Module 2 : Comparison of alternatives

Lecture 1 : Comparison of alternatives

Comparison of alternatives: -
For most of the engineering projects, equipments etc., there are more
than one feasible alternative. It is the duty of the project management
team (comprising of engineers, designers, project managers etc.) of the
client organization to select the best alternative that involves less cost
and results more revenue. For this purpose, the economic comparison of
the alternatives is made. The different cost elements and other
parameters to be considered while making the economic comparison of
the alternatives are initial cost, annual operating and maintenance cost,
annual income or receipts, expected salvage value, income tax benefit
and the useful life. When only one, among the feasible alternatives is
selected, the alternatives are said to be mutually exclusive.

As already mentioned in module-1, the cost or expenses are generally

known as cash outflows whereas revenue or incomes are generally
considered as cash inflows. Thus in the economic comparison of
alternatives, cost or expenses are considered as negative cash flows. On
the other hand the income or revenues are considered as positive cash
flows. From the view point of expenditure incurred and revenue
generated, some projects involve initial capital investment i.e. cash
outflow at the beginning and show increased income or revenue i.e. cash
inflow in the subsequent years. The alternatives having this type of cash
flow are known as investment alternatives. So while comparing the
mutually exclusive investment alternatives, the alternative showing
maximum positive cash flow is generally selected. In this case, the
investment is made at the beginning to gain profit at the future period of
time. Example for such type alternatives includes purchase of a dozer by a
construction firm. The construction firm will have different feasible
alternatives for the dozer with each alternative having its own initial
investment, annual operating and maintenance cost, annual income
depending upon the production capacity, useful life, salvage values etc.
Thus the alternative which will yield more economic benefit will be
selected by the construction firm. There are some other projects which
involve only costs or expenses throughout the useful life except the
salvage value if any, at the end of the useful life. The alternatives having
this type of cash flows are known as cost alternatives. Thus while
comparing mutually exclusive cost alternatives, the alternative showing
minimum negative cash flow is generally selected. Example for such type
alternatives includes construction of a government funded national
highway stretch between two regions. For this project there will be
different feasible alternatives depending upon length of the stretch, type
of pavement, related environmental, social and regulatory aspects etc.
Each alternative will have its initial cost of construction, annual repair and
maintenance cost and some major repair cost if any, at some future point
of time. The alternative that will exhibit lowest cost will be selected for the
construction of the highway stretch.

The differences in different parameters namely initial capital investment,

annual operation cost, annually generated revenue, expected salvage
value, useful life, magnitude of output and its quality, performance and
operational characteristics etc. may exist among the mutually exclusive
alternatives. Thus the economic analysis of the mutually exclusive
alternatives is generally carried out on the similar or equivalent basis
since each of the feasible alternatives will meet the desired requirements
of the project, if selected.

The economic comparison of mutually exclusive alternatives can be

carried out by different equivalent worth methods namely present worth
method, future worth method and annual worth method. In these methods
all the cash flows i.e. cash outflows and cash inflows are converted into
equivalent present worth, future worth or annual worth considering the
time value of money at a given interest rate per interest period.

Comparison of alternatives by present worth method:

In the present worth method for comparison of mutually exclusive
alternatives, the future amounts i.e. expenditures and incomes occurring
at future periods of time are converted into equivalent present worth
values at a certain rate of interest per interest period and are added to
present worth occurring at ‘0’ time. The converted equivalent present
worth values are always less than the respective future amounts since the
rate of interest is normally greater than zero. The cash flow of the
mutually exclusive alternatives may consist of future expenditures and
incomes in different forms namely randomly placed single amounts,
uniform amount series commencing from end of year 1, randomly placed
uniform amount series i.e. commencing at time period other than end of
year 1, positive and negative uniform gradient series starting either from
end of year 1 or at different time periods and geometric gradient series
etc. The different compound interest factors namely single payment
present worth factor, uniform series present worth factor and present
worth factors for arithmetic and geometric gradient series etc. will be
used to convert the respective future amounts to the equivalent present
worth values for different alternatives.

The methodology for the comparison of mutually exclusive alternatives by

the present worth method depends upon the magnitude of useful lives of
the alternatives. There are two cases; a) the useful lives of alternatives
are equal and b) the useful lives of alternatives are not equal. The
alternatives having equal useful lives are designated as equal life span
alternatives whereas the alternatives having unequal life spans are
referred as different life span alternatives.

a) Equal life span alternatives

The comparison of mutually exclusive alternatives having equal life spans
by present worth method is comparatively simpler than those having
different life spans. In case of equal life span mutually exclusive
alternatives, the future amounts as already stated are converted into the
equivalent present worth values and are added to the present worth
occurring at time zero. Then the alternative that exhibits maximum
positive equivalent present worth or minimum negative equivalent
present worth is selected from the considered feasible alternatives.

a) Different life span alternatives

In case of mutually exclusive alternatives, those have different life spans,
the comparison is generally made over the same number of years i.e. a
common study period. This is because; the comparison of the mutually
exclusive alternatives over same period of time is required for unbiased
economic evaluation of the alternatives. If the comparison of the
alternatives is not made over the same life span, then the cost alternative
having shorter life span will result in lower equivalent present worth i.e.
lower cost than the cost alternative having longer life span. Because in
this case, the cost of the short span alternative is considered only for a
shorter period of time, even though this alternative may not be
economical. In case of mutually exclusive investment alternatives, the
alternative with longer life span will result in higher equivalent present
worth i.e. higher positive equivalent worth, as the costs, revenues, savings
through reduced costs is considered over a longer period of time than the
alternative with shorter life span. Thus in order to minimize the effect of
such kind of discrepancy on the selection of best alternative from the
considered feasible alternatives, the comparison is made over the same
life span.

The two approaches used for economic comparison of different life span
alternatives are as follows;

1. Comparison of mutually exclusive alternatives over a time period

that is equal to least common multiple (LCM) of the individual life
spans
 2. Comparison of mutually exclusive alternatives over a study period
which is not necessarily equal to the life span of any of the
alternatives.

In the first approach the comparison is made over a time period equal to
the least common multiple of the life spans of mutually exclusive
alternatives. The cash flow of the alternatives i.e. cash flow of the first
cycle is repeated and the number of repetitions depends upon the value of
least common multiple of life spans between the mutually exclusive
alternatives. It may be noted here that the cash flow i.e. all the costs and
revenues of the alternatives in the successive cycle will be exactly same
as that in the first cycle. For example if there are two alternatives with
useful lives of 4 years and 5 years. Then the alternatives will compared
over a period of 20 years (least common multiple of life spans) at the
given rate of interest per year. Thus the cash flow of the alternative
having the life span of 4 years will be repeated 5 times including the first
cycle whereas the cash flow of the alternative with life span of 5 years will
be repeated 4 times including the first cycle. After that the most
economical alternative will be selected. Taking another example, there are
two alternatives with life spans of 5 years and 10 years. In this case the
alternatives will be compared over a period of 10 years (LCM). Thus the
alternative with life span of 5 years will be analyzed for 2 cycles whereas
the alternative with 10 year life span will be analyzed for one cycle only at
the given rate of interest per year.
In the second approach, a study period is selected over which the
economic comparison of mutually exclusive alternatives is carried out. The
length of the study period will depend on the overall benefit of the project
i.e. it may be shorter or longer (as compared to useful lives of the
individual alternatives) depending upon the short-term or long-term
benefits as desired for the project. Thus the cash flows of the alternatives
occurring during the study period are only considered for the economic
comparison. However if any alternative possesses salvage value at the
end of its useful life and that occurs after the study period, then its
equivalent value must be included in the economic analysis. The values of
equivalent present worth of the mutually exclusive alternatives are
calculated over the selected study period and the alternative showing
maximum positive equivalent present worth or minimum negative
equivalent present worth is selected.

Lecture 2 : Comparison by present worth

method - I
Comparison by present worth method:-

Now some examples showing the use of present worth method for
comparison of mutually exclusive alternatives are presented. First the
comparison of equal life span mutually exclusive alternatives by present
worth method will be illustrated followed by comparison of different life
span alternatives. The following examples are formulated only to
demonstrate the use of different methods for comparison of alternatives.
The values of different cost and incomes mentioned in the examples are
not the actual ones pertaining to a particular item. In addition it may also
be noted here that the cash flow diagrams have been drawn not to the
scale. These are merely graphical representations.

Example -1

There are two alternatives for purchasing a concrete mixer. Both the
alternatives have same useful life. The cash flow details of alternatives are
as follows;

Alternative-1: Initial purchase cost = Rs.3,00,000, Annual operating and

maintenance cost = Rs.20,000, Expected salvage value = Rs.1,25,000,
Useful life = 5 years.

Alternative-2: Initial purchase cost = Rs.2,00,000, Annual operating and

maintenance cost = Rs.35,000, Expected salvage value = Rs.70,000,
Useful life = 5 years.

Using present worth method, find out which alternative should be

selected, if the rate of interest is 10% per year.

Solution:
Since both alternatives have the same life span i.e. 5years, the present
worth of the alternatives will be compared over a period of 5 years. The
cash flow diagram of Alternative-1 is shown in Fig. 2.1.
As already mentioned Module-1, the cash outflows i.e. costs or
expenditures are represented by vertically downward arrows whereas the
cash inflows i.e. revenue or income are represented by vertically upward
arrows. The same convention is adopted here.
Fig. 2.1 Cash flow diagram of Alternative-1

The equivalent present worth of Alternative-1 i.e. PW1 is calculated as

follows;
The initial cost, P = Rs.3,00,000 (cash outflow),
Annual operating and maintenance cost, A = Rs.20,000 (cash outflow),
Salvage value, F = Rs.1,25,000 (cash inflow).
PW1 = - 3,00,000 - 20,000(P/A, i, n) + 1,25,000(P/F, i, n)
PW1 = - 3,00,000 - 20,000(P/A, 10%, 5) + 1,25,000(P/F, 10%, 5)
Now putting the mathematical expressions of different compound interest
factors (as mentioned in Module-1) in the above expression for PW1 (in
Rs.) results in the following;

PW1 = - 3,00,000 -75,816 + 77,613

PW1= - Rs.2,98,203

The cash flow diagram of Alternative-2 is shown in Fig. 2.2.

Fig. 2.2 Cash flow diagram of Alternative-2

Now the equivalent present worth of Alternative-2 i.e. PW2 (in Rs.) is
calculated as follows;
The initial cost, P = Rs.2,00,000 (cash outflow),
Annual operating and maintenance cost, A = Rs.35,000 (cash outflow),
Salvage value, F = Rs.70,000 (cash inflow).

PW2 = - 2,00,000 - 35,000(P/A, i, n) + 70,000(P/F, i, n)

PW2 = - 2,00,000 - 35,000(P/A, 10%, 5) + 70,000(P/F, 10%, 5)

PW2 = - 2,00,000 - 35,000 X 3.7908 + 70,000 X 0.6209

PW2 = - 2,00,000 - 13,2678 + 43,463
PW2= - Rs.2,89,215

Comparing the equivalent present worth of both the alternatives, it is

observed that Alternative-2 will be selected as it shows lower negative
equivalent present worth compared to Alternative-1 at the interest rate of
10% per year.

The equivalent present worth of both the alternatives can also be

calculated by using the values of compound interest factors from interest
tables. The equivalent present worth of Alternative-1 i.e. PW1 is calculated
as follows;

PW1 = - 3,00,000 – 20,000 (P/A, i, n ) + 1,25,000 (P/F, i, n )

PW1 = - 3,00,000 – 20,000 (P/A, 10%, 5 ) + 1,25,000 (P/F, 10%, 5 )

The values of compound interest factors i.e. (P/A, i, n) and (P/F, i, n) can
be obntained from the interest tables (discrete compounding) available in
texts cited in the list of references [1, 7, 14]. Now referring to the interest
table for 10% interest rate, the values of compound interest factors
i.e. (P/A, 10%, 5) and (P/F, 10%, 5) at interest rate (‘i' ) of 10% and for
interest period (‘n' ) of 5 years are obtained at the intersection of these
factors and interest period ‘n' equal to 5 i.e. the values are obtained
from P/A column and P/F column at ‘n' equal to 5 from the interest table
(discrete compounding) corresponding to 10% interest rate. The obtained
values of (P/A, 10%, 5) and (P/F, 10%, 5) are 3.7908 and 0.6209
respectively (same as those obtained using mathematical expressions of
these factors).

Now putting the values of compound interest factors in the above

expression, the equivalent present worth of Alternative-1 i.e. PW1 is
calculated as follows;

PW1 = - 3,00,000 -75,816 + 77,613

PW1 = - Rs.2,98,203

Now the calculation of equivalent present worth of Alternative-2

i.e. PW2 (in Rs.) is presented below.

