ENGR 301 Engineering Management Principles and Economics

Tutorial 9 - Solution

1. Two devices are available to perform a necessary function for 3 years. The initial cost for each device at time zero and
subsequent annual savings produced by the device are shown in the table below. If the required interest rate is 8%,
determine which device should be purchased using present worth analysis?

Year 0 1 2 3
Device A –$9,000 $4,500 $4,500 $4,500
Device B –$14,500 $6,000 $6,000 $8,000

PW (device A) = – $9000 + $4500(P/A, 8%,3) = -$9000 + $4500(2.577) = $2597

PW (device B) = – $14,500 + $6000(P/A,8%,2) + $8000(P/F,8%,3)

= – $14500 + $6000(1.7832) + $8000(0.79383) = $2550

Both alternatives meet the minimum acceptable rate of return, because both are positive, and their net present worths
are quite similar. In this case other considerations must be involved in the choice, such as availability of the extra
$5500 needed to purchase device B.

2. Assets A1 and A2 have the capability of satisfactorily performing the required function. A2 has an initial cost of $3200
and an expected salvage value of $400 at the end of its 4-year economic life cycle. Asset A1 costs $900 less initially,
with an economic life 1 year shorter than that of A2, but it has no salvage value and its annual operating costs exceed
those of A2 by $250. When the required rate of return is 15%, which alternative is preferred using present worth
analysis when compared by:
a. The least common-multiple method
b. A 2-year study period (assuming the assets are needed for only 2 years)?

a. The least common multiple of lives is based on the assumption that assets will be replaced by identical models
possessing the same costs. Equivalent service results from comparing costs over a period divisible evenly by the
economic lives of the alternatives; in this case the least common multiple is 12 years.

PW(A1) = – $2300 – $2300(P/F,15%,3) – $2300(P/F,15%,6) – $2300(P/F,15%,9) – $250(P/A,15%,12)

= – $2300 – $2300(0.6575) – $2300(0.4323) – $2300(0.2842) – $250(5.2406) = –$6816

PW(A2) = – $3200 – $2800(P/F,15%,4) – $2800(P/F,15%,8) + $400(P/F, 15%,12)

= – $3200 – $2800(0.5717) – $2800(0.3269) + $400(0.1869) = –$5642

The present worth advantage of A2 over A1 for 12 years of service is $6816 – $5642 = $1174

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 b. S= 0 for alternatives A1 and A2 after 2 years of service
PW(A1) = –$2300 – $250(P/A,15%,2) = –$2300 – $250(1.6257) = –$2707

PW(A2) = –$3200

The salvage value of A2 that would make the PW(A1) = PW(A2) is

$2707 = $3200 – S(P/F,15%,2)
S= ($3200-$2707)/(P/F,15%,2) = $493/0.7561 = $652
This means that A2 is preferred to A1 when the resale value of A2 at the end of 2 years is more than $652 greater
than the resale value of A1 at the same time.

3. While in college Candice received $10,000 in student loans at 5% interest. She will graduate in June and is expected
to begin repaying the loans in either 5 or 10 equal annual payments. Compute her yearly payments for both repayment
plans.

5 YEARS: A = P(A/P, i, n) = 10,000(A/P, 5%, 5) = $2,310.00

10 YEARS: A = P(A/P, i, n) = 10,000(A/P, 5%, 10) = $1,295.00

4. What uniform annual payment for 12 years is equivalent to receiving all of these at an interest rate of 8%:
$3000 at the end of each year for 12 years
$20000 today
$4000 at the end of 6 years
$800 at the end of each year forever
$10,000 at the end of 15 years

Convert all above amounts into equivalent annual amounts.

A1 = $3,000
A2 = 20,000(A/P, 8%, 12) = $2,654
A3 = 4,000(P/F, 8%, 6)(A/P, 8%, 12) = $334.51
A4 =(800/.08)(A/P, 8%, 12) = $1,327 (800/year forever is equivalent to P = A/i = 800/0.08)
A5 = 10,000(P/F, 8%, 15)(A/P, 8%, 12) = $418.27

Σ Ai = 3,000 + 2,654 + 334.51 + 1,327 + 418.27 = $7,733.78

5. A land surveyor just starting in private practice needs a van to carry crew and equipment. He can lease a used van for
$3,000 per year, paid at the beginning of each year, in which case maintenance is provided. Alternatively, he can buy
a used van for $7,000 and pay for maintenance himself. He expects to keep the van three years at which time he could
sell it for $1,500. What is the most he should pay for uniform annual maintenance to make it worthwhile buying the
van instead of leasing it, if his Minimum Attractive Rate of Return (MARR) is 20%?

