Present Worth AnalysisPresent Worth Analysis

Chapter 5Chapter 5

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.

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.

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.

Present Worth Analysis of Equal-Life Alternatives

One alternative:

Calculate the PW using the MARR. If PW > 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.

Present Worth Analysis of Equal-Life Alternatives

For one of more independent projects, select all projects with PW > 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.

Present Worth Analysis of Different-Life Alternatives

THE PRESENT WORTH OF THE PRESENT WORTH OF THE ALTERNATIVES THE ALTERNATIVES

MUST BE COMPARED MUST BE COMPARED OVER THE SAME OVER THE SAME

NUMBER OF YEARS!NUMBER OF YEARS!

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.

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.

Analysis period implied in comparing mutually exclusive alternatives

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 > 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.

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.