PW2 = - 2,00,000 – 35,000 (P/A, i, n ) + 70,000 (P/F, i, n )

PW2 = - 2,00,000 – 35,000 (P/A, 10%, 5 ) + 70,000 (P/F, 10%, 5 )

Now putting the values of compound interest factors in the above

expression (same as above) the equivalent present worth of Alternative-2
i.e. PW2 is calculated as follows;

PW2 = - 2,00,000 – 1,32,678 + 43,463

PW2 = - Rs.2,89,215

It may be noted that in the above example only cost components and the
salvage value of the alternatives were considered for comparison. In the
next example, same problem as mentioned in Example-1 will be discussed
by taking into account the annual revenues of the alternatives.

Example -2

Alternative-1: Initial purchase cost = Rs.3,00,000, Annual operating and

maintenance cost = Rs.20000, Expected salvage value = Rs.1,25,000,
Useful life = 5 years.

Alternative-2: Initial purchase cost = Rs.2,00,000, Annual operating and

maintenance cost = Rs.35000, Expected salvage value = Rs.70,000,
Useful life = 5 years.

The annual revenue to be generated from production of concrete (by

concrete mixer) from Alternative-1 and Alternative-2 are Rs.50,000 and
Rs.45,000 respectively. Compute the equivalent present worth of the
alternatives at the same rate of interest as in Example-1 i.e. 10% per year
and find out the economical alternative.

Solution:
The cash flow diagram of Alternative-1 is shown in Fig. 2.3.

Fig. 2.3 Cash flow diagram of Alternative-1

The equivalent present worth of Alternative-1 is calculated as follows;

PW1 = - 3,00,000 - 20,000 (P/A, i, n) + 50,000 (P/A, i, n) + 1,25,000 (P/F, i,
n)
PW1 = - 3,00,000 - 20,000 (P/A, 10%, 5) + 50,000 (P/A, 10%, 5) +
1,25,000 (P/F, 10%, 5)
PW1 = - 3,00,000 + (50,000 – 20,000) (P/A, 10%, 5) + 1,25,000 (P/F, 10%,
5)
PW1= - 3,00,000 + 30,000 (P/A, 10%, 5) + 1,25,000 (P/F, 10%, 5)

PW1 = - 2,00,000 - 35,000 X 3.7908 + 70,000 X 0.6209

PW1 = - 3,00,000 + 1,13,724 + 77,613
PW1 = - Rs.1,08,663

The cash flow diagram of Alternative-2 is shown in Fig. 2.4.

Fig. 2.4 Cash flow diagram of Alternative-2

Now the equivalent present worth of Alternative-2 i.e. PW2 (in Rs.) is
calculated as follows;
PW2= - 2,00,000 - 35,000 (P/A, i, n) + 45,000 (P/A, i, n) + 70,000 (P/F, i, n)
PW2 = - 2,00,000 - 35,000 (P/A, 10%, 5) + 45,000 (P/A, 10%, 5) + 70,000
(P/F, 10%, 5)
PW2 = - 2,00,000 + (45,000 – 35,000) (P/A, 10%, 5) + 70,000 (P/F, 10%, 5)
PW2 = - 2,00,000 + 10,000 (P/A, 10%, 5) + 70,000 (P/F, 10%, 5)

PW2 = - 2,00,000 + 37,908 + 43,463

PW2= - Rs.1,18,629

Comparing the equivalent present worth of the both the alternatives, it is

observed that Alternative-1 will be selected as it shows lower cost
compared to Alternative-2. The annual revenue to be generated by the
alternatives made the difference as compared to the outcome obtained in
Example-1.

When there are more than two alternatives for the selection of the best
economical alternative by present worth method, the same procedure as
mentioned earlier for the case of two alternatives is followed and
illustrated in the next example.

Example -3
A construction contractor has three options to purchase a dump truck for
transportation and dumping of soil at a construction site. All the
alternatives have the same useful life. The cash flow details of all the
alternatives are provided as follows;
Option-1: Initial purchase price = Rs.25,00,000, Annual operating cost
Rs.45,000 at the end of 1st year and increasing by Rs.3000 in the
subsequent years till the end of useful life, Annual income = Rs.1,20,000,
Salvage value = Rs.5,50,000, Useful life = 10 years.

Option-2: Initial purchase price = Rs.30,00,000, Annual operating cost =

Rs.30,000, Annual income Rs.1,50,000 for first three years and increasing
by Rs.5000 in the subsequent years till the end of useful life, Salvage
value = Rs.8,00,000, Useful life = 10 years.

Option-3: Initial purchase price = Rs.27,00,000, Annual operating cost

Rs.35,000 for first 5 years and increasing by Rs.2000 in the successive
years till the end of useful life, Annual income = Rs.1,40,000, Expected
salvage value = Rs.6,50,000, Useful life = 10 years.

Using present worth method, find out which alternative should be

selected, if the rate of interest is 8% per year.
Solution:
The cash flow diagram of Option-1 is shown in Fig. 2.5.

Fig. 2.5 Cash flow diagram of Option-1

For Option-1, the annual operating cost is in the form of a positive uniform
gradient series with gradient starting from end of year ‘2’. The operating
cost at the end of different years can be split into the uniform base
amount of Rs.45,000 and the gradient amount in multiples of Rs.3000 as
shown in Fig. 2.6.
Fig. 2.6 Cash flow diagram of Option-1 with annual operating cost
split into uniform base amount and gradient amount

The present worth of the uniform gradient series will be located at the
beginning i.e. in year ‘0’ i.e. 2 years before the commencement of the
uniform gradient.

Now the equivalent present worth (in Rs.) of Option-1 is calculated as

follows;
PW1 = - 25,00,000 - 45,000 (P/A, i, n) - 3000 (P/G, i, n) + 1,20,000 (P/A, i,
n) + 5,50,000 (P/F, i, n)
PW1 = - 25,00,000 - 45,000 (P/A, 8%, 10) - 3000 (P/G, 8%, 10) +
1,20,000 (P/A, 8%, 10) + 550000 (P/F, 8%, 10)
PW1 = - 25,00,000 + (1,20,000 - 45,000) (P/A, 8%, 10) - 3000 (P/G, 8%,
10) + 5,50,000 (P/F, 8%, 10)
Now putting the values of different compound interest factors (the
expressions in terms of ‘i’ and ‘n’ already stated in Module-1) in the above
expression for PW1 results in the following;
PW1 = - 25,00,000 + 75,000 X 6.7101 - 3000 X 25.9768 + 5,50,000 X
0.4632
PW1 = - 25,00,000 + 50,3258 - 77,930 + 25,4760
PW1 = - Rs.18,19,912

The cash flow diagram of Option-2 is shown in Fig. 2.7.

Fig. 2.7 Cash flow diagram of Option-2

For Option-2, the annual income is in the form of a positive uniform

gradient series with gradient starting from end of year ‘4’. The annual
income can be split into the uniform base amount of Rs.1,50,000 and the
gradient amount in multiples of Rs.5000 starting from end of year ‘4’ and
is shown in Fig. 2.8.

Fig. 2.8 Cash flow diagram of Option-2 with annual income split
into uniform base amount and gradient amount
The equivalent present worth of the gradient series (of the annual income)
starting from end of year ‘4’ will be located at the end of year ‘2’ i.e. 2
years before the start of the gradient. Further the present worth of this
amount at beginning i.e. at time ‘0’ will be obtained by multiplying the
equivalent present worth ‘Pg’ (shown in Fig. 2.8)at the end of year ‘2’
(which is a future amount) with the single payment present worth
factor (P/F, i, n).

Now the equivalent present worth (in Rs.) of Option-2 is determined as

follows;
PW2 = - 3000000 - 30000(P/A, 8%, 10) + 150000(P/A, 8%, 10) + Pg (P/F,
8%, 2) + 800000(P/F, 8%, 10)
Now in the above expression, Pg will be replaced by G (P/G, i, n) i.e.
5000(P/G, 8%, 8).
PW2 = - 3000000 - 30000(P/A, 8%, 10) + 150000(P/A, 8%, 10) +
5000(P/G, 8%, 8) (P/F, 8%, 2) + 800000(P/F, 8%, 10)
PW2 = - 3000000 + (150000 - 30000) (P/A, 8%, 10) + 5000(P/G, 8%, 8)
(P/F, 8%, 2) + 800000 (P/F, 8%, 10)
Now putting the values of different compound interest factors in the above
expression for PW2 results in the following;
PW2= - 3000000 + 120000 X 6.7101 + 5000 X 17.8061 X 0.8573 +
800000 X 0.4632
PW2= - 3000000 + 805212 + 76326 + 370560
PW2 = - Rs.1747902

The cash flow diagram of Option-3 is shown in Fig. 2.9.

Fig. 2.9 Cash flow diagram of Option-3

For Option-3, the annual operating cost is in the form of a positive uniform
gradient series with gradient starting from end of year ‘6’. The annual
operating cost can thus be split into the uniform base amount of Rs.35000
and the gradient amount in multiples of Rs.2000 starting from end of year
‘6’ (shown in Fig. 2.10).

The equivalent present worth of the gradient series for the annual
operating cost starting from end of year ‘6’ will be located at the end of
year ‘4’. Further the present worth of this amount at time ‘0’ will be
determined by multiplying the equivalent present worth ‘Pg’ (shown in
Fig. 2.10)at the end of year ‘4’ with the single payment present worth
factor (P/F, i, n).

Fig. 2.10 Cash flow diagram of Option-3 with annual operating

cost split into uniform base amount and gradient amount

The equivalent present worth (in Rs.) of Option-3 is obtained as follows;

PW3 = - 2700000 - 35000 (P/A, 8%, 10) - Pg(P/F, 8%, 4) + 140000 (P/A,
8%, 10) + 650000 (P/F, 8%, 10)
Now in the above expression, Pg will be replaced by G (P/G, i, n) i.e. 2000
(P/G, 8%, 6).
PW3 = - 2700000 - 35000 (P/A, 8%, 10) - 2000(P/G, 8%, 6) (P/F, 8%, 4) +
140000 (P/A, 8%, 10) + 650000 (P/F, 8%, 10)
PW3 = - 2700000 + (140000 - 35000) (P/A, 8%, 10) - 2000(P/G, 8%, 6)
(P/F, 8%, 4) + 650000 (P/F, 8%, 10)
Now putting the values of different compound interest factors in the above
expression, the value of PW3 is given by;
PW3= - 2700000 + 105000 X 6.7101 - 2000 X 10.5233 X 0.7350 + 650000
X 0.4632
PW3= - 2700000 + 704561 - 15469 + 301080
PW3 = - Rs.1709828

From the comparison of equivalent present worth of all the three mutually
exclusive alternatives, it is observed that Option-3 shows lowest negative
equivalent present worth as compared to other options. Thus Option-3 will
be selected for the purchase of the dump truck.
Lecture 3 : Comparison by present worth
method - II
Comparison by present worth method:-
After the illustration of comparison of equal life span mutually exclusive
alternatives, now some examples illustrating the use of present worth
method for comparison of different life span mutually exclusive
alternatives are presented.

Example - 4

A material testing laboratory has two alternatives for purchasing a

compression testing machine which will be used for determining the
compressive strength of different construction materials. The alternatives
are from two different manufacturing companies. The cash flow details of
the alternatives are as follows;

Alternative-1: Initial purchase price = Rs.1000000, Annual operating

cost = Rs.10000, Expected annual income to be generated from testing of
different construction materials = Rs.175000, Expected salvage value =
Rs.200000, Useful life = 10 years.

Alternative-2: Initial purchase price = Rs.700000, Annual operating cost

= Rs.15000, Expected annual income to be generated from testing of
different construction materials = Rs.165000, Expected salvage value =
Rs.250000, Useful life = 5 years.

Using present worth method, find out the most economical alternative at
the interest rate of 10% per year.

Solution:
The alternatives have different life spans i.e. 10 years and 5 years. Thus
the comparison will be made over a time period equal to the least
common multiple of the life spans of the alternatives. In this case the least
common multiple of the life spans is 10 years. Thus the cash flow of
Alternative-1 will be analyzed for one cycle (duration of 10 years) whereas
the cash flow of Alternative-2 will be analyzed for two cycles (duration of 5
years for each cycle). The cash flow of the Alternative-2 for the second
cycle will be exactly same as that in the first cycle.

The cash flow diagram of Alternative-1 is shown in Fig. 2.11.

