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Economic Evaluation

of Alternatives
OBJECTIVES After studying this chapter, you should
be able to understand:
1. What is Economic Evaluation of Alternatives
2. Different Methods in EEA
3. Numerical / Problems
LEARNING
Introduction

• Alternatives are developed from project proposals to


accomplish a stated purpose.
• Some projects are economically and technologically viable,
and others are not.
• Once the viable projects are defined, it is possible to
formulate the alternatives.
• It is important to classify an alternative’s cash flows as
revenue based or cost-based.
Bases for Comparison of Alternatives
There are several bases for comparing the worthiness of the
projects. These bases are:

i. Present worth method


ii. Future worth method
iii. Annual equivalent method
iv. Capital recovery method
v. Rate of return method
Present Worth Method
In this method of comparison, the cash flows of each
alternatives will be reduced to time zero by assuming an interest
rate i. Then depending on the type of the decision the best
alternatives will be selected by comparing the present worth of
both the alternatives.

Two methods in calculating the present worth:


• Cost dominated cash flow diagram
• Revenue dominated cash flow diagram
Present Worth Method
Cost dominated cash flow diagram:
In the cost dominated cash flow diagram, the costs (out flows) will be
assigned with a positive sign and the profits, revenue and salvage
value (inflows) will be assigned with negative sign.
Revenue dominated cash flow diagram:
In a revenue/ profit dominated cash flow diagram, the profit, the
revenue salvage value (all inflow to an organization) will be assigned
with a positive sign. The costs (outflows) will be assigned with
negative sign.
Present Worth Method
Cost dominated cash flow diagram:
A generalized cash flow diagram to demonstrate the present worth method of
comparison is shown below.

Where,
P – Represents initial investment
Cj – Net cost of the operation and maintenance at the end of j th year.
S – Represent the salvage value at the end of n th year
Present Worth Method
Cost dominated cash flow diagram:

To compute the present worth amount of the above cash flow diagram
for a given interest rate i,

In the above formula, expenditure is taken as positive sign and revenue


as negative. The alternative with minimum present worth amount
should be selected as the best alternative.
Present Worth Method
Revenue dominated cash flow diagram:

Where,
P – Represents initial investment
Rj – Net revenue at the end of jth year.
S – Represent the salvage value at the end of nth year
Present Worth Method
Revenue dominated cash flow diagram:

To compute the present worth amount of the above cash flow


diagram for a given interest rate i,

In the above formula, expenditure is taken as negative sign and


revenue as positive. The alternative with maximum present
worth amount should be selected as the best alternative.
Solved Problems
1. A Construction company receives two bids for a elevator to be
installed in their newly constructed apartment, the details of which is
given in the following table.
Bidding Construction Company estimates
Company
Initial Cost (Rs) Service life (years) Annual operations &
maintenance cost (Rs)
1 5,80,000 15 29,000
2 6,40,000 15 30,800

Determine the best bid based on the present worth method of


comparison assuming 12% interest rate, compounded annually.
Solved Problems
2. The following table gives an initial outlay and annual revenue of a
production firm using three different technologies. Find the best
alternative if the interest rate is 20% compounded annually.
Initial Annual Revenue Life (years)
Outlay (Rs) (Rs)
Alternative 1 13,00,000 4,00,000 10
Alternative 2 21,00,000 6,50,000 10
Alternative 3 23,00,000 8,60,000 10
Solved Problems
3. Investment proposals A and B have the net cash flows as follows:
Proposal End of years

0 1 2 3 4
A (Rs) -10,000 3,000 3,000 7,000 6,000
B (Rs) -10,000 6,000 6,000 3,000 3,000

Compare the present worth of A with that of B at i=18%. Which proposal


should be selected ?
4. A granite company is planning to buy a fully automated granite cutting
machine. If it is purchased under down payment, the cost of the machine
is Rs 16,00,000. If it is purchase under installment basis, the company has
to pay 25% of the cost at the time of purchase and the remaining amount
in 10 annual equal installments of Rs 2,00,000 each. Suggest the best
alternative for the company using the present worth basis at i=18%,
compounded annually.
Solved Problems
5. A small business with an initial outlay of Rs 12,000 yields Rs10,000
during the first year of its operation and the yield increases by Rs 1,000
from its second year of operation up to its 10th year of operation. At the
end of the life of the business, the salvage value is zero. Find the
present worth of the business by assuming an interest rate of 18%,
compounded annually.

