ENME619.

12 Fundamentals of Pipeline Economics

TOPIC 3 PRESENT WORTH COMPARISONS

Textbook:
• Riggs, J.L., Bedworth, D.D., Randhawa, S.U., and Khan, A.M., Engineering
Economics, 2nd Canadian Edition, McGraw Hill, 1997, Chapter 3.
Supplementary Readings:
• Blank, L., and Tarquin, A., Engineering Economy, 6th Edition, McGraw Hill, 2005,
Chapter 5.
• Park, C.S., Pelot, R., Porteous, K.C., and Zuo, M.J., Contemporary Engineering
Economics, 2nd Canadian Edition, Addison Wesley Longman, 2001, Chapters 2, 3.
• Steiner, H.M., Engineering Economic Principles, 2nd Edition, McGraw Hill, 1996,
Chapter 5.

3.1 What is the present worth?

Case 1: A friend who is trying to finance a small restaurant venture offers you payment of
$2,000, $4,000, and $7,000 at the end of each of 3 years in order to repay a loan of
$10,000. You are going to charge him an interest rate of 10 percent, which you
would otherwise make on certificates of deposit, in order to do him this favour. This
is a low rate, considering the greater risk of a restaurant in relation to a certificate of
deposit and probable inflation over the next 3 years. Should you lend him the money
on the repayment terms he offers?
Solution:
By the concept of time-value equivalence, your friend’s offer can be discounted by
10% interest rate to its present value:
Your friend’s offer=(2000)(P/F,10,1)+(4000)(P/F,10,2)+(7000)(P/F,10,3)
=(2000)*(0.9091)+(4000)*(0.8264)+(7000)*(0.7513)
=1818.20+3305.60+5259.10=$10,382.90> $10,000
This calculation indicates that if you ignore the risk, you will get $382.90 more to
accept your friend’s offer than you invest on the certified deposits at 10% interest
rate.
Hence the three payments will be acceptable.

Present worth
In general, (Bj= benefit of period j, Cj= cost of period j)
N
if ∑ ( Bj − Cj )( P / F , i, j ) > 0 , the investment is worth to be considered.
j =0
In a special case, when (Bj- Cj) is a constant (BN-CN), the condition is simplified as:
− P + ( BN − CN )( P / A, i, N ) > 0

3.2 Present worth comparisons

a. Comparing two investment alternatives
Case 2: A railroad in Equador whose location was determined a century ago has proposed
certain relocation projects to the government of the country in the hope of obtaining

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funds. One section can be relocated in two new alignments with characteristics as
follows:
Location 1 Location 2
Initial cost ($000,000) 102 140
Annual operation and maintenance ($000,000) 4 2
Annual benefit ($000,000) 20 26
Economic life (years) 40 40
Salvage value 0 0
The public opportunity cost of capital is 12 percent. Which of the locations is more
economical? Or should the project be abandoned?
Solution:
1) Individual analysis
Location 1
-102+(20-4)(P/A,12,40)=-102+16(8.2438)=29.90 (million)
Location 2
-140+(26-2)(P/A,12,40)=-140+24(8.2438)=57.85 (million)
2) Incremental analysis
-(140-102)+[(26-2)-(20-4)](P/A,12,40)=-38+8(8.2438)
=27.95 (million)=57.85-29.90
Alternative 2 is better than alternative 1.

In general
Net Present Value (NPV)
N
NPV 2 − 1 = ∑ [( Bj − Cj )2 − ( Bj − Cj )1]( P / F , i, j ) ≥ 0
j =0
= PV 2 − PV 1 ≥ 0

b. Alternatives with different lives

Case 3: Imagine two alternative proposals for an urban transit system. The first has a service
life of 20 years, the second one of 40 years. First costs of the systems are $100
million and $150 million, respectively. Net benefits of both including externalities
are equal at $30 million per year. The resource opportunity cost is 12 percent. There
will be no salvage values in the end.
Solution:
Alternative 1:
NPV1-0=30(P/A,12,40)-100(P/F,12,20)-100
=30*(8.2438)-100*(0.1037)-100
=247.314-10.37-100=$136.944 million >0
Incremental analysis:
NPV2-1=(30-30)(P/A,12,40)+100(P/F,12,20)-(150-100)
=100*(0.1037)-50=10.37-50= -$39.63 million <0
Alternative 1 is better.