Fig. 2.11 Cash flow diagram of Alternative-1

The equivalent present worth PW1 (in Rs.) of Alternative-1 is calculated as

follows;
PW1 = - 1000000 - 10000(P/A, i, n) + 175000(P/A, i, n) + 200000(P/F, i, n)
PW1 = - 1000000 - 10000(P/A, 10%, 10) + 175000(P/A, 10%, 10) +
200000(P/F, 10%, 10)
PW1 = - 1000000 + (175000 - 10000) (P/A, 10%, 10) + 200000(P/F, 10%,
10)
Putting the values of different compound interest factors in the above
expression for PW1;
PW1 = - 1000000 + 165000 X 6.1446 + 200000 X 0.3855
PW1 = - 1000000 + 1013859 + 77100
PW1 = Rs.90959

The cash flow diagram of Alternative-2 is shown in Fig. 2.12. As the least
common multiple of the life spans of the alternatives is 10 years, the cash
flow of Alternative-2 is shown for two cycles with each cycle of duration 5
years.
Fig. 2.12 Cash flow diagram of Alternative-2 for two cycles

In the cash flow diagram of Alternative-2, the initial purchase price of

Rs.700000 is again located at the end of year ‘5’ i.e. at the end of first
cycle or the beginning of the second cycle. In addition the annual
operating cost and the annual income are also repeated in the second
cycle from end of year ‘6’ till end of year ‘10’. Further the salvage value of
Rs.250000 is also located at end of year ‘10’ i.e. at the end of second
cycle.

The equivalent present worth PW2 (in Rs.) of Alternative-2 is determined

as follows;
PW2 = - 700000 - 15000(P/A, 10%, 10) + 165000(P/A, 10%, 10) +
250000(P/F, 10%, 5) - 700000(P/F, 10%, 5) + 250000(P/F, 10%, 10)
PW2 = - 700000 + (165000 - 15000) (P/A, 10%, 10) - (700000 – 250000)
(P/F, 10%, 5) + 250000(P/F, 10%, 10)
Putting the values of different compound interest factors in the above
expression for PW2results in the following;
PW2 = - 700000 + 150000 X 6.1446 - 450000 X 0.6209 + 250000 X
0.3855
PW2 = - 700000 + 921690 - 279405 + 96375
PW2= Rs.38660

Thus from the comparison of equivalent present worth of the alternatives,

it is evident that Alternative-1 will be selected for purchase of the
compression testing machine as it shows the higher positive equivalent
present worth.
In the following example, the comparison of different life span mutually
exclusive alternatives having expenditure or income in the form of
gradient series by present worth method is illustrated.

Example -5

A construction firm has decided to purchase a dozer to be employed at a

construction site. Two different companies manufacture the dozer that will
fulfill the functional requirement of the construction firm. The construction
firm will purchase the most economical one from one of these companies.
The alternatives have different useful lives. The cash flow details of both
alternatives are presented as follows;

Company-A Dozer: Initial purchase cost = Rs.3050000, Annual operating

cost Rs.40000 at end of 1 st year and increasing by Rs.2000 in the
subsequent years till the end of useful life, Annual income = Rs.560000,
Expected salvage value = Rs.1050000, Useful life = 6 years.

Company-B Dozer: Initial purchase cost = Rs.4000000, Annual operating

cost = Rs.55000, Annual revenue to be generated Rs.600000 at the end of
1 st year and increasing by Rs.5000 in the subsequent years till the end of
useful life, Expected salvage value = Rs.1000000, Useful life = 12 years.

Using present worth method, find out the most economical alternative at
the interest rate of 7% per year.

Solution:

Since the alternatives have different life spans i.e. 6 and 12 years, the
comparison will be made over a time period equal to the least common
multiple of the life spans of the alternatives i.e. 12 years. The cash flow of
Company-A Dozer will be analyzed for two cycles i.e. duration of 6 years
for each cycle. The cash flow of Company-B Dozer will be analyzed for one
cycle i.e. duration of 12 years.

The cash flow diagram of Company-A Dozer is shown in Fig. 2.13. Since
the least common multiple of the life spans of the alternatives is 12 years,
the cash flow is shown for two cycles.
Fig. 2.13 Cash flow diagram of Company-A Dozer for two cycles

For Company-A Dozer, the annual operating cost is in the form of a

positive uniform gradient series which can be split into the uniform base
amount of Rs.40000 and the gradient amount in multiples of Rs.2000
starting from end of year ‘2' for first cycle as shown in Fig. 2.14. The
equivalent present worth of this gradient for cycle one will be located at
the beginning i.e. in year ‘0'. However for second cycle, the equivalent
present worth of the gradient for the annual operating cost starting from
end of year ‘8' (shown in Fig. 2.14) will be located at the end of year ‘6'.
Further the present worth of this amount at time ‘0' will be determined by
multiplying the equivalent present worth of the gradient at the end of year
‘6' with the single payment present worth factor (P/F, i, n) .
Fig. 2.14 Cash flow diagram of Company-A Dozer for two
cycles with annual operating cost split into uniform base amount
and gradient amount

The equivalent present worth PWA (in Rs.) of Company-A Dozer is

calculated as follows;

PWA = - 3050000 - 40000 (P/A, 7%, 12) - 2000 (P/G, 7%, 6) +

560000 (P/A, 7%, 12) + 1050000 (P/F, 7%, 6) - 3050000 (P/F, 7%, 6) -
2000 (P/G, 7%, 6) (P/F, 7%, 6) + 1050000 (P/F, 7%, 12)

PWA = - 3050000 + (560000 - 40000) (P/A, 7%, 12) - 2000 (P/G, 7%, 6) -
(3050000 - 1050000) (P/F, 7%, 6) - 2000 (P/G, 7%, 6) (P/F, 7%, 6) +
1050000 (P/F, 7%, 12)

Putting the values of different compound interest factors in the above

expression;

PWA = - 3050000 + 4130204 - 21957 - 1332600 - 14630 + 466200

PWA = Rs.177217

The cash flow diagram of Company-B Dozer is shown in Fig. 2.15.

Fig. 2.15 Cash flow diagram of Company-B Dozer

For Company-B Dozer, the annual revenue is in the form of a positive

uniform gradient series that can be split into the uniform base amount of
Rs.600000 and gradient amount in multiples of Rs.5000 as shown in Fig.
2.16. The equivalent present worth of this gradient amount will be located
at the beginning i.e. in year ‘0'.
Fig. 2.16 Cash flow diagram of Company-B Dozer with annual
revenue split into uniform base amount and gradient amount

The equivalent present worth PWB (in Rs.) of Company-B Dozer is

determined as follows;

PWB = - 4000000 - 55000 (P/A, 7%, 12) + 600000 (P/A, 7%, 12) +
5000 (P/G, 7%, 12) + 1000000 (P/F, 7%, 12)

PWB = - 4000000 + (600000 - 55000) (P/A, 7%, 12) + 5000 (P/G, 7%,
12) +

1000000 (P/F, 7%, 12)

Now putting the values of different compound interest factors in the above
expression for PW B results in the following;

PWB= - 4000000 + 4328772 + 186753 + 444000

PWB= Rs.959525

Thus from the comparison of equivalent present worth of the alternatives,

it is evident that the construction firm should select Company-B Dozer
over Company-A Dozer, as it shows higher positive equivalent present
worth i.e. PWB > PWA.
 Lecture 4 : Comparison of alternatives by future
worth method
Comparison of alternatives by future worth method:

In the future worth method for comparison of mutually exclusive

alternatives, the equivalent future worth (i.e. value at the end of the
useful lives of alternatives) of all the expenditures and incomes occurring
at different periods of time are determined at the given interest rate per
interest period. As already mentioned, the cash flow of the mutually
exclusive alternatives may consist of expenditures and incomes in
different forms. Therefore the equivalent future worth of these
expenditures and incomes will be determined using different compound
interest factors namely single payment compound amount factor, uniform
series compound amount factor and future worth factors for arithmetic
and geometric gradient series etc.

The use of future worth method for comparison of mutually exclusive

alternatives will be illustrated in the following examples. Similar to present
worth method, first the comparison of equal life span alternatives by
future worth method will be illustrated followed by comparison of different
life span alternatives. Some of the examples already worked out by the
present worth method will be illustrated using the future worth method in
addition to some other examples.

Example -6 (Using data of Example-1)

There are two alternatives for purchasing a concrete mixer. Both the
alternatives have same useful life. The cash flow details of alternatives are
as follows;

Alternative-1: Initial purchase cost = Rs.300000, Annual operating and

maintenance cost = Rs.20000, Expected salvage value = Rs.125000,
Useful life = 5 years.

Alternative-2: Initial purchase cost = Rs.200000, Annual operating and

maintenance cost = Rs.35000, Expected salvage value = Rs.70000,
Useful life = 5 years.

Using future worth method, find out which alternative should be selected,
if the rate of interest is 10% per year.

Solution:

The future worth of the mutually exclusive alternatives will be compared

over a period of 5 years. The equivalent future worth of the alternatives
can be obtained either by multiplying the equivalent present worth of
each alternative already obtained by present worth method with the
single payment compound amount factor or determining the future worth
of expenditures and incomes individually and adding them to get the
equivalent future worth of each alternative.

The equivalent future worth of Alternative-1 is obtained as follows;

PW1 is the equivalent present worth of Alternative-1 which is equal to -

Rs.298203 (referring to Example-1). (F/P, i, n) is the single payment
compound amount factor.

Now putting the value of single payment compound amount factor in the
above expression;

FW1 = -Rs.480256

The equivalent future worth of Alternative-1 can also be determined in the

following manner (Referring to cash flow diagram of Alternative-1, Fig.
2.1);

Now putting the values of different compound interest factors in the above
expression;

FW1 = -Rs.480252

Now it can be seen that the calculated future worth of Alternative-1 by

both ways is same. The minor difference between the values is due to the
effect of decimal points in the calculations.

The equivalent future worth of Alternative-2 is calculated as follows;

PW2 is the equivalent present worth of Alternative-2 which is equal to -

Rs.289215 (referring to Example-1).
Now putting the value of single payment compound amount factor in the
above expression;

FW2 = -Rs.465781

The equivalent future worth of Alternative-2 can also be determined in the

same manner as in case of Alternative-1 and is presented as follows
(Referring to cash flow diagram of Alternative-2, Fig. 2.2);

Now putting the values of different compound interest factors in the above
expression;

FW2 = -Rs.465779

Thus the future worth of Alternative-2 obtained by both methods is same.

In this case also the minor difference between the values is due to the
effect of the decimal points in the calculations.

Comparing the equivalent future worth of the both the alternatives, it is

observed that Alternative-2 will be selected as it shows lower negative
equivalent future worth as compared to Alternative-1. This outcome of the
comparison of the alternatives by future worth method is same as that
obtained from the present worth method (Example-1). This is due to the
equivalency relationship between present worth and future worth through
compound interest factors at the given rate of interest per interest period.

Example -7

There are two alternatives for a construction firm to purchase a road roller
which will be used for the construction of a highway section. The cash flow
details of the alternatives are as follows;

Alternative-1: Initial purchase cost = Rs.1500000, Annual operating cost

= Rs.35000 starting from the end of year ‘2' (negligible in the first year)
till the end of useful life, Annual revenue to be generated = Rs.340000 for
first 4 years and then Rs.320000 afterwards till the end of useful life,
Expected salvage value = Rs.430000, Useful life = 8 years.

Alternative-2: Initial purchase cost = Rs.1800000, Annual operating cost

= Rs.25000, Annual revenue to be generated = Rs.365000, Expected
salvage value = Rs.550000, Useful life = 8 years.
Find out the most economical alternative on the basis of equivalent future
worth at the interest rate of 9.5% per year.

Solution:

The cash flow diagram of Alternative-1 is shown in Fig. 2.17.

Fig. 2.17 Cash flow diagram of Alternative-1

From Fig. 2.17, it is observed that there are two uniform amount series for
the annual income i.e. first series with Rs.340000 from end of year ‘1' till
end of year ‘4' and second one with Rs.320000 from end of year ‘5' till end
of year ‘8'. For the first series, the equivalent present worth at time ‘0' will
be calculated first and then it will be multiplied with single payment
compound amount factor i.e. (F/P, i, n) to calculate its equivalent future
worth . For the second uniform series with Rs.320000, the future worth
will be calculated by multiplying the uniform amount i.e. Rs.320000 with
uniform series compound amount factor by taking the appropriate ‘ n' i.e.
number of years.

The annual operating cost is in the form of a uniform amount series, which
starts from end of year ‘2' till the end of useful life i.e. the uniform amount
series is shifted by one year.

The equivalent future worth of the Alternative-1 i.e. FW1 is computed as

follows;

Putting the values of different compound interest factors in the above

expression results in the following;

FW1 = Rs.728849
The cash flow diagram of Alternative-2 is shown in Fig. 2.18.

Fig. 2.18 Cash flow diagram of Alternative-2

The equivalent future worth of the Alternative-2 i.e. FW2 is calculated as

follows;

Now putting the values of different compound interest factors in the above
expression results in the following;

FW2 = Rs.647848

Comparing the equivalent future worth of the alternatives, it is observed

that Alternative-1 shows higher positive equivalent future worth as
compared to Alternative-2. Thus Alternative-1 will be selected for
purchase of the road roller.