6. A finance company advertises two investment plans. In plan1, the


company pays Rs 12,000 after 15 years for every Rs 1,000 invested
now. In plan2, for every Rs 1,000 invested, the company pays Rs 4,000
at the end of the 10th year and Rs 4,000 at the end of 15th year. Select
the best investment plan from the investor’s point of view at i=12%,
compounded annually.
Solved Problems
1. Soln: Bidding Company 1
Given data: P= Rs. 5,80,000/- ; A = Rs. 29,500/- ; N = 15 yrs
i = 12% compounded annually
The CFD for the first bid is shown below:
0 1 2 14 15
t

Rs. 29,000
Rs. 5,80,000 i =12 %

The present worth of the bid 1 is given by,


PW (i%) = P + A (P/A, i , n)
= 5,80,000 + 29,000 (P/A, i , n)
= 5,80,000 + 29,000 (P/A, 12 , 15)
= 5,80,000 + 29,000 (6.81086)= Rs. 7,80,920.37/-
Solved Problems
1. Soln: Bidding Company 2
Given data: P= Rs. 6,40,000/- ; A = Rs. 30,800/- ; N = 15 yrs
i = 12% compounded annually
The CFD for the first bid is shown below:
0 1 2 14 15
t

Rs. 30,800
Rs. 6,40,000 i =12 %

The present worth of the bid 1 is given by,


PW (i%) = P + A (P/A, i , n)
= 6,40,000 + 30,800 (P/A, i , n)
= 6,40,000 + 30,800 (P/A, 12 , 15)
= 6,40,000 + 30,800 (6.81086)= Rs. 8,49,774.49/-
Solved Problems
2. Soln: Alternative 1
Given data: P= Rs. 13,00,000/- ; A = Rs. 4,00,000/- ; N = 10 yrs
i = 20% compounded annually
The CFD for the first bid is shown below:
A= Rs. 4,00,000
t
0
1 2 9 10
i =20 %

P= Rs. 13,00,000
The present worth of the bid 1 is given by,
PW (20%) = - P + A (P/A, i , n)
= -13,00,000 + 4,00,000 (P/A, i , n)
= -13,00,000 + 4,00,000 (P/A, 20,10)
= -13,00,000 + 4,00,000 (4.19247) = Rs. 3,76,988/-
Solved Problems
3. Soln: Proposal A
Given data: P= Rs. 10,000/- ; N = 4 yrs
i = 18% compounded annually
The CFD for the first bid is shown below:
3,000 3,000 7,000 6,000

t
0
1 2 3 4
i =18 %

P= Rs. 10,000
The present worth of proposal A is given by,
PW (18%) = - P + A (P/F, i , n)
= -10,000 + 3,000 (P/F, 18, 1) + 3,000 (P/F, 18, 2) +

7,000 (P/F, 18, 3) + 6,000 (P/F, 18, 4)


Solved Problems
3. Soln: Proposal B
Given data: P= Rs. 10,000/- ; N = 4 yrs
i = 18% compounded annually
The CFD for the first bid is shown below:
6,000 6,000 3,000 3,000

t
0
1 2 3 4
i =18 %

P= Rs. 10,000
The present worth of proposal A is given by,
PW (18%) = - P + A (P/F, i , n)
= -10,000 + 6,000 (P/F, 18, 1) + 6,000 (P/F, 18, 2) +

3,000 (P/F, 18, 3) + 3,000 (P/F, 18, 4)


Solved Problems
4. Soln: There are two alternatives available for the company
1. Down payment of Rs 16,00,000
2. Down payment of Rs 4,00,000 and 10 annual equal
installments of Rs 2,00,000 each
The CFD is shown below:
0 1 2 3 10
t

2,00,000 2,00,000 i =18 % 2,00,000


Rs. 4,00,000

The present worth of the bid 1 is given by, PW (18%) = P + A (P/A, i , n)


= 4,00,000 + 2,00,0000 (P/A, 18 , 10)
= 4,00,000 + 2,00,0000 (4.4941) = Rs. 12,98,820/-
The present worth of this option is Rs. 12,98,820, which is less than the first
option. Hence the company should select the second alternative to buy.
Solved Problems
5. Soln:
Given data: P= Rs. 12, 000/- ; A= Rs 10,000; n = 10 yrs
G = Rs 1,000 ; i = 18% compounded annually
The CFD for the small business is shown below:
19,000
11,000 12,000
10,000

t
0
1 2 3 10
i =18 %

P= Rs. 12,000

The equation of present worth is given by,


PW (18%) = -12,000 + (10,000 + 1,000*(A/G, 18, 10)) * (P/A, 18, 10)

= -12,000 + (10,000 + 1,000 * 3.1936) * 4.494)