c. Alternatives with salvage values

Case 4: A bridge over a river will have an initial cost of $5 million. Benefits are calculated

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to be $800,000 per year for 30 years. The salvage value at the end of the life of the
bridge is thought to be $50,000. Another alternative to bridging the river is to
construct a ferry. The initial cost will be $200,000. Benefits will be $60,000 per year
for 10 years with a $20,000 salvage value at the end of that time. If the opportunity
cost of public funds is thought to be 15 percent, which alternative should be chosen?
Solution:
Ferry
NPVFerry-Nothing=-200+60(P/A,15,30)+(-200+20)(P/F,15,10)+
(-200+20)(P/F,15,20)+20(P/F,15,30)
=-200+60*(6.5660)-180*(0.2472)-180*(0.0611)+20*(0.0151)
=-200+393.96-44.496-10.998+0.302=138.768*1000=$138,768
Incremental:
NPVBridge-Ferry =-(5000-200)+(800-60)(P/A,15,30)-(0-180)(P/F,15,10)-
(0-180(P/F,15,20)+(50-20)(P/F,15,30)
=-4800+740*(6.5660)+180*(0.2472)+180*(0.0611)+30*(0.0151)
=114.787*1000=$114,787
Bridge is better than ferry

d. Alternatives with deferred investments

Case 5: Two alternatives are being considered by the St. Francis Water Authority for
replacement of an existing water line. Alternative 1 is to install an 18-inch main now
and an additional 18-inch main 10 years hence alongside it. The initial cost of each
18-inch main is $125,000. The total economic life of the installation of both mains in
this manner is estimated to be 40 years. No salvage value is expected. Alternative 2
is to install a single 26-inch main now at a cost of $200,000. No salvage value is
anticipated for this alternative at the end of its 40-year life. If the opportunity cost of
capital of this organisation is 8 percent after all considerations of inflation are taken
into account, which alternative should be chosen?
Solution:
Incremental analysis (but not include null alternative):
NPV 26in-18in= -(200,000-125,000)+(0-0)(P/A,8,40)-(0-125,000)(P/F,8,10)
= -75,000+125,000*(0.4632)= -75,000+57,900= -$17,100
Therefore, the 26-inch main is not justified.

3.3 Perpetual Investments

When N→∞, the investment is called perpetual investment. In practice, perpetual
investments mean different kinds of long term investments, eg. bonds, fund, fixed term bank
deposit, etc. The capital (or capitalised cost) can be calculated by: P=A/i.

Case 6: If by perpetual investment at 8 percent interest rate we want to return a loan of 10

million dollars in 50 years, what is the principle (or capitalised cost) to be invested?
Solution:
A=10,000,000(A/P,8,50)=10,000,000*(0.0817)=$817,000
P=A/i=817,400/0.08=$10,212,500

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3.4 Application of Present Worth Comparison Method

Case 7: An oil/gas company is considering the acquisition of a piece of new equipment. The
required initial investment of $75,000 and the projected cash benefits before tax over
the 3-year’s project life are as follows: The end of year 1: $24,400; The end of year
2: $27,340; The end of year 3: $55,760. Ignore tax and inflation factors, evaluate the
economic merit of the acquisition. The company’s MARR (minimum attractive rate
of return) is known to be 15%.
Solution:
PW=-75,000+24,400(P/F,15,1)+27,340(P/F,15,2)+55,760(P/F,15,3)
=-75000+24400*(0.8696)+27340*(0.7561)+55760*(0.6575)=$3552.21.
Since the project results in a positive present worth of $3552.21, the project is acceptable.