Lecture 5 : Comparison by future worth

method
Comparison by future worth method:-

In the following example, the comparison of three mutually exclusive

alternatives by future worth method will be illustrated. The data presented
in Example-3 will be used for comparison of the alternatives by the future
worth method.

Example -8 (Using data of Example-3)

A construction contractor has three options to purchase a dump truck for

transportation and dumping of earth at a construction site. All the
alternatives have the same useful life. The cash flow details of all the
alternatives are presented as follows;

Option-1: Initial purchase price = Rs.2500000, Annual operating cost

Rs.45000 at the end of 1 st year and increasing by Rs.3000 in the
subsequent years till the end of useful life, Annual income = Rs.120000,
Salvage value = Rs.550000, Useful life = 10 years.

Option-2: Initial purchase price = Rs.3000000, Annual operating cost =

Rs.30000, Annual income Rs.150000 for first three years and increasing
by Rs.5000 in the subsequent years till the end of useful life, Salvage
value = Rs.800000, Useful life = 10 years.

Option-3: Initial purchase price = Rs.2700000, Annual operating cost

Rs.35000 for first 5 years and increasing by Rs.2000 in the successive
years till the end of useful life, Annual income = Rs.140000, Expected
salvage value = Rs.650000, Useful life = 10 years.

Using future worth method, find out which alternative should be selected,
if the rate of interest is 8% per year.

Solution:

The cash flow diagram of Option-1 is shown here again for ready
reference.

Fig. 2.6 Cash flow diagram of Option-1 with annual operating cost
split into uniform base amount and gradient amount (shown for
ready reference)

The equivalent future worth (in Rs.) of Option-1 is determined as follows;

Now putting the values of different compound interest factors in the above
expression for FW 1 results in the following;

FW1 = - Rs.3929001

The cash flow diagram of Option-2 is shown again for ready reference.

Fig. 2.8 Cash flow diagram of Option-2 with annual income split
into uniform base amount and gradient amount (shown for ready
reference)

The equivalent present worth of the gradient series (of the annual income)
starting from end of year ‘4' will be located at the end of year ‘2'. The
future worth of this amount at end of year ‘10' will be obtained by
multiplying the equivalent present worth ‘ Pg ' (shown in Fig. 2.8) at the
end of year ‘2' with the single payment compound amount factor (F/P, i,
n) . The equivalent future worth (in Rs.) of Option-2 is determined as
follows;
Now replacing Pg with G (P/G, i, n) i.e. 5000( P/G, 8%, 8 ) in the above
expression;

It may be noted here that, in the above expression, 5000 (P/G, 8%, 8) (F/P,
8%, 8) can be replaced by 5000 (F/G, 8%, 8) and will result in the same
value.

Now putting the values of different compound interest factors in the above
expression;

FW2= - 6476700 + 1738392 + 164787 + 800000

FW2 = - Rs.3773521

The cash flow diagram of Option-3 is shown here again for ready
reference.

Fig. 2.10 Cash flow diagram of Option-3 with annual operating

cost split into uniform base amount and gradient amount (shown
for ready reference)

For the annual operating cost, the equivalent present worth of the
gradient series starting from end of year ‘6' will be located at the end of
year ‘4'. The future worth of this amount at end of year ‘10' will be
determined by multiplying the equivalent present worth ‘ Pg ' (shown in
Fig. 2.10) at the end of year ‘4' with the single payment compound
amount factor (F/P, i, n) .

The equivalent future worth (in Rs.) of Option-3 is determined as follows;

Now replacing Pg with G (P/G, i, n) i.e. 2000( P/G, 8%, 6 ) in the above
expression;

In the above expression, 2000 (P/G, 8%, 6) (F/P, 8%, 6) can also be
replaced by 2000 (F/G, 8%, 6) .

Now putting the values of different compound interest factors in the above
expression;

FW 3 = - Rs.3691336

Comparing the equivalent future worth of all the three alternatives, it is

evident that Option-3 shows lowest negative equivalent future worth as
compared to other options. Thus Option-3 will be selected for the
purchase of the dump truck. This outcome obtained by future worth
method is same as that obtained from the present worth method
(Example-3) i.e. Option-3 is the most economical alternative.

After carrying out the comparison of equal life span mutually exclusive
alternatives, now the illustration of future worth method for comparison of
different life span mutually exclusive alternatives is presented.

Example -9 (Using data of Example-4)

A material testing laboratory has two alternatives for purchasing a

compression testing machine which will be used for determining the
compressive strength of different construction materials. The alternatives
are from two different manufacturing companies. The cash flow details of
the alternatives are as follows;

Alternative-1: Initial purchase price = Rs.1000000, Annual operating

cost = Rs.10000, Expected annual income to be generated from testing of
different construction materials = Rs.175000, Expected salvage value =
Rs.200000, Useful life = 10 years.

Alternative-2: Initial purchase price = Rs.700000, Annual operating cost

= Rs.15000, Expected annual income to be generated from testing of
different construction materials = Rs.165000, Expected salvage value =
Rs.250000, Useful life = 5 years.
Find out the most economical alternative at interest rate of 10% per year
by future worth method.

Solution:

As the alternatives have different life spans i.e. 10 years and 5 years, the
comparison will be made over a time period equal to the least common
multiple of the life spans of the alternatives i.e. 10 years. Thus the cash
flow of Alternative-1 is analyzed for one cycle (duration of 10 years)
whereas that of cash flow of Alternative-2 is analyzed for two cycles of
duration 5 years each (already mentioned in Example-4).

The cash flow diagram of Alternative-1 is shown here again for ready
reference.

Fig. 2.11 Cash flow diagram of Alternative-1 (shown for ready

reference)

The equivalent future worth FW 1 (in Rs.) of Alternative-1 is determined as

follows;

Putting the values of different compound interest factors in the above

expression;

FW1 = Rs.235971

The cash flow diagram of Alternative-2 is shown here again for ready
reference.
The equivalent future worth FW2 (in Rs.) of Alternative-2 is determined as
follows;
Fig. 2.12 Cash flow diagram of Alternative-2 for two cycles

Putting the values of different compound interest factors in the above

expression for FW2results in the following;

FW2 = Rs.100295

Thus Alternative-1 will be selected for purchase of the compression testing

machine, as it shows the higher positive equivalent future worth as
compared to Alternative-2.

Lecture 6 : Comparison of alternatives

by annual worth method
Comparison of alternatives by annual worth method:

In this method, the mutually exclusive alternatives are compared on the

basis of equivalent uniform annual worth. The equivalent uniform annual
worth represents the annual equivalent value of all the cash inflows and
cash outflows of the alternatives at the given rate of interest per interest
period. In this method of comparison, the equivalent uniform annual worth
of all expenditures and incomes of the alternatives are determined using
different compound interest factors namely capital recovery factor,
sinking fund factor and annual worth factors for arithmetic and geometric
gradient series etc. Since equivalent uniform annual worth of the
alternatives over the useful life are determined, same procedure is
followed irrespective of the life spans of the alternatives i.e. whether it is
the comparison of equal life span alternatives or that of different life span
alternatives. In other words, in case of comparison of different life span
alternatives by annual worth method, the comparison is not made over
the least common multiple of the life spans as is done in case of present
worth and future worth method. The reason is that even if the comparison
is made over the least common multiple of years, the equivalent uniform
annual worth of the alternative for more than one cycle of cash flow will
be exactly same as that of the first cycle provided the cash flow i.e. the
costs and incomes of the alternative in the successive cycles is exactly
same as that in the first cycle. Thus the comparison is made only for one
cycle of cash flow of the alternatives. This serves as one of greater
advantages of using this method over other methods of comparison of
alternatives. However if the cash flows of the alternatives in the
successive cycles are not the same as that in the first cycle, then a study
period is selected and then the equivalent uniform annual worth of the
cash flows of the alternatives are computed over the study period.

Now the comparison of mutually exclusive alternatives by annual worth

method will be illustrated in the following examples. First the data
presented in Example-2 will be used for comparison of the alternatives by
the annual worth method.

Example -10 (Using data of Example-2)

There are two alternatives for purchasing a concrete mixer and following
are the cash flow details;

Alternative-1: Initial purchase cost = Rs.300000, Annual operating and

maintenance cost = Rs.20000, Expected salvage value = Rs.125000,
Useful life = 5 years.

Alternative-2: Initial purchase cost = Rs.200000, Annual operating and

maintenance cost = Rs.35000, Expected salvage value = Rs.70000,
Useful life = 5 years.

The annual revenue to be generated from production of concrete (by

concrete mixer) from Alternative-1 and Alternative-2 are Rs.50000 and
Rs.45000 respectively. Compute the equivalent uniform annual worth of
the alternatives at the interest rate of 10% per year and find out the
economical alternative.

Solution:
The cash flow diagram of Alternative-1 i.e. Fig. 2.3 is shown here again for
ready reference.

Fig. 2.3 Cash flow diagram of Alternative -1

The equivalent uniform annual worth of Alternative-1 i.e. AW1 is computed

as follows;

Here Rs.20000 and Rs.50000 are annual amounts.

Now putting the values of different compound interest factors;

AW1= - Rs.28665

The cash flow diagram of Alternative-2 is shown here again for ready
reference.

Fig. 2.4 Cash flow diagram of Alternative -2

Now the equivalent uniform annual worth of Alternative-2 i.e. AW 2 is
calculated as follows;

For alternative-2, Rs.35000 and Rs.45000 are annual amounts.

Now putting the values of different compound interest factors in the above
expression;

AW2= - Rs.31294

From this comparison, it is observed that Alternative-1 will be selected as

it shows lower negative equivalent uniform annual worth compared to
Alternative-2. This outcome is in consistent with the outcome obtained by
present worth method in Example-2.

Example -11

A material supply contractor has two options (i.e. from two different
manufacturing companies, Company-1 and Company-2) to purchase a
tractor for supply of construction materials. The details of cash flow of the
two options are given below;

Company-1 Tractor: Initial purchase cost = Rs.2000000, Annual

operating cost including labor and maintenance = Rs.50000, Cost of new
set of tires to be replaced at the end of year ‘3', year ‘6'and year ‘9' =
Rs.110000 each, Expected salvage value = Rs.520000, Useful life = 10
years.

Company-2 Tractor: Initial purchase cost = Rs.2200000, Annual

operating cost including labor and maintenance = Rs.27000, Cost of new
set of tires to be replaced at the end of year ‘4' and year ‘8' = Rs.120000
each, Expected salvage value = Rs.700000, Useful life = 10 years.

Determine which company tractor should be selected on the basis of

equivalent uniform annual worth at the interest rate of 12% per year.

Solution:

The cash flow diagram of Company-1 tractor is shown in Fig. 2.19.

Fig. 2.19 Cash flow diagram of Company-1 Tractor

From the cash flow diagram it is noted that three single amounts i.e.
Rs.110000 each are located at the end of year ‘3', year ‘6' and year ‘9'.
For these amounts, first the equivalent present worth at time ‘0' is
determined and then equivalent annual worth of this present worth is
computed using the appropriate compound interest factor.

The equivalent uniform annual worth of Company-1 tractor is determined

as follows;

Now putting the values of different compound interest factors in the above
expression;

AW1 = - 405104

The cash flow diagram of Company-2 tractor is shown in Fig. 2.20.

Fig. 2.20 Cash flow diagram of Company-2 Tractor

From Company-2 tractor, two single amounts i.e. Rs.120000 each are
located at the end of year ‘4', and year ‘8'. Similar to first alternative, first
the equivalent present worth at time ‘0' of these amounts is determined
and then equivalent annual worth is computed.
The equivalent uniform annual worth of Company-2 tractor is computed as
follows;

Now putting the values of different compound interest factors in the above
expression;

AW2 = - 398577

From the above comparison, it is observed that Company-2 Tractor shows

lower negative equivalent uniform annual worth as compared to
Company-1 tractor. Thus the contractor should select Company-2 Tractor
for purchase.

Lecture 7 : Comparison by annual

worth method
Comparison by annual worth method:

Now the comparison of alternatives with cash flows involving

gradient series and randomly placed single amount by annual
worth method will be illustrated followed by the comparison of
different life span alternatives.

Example -12

Compare the following equipment on the basis of the equivalent

uniform annual worth and find out the most economical one at
the interest rate of 9.5% per year.

Equipment-A

Cash flow details:

Initial purchase cost = Rs.5000000

Annual operating cost = Rs.60000 at the end of year ‘1' and

increasing by Rs.3000 in the subsequent years till the end of
useful life.

Annual income = Rs.770000

Cost of one time major repair = Rs.200000 at the end of year ‘8'

Expected salvage value = Rs.1400000

Useful life = 12 years

Equipment-B

Cash flow details:

Initial purchase cost = Rs.4600000

Annual operating cost = Rs.75000

Annual income = Rs.710000 for the first 5 years and increasing by

Rs.5000 in the subsequent years till the end of useful life.

