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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

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:

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.

• 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,

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:

diagram for a given interest rate i,

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

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

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.

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 %

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 %

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) +

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) +

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

Rs. 4,00,000

= 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

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

Solved Problems

6. Soln: plan 1

12,000

0

1 2 3 15

i =12 %

P= 1,000

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

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 %

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

P=Rs. 15,00,000

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,

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

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

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 %

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)

0.75614

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

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,

i

i

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

0.06

0.06

= Rs 2,18,387.50 /-

Recap

Alternatives

2. Different Methods in EEA

3. Numerical / Problems

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