Case 8: Two alternative pipeline facilities P1 and P2 are under economic assessment. P2 has
an initial cost of $3200 and an expected salvage value of $400 at the end of its 4-
year service life. P1 costs $900 less initially, with an economic life 1 year shorter
than that of P2; but P1 has no salvage value, and its annual operating costs exceed
those of P2 by $250. When the company’s MARR or required rate of return is 15%,
state which alternative is preferred? If we assume that a selected facility is only
needed for 2 years, what suggestion you would like to make for this assessment?
Solution:
NPV P2-P1=-900+250(P/A,15,12)-(3200-400)[(P/F,15,4)+(P/F,15,8)]
+400(P/F,15%,12)+2300[(P/F,15%,3)+(P/F,15%,6)+(P/F,15%,9)]
=-900+250*(5.4206)-2800*(0.5718+0.3269)
+400*(0.1869)+2300*(0.6575+0.4323+0.2843)
=-900+1355.15-2516.36+74.76+3160.43=$1173.98
Since the NPV of P2 over P1 is $1173.98, P2 should be selected.
NPV P2-P1=-3200+2300+250(P/A,15%,2)+ S P2-P1 (P/F,15%,2)=0
S P2-P1=(900-250*(1.6257))/(0.7561)=$652.79
If P2 can get $652.79 salvage value more than the salvage value of P1, P2 is preferred.
Otherwise, P1 is justified.

3.5 Tutorial questions

a. Problem 1
Two alternate plans in the design of some small industrial buildings are summarised
here:
Plan 1 Plan 2
First cost ($) 25,000 50,000
Life (years) 10 20
Salvage value ($) 5,000 0
Annual cost ($) 6,000 2,500
One of these two plans is certain to be chosen; therefore it is not necessary to
consider the null alternative (status quo). Tax and inflation considerations have been
included in the cash flows.
1) Using a minimum attractive rate of return of 20 percent before income taxes,

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compare the plans on the basis of present worth. Assume that all
replacements have the same first costs, lives, and salvage values and annual
disbursements as the initial facilities. Which plan should be chosen?
2) Using the present-worth method, but this time by incremental analysis, select
the best plan.
3) How can you check the answer given by (a) against that given by (b)?

b. Problem 2
Two air compressor makers are being compared for a large construction company
with a view toward standardisation on one make. The date for use in an economic
analysis are as follows:
Make First cost($) Annual cost($) Life(Years) Salvage Value($)
Fairbanks 8,000 600 4 1,000
Stromberg 10,000 500 5 1,000
The opportunity cost of capital for this company is 25 percent before taxes. Do a
present-worth before-tax analysis, and a recommendation. The tax consequences of
the compressors are thought to be equal. Inflation consideration will also be the
same for both makes.

c. Problem 3
A couple decide to provide for their old age by setting aside a sum of money each
year for the next 20 years. At the end of the 21st tear, they wish to withdraw $25,000
and to continue to withdraw $25,000 per year perpetually.
If their opportunity cost of capital is 10 percent, how much must they invest each
year for the next 20 years? Assume that 10 percent is the return they can receive on
their funds after they have allowed for inflation and after they have paid their taxes.

d. Problem 4
The interest rate on home loans has dropped from 9.5 percent to 8 percent in the
time you have hesitated about buying a house. On the prospective loan of $66,600
that you will need to buy the house you have in mind over a term of 30 years, how
much has this drop in the interest rate saved you in terms of present worth, if your
personal opportunity cost of capital is 10 percent? Do not consider tax effects.

e. Problem 5
Two alternative plans for electrical switching gear are estimated to have the
following features:
Plan 1 Plan 2
First cost ($) 28,000 50,000
Life (years) 10 20
Salvage value ($) 3,000 0
Annual cost ($) 5,000 2,600
One of these plans is certain to be chosen. The Opportunity cost of capital, before
taxes, for this firm is 15 percent. Using the net-present-worth method, before taxes,
Choose between the plans.

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Answers to tutorial questions

Problem 1 1) NPW1=-$57,319, NPW2=-$62,175, select plan 1.
2) NPW2-1=-$4856, select plan 1.
3) NPW2-NPW1=NPW2-1.
Problem 2 NPWF=-$15,079, NPWS=-$16,198, NPWF-S=$1119,
choose Fairbanks.
Problem 3 F20=25,000/0.10=$250,000, A=$4,365.
Problem 4 The difference in the payment=$858, NPW=$8087.
Problem 5 PW1=-$65,290, PW2=-$66,273, select plan 1.

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