Cost of one time major repair = Rs.230000 at the end of year ‘6'

Expected salvage value = Rs.1200000

Useful life = 12 years

Solution:

The cash flow diagram of Equipment-A is shown in Fig. 2.21.

Fig. 2.21 Cash flow diagram of Equipment-A

The annual operating cost is in the form of a positive uniform

gradient series. This can be split into the uniform base amount of
Rs.60000 and gradient amount in multiples of Rs.3000 starting
from end of year ‘2' till the end of useful life as shown in Fig.
2.22.

Fig. 2.22 Cash flow diagram of Equipment-A with annual

operating cost split into uniform base amount and gradient
amount

The equivalent uniform annual worth of Equipment-A is

determined as follows;

Now putting the values of different compound interest factors in

the above expression results in the following;

AWA = Rs.34306

The cash flow diagram of Equipment-B is shown in Fig. 2.23.

Fig. 2.23 Cash flow diagram of Equipment-B

For Equipment-B, the annual income is in the form of a positive uniform

gradient series with gradient starting from end of year ‘6'. The annual
income is split into the uniform base amount of Rs.710000 and the
gradient amount in multiples of Rs.5000 starting from end of year ‘6' till
the end of useful life as shown in Fig. 2.24.

Fig. 2.24 Cash flow diagram of Equipment-B with annual income

split into
uniform base amount and gradient amount
For the gradient series (of annual income), the equivalent present worth
will be located at the end of year ‘4' i.e. 2 years before the start of the
gradient. Then the present worth of this amount at time ‘0' will be
calculated and after that the equivalent annual worth of this amount will
be determined.

The equivalent uniform annual worth of Equipment-B is determined as

follows;

AWB = Rs.23207

From the comparison by annual worth method, it is observed that

Equipment-A exhibits higher positive equivalent uniform annual worth as
compared to Equipment-B. Thus the Equipment-A is the most economical
alternative.

Example -13

Using the annual worth method, compare the following machines having
different life spans at an interest rate of 11.5% per year.

Machine-1

Cash flow details:

Initial purchase price = Rs.1200000

Annual operating cost = Rs.38000

Annual revenue = Rs.210000 for first 6 years and then Rs.225000

afterwards till the end of useful life.

Expected salvage value = Rs.320000

Useful life = 14 years

Machine-2

Cash flow details:

Initial purchase price = Rs.1400000

Annual operating cost = Rs.26000

Annual revenue = Rs.290000

Expected salvage value = Rs.450000

Useful life = 7 years

Solution:

The cash flow diagram of Machine-1 is shown in Fig. 2.25.

Fig. 2.25 Cash flow diagram of Machine-1

It may be noted here that the annual revenue is in the form of two uniform
annual amount series i.e. one with annual amount of Rs.210000 from
beginning till end of year ‘6' and the second one with annual amount of
Rs.225000 from end of year ‘7' till the end of useful life (as shown in Fig.
2.25). The annual revenue in the cash flow diagram can also be
represented as annual amount of Rs.210000 from beginning till the end of
useful life and the annual amount of Rs.15000 from end of year ‘7' till the
end of useful life as shown in Fig. 2.26.

Fig. 2.26 Cash flow diagram of Machine-1 with simplified

representation of annual revenue

For the annual revenue of Rs.15000 from end of year ‘7' till the end of
useful life, first the equivalent future worth is calculated followed by the
calculation of the equivalent annual worth.

The equivalent uniform annual worth of Machine-1 is computed as follows;

Now putting the values of different compound interest factors;

AW1 = Rs.11617

The cash flow diagram of Machine-2 is shown in Fig. 2.27.

Fig. 2.27 Cash flow diagram of Machine-2

The equivalent uniform annual worth of Machine-2 is calculated as follows;

Now putting the values of different compound interest factors in the above
expression;

AW2= Rs.7373

As already stated, the equivalent uniform annual worth for more than one
cycle of cash flow will be same as that for the first cycle provided the cash
flow in the successive cycles is exactly same as that in the first cycle. For
illustration of this note, the cash flow of Machine-2 is repeated for two
cycles with life span of 7 years each (least common multiple of life spans
of the alternatives is 14 years).

The cash flow diagram of Machine-2 for two cycles is shown in Fig. 2.28
Fig. 2.28 Cash flow diagram of Machine-2 repeated for two cycles

The equivalent uniform annual worth of Machine-2 is determined as

follows;

Now putting the values of different compound interest factors in the above
expression results in the following;

AW2 = Rs.7378

Now it can be seen that, the calculated equivalent uniform annual worth
of Machine-2 for two cycles of cash flow is same as that with only one
cycle i.e. first cycle. The minor difference among the values is due to the
effect of decimal points in the above calculations.

Lecture 8 : Rate of return

The rate of return technique is one of the methods used in selecting an
alternative for a project. In this method, the interest rate per interest
period is determined, which equates the equivalent worth (either present
worth, future worth or annual worth) of cash outflows (i.e. costs or
expenditures) to that of cash inflows (i.e. incomes or revenues) of an
alternative. The rate of return is also known by other names namely
internal rate of return (IRR), profitability index etc. It is basically the
interest rate on the unrecovered balance of an investment which becomes
zero at the end of the useful life or the study period. In the following
lectures, the rate of return is denoted by “ir”.

Using present worth, the equation for rate of return can be written as
follows;

PWc = PW1 ……………………………… (2.1)

PWc = Present worth of cash outflows (cost or expenditure)

PWi = Present worth of cash inflows (income or revenue)
As already stated in earlier lectures, cost or expenditures are considered
as negative cash flows whereas income or revenues are considered as
positive cash flows.

Equation (2.1) can be rewritten as;

0 = − PWc + PW1 ………………………….. (2.2)

In the above equation the net present worth is zero.

Now putting the expressions for present worth of cash outflows and that of
cash inflows in equation (2.1) results in the following expression;

(2.3)

On left hand side of the above equation, Po is the initial cost at time zero
and FC (single amount) and AC (uniform amount series) are the
expenditures occurring at future period of time. Similarly on the right hand
side of the equation, FI (single amount) and AI (uniform amount series) are
the incomes or revenues occurring at future period of time. The value of
interest period ‘n’ will vary depending upon the occurrence of the future
amounts (either expenditure or income).

Equation (2.3) can be rewritten as follows;

The value of rate of return ‘ir’ can be calculated by solving the above
equation. The equation (2.4) can be solved either manually through trial
and error process or using Microsoft Excel spreadsheet. The first method
i.e. trial and error process for determination of the rate of return
consumes more time whereas the second method is faster. However the
trial and error method gives a clear understanding of the analysis of
calculation for the rate of return. Similar to equivalent present worth, the
rate of return can also be determined by finding out the interest rate at
which the net future worth or net annual worth is zero.

After determination of the rate of return for a given alternative, it is

compared with minimum attractive rate of return (MARR) to find out the
acceptability of this alternative for the project. If the rate of return i.e. ir is
greater than or equal to MARR, then the alternative will be selected or
else it will not be selected. The MARR is the minimum rate of return from
the investment, which is acceptable. In other words it is the minimum rate
of return below which the investment alternatives are economically not
acceptable. The minimum attractive rate of return (MARR) serves as an
important criteria while selecting a single alternative or comparing
mutually exclusive alternatives whenever the investments are made. For
an organization, it is governed by various parameters namely availability
of financially viable projects, amount of fund available for investment
along with the associated risk, and type of organization (i.e. government,
public sector, private sector etc.).

The difference between equivalent worth methods (present worth

method/future worth method/annual worth method) and rate of return
method is that; in case of former, the equivalent worth of the cash inflows
and cash outflows are determined at MARR whereas in case of latter, a
rate is determined which equates the equivalent worth of cash inflows to
that of the cash outflows and the resulting rate is compared against
MARR. The rate of return and MARR are expressed in terms of percentage
per period i.e. mostly percentage per year.

In the following example, the illustration of the procedure for

determination of rate of return for an alternative is presented.

Example -14

A construction firm is planning to invest Rs.800000 for the purchase of a

construction equipment which will generate a net profit of Rs.140000 per
year after deducting the annual operating and maintenance cost. The
useful life of the equipment is 10 years and the expected salvage value of
the equipment at the end of 10 years is Rs.200000. Compute the rate of
return using trial and error method based on present worth, if the
construction firm's minimum attractive rate of return (MARR) is 10% per
year.

Solution:

The cash flow diagram of the construction equipment is shown in Fig.

2.29.
Fig. 2.29 Cash flow diagram of the construction equipment

For determination of rate of return ‘ir’ of the construction equipment, first

the equation for net present worth of cash inflows and cash outflows is
equated to zero. Then using the trial and error method the value of ‘ir’ is
determined. The net present worth of cash inflows and cash outflows of
the construction equipment is given by the following expression.

For determining the value of ‘ir’ the net present worth is equated to zero.

Now the above equation will be solved through trial and error process to
find out the value of ir. Basically a positive value and a negative value of
the net present worth will be determined at rate of return values close to
the actual one and then by linear interpolation between these two values,
the actual rate of return will be calculated. For finding out the rate of
return values (close to the actual one), those will give a positive value and
a negative value of net present worth, one has to carry out a number of
trial calculations at various values of ir.

Since MARR is 10%, first assume a value of ir equal to 8% and compute

the net present worth. Now putting the values of different compound
interest factors in the expression for net present worth at ir equal to 8%
results in the following;

PW = Rs.232054
The above calculated net present worth at ir equal to 8% is greater than
zero, now assume a higher value of ir i.e. 12% for the next trial and
compute the net present worth.

PW = Rs.55428

As observed from this calculation, the net present worth is decreased at

higher value of ir. Thus for getting a negative value of net present worth,
assume further higher value of ir than the previous trial and take 14% for
the next trial and determine the net present worth.

PW = -Rs.15806

Since a negative value of net present worth at ir equal to 14% is obtained

(as above), the actual value of rate of return is less than 14%. The actual
rate of return is now obtained by doing linear interpolation either between
8% and 14% or between 12% and 14%. However for obtaining a more
accurate value of rate of return, the linear interpolation is carried out
between 12% and 14% and is given as follows;
On solving the above expression, the value of ir is found to be 13.55% per
year which is greater than MARR (10%). Now using the using Microsoft
Excel spreadsheet and entering year-wise cash inflows and cash out flows,
the value of rate of return is found to be 13.53% (using the function ‘IRR’).
However this minor difference in the value of ir obtained from both the
methods can be minimized by finding out the net present worth at narrow
range of interest rate values and carrying out linear interpolation between
these values (trial and error method) to find out the more precise value
close to the actual rate of return.

The net present worth of the construction equipment at MARR i.e. 10% is
given by;

PW = Rs.137344 at MARR (10%)

The net present worth of the construction equipment at MARR is greater
than zero and the rate of return is greater than MARR. Thus the purchase
of the construction equipment is economically justified. It may be noted
here that when the equivalent worth of an investment is greater than zero
at interest rate equal to MARR, then the rate of return of the investment is
greater than MARR.

The rate of return ‘ir’ can also be determined by equating the net annual
worth to zero. For the above construction equipment, the net equivalent
annual worth at different values of ir are calculated as follows;
On solving the above expression, the value of ir is found to be 13.55% per
year which is greater than MARR (10%). Now using the using Microsoft
Excel spreadsheet and entering year-wise cash inflows and cash out flows,
the value of rate of return is found to be 13.53% (using the function ‘IRR’).
However this minor difference in the value of ir obtained from both the
methods can be minimized by finding out the net present worth at narrow
range of interest rate values and carrying out linear interpolation between
these values (trial and error method) to find out the more precise value
close to the actual rate of return.

The net present worth of the construction equipment at MARR i.e. 10% is
given by;

PW = Rs.137344 at MARR (10%)

The net present worth of the construction equipment at MARR is greater
than zero and the rate of return is greater than MARR. Thus the purchase
of the construction equipment is economically justified. It may be noted
here that when the equivalent worth of an investment is greater than zero
at interest rate equal to MARR, then the rate of return of the investment is
greater than MARR.

The rate of return ‘ir’ can also be determined by equating the net annual
worth to zero. For the above construction equipment, the net equivalent
annual worth at different values of ir are calculated as follows;

Now carrying out the linear interpolation between 12% and 14%;
On solving the above expression, the value of ir is found to be 13.52% per
year. The minor difference in the values of ir from present worth and
annual worth methods is due to the effect of decimal points in the
calculations. Similar to present worth and annual worth methods, the rate
of return ‘ir’ can also be determined by equating the net future worth to
zero.

