Theme 6 Basis for comparison of alternatives
6.1 Present Worth
Newnan Chpt 5 pp.138-144
The present worth is a net equivalent amount at the present that
represents the difference between the equivalent disbursements and the
equivalent receipts of an investment’s cash flow for a selected interest
rate.
Characteristics of the present worth method:
1. It considers the time value of money according to the value of i selected
for the calculation.
2. It concentrates the equivalent value of any cash flow in a single index at
a particular point in time (t = 0).
3. A Single unique value of the present worth is associated with each
interest rate used, no matter what the investment’s cash flow pattern
may be.
4. The more positive the present worth value, the more attractive the
investment would be.
5. The present worth value represent the value that would be added to the
value of the firm if the project is accepted.
6.2 Mutually Exclusive Projects
In many engineering situations it is necessary to select the most
economically attractive project or alternative from a number of alternative
projects, which all resolve the same problem or meet the same need.
Acceptance of one automatically rejects all of the others. Such projects
are said to be mutually exclusive.
Mutually exclusive alternatives compete with one another in the
evaluation.
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Mutually exclusive alternatives are compared with each other.
The alternative with most positive NPV, FV, or AE (Annual
Equivalence) is the most economically feasible alternative.
6.3 Independent Projects
The economic attractiveness of each of these projects can be measured,
and an accept or reject decision made without reference to any of the other
projects. The decision on any one project has no effect on the decision
made on another project. Such projects are said to be independent.
Independent projects are therefore measured against the “do nothing”
option. The present worth of the “do nothing” option is 0.
NPV, FV, AE is calculated over the true project life. If unlimited funds are
available, all independent projects with a positive NPV, FV and AE can
be accepted.
The cash flow for independent projects should always be a positive cash
flow.
Independent alternatives
Unlimited funds:
All positive NPV, FV, AE to be accepted.
Limited funds:
All combinations of alternatives with positive NPV, FV, AE to be
considered. Combination with highest positive NPV, FV, AE and total initial
investment does not exceed the budget limit, to be accepted.
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6.4 Present Worth (un-equal lives)
Newnan Chpt 5 pp.144-147
The PW of the alternatives must be compared over the same number of
years.
A fair comparison can be made only when the PW represents costs and
receipts associated with equal service. Failure to compare equal service
will always favour a shorter-lived alternative.
The equal-service requirement can be satisfied by either of two
approaches:
1. Repeatability principle.
2. Study period approach.
6.4.1 Repeatability Principle
Compare the alternatives over a period of time equal to the least common
multiple (LCM) of their lives. (Also called the repeatability principle)
Assumptions for the LCM method
1. The service provided by the alternatives will be needed for LCM of years
or more.
2. The selected alternatives will be repeated over each life cycle of the LCM
in exactly the same manner.
3. The cash flow estimates will be the same in every life cycle. This
assumption is 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 the cash flow is expected to change by any other
rate, the PW analysis must be conducted using constant-Rands, which
considers inflation.
6.4.2 The Study Period Approach
Study (analysis period)
The study or analysis period is the time span over which the economic
effects of an investment will be evaluated.
The Study Period Approach
A time horizon is chosen over which the economic analysis is conducted,
and only those cash flows, which occur during that time period, are
considered relevant to the analysis. An estimated market value at the end
of the study period must be made.
Consider the study period to be the required service period. When the
required service period is not stated at the outset, the analyst must
choose an appropriate analysis period over which to study the
alternative investment projects.
We must compare projects with different useful lives over an equal time
span, which may require adjustments in our analysis (rent or buy new
equipment to fill the gap in the time period).
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When the useful life of an investment project does not match the analysis
or required service period, we must make further adjustments in our
analysis (estimate of salvage value).