Lease: EAC = 3,000(F/P, 20%, 1) = 3,000(1.20) = 3,600

Buy: EAC = 7,000(A/P, 20%, 3) + M - 1,500(A/F, 20%, 3)

M = 3,600 - 2,910.85 = $ 689.15

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6. The town of South Battleford is considering building a bypass for truck traffic around the downtown commercial area.
The bypass will provide merchants and shoppers with benefits that have an estimated value of $500,000 per year.
Maintenance costs will be $125,000 per year. If the bypass is properly maintained, it will provide benefits for a very
long time. The actual life of the bypass will depend on factors such as future economic conditions that cannot be
forecast at the time the bypass is being considered. It is therefore reasonable to model the flow of benefits as though
they will continue indefinitely. If the interest rate is 10%, what is the present worth of benefits minus maintenance
costs?

For capitalized cost, P = A / i = (500,000 – 125,000) / 0.1 = $3,750,000

7. A mechanical engineer has decided to introduce automated materials-handling equipment for a production line. He
must choose between two alternatives: building the equipment or buying the equipment off the shelf. Each alternative
has a different service life and a different set of costs.

Alternative 1: build custom automated materials-handling equipment

First cost: $15,000
Labour: $3300 per year
Power: $400 per year
Maintenance: $2400 per year
Taxes and Insurance: $300 per year
Service life: 10 years

Alternative 2: buy off-the-shelf standard automated materials-handling equipment

First cost: $25,000
Labour: $1450 per year
Power: $600 per year
Maintenance: $3075 per year
Taxes and insurance: $500 per year
Service life: 15 years

If the interest rate is 9%, determine which alternative is better using both Present Worth and Annual Cash Flow Analysis.

Using the Present Worth Method

We can apply the least common multiple of lives or repeated lives method. The least common multiple of 10 and 15
is 30 years. Alternative 1 will be repeated twice (after 10 years and 20 years), while alternative 2 will be repeated
once (after 15 years) during the 30-year period. At the end of 30 years, both alternatives will be completed
simultaneously.

Alternative 1: build custom automated materials-handling equipment and repeat twice.

PW (alternative 1) = –15,000 – 15,000(P/F,9%,10) – 15,000(P/F,10%,20) – (3300+400+2400+300)(P/A,9%,30)
= –15,000 – 15,000(0.42241) – 15,000(0.17843) – 6400(10.273) = –89,760

Alternative 2: Buy off-the-shelf standard automated materials-handling equipment and repeat twice
PW (alternative 2) = –25,000 –25,000(P/F,9%,15) – (1450+600+3075+500)(P/A,9%,30)
= –25,000 – 25,000(0.27454) – 5625(10.273) = –89,649

Since the alternatives have a very similar present worth, one should consider other factors in making this decision.

Using the Annual Cash Flow Analysis Method

There is no need to give the alternatives equal lives when using the annual cash flow analysis method.
AW (alternative 1) = –15,000(A/P,9%,10) – 6400 = –15,000(0.15582) – 6400 = –8737
AW (alternative 2) = –25,000(A/P,9%,15) – 5625 = –25,000(0.12406) – 5625 = –8726

Since the alternatives have a very similar annual worth, one should consider other factors in making this decision.

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 ENGR 301
Tutorial 10 – Solutions

1. Consider two investment projects with the following cash flow transactions:

n Project 1 Project 2
0 –$2000 –$2000
1 0 $1300
2 0 $1500
3 0 0
4 $3500 0
Compute the rate of return for each project.

Project 1
We can derive the rate of return for each project by solving for i in the PW or FW. Here we use
solve for i in the future worth.