From the above example, a unique value of rate of return was obtained for
the construction equipment (on the basis of its cash inflow and cash
outflow). This is due to the fact that, there was only one sign change in
the cash flows i.e. minus sign at time zero for the cash outflow followed by
plus sign for cash inflows during the remaining periods. However in some
cases, depending upon the cash flow it is possible to get multiple values
of rate of return, those satisfy the rate of return equation of the equivalent
worth of cash inflows and cash out flows. This may happen due to more
than one sign change in the cash flows e.g. cash outflow (negative) at
beginning (time zero) followed cash inflows (positive) at end of year 1 and
2 and then cash outflow (negative) at end of year 3 etc. Thus while
selecting an alternative that has multiple values of rate of return
(depending on the cash flow), other method of economic evaluation may
be adopted to find out the economical suitability of the alternative.

Lecture 9 : Incremental Rate of Return

–I
When the best alternative (economically suitable) is to be selected from
two or more mutually exclusive alternatives on the basis of rate of return
analysis, the incremental investment analysis is used. In incremental rate
of return method, the alternative with larger investment is selected,
provided the incremental (extra) investment over the lower investment
alternative produces a rate of return that is greater than or equal to MARR.
In other words if the additional benefits i.e. increased productivity,
increased income, reduced operating expenditure etc. achieved at the
expense of extra investment (associated with larger investment
alternative) are more than that could have been obtained from the
investment of same amount at MARR elsewhere by the organization, then
this additional capital should be invested.

In incremental rate of return method, the economically acceptable lower

investment alternative is considered as the base alternative against which
the higher investment alternative is compared. The cash flow of higher
investment alternative is considered equal to the cash flow of lower
investment alternative plus the incremental cash flow i.e. difference in
cash flow between the higher investment and lower investment
alternatives.

When using rate of return method for comparing two or more mutually
exclusive alternatives, the analysis must be done correctly, otherwise it
may lead to incorrect ranking of the alternatives. However this problem is
avoided in incremental investment rate of return analysis. In this
technique, the individual rate of return values on total cash flow of the
mutually exclusive alternatives are not compared against each other
rather the rate of return (or IRR) of the mutually exclusive alternatives or
the rate of return of the incremental investment is compared against
MARR.

The procedures for comparison of mutually exclusive cost alternatives and

that of mutually exclusive investment alternatives using incremental
investment rate of return analysis are mentioned below. The details about
cost and investment alternatives are already stated in Lecture-1 of Module
2.

Steps for comparison of cost alternatives:

i) First arrange the mutually exclusive cost alternatives on the basis of

increasing initial capital investment. The lowest capital investment
alternative is considered as the base alternative (B).
ii) The incremental cash flow is calculated between the base alternative
(B) and the next higher capital investment alternative (H) over the useful
life.

iii) Then the rate of return ‘ir (H-B)’ of this incremental investment is
calculated (procedure as stated earlier) by equating the net equivalent
worth (present worth or annual worth or future worth) to zero.

iv) If the calculated ‘ ir (H-B)’ is greater than or equal to MARR, then

alternative ‘B’ is removed from further analysis. Alternative ‘H’ now
becomes the new base alternative and is compared against the next
higher capital investment alternative. If ‘ir (H-B)’ is less than MARR, then
alternative ‘H’ is removed from further analysis and alternative ‘B’
remains as the base alternative and is compared against the next higher
investment alternative (alternative with investment higher than ‘H’).

v) Steps ii) to iv) are repeated till only one alternative is left i.e. the best
alternative which justifies the incremental investment associated with.

Steps for comparison of investment alternatives:

i) Arrange the mutually exclusive investment alternatives on the basis of

increasing initial capital investment.

ii) Then the rate of return (IRR) on total cash flow of the lowest
investment alternative is determined (procedure already stated earlier) to
find out its acceptability as the base alternative. If the calculated rate of
return is greater than or equal to MARR, this is selected as the base
alternative. If the calculated rate of return is less than MARR, then this
alternative is not considered for further analysis and the acceptability of
the next higher investment alternative as base alternative is found out by
calculating the rate of return on its total cash flow and comparing against
MARR. This process is continued till the base alternative ‘B’ (acceptable
alternative for which rate of return greater than or equal to MARR) is
obtained. If no alternative is obtained in this manner i.e. rate of return less
than MARR, then do-nothing alternative is selected. The do-nothing
alternative indicates that all the investment alternatives are rejected.
Similar to the comparison of cost alternatives, the incremental cash flow is
now calculated between the base alternative (B) and the next higher
investment alternative (H) over the useful life.

Steps iii) to v) as mentioned above for the comparison of cost alternatives

are then followed to select the best alternative.
The comparison of cost alternatives is illustrated in the following example.

Example -15
The development authority of a city has to select a pumping unit from four
feasible mutually exclusive alternatives for supply of water to a particular
location of the city. The details of cash flow and the useful life of all the
alternatives are presented in the following table. The minimum attractive
rate of return (MARR) is 20% per year. Select the best alternative using
the incremental investment rate of return analysis.

Solution:

The cash flow and useful life of all the alternatives are presented in Table
2.1.

As seen from the above table, these are cost alternatives involving all
cash outflows (negative cash flows) except for the salvage value (positive
cash flow) at the end of useful life. The alternatives are not in the
increasing order of capital investment as observed from Table 2.1. The
alternatives are now arranged in the increasing order of capital
investment as shown in Table 2.2 and cash outflows and cash inflows are
shown with negative and positive signs respectively.
After arranging the alternatives in increasing order of capital investment,
alternative-2 (A2) now becomes the base alternative (lowest capital
investment with Rs.6600000) and it is compared with the next higher
investment alternative i.e. alternative-4 (A4) with capital investment of
Rs.7400000. The incremental cash flow between the two alternatives A2
and A4 is given as follows;

Incremental capital investment = -Rs.7400000 – (-Rs.6600000) = -

Rs.800000 at beginning i.e. at time zero.

Incremental annual operating and maintenance cost from end of year 1 till
end of year 10
= -Rs.970000 – (-Rs.1185000) = Rs.215000

Incremental salvage value = Rs.1865000 – Rs.1780000 = Rs.85000 at end

of year 10
In order to find out the rate of return (IRR) of this incremental cash flow,
the net present worth is equated to zero.

The value of rate of return ‘ir’ is now calculated by solving the above
equation either manually through trial and error process with linear
interpolation or using Microsoft Excel spreadsheet (already mentioned
earlier). For faster calculation, the rate of return is calculated using
Microsoft Excel spreadsheet after entering year-wise cash inflows and cash
out flows. The value of rate of return is found to be 24.06% (using the
function ‘IRR’ in Excel spreadsheet). As rate of return of the incremental
cash flow is greater than MARR (20%), the incremental investment
associated with alternative-4 (A4) is justified and alternative-2 (A2) is now
removed from further analysis. Alternative-4 now becomes the new base
alternative and is compared with next higher capital investment
alternative i.e. alternative-1 (A1) with investment of Rs.7800000. The rate
return of this incremental investment is calculated in same manner as
above. The entire calculation is now presented in the Table 2.3.

In Table 2.3 the incremental values between the alternatives indicate the
difference in cash flows between them.

The outcomes of the incremental investment analysis for the comparison

of cost alternatives as presented in Table 2.3 are briefly described below.

 Comparison between alternatives A2 (base alternative)

and A4 (next higher capital investment alternative). The obtained
rate of return form the incremental investment analysis is 24.06%
which is greater than MARR (20%). Alternative-2 (A2) is eliminated
from further analysis and alternative-4 (A4) is the new base
alternative.

 Now comparison between alternatives A4 and A1 (next higher

capital investment alternative). The obtained rate of return form the
 incremental investment is 28.65% and is greater than MARR. Thus
alternative-4 (A4) is eliminated from further analysis and
alternative-1 (A1) is the new base alternative.

 Finally comparison between alternatives A1 and A3 (next higher

capital investment alternative). The rate of return obtained from the
incremental investment analysis is 14.09% which is less than MARR
(20%). Thus the incremental investment associated with alternative-
3 (A3) i.e. largest capital investment alternative is not justified
and hence alternative-1 (A1) is selected as the best
alternative, as no other alternative is left for comparison. In
addition, the present worth of the incremental investment
associated with alternative-1 (A1) over alternative-4 (A4) at MARR
i.e. 20% is greater than zero i.e. Rs.132978>0.

 It can be seen here that, the largest capital investment

alternative (A3) is not selected because the incremental investment
associated with it results in a rate of return which is less than MARR.
In addition the present worth of the incremental investment
associated with alternative-3 (A3) over alternative-1 (A1) at MARR
i.e. 20% is less than zero i.e. –Rs.66150<0.

Now the values of equivalent present worth of the total cash flow of the
cost alternatives at MARR (20%) are found to be -Rs.11280643, -
Rs.11165528, -Rs.11098700 and -Rs.11032550 for alternatives A2, A4, A3
and A1 respectively. Thus alternative A1 (the best alternative) exhibits
lowest negative equivalent present worth as compared to other cost
alternatives.

Lecture 10 : Incremental Rate of Return

– II
Incremental Rate of return:-

The comparison of investment alternatives using incremental investment

rate of return analysis is illustrated in the following example.

Example -16

A construction company is planning to invest for the purchase of a heavy

construction equipment which will be used at a construction site. There
are four feasible alternatives and the detailed cash flow of all the
alternatives are presented in Table 2.4. Each alternative has the useful life
of 8 years. If the company’s MARR is 12% per year, select the best
alternative using the incremental investment rate of return analysis.
Solution:

The cash flow and useful life of all the alternatives are presented in Table
2.4.

As observed from Table 2.4, these are investment alternatives having

positive cash flows (cash inflows). As the alternatives are not in the
increasing order of investment, they are now arranged in the increasing
order of investment as shown in Table 2.5.

After arranging the alternatives in increasing order of investment, the

acceptability of the lowest investment alternative i.e. alternative B1 as
base alternative is checked by finding out the rate of return on its total
cash flow. The rate of return is found out by equating net present worth of
alternative B1 to zero.
As already stated, the value of rate of return ‘ir’ is calculated by solving
the above equation either manually through trial and error process with
linear interpolation or using Microsoft Excel spreadsheet. The value of rate
of return is found to be 10.91% (using the function ‘IRR’ in Excel
spreadsheet), which is less than company’s MARR i.e. 12%. Thus
alternative B1 is eliminated from further calculation and the acceptability
of next higher investment alternative i.e. B3 is checked in the same
manner as above. The rate of return on total cash flow of alternative B3 is
determined by equating the net present worth to zero.

From this equation the value of rate of return is found to be 13.84% (using
the function ‘IRR’ in Excel spreadsheet), which is greater than company’s
MARR i.e. 12%. Thus Alternative B3 becomes the base alternative and it is
compared with the next higher investment alternative B4. Now the rate of
return of the incremental cash flow between the two alternatives B3 and
B4 is calculated and compared with MARR to check suitability of the
incremental investment associated with alternative B4. The entire
calculation for selecting the best alternative is now presented in Table 2.6.
In the above table the incremental values between the alternatives
indicate the difference in their cash flows.

In Table 2.6, the total cash flows of the individual alternatives and
incremental cash flows (comparison between two alternatives) are written
in different colour fonts for ease of understanding. For alterative B1 and
B3, total cash flows and for comparison between B4 – B3

and B2 – B4 the incremental cash flows are provided in the above table.

The outcomes of the incremental investment analysis for comparison of

investment alternatives (presented in Table 2.6) are briefly described
below.

 Checking the acceptance of lowest investment alternative B1 as

base alternative by calculating the rate of return on its total cash
flow. The obtained rate of return is 10.91% which is less than MARR
(12%). Alternative B1 is now eliminated from further analysis.

 Now checking the acceptance of next higher investment

alternative B3 as the base alternative by finding out the rate of
 return on its total cash flow. The obtained rate of return is 13.84%
which is greater than MARR (12%). Thus alternative B3 now
becomes the base alternative.

 Now comparison between alternatives B3 and next higher

investment alternative B4. The rate of return form the incremental
investment analysis is found to be 18.52% which is greater than
MARR (12%). Thus alternative B3 is eliminated from further analysis
and alternative B4 is the new base alternative as the incremental
investment is justified.

 Finally comparison between alternatives B4 and B2 (next higher

investment alternative). The obtained rate of return from the
incremental investment is 17.69% which is greater than MARR
(12%). Thus the incremental investment associated with
alternative B2 is justified and alternative B2 is selected as the
best alternative, as there is no other alternative remaining for
comparison. Further the present worth of the incremental
investment associated with alternative B2 over alternative B4 at
MARR (12%) is greater than zero as observed from Table 2.6.

Now the values of equivalent present worth of the total cash flow of
individual alternatives at MARR (12%) are found to be -Rs.100145,
Rs.194759, Rs.326618 and Rs.377829 for alternatives B1, B3, B4 and B2
respectively. Thus alternative B2 exhibits highest positive equivalent
present worth as compared to other alternatives which is in agreement
with outcome obtained from the incremental investment analysis.

For comparison of mutually exclusive alternatives, those have different life

span, the comparison using incremental rate of return analysis must be
made over the same number of years i.e. least common multiple of the
individual life span as in case of comparison using present worth method
in earlier lectures.