6.5 Decision Between Alternatives
6.5.1 Equal Project Lives
Explanation of methodology for comparing revenue projects with un-equal
project lives
Explanation of methodology for comparing service projects with unequal
project lives
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6.5.2 Un-equal Project Lives
Explanation of methodology for comparing revenue projects /
services (with un-equal project lives)
6.5.2.1 No salvage value
n = 3 < Longest project life
6.5.2.2 Salvage value
n = 3 < Longest project life
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n = 3 < Longest project life
6.5.2.3 No salvage value
n = 5 > shortest project life
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6.5.2.4 LCM Method
n Infinity (LCM Method)
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Finite service requirement
1. Analysis period equals project lives
NPV = -209000 + 65000(P/A, 12, 5) + 90000(P/F, 12, 5)
= 76379
NPV = -294000 + 74000(P/A, 12, 5) + 200000(P/F, 12, 5)
= 85639
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NPV = -294000 + 58000(P/A, 12, 5) + 200000(P/F, 12, 5)
= 82497
Alternative B recommended
2. Project life longer than the analysis period
Study period: 2 years i = 15%
Alternative A has the least negative value
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3. Project life is shorter than analysis period
Study period: 5 years i = 15%
Alternative B the better option
4. Analysis period coincides with longest project life (revenue
projects)
Study period: 5 years i = 15%
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Alternative A the better option
5. Lowest common multiple of project lives
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6.6. The Future Worth
Newnan Chpt 9 pp.266-273
The future worth represents the difference between the equivalent receipts
and disbursements at some common point in the future.
Decision criteria:
Once the FW is determined, the selection guidelines are the same as with
PW analysis.
FW 0 means the MARR is met or exceeded (for one alternative).
For two or more mutually exclusive alternatives, select the one with the
numerically larger (largest) FW value.
For independent alternatives accept all alternatives with a FW 0
Future worth of different life alternatives
Only revenue projects!!!!
6.7 Annual Equivalence (AE)
Newnan Chpt 5 pp.170-185
The annual equivalent is the annual equivalent receipts less the annual
equivalent disbursements of a cash flow.
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6.7.1 Evaluating Alternatives by Annual Worth Analysis
Newnan Chpt 6 pp.178-179
Only one alternative
AW 0, the MARR is met or exceeded. Project therefore economically
viable.
Mutually exclusive alternatives
Calculate AW at the MARR. Choose the lowest cost or highest income AW
value.
Independent alternatives (only revenue projects)
Choose all the alternatives with AW value 0.
6.7.2 Repeating Cash Flows
Newnan Chpt 6 pp.179-180
900 900 900
400 400 400
0 1 2 3 4 n-2 n-1 n
-1000 -1000 -1000
AE(10%) = [-1000 + 400(P/F, 10, 1) + 900(P/F, 10, 2)](A/P, 10, 2)
= 61.93
6.7.3 Comparing Alternatives with Different Lives using the AW
Value
Newnan Chpt 6 pp.170-185
Assumptions:
The services provided are needed for the indefinite future.
The selected alternative will be repeated for succeeding life cycles in
exactly the same manner as for the first cycle.
All cash flows will have the same estimated values.
The AW value has to be calculated for only one cycle.
For mutually exclusive alternatives the AW is calculated over the actual
project life of each alternative and then choose the lowest cost or highest
income AW value.
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6.7.4. Capital Recovery with Return
Notes para 6.7.4
The capital recovery with return [CR(i)] for any investment is the equal
annual cash flow over its life , equivalent to the capital costs of the
investment represented by the initial outlay and the eventual salvage
value.
AE(i)(cost of capital)
CR(i)=AE(i)(first cost)–AE(i)(salvage value)
CR(i) = P(A/P,i,n) – F(A/F,i,n)
Since: (A/F,i,n) = (A/P,i,n) – 1
By substitution:
CR(i) = P(A/P,i,n) – F[(A/P,i,n) – i]
And : CR(i) = (P – F)(A/P,i,n) + Fi
An asset with a first cost of R5000 has an estimated service life
of 5 years and an estimated salvage value of R1000 is
compared to an asset B with a first cost of R6000, an estimated
service life of 5 years and an estimated salvage value of R1500.
The MARR = 10%.
A: 1000
0 5
5000
CR(10) = (5000 – 1000)(A/P, 10, 5) + 1000(0.10)
= 1155.20
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B: 1500
0 5
6000
CR(10) = (6000 – 1500)(A/P, 10, 5) + 1500(0.10)
= 1337.10
Asset A would be preferred on grounds of its lower capital recovery value.