Solved Problems
6. Soln: plan 1

The CFD for plan1 is shown below:


12,000

0
1 2 3 15
i =12 %

P= 1,000

The equation of present worth is given by,


PW (12%) = -1,000 + 12,000 (P/F, 12%, 15)
= -1,000 + 12,000 (0.1827)
= Rs 1,192.40/-
Solved Problems
6. Soln: plan 2

The CFD for plan 2 is shown below:


4,000 4,000

0
1 2 3 10 15
i =12 %

P= 1,000
The equation of present worth is given by,
PW (12%) = -1,000 + 4,000 (P/F, 12%, 10)
+ 4000 (P/F, 12%,15)
= -1,000 + 4,000 (0.3220) + 4,000 (0.1827)
= Rs 1,018.80/-
Present Worth Method – Unequal Lives
• When the assets have unequal lives, there must be comparison between
the alternatives based on equivalent outcomes.
• For example, a magazine offers the subscription for 3 years for Rs. 325
and for 5 years Rs 500. In this case comparison base on Rs 325 and Rs
500 will be inappropriate, because paying extra Rs 175 buys 2 more
years of issues.
• The following two methods are most commonly used to make comparison of
assets having unequal lives:
1. Common multiple method
2. Study period method
1. Common Multiple Method
• In this method, alternatives are co-terminated by selecting an analysis period
which is the Least Common Multiple (LCM) of the lives of the involved assets.
• For example, if the assets had lives of 3 and 4 years, then the Least Common
Multiple (LCM) is 12 years, which means the asset with 3 years life will be
replaced 4 times and that with life of 4 years will be replaced 3 times respectively.
Problem 7: Two types of trucks are available for transportation use. They are
needed for 10 years. The details are,
Details Truck A Truck B
First Cost Rs 10,00,000 Rs 15,00,000
Estimated annual Rs 20,000 Rs 15,000
maintenance cost
Estimated life 5 years 10 years
Estimated salvage value Rs 2,00,000 Rs 5,00,000

Both the truck deliver same amount of work. Assume interest rate of 7%. Which
truck is to be preferred on present worth basis?
Solved Problems
7.Soln: This is a problem with unequal lives. We can use common multiple
method for making a comparison. In this case the LCM is 10 years.
Truck 1: Given data: P= Rs. 10,00,000/- ; A = Rs. 20,000/- ; N = 5 yrs
i = 7% ; S = Rs. 2,00,000
The CFD for Truck A is shown below: S=Rs. 2,00,000
S=Rs. 2,00,000

0 1 2 3 4 5 6 7 8 9 10
t

Rs. 20,000 i =7 %

P=Rs. 10,00,000 P=Rs. 10,00,000


Solved Problems
The present worth of the truck A is given by,
PWA (7%) = 10,00,000 + A (P/A, i , 10) + 8,00,000 (P/F, i , 5)
- 2,00,000 (P/F, i , 10)
= 10,00,000 + 20,000 (7.02358) + 8,00,000 (0.71299)
- 2,00,000 (0.50835)
= Rs. 16,09,193.85 /-
Truck B: Given data
P = Rs. 15,00,000
A = Rs. 15,000
N = 10 years
S = Rs. 5,00,000
i = 7% compounded annually
Solved Problems
S=Rs. 5,00,000

0 1 2 3 8 9 10
t

Rs. 15,000 i =7 % Rs. 15,000

P=Rs. 15,00,000

The present worth of the truck A is given by,


PWB (7%) = 15,00,000 + A (P/A, 7 , 10) - 5,00,000 (P/F, 7 , 10)
= 15,00,000 + 15,000 (7.02358) - 5,00,000 (0.50835)
= Rs. 13,51,178.7 /-
Comparing the present worth of truck A and truck B, truck B is chosen.
Solved problems
Problem 8: Assets A1 and A2 have the capability of satisfactorily performing a

required function. Asset A2 has an initial cost of Rs 32,000 and an expected salvage

value of Rs 4000 at the end of its 4 year service life. Asset A 1 costs 9000 less

initially, with an economic life 1 year shorter than that of A 2 ; but A1 has no salvage

value, and its annual operating costs exceed those of A 2 by Rs 2500. When the
required rate of return is 15% state which alternative is preferred when comparison
is by,

a)The repeated – project method

b)A2 year study period assuming the assets are needed for only 2 years.
Solved Problems
8. Soln: a) The repeated – project method
We can use common multiple method for making a comparison. In this
case the LCM is 12 years.
Asset A1
Given data: P= Rs. 23,000/- ; A = Rs. 2500/- ; n = 3 yrs ; i = 15%
i =15 %