The important points to be noted for comparison of mutually exclusives

alternatives using incremental investment rate of return analysis are as
follows.

 The alternative with larger investment should be selected if the

incremental (extra) investment associated with it over the lower
investment alternative produces a rate of return that is greater than
or equal to MARR.

 While comparing the alternatives, at first instance the alternative

with highest rate of return on its total cash flow should not be
selected as the best alternative. After carrying out the incremental
investment rate of return analysis, the selection of the best
 alternative may match (depending on the cash flow) with the
alternative with highest rate of return on its total cash flow. The rate
of return of the alternatives B1, B2, B3 and B4 (Example 16) on their
total cash flows are found to be 10.91%, 14.80%, 13.84% and
14.59% respectively (calculations not shown in the example). Thus
Alternative B2 having highest rate of return (also greater than MARR
i.e. 14.80% > 12%) was not selected as the best alternative at first
instance. However from outcome of incremental investment rate of
return analysis, alternative B2 was selected as the best alternative
that matched with the alternative having highest rate of return.

 Similarly the alternative with highest capital investment and has

rate of return (on its total cash flow) greater than or equal to MARR,
should not be selected as the best alternative at first instance.
However the outcome of the incremental investment rate of return
analysis for the best alternative may coincide with the highest
investment alternative (with rate of return on its total cash flow
greater than or equal to MARR). From incremental investment rate
of return analysis, alternative B2 (Example 16) was selected as the
best alternative, which happened to be the highest investment
alternative with rate of return on its total cash flow greater than
MARR.

 The higher capital investment alternative associated with the

incremental capital investment that exhibits highest rate of return
should not be selected as the best alternative. As observed from
Example 16, incremental investment having highest rate of return
(18.52%) was between alternatives B4 and B3 and the higher
investment alternative associated with this incremental investment
was B4. On the other hand, the rate of return on the incremental
capital investment between B2 and B4 was 17.69% and the higher
investment alternative associated with this incremental investment
was B2. From the incremental rate of return analysis, alternative B2
was selected as the best alternative in place of B4, even though the
rate of return on incremental investment associated with B4
(comparison between B4 and B3) was greater than the rate of return
on the incremental investment associated with B2 (comparison
between B2 and B4) i.e. 18.52% > 17.69%.

Lecture 11 : Capitalized Cost Analysis –

I
Capitalized cost analysis:-

Capitalized cost represents the present worth of an alternative

for a project that is going to serve for a longer period of time i.e.
for an infinite period of time. As the name indicates, it refers to
the present worth of mainly cost or expenditures (cash outflows)
of the alternative over infinite period of time. Capitalized worth
refers to present worth of expenditures and revenues of an
alternative over infinite period of time.

The capitalized cost method is used for comparison of mutually

exclusive alternatives which have perpetual service life (assumed
to serve forever). The examples of this kind of projects are
bridges, dams, irrigation projects, water supply systems for
cities, pipeline projects etc. This method an also be used for
finding out the capitalized cost of permanent
fellowship/scholarship endowment in educational institutes and
other organizations.

As already stated, capitalized cost/worth is the present worth of

an alternative that has a perpetual or permanent cash flow
series. The capitalized cost/worth of a perpetual cash flow having
uniform amount series with end of year payments ‘A’ is obtained
as follows.

The present worth of a uniform amount series is given by;

P = present worth, A = end of year payment of uniform amount

series, i = interest rate per year and n = number of interest
periods (already stated in Module 1)
The above equation can be rewritten as;

In the above expression, when ‘n’ approaches infinity (i.e. for

perpetual cash flow series), the term “1/(1+i)n” gets neglected
and present worth ‘P’ becomes capitalized cost/worth, the
expression of which is given by;

Thus the above expression can be explained by a simple example.

If a person deposits an amount of Rs.100000 in a bank at an
interest rate of 10% per year, then how much money the person
can withdraw from the bank every year without reducing the
original deposit.

- The amount of interest accumulated (i.e. amount of money the

person can withdraw without reducing the deposit) at the end of
1st year is Rs.10000 (100000 x 0.10).

- After withdrawal of Rs.10000 at the end of 1st year, the amount

that will remain in his bank account is Rs.100000, which will again
earn an interest amount of Rs.10000 at the end of 2nd year. After
withdrawal of Rs.10000 at the end of 2nd year, the person will
have again the same amount of Rs.100000 in his bank account
that will further earn the same interest amount at the end of 3rd
year. This process can be continued perpetually generating an
interest amount of Rs.10000 (A = P x i) without changing the
original deposit of Rs.100000. This example is similar to creating
a scholarship endowment in a university that will give a
scholarship of Rs.10000 every year indefinitely, by depositing
Rs.100000 in a saving bank account at interest rate of 10% per
year compounded annually.

The capitalized cost of a single amount occurring at regular

intervals in future period of time is calculated by first finding out
the equivalent uniform annual worth ‘A' of the uniform series and
then dividing by the interest rate ‘i'.

The calculation of capitalized cost of an alternative is illustrated

in the following example.

Example -17

A public project has an initial cost of Rs.11000000 and annual

operating and maintenance cost of Rs.700000. Further the project
will have one time major repair work of Rs.2000000 at the end of
15 year. Find out the capitalized cost of the alternative if interest
rate is 12% per year.

Solution:

The capitalized cost of the alternative is equal to sum of the

initial cost, present worth of one time major repair cost and
capitalized cost of the annual operating and maintenance cost.

The total capitalized cost of the alternative is given by;

Capitalized cost = -Rs.17198733

Therefore the capitalized cost of the alternative for the public

project is found to be Rs.17198733.

Lecture 12 : Capitalized Cost Analysis - II

Capitalized cost analysis:-

The capitalized cost can also be used for comparison of two or more
mutually exclusive alternatives which are assumed to serve perpetually. In
this case the comparison of the alternatives is made over same time
period i.e. infinite period of time. The alternative that shows lowest
capitalized cost is selected as the best alternative.

In the following examples, the calculation of capitalized cost of an

alternative and the comparison of mutually exclusive alternatives on the
basis of capitalized cost are illustrated.

Example -18

The initial cost of an infrastructure development project which is expected

to serve residents of a city perpetually is Rs.15000000. The annual
operating cost is Rs.800000 for first 10 years and Rs.900000 in the
subsequent years (i.e. from year 11 onwards). The expected cost of
renovation at the end of every 15 years is Rs.1800000. Find out the
capitalized cost of the project at interest rate of 8% per year.

Solution:
The cash flow diagram of the project for a part of service life is shown in
Fig. 2.30

The total capitalized cost of the project is equal to sum of the initial cost
and capitalized cost of annual operating cost and renovation cost.

Fig. 2.30 Cash flow diagram of the project

The annual operating cost is Rs.800000 for first 10 years followed by

Rs.900000 thereafter. This can be represented as Rs.800000 from end of
year 1 to infinite period of time and Rs.100000 from end of year 11 to
infinity as shown in Fig. 2.30. Thus the capitalized cost of the annual
operating cost is equal to the sum of capitalized cost of these two
components.

Capitalized cost of the annual operating cost:

In the above expression, the capitalized cost of Rs.100000 from end of

year 11 till infinity is located at the end of year 10. Now the present worth
(i.e. amount at time zero) of this amount is calculated by multiplying it
with single payment present worth factor.

Capitalized cost = -Rs.10579000

The capitalized cost of the annual operating cost can also be calculated by
considering Rs.800000 from end of year 1 till end of year 10 and
Rs.900000 from end of year 11 till infinity. The calculation is shown below.
In this expression, first the present worth of uniform series with annual
amount of Rs.800000 for first 10 years is calculated. Then the capitalized
cost of Rs.900000 from end of year 11 till infinity is calculated in the same
manner as for Rs.100000 in the first approach.

Capitalized cost = -Rs.10579080

Thus it can be seen that the capitalized cost of annual operating cost by
both ways is same. The minor difference between the values is due to the
effect of decimal points in the calculations.

Capitalized cost of renovation component:

The renovation will take place at the end of every 15 years i.e. at the end
of 15th year, 30th year, 45th year etc. In order to calculate the capitalized
cost of renovation component (Rs.1800000) at the end of every 15 years,
first the uniform annual amount ‘A’ of the equivalent uniform series for
the first 15 years is calculated. This amount ‘A’ will be same for the
subsequent intervals i.e. from end of year 16 till end of year 30, from end
of year 31 till end of till year 45 and so on (shown in Fig. 2.31). Then the
uniform amount ‘A’ is divided by the interest rate.

Fig. 2.31 Cash flow diagram for periodic renovation cost of the
project

Capitalized cost = -Rs.828000

Now the total capitalized cost of the project is equal to initial cost plus
capitalized cost of annual operating cost and renovation cost.
Capitalized cost = -Rs.15000000 -Rs.10579000 -Rs.828000
Capitalized cost = -Rs.26407000
Therefore the capitalized cost of the infrastructure development project
is Rs.26407000.

Example -19

There are two alternatives for a water supply project in a city. The details
of cash flow of the alternatives are shown below.

Alternative-1

Initial cost = Rs.20000000

Annual operating cost = Rs.1600000
Cost of renovation = Rs.2500000 at the end of every 17 years
One time upgrading cost = Rs.3200000 at the end of 22 year

Alternative-2

Initial cost = Rs.26000000

Annual operating cost = Rs.1200000
Cost of renovation = Rs.3500000 at the end of every 20 years
Compare the alternatives on the basis of capitalized cost and find out the
economical alternative if the rate of interest is 9% per year

Solution:

The capitalized cost of Alternative-1 will be equal to initial cost plus the
capitalized cost of annual operating cost, periodic renovation cost and one
time upgrading cost.
The capitalized cost of Alternative-1 is calculated as follows;

Capitalized cost = -Rs.39008418 (Alternative-1)

The capitalized cost of Alternative-2 will be equal to initial cost plus the
capitalized cost of annual operating cost and periodic renovation cost.

The capitalized cost of Alternative-2 is obtained as follows;

Capitalized cost = -Rs.40091666 (Alternative-2)

The capitalized cost of altenative-1 and Alternative-2 are found to

be Rs.39008418 and Rs.40091666 respectively. Thus Alternative-1 is
the economical as it shows lower capitalized cost (lower negative value)
as compared to Alternative-2.

Lecture 13 : Benefit-cost analysis

Benefit-cost analysis:-

The benefit-cost analysis method is mainly used for economic evaluation

of public projects which are mostly funded by government organizations.
In addition this method can also used for economic evaluation of
alternatives for private projects. The main objective of this method is used
to find out desirability of public projects as far as the expected benefits on
the capital investment are concerned. As the name indicates, this method
involves the calculation of ratio of benefits to the costs involved in a
project.

In benefit-cost analysis method, a project is considered to be desirable,

when the net benefit (total benefit less disbenefits) associated with it
exceeds its cost. Thus it becomes imperative to list out separately the
costs, benefits and disbenefits associated with a public project. Costs are
the expenditures namely initial capital investment, annual operating cost,
annual maintenance cost etc. to be incurred by the owner of the project
and salvage value if any is subtracted from the costs. Benefits are the
gains or advantages whereas disbenefits are the losses, both of which are
experienced by the owner in the project. In case of public projects which
are funded by the government organizations, owner is the government.
However this fund is generally taxpayers’ money i.e. tax collected by
government from general public, thereby the actual owners of public
projects are the general public. Thus in case of public projects, the cost is
incurred by the government whereas the benefits and disbenefits are
mostly experienced by the general public.

In order to know the costs, benefits and disbenefits associated with a

public project, consider that a public sector organization is planning to set
up a thermal power plant at a particular location. The costs to be incurred
by the public sector organization are cost of purchasing the land required
for the thermal power plant, cost of construction of various facilities, cost
of purchase and installation of various equipments, annual operating and
maintenance cost, and other recurring costs etc. The benefits associated
with the project are generation of electric power that will cater to the need
of the public, generation of revenue by supplying the electricity to the
customers, job opportunity for local residents, development other
infrastructure in the nearby areas etc. The disbenefits associated with
project are loss of land of the local residents on which the thermal power
plant will come up. If it is agricultural land, then the framers will lose their
valuable land along with the annual revenue generated from farming,
even though they get money for their land from the public sector
organization at the beginning. The other disbenefits to the local residents
are greater likelihood of air pollution in the region because of the thermal
power plant, chances of contamination of water in the nearby water-
bodies etc.

In benefit-cost analysis method, the time value of money is taken in to

account for calculating the equivalent worth of the costs and benefits
associated with a project. The benefit-cost ratio of a project is calculated
by taking the ratio of the equivalent worth of benefits to that of the costs
associated with that project. Either of present worth, annual worth or
future worth methods can be used to find out the equivalent worth of
costs and benefits associated with the project.

