -$10,000 (P/F, 11%, 20) = - $1240
– -$10,000 (P/F, 11%, 40) = - $154
– Total = $135,326
• First cost, salvage value appear twice!
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Example
• Which option is better?
– Option B has:
• Longer lifetime
• Lower annual cost
• Higher salvage value at end of life
– But two copies of option A can provide 40
years of service with lower present worth!
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Projects with different lives
• To evaluate based on present worth:
– Must convert lifetimes of all projects to their
least common multiple!
– In this example, that was easy:
• Least common multiple of 20 and 40 is 40
– In some problems, it can get complicated:
• Least common multiple of 7 and 12 is 84!
• Would need 12 copies of one, 7 of the other
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Projects with perpetual lives
• Some projects may last so long that they
can be modeled as perpetual!
• Even projects with perpetual lives can
have a finite present worth:
– Why?
• General formula for perpetual lives:
P = A/i*, or A = P i*
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Example
• First cost = $50,000
– Annual cost = $9,000/year forever
– Interest rate i* = 11%
• Present worth:
– $50,000 + $9,000/.11 = $131,818
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Perpetual lives
• Some perpetual costs are not annual
– For example, every 20 years we may:
• Need to purchase new equipment ($50,000)
• Get salvage value of old equipment ($10,000)
• To convert perpetual recurrent costs to
present worth:
– First convert to annual
– Then divide by i* to get present worth
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Example
• Every 20 years we:
– Need to purchase new equipment
• $50,000
– Get salvage value of old equipment
• $10,000; (note:- replacement cost: purchase of
new equipment – salvage value)
• Annualized cost is:
– $40,000 (A/F, 11%, 20) = $623
– Present worth = $623/i* = $5664
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Example
• Present worth of continuing project A in
perpetuity:
– First cost in year 0 = $50,000
– Annual cost $9,000/i = $81,818
– $40,000 (A/F, 11%, 20)/i = $5664
• (Replacement cost minus salvage value)
– Total present worth = $137,482
• Only slightly greater than 2 copies ($135,326)
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Perpetual lives
• Why use perpetual lives?
• Avoids the need to analyze numerous
copies of a project:
– If least common multiple of lives is large
• Can simply convert all projects to their
perpetual equivalent
– (Assuming an infinite number of copies)
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Projects with different lives
• The comparison methods so far:
– Least common multiple of lifetimes
– Perpetual lifetimes
make sense if the best option would be
used for an extended period of time
• This may not always be the case:
– e.g., computers (due to rapid change)
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