0 1 2 3 4 5 6 7 8 9 10 11 12
years

A= Rs. 2500

P=Rs. 23,000 P=Rs. 23,000 P=Rs. 23,000 P=Rs. 23,000


Solved Problems
The present worth of A1 is given by,
PW (15%) = P + P(P/F,i,3) + P(P/F,i,6) + P(P/F,i,9) + A(P/A,i,12)
= 23,000 + 23,000 (P/F, i , 3) + 23,000(P/F, i , 6)
+ 23,000(P/F, i , 9) + 2500(P/A, i, 12)
= 23,000 + 23,000 (0.65752) + 23,000 (0.43233)
+ 23,000 (0.28426) + 2500 (5.42062)
= Rs. 68,156.08 /-

Asset A2

Given data: P= Rs. 32,000/- ;


S = Rs. 4000/- ;
n = 4 yrs ;
i = 15%
Solved Problems
Asset A2
S=Rs. 4,000 S=Rs. 4,000 S=Rs. 4,000

0 4 8 12
years
i =15 %

P=Rs. 32,000 P=Rs. 32,000 P=Rs. 32,000

The present worth of A2 is given by,


PW (15%) = P + P-S(P/F,i,4) + P-S(P/F,i,8) - S(P/F,i,12)
= 32,000 + 28,000(P/F, i, 4) +28,000(P/F, i, 8) – 4000(P/F,i,12)
= 32,000 + 28,000(0.57175) +28,000(0.32691) – 4000(0.18691)
= Rs. 56,414.84/-
Solved Problems
b) Study period method:
In this case during the study period of two years the
assets will be disposed off after their service for 2 years. Hence it is
essential to find the salvage value of the assets. The minimum resale
value can be calculated in this case to make the alternatives equivalent.
After this, only a judgment is necessary to decide whether the market
value is above or below this level.
Assuming a minimum salvage value of S=0 for assets A1 and A2 after
two years of service, we have the present worth,
PW(A1) = 23,000 + 2500 (P/A,i,2) = 23,000 + 2500 (1.62571)
= Rs. 27064.275/-
PW(A2) = 32,000/-
This means A1 has the lower PW costs for a 2 year period for zero
salvage value
Solved Problems
The salvage value of A2 which makes
PW(A2) = PW(A1) is
32000 – S (P/F,i,2) = Rs. 27064.275
S = 32000 – 27062.275
(P/F, 15 ,2)

S = Rs. 4935.725 = Rs. 6527.53/-


0.75614

This means A2 is preferred to A1 if the resale value of A2 at the end of


year 2 is more than Rs. 6527.53/-. This is greater than the resale value
of A1 at the same time.
Assets having Infinite Lives – A
Comparison
• The evaluation of assets assumed to have infinite lives is done by
calculating the capitalized cost.
Capitalized cost = First cost + disbursements for a period N= ∞
•If P is the first cost, then
• Capitalized cost = P + A (P/A, i, ∞) = P + A 1 =P+ A
i i
where A is the uniform difference between annual receipts and
disbursements.
• When there is no revenue, capitalized cost is given by,
Capitalized cost = P + Disbursements
i
• This type of comparison is used to study dams, tunnels and similar
structures that provide extended service.
Solved problems
Problem : A music academy has received a gift cheque of Rs 5,00,000 for the
construction and continuous upkeep of a music shell. Annual maintenance for a
shell is estimated to be Rs15,000. In addition, Rs 25,000 will be needed every
10 years for painting and major repairs.

How much will be left for the initial construction costs, after funds are allocated
for perpetual upkeep? Deposited funds can earn 6% annual interest and these
returns are not subject to taxes.
Solved Problems
Soln: The cash flow diagram for the given case is shown below.
0 1 10 20
years

A = 25,000 A = 25,000
i =6 %
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
years

A=Rs. 15,000+25000 ( A/F , 6 , 10 )


Solved problems
The annual disbursements include Rs 15,000 for maintenance and annual
payments necessary to accumulate Rs 25,000 every 10 years. We have,

Capitalized cost = First cost + Annual disbursements


i

Or First cost = Capitalized cost - A


i
= Rs 5,00,000 - Rs 15000 + 25000 (A/F, 6 , 10)
0.06

= Rs 5,00,000 - Rs 15000 + 25000 ( 0.0759)


0.06
= Rs 2,18,387.50 /-
Recap

1. What is Economic Evaluation of


Alternatives
2. Different Methods in EEA
3. Numerical / Problems