FW(i) = –$2000(F/P,i,4) + $3500 = 0

$3500 = $2000(F/P,i,4) = $2000(1+i)4
1.75 = (1+i)4
i= 4√1.75 –1 = 0.1502 or 15.02%

Project 2
We may write the NPW expression for this project as

PW(i) = –$2000 + $1300(P/F,i,1) + $1500(P/F,i,2) = 0

= –$2000 + $1300/(1+i) + $1500/(1+i)2 = 0

Let x = 1/(1+i), rewrite PW(i) as a function of x as follows:

PW(x) = –$2000 + $1300x + $1500x2 = 0

This is a quadratic equation that has the following solution:

±
X = [–1300 √13002 – 4(1500)(-2000)]/2(1500)
±
= [–1300 3700] / 3000

= 0.8 or –1.667

replacing x values and solving for i gives:

i= 25%
i= –160%

An interest rate less than –100% has no economic significance, therefore the project’s i is 25%
2. The Imperial Chemical
C Commpany is cons sidering purch
hasing a chem mical analysiss machine
worth
w $13,000. Although the e purchase off this machinee will not prod
duce any incrrease in saless
re
evenues, it will result in a reduction of la
abour costs. In
n order to opeerate the macchine properlyy,
it must be calib
brated each year.
y The mac chine has an expected life of 6 years, after which it
will
w have no sa alvage value. The following g table summ arizes the annual savings in labour cosst
annd the annual maintenance costs in calibration over 6 years:

Year (n) Costs ($) Saving

gs ($) Net Cash F
Flow ($)
0 13,000
0 -13,000
1 2,300 6,000 3,700
2 2,300 7,000 4,700
3 2,300 9,000 6,700
4 2,300 9,000 6,700
5 2,300 9,000 6,700
6 2,300 9,000 6,700

Find the
t rate of retturn for this prroject.

We sttart with a gue

essed rate of 25%. The pre
esent worth o
of the cash flo
ows is:

PW(225%) = -$13,0
000 + $3700(P
P/F,25%,1) + $4700(P/F,25
5%,2) + $670
00(P/A,25%,4
4)(P/F,25%,2))
= $30
095

Sincee the present worth

w is +ive we must raise
e the interestt rate to bring the PW towa
ard zero. Use
an intterest rate of 35%:
3

PW(3
35%) = –$13,0
000 + $3700(P/F,35%,1) +$4700(P/F,35
+ 5%,2) +$6700
0(P/A,35%,4))(P/F,35%,2)
= –$339

PW(i)) will be zero at

a i somewhe
ere between 25%
2 and 35%
%. Using linearr interpolation
n:

5% + (35%–2
I*≅ 25 25%)[(3095–00)/(3095 – (–3
339))]
= 25% + 10%(0.9013)
= 34.01%

We caan check to see how close e this value is to the precise

e value of i* b
by computing the present
worth at this interpolated value.

PW(3 000 + $3700(P/F,34%,1) + $4700(P/F,3

34%) = –$13,0 34%,2) +$670
00(P/A,34%,4
4)(P/F,34%,2))
= –$50.58

As this is not zero we may recompute i* at a lower interesst rate, say 33

3%
PW(33%) = –$13000+$3700(P/F,33%,1) + $4700(P/F,3%,2) +$6700((P/A,33%,4)(P/F,33%,2)
= $248.56

With another round of linear interpolation we approximate:

i* = 33% + (34%–33%)[(248.56–0)/(248.56–(–50.58))]
= 33% + 1%(0.8309) = 33.83%

At this rate,
PW(33.83%) = –$13000 + $3700(P/F,33.83%,1) + $4700(P/F,33.83%,2) +
$6700(P/A,33.83%,4)(P/F,33.83%,2)
= –$0.49

3 All projects are investments. The projects are already ranked from lowest to highest first cost.
The incremental analyses are thus done on 2 – 1, 3 – 1, 4 – 1, 3 – 2, 4 – 2 and 4 – 3.

a. With a MARR of 16%, do projects 1, 3 and 4 as their IRR’s meet or exceed 16%.

b. For MARR = 15%: The current best is alternative 1, which has the least first cost and IRR >
MARR.

Challenge 1 with 2: incremental IRR is 9%; challenge fails.

Challenge 1 with 3: incremental IRR is 17%; challenge succeeds. Hence, 3 is current best.

Challenge 3 with 4: incremental IRR is 13%; challenge fails.

Select 3.

c. For MARR = 17%: The current best is alternative 1, which has the least first cost and IRR >
MARR.

Challenge 1 with 2: incremental IRR is 9%; challenge fails.

Challenge 1 with 3: incremental IRR is 17%; challenge still succeeds. Hence, 3 is current best.

Challenge 3 with 4: incremental IRR is 13%; challenge fails.

Select 3.