6.8. Internal rate of return (IRR)
Newnan Chpt 7 pp.196-209
A projects’ return is referred to as the internal rate of return (IRR) or the
yield promised by an investment project over its useful life.
The internal rate of return (IRR) is the interest rate that causes the
equivalent receipts of a cash flow to equal the equivalent disbursements of
that cash flow.
The IRR for an investment is the interest rate i* that satisfies the following
equation:
NPW = FW = AE = 0
6.8.1 Evaluating Alternatives by IRR
Newnan Chpt 7 pp.196-204
The IRR can only be calculated for revenue projects. Service projects
(projects with negative cash flow) have no NPV = 0
Only one alternative:
Alternative economically viable if the IRR MARR
Independent alternatives:
All alternatives with an IRR MARR can be accepted if funds are
available.
Mutually exclusive alternatives:
Accept the alternative with the highest IRR and MARR
6.8.2 Cautions when using rate of return
Newnan Chpt 7 pp.201-202
Multiple i* values:
Newnan Appendix7A pp.226-236
Depending upon the sequence of net cash flow, there may be more
than one real-number root to the IRR equation, resulting in more than
one i* value.
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Inconsistent ranking problem:
Depending on the MARR value the PW method can offer a different
answer than the rate of return.
If the MARR is equal to MARR 1 the PW method would favour project A
and the IRR would favour B.
6.9 The Payback Period Method
Newnan Chpt 9 pp.276-280
The pay back period is the estimated time, usually in years, it will
take for the estimated revenues and other economic benefits to recover
the initial investment at a stated rate of return.
The payback period is defined as the smallest value of n that satisfies the
equation:
End of year A B C
0 - 1000 - 1000 - 700
1 + 500 + 200 - 300
2 + 300 + 300 + 500
3 + 200 + 500 + 500
4 + 200 + 1000 0
5 + 200 + 2000 0
6 + 200 + 4000 0
Present Worth i = 0% + 600 + 7000 0
Payback period (years) 3 3 3
Deficiencies of the method:
Fails to consider the time value of money.
Fails to consider the consequences of the investment following the
payback period, including the magnitude and timing of the cash flows
and the expected life of the investment.
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6.10. Payback Period with Interest
Newnan Chpt 9 pp.279-280
Payback period and Project Balance diagram in support role
Payback with interest determines the length of time required until the
investment’s equivalent receipts exceed the equivalent capital outlays.
i = 15%
Y 0 1 2 3 4 5 6
Cash -1000 500 300 200 200 200 200
flow
Project Balance at t = 5 years:
-1000
+500(P/F,15,1)
+300(P/F,15,2)
+200(P/F,15,3)
+200(P/F,15,4)
+ 200(P/F,15,5)
=7
At n = 5 Project balance becomes 0
6.11 Capitalized Equivalent Amount
Newnan Chpt 5 pp.147-155
The capitalised equivalent represents a basis of comparison that consists
of finding a single amount at the present which, at a given rate of interest,
will be equivalent to the net difference of receipts and disbursements if a
given cash flow pattern is repeated in perpetuity.
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6.11.1 Procedure for Calculating the Capitalized Cost (CC)
Draw a cash flow diagram showing all nonrecurring(ones off) and at least
two cycles of recurring(periodic) cash flows.
Calculate the PW of all non-recurring amounts. This is the CC value for
non-recurring costs.
Calculate the equivalent uniform annual worth (A) through one life cycle
of all recurring costs.
Add these AW values to the other uniform amounts occurring in years 1
through infinity. This results in a total equivalent uniform annual worth.
Divide the AW obtained in step 4 by the interest rate i.
Add all the CC values calculated in steps 2 and 5.
Newnan Chpt 5 pp.147-150
Non-recurring costs
R150000 t=0
R 50000 t = 10
0 10 13 26
50000
150000
CC(5%) = -150000 – 50000(P/F, 5, 10)
= -180695
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Recurring costs at intervals
Recurring cost annually
Recurring cost annually
CC (Total) = -180695 – 16950 – 100000 – 49362
= - 347007
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