The benefit-cost ratio of projects is determined in different forms namely

conventional benefit-cost ratio and modified benefit-cost ratio. The
benefit-cost ratio is generally designated as B/C ratio.

Conventional B/C ratio

The conventional benefit-cost ratio of a project is mentioned as follows;

The disbenefits associated with the project are subtracted from the
benefits in the numerator of the ratio to obtain the net benefit associated
with the project. Similarly the equivalent worth of salvage value of the
initial investment is subtracted from equivalent worth of cost in the
denominator of the ratio. The total cost mainly consists of initial cost
(initial capital investment) plus the operating and maintenance cost.

As already stated the equivalent worth may be calculated either by

present worth method, annual worth method or future worth method.
Thus the expression for conventional benefit-cost ratio (B/C ratio) is
mentioned as follows;

In the above expressions, PW, AW, and FW refer to equivalent present

worth, annual worth and future worth respectively.

Modified B/C ratio

In the modified benefit-cost ratio method, the operating and maintenance

cost is subtracted from the benefits in the numerator of the ratio. In other
words, operating and maintenance cost is considered similar to the
disbenefits. The expression for modified benefit-cost ratio using PW, AW or
FW is given as follows;

A project is considered to be acceptable when the conventional or

modified B/C ratio is greater than or equal to 1.0. The illustration of
conventional and modified B/C ratio methods is described in the following
example.

Example -20

The cash flow details of a public project is as follows

Initial cost = Rs.21000000
Annual operating cost = Rs.1600000
Worth of annual benefits = Rs.5000000
Worth of annual disbenefits = Rs.1100000
Salvage value = Rs.4000000
Interest rate per year = 8% and useful lie = 30 Years
Using benefit-cost ratio method (both conventional and modified), find out
the economical acceptability of the public project. Use PW, AW and FW
methods to find out the equivalent worth of costs, benefits and
disbenefits.

Solution:

First the conventional benefit-cost ratio (B/C ratio) of the project is

computed.

Conventional B/C ratio using Present worth:

The conventional benefit-cost ratio of the public project is calculated as

follows;

Conventional B/C ratio = 1.137

Conventional B/C ratio using Annual worth:

 C
onventional B/C ratio = 1.137

Conventional B/C ratio using Future worth:

Conventional B/C ratio = 1.137

As calculated above, the conventional benefit-cost ratio is found to be

same by using any of the equivalent worth methods i.e. PW method, AW
method or FW method. As the benefit-cost ratio of the public project is
1.137 (i.e. greater than 1.0), the project is acceptable.

Now the modified benefit-cost ratio (B/C ratio) of the project is calculated.

Modified B/C ratio using Present worth:

The modified benefit-cost ratio of the public project is calculated as

follows;
Modified B/C ratio = 1.257

Modified B/C ratio using Annual worth:

Conventional B/C ratio = 1.257

Modified B/C ratio using Future worth:

Modified B/C ratio = 1.257

The modified benefit-cost ratio of the public project is found to be 1.257.

As observed from above calculations, the B/C ratio of the project from
both methods (conventional and modified) is greater than 1.0, although
the value is different. It may be noted here that, although the magnitude
of benefit-cost ratio differs between two methods i.e. conventional B/C
ratio and modified B/C ratio, but the decision to select or not a project is
not changed by use of any of the two methods.

Lecture 14 : Incremental benefit-cost ratio

analysis
Incremental benefit-cost ratio analysis:-

The incremental benefit-cost ratio analysis is used to select the best

alternative from a set of mutually exclusive alternatives. Similar to
incremental rate of return analysis, in this method also the incremental
cash flow between the alternatives i.e. the differences in benefits and
costs between the alternatives are calculated and then the ratio of the
equivalent worth of incremental benefits to that of incremental costs is
found out. In this method, the alternative with large cost is selected, if the
incremental benefits justify the extra cost associated with it. In other
words if the incremental B/C ratio is greater than or equal to 1.0, then the
larger cost alternative is selected. If incremental B/C ratio is less than 1.0,
then lower cost alternative is selected. While comparing the mutually
exclusive alternatives, the alternative with maximum B/C ratio (on its total
cash flow) should not be selected as the best alternative at first instance
because the maximization of B/C ratio may not guarantee that, best
alternative is selected. However after carrying out the incremental B/C
ratio analysis, the selection of the best alternative may match with the
alternative with maximum B/C ratio on its total cash flow.
The incremental benefit-cost ratio analysis for comparison of mutually
exclusive alternatives is carried out in the following steps;

1. First, all the alternatives are arranged in increasing order of

equivalent worth of costs. The equivalent worth of cost of
alternatives may be determined either by present worth method,
annual worth method or future worth method.

2. The alternative with lowest equivalent cost is now compared with

do-nothing alternative (initial base alternative). In other words the
B/C ratio of lowest equivalent cost alternative on its total cash flow
 is calculated. If calculated B/C ratio is greater than or equal to 1.0,
then the lowest equivalent cost alternative becomes the new base
alternative. On the other hand if B/C ratio is less than 1.0, then this
alternative is removed from further analysis and the acceptability of
the next higher equivalent cost alternative as base alternative is
found in the same manner as that was carried out for the alternative
with lowest equivalent cost. This process is continued till the base
alternative (acceptable alternative for which B/C ratio is greater
than or equal to 1.0) is obtained. If no alternative is obtained in this
manner, then do-nothing alternative is selected i.e. none of the
alternatives are selected, if this is an option.

3. Now the incremental benefit, DB and incremental cost, DC (i.e.

difference in benefits and costs) between next higher equivalent
cost alternative and the base alternative are calculated and then
incremental B/C ratio (DB/DC) i.e. ratio of the equivalent worth of
incremental benefits to that of incremental costs is obtained. If the
incremental B/C ratio (DB/DC) is greater than or equal to 1.0, then
the base alternative is removed from further analysis and the next
higher equivalent cost alternative becomes the new base
alternative. On the other hand if DB/DC is less than 1.0, then the
higher equivalent cost alternative is eliminated form further analysis
and base alternative remains the as the base. Then the incremental
B/C ratio is calculated between the next higher equivalent cost
alternative and the base alternative. This process is continued till
the last alternative is compared and in this way the best alternative
is selected which justifies the extra cost associated with it from the
incremental benefits.
4. The incremental B/C ratio analysis is illustrated in the following example.
5. Example -21

There are four mutually exclusive alternatives for a public project. Select the
best alternative using incremental B/C ratio analysis if interest rate is 7% per
year. The cash flow details of the alternatives are shown in the following
table. Each alternative has the useful life of 40 years.
6. Table 2.7 Cash flow of alternatives for the project
 7.

8. Solution:
First the conventional B/C ratio will be used for the incremental benefit-cost
analysis for the comparison of above mutually exclusive alternatives. Present
worth method will be used for the calculation of equivalent worth of benefits
and costs.

In order to arrange the alternatives in the increasing order of equivalent cost,

first the equivalent worth (present worth) of the costs of all the four
alternatives are calculated.

Present worth of costs of Alternative-1 (A1):

PW of costs of A1 = 101000000 + 6700000(P/A, i, n)

PW of costs of A1 = 101000000 + 6700000(P/A, 7%, 40)
PW of costs of A1 = 101000000 + 6700000 X 13.3317
PW of costs of A1 = 190322390
9. Present worth of costs of Alternative-2 (A2):

PW of costs of A2 = 112000000 + 6450000(P/A, i, n)

PW of costs of A2 = 112000000 + 6450000(P/A, 7%, 40)
PW of costs of A2 = 112000000 + 6450000 X 13.3317
PW of costs of A2 = 197989465
10. Present worth of costs of Alternative-3 (A3):

PW of costs of A3 = 145200000 + 5780000(P/A, i, n)

PW of costs of A3 = 145200000 + 5780000(P/A, 7%, 40)
PW of costs of A3 = 145200000 + 5780000 X 13.3317
PW of costs of A3 = 222257226
11. Present worth of costs of Alternative-4 (A4):

PW of costs of A4 = 122800000 + 6135000(P/A, i, n)

PW of costs of A4 = 122800000 + 6135000(P/A, 7%, 40)
PW of costs of A4 = 122800000 + 6135000 X 13.3317
PW of costs of A4 = 204589980
12. As observed from the above calculations, the order of alternatives from lowest
equivalent cost to highest equivalent cost is A1, A2, A4 and A3.
13. The lowest equivalent cost alternative A1 is first compared against do-nothing
alternative i.e. the B/C ratio of alternative A1 on its cash flow is calculated.
14.
15. B/C ratio of alternative A1 = 1.150

As the B/C ratio of alternative A1 is greater than 1.0, A1 now becomes the
base alternative and is compared against the next higher equivalent cost
alternative i.e. alternative A2. Now the incremental benefits and incremental
costs between A2 and A1 are calculated and the incremental B/C ratio is
obtained.
16. Incremental annual benefits (between A2 and A1) = 17200000 - 16420000 =
780000
Present worth (PW) of incremental annual benefits = 780000(P/A, 7%, 40)
= 780000 X 13.3317 =
10398726
PW of incremental benefits (between A2 and A1) = Rs.10398726
17. Incremental annual benefits (between A2 and A1) = 112000000 - 101000000
= 11000000
Incremental annual operating and maintenance cost (between A2 and A1) =
6450000 - 6700000
= -
250000
Present worth (PW) of incremental annual benefits = 11000000 - 250000(P/A,
7%, 40)
= 11000000 - 250000 X
13.3317 = 7667075
PW of incremental costs (between A2 and A1) = Rs.7667075

18.
19. Incremental B/C ratio (between alternative A2 and A1) = 1.356

The incremental B/C ratio between alternatives A2 and A1 can also be

calculated by finding out the ratio of the differences in present worth of
benefits of alternatives to that of costs. This calculation is shown below.
20. PW of benefits of alternative A1 = 16420000(P/A, 7%, 40)
= 16420000 X 13.3317 = 218906514
PW of costs of alternative A1 = 101000000 + 6700000(P/A, 7%, 40)
= 101000000 + 6700000 X 13.3317 =
190322390
PW of benefits of alternative A2 = 17200000(P/A, 7%, 40)
= 17200000 X 13.3317 = 229305240
PW of costs of alternative A2 = 112000000 + 6450000(P/A, 7%, 40)
= 12000000 + 6450000 X 13.3317 = 197989465
 21. Thus same incremental B/C ratio is obtained.

As the incremental B/C ratio is greater than 1.0, alternative A2 becomes the
new base alternative and alternative A1 is removed from further analysis.
Alternative A2 is now compared against the next higher equivalent cost
alternative i.e. alternative A4. The incremental B/C ratio between alternatives
A4 and A2 is determined in the same manner as that was determined
between alternatives A2 and A1.
22. Now the entire calculation for selecting the best alternative using incremental
B/C ratio analysis is presented in Table 2.8.
23. Table 2.8 Comparison of alternatives using incremental B/C ratio*
analysis
24.

25. * Conventional B/C ratio

The comparison of above alternatives using incremental B/C ratio analysis

as shown in Table 2.8 is briefly presented below.

 The lowest equivalent cost alternative A1 is compared against the

do-nothing alternative (initial base alternative). In other words B/C
ratio of alternative A1 on its total cash flow is calculated. The
obtained B/C ratio is 1.150 which is greater than 1.0. Thus
alternative A1 now becomes the new base alternative.

 Now alternative A1 is compared against the next higher equivalent

cost alternative i.e. A2. The incremental B/C ratio between
alternatives A2 and A1 is calculated. The calculated incremental B/C
ratio is 1.356 which is greater than 1.0. Thus alternative A2 now
becomes the base alternative and alternative A1 is eliminated from
further analysis.

 Alternative A2 is now compared against the next higher equivalent

cost alternative i.e. alternative A4. The calculated incremental B/C
 ratio between alternatives A4 and A2 is 1.414 (greater than 1.0).
Alternative A4 now becomes the base alternative and
alternative A2 is eliminated.

 Alternative A4 is now compared against the next higher equivalent

cost alternative i.e. alternative A3 (last alternative). The
incremental B/C ratio between
alternatives A3 and A4 is 0.906 which is less than 1.0. Thus the
incremental cost associated with alternative A3 is not justified.
Hence alternative A4 is selected as the best alternative as no
other alternative is left for comparison. In other words
alternative A4 is the highest equivalent cost alternative which is
associated with the last justified increment i.e. incremental B/C ratio
greater than 1.0.

It may be noted here that the B/C ratios of the alternatives on their
individual cash flows could have been calculated at the beginning of the
analysis to eliminate any alternative(s) that has a B/C ratio less than 1.0
and that alternative(s) need not be considered further in the incremental
benefit-cost ratio analysis. However this step is not necessary because the
alternative with B/C ratio less than 1.0 on its cash flow will eliminated in
the process of incremental analysis. In this example the values of B/C ratio
of the alternatives A1, A2, A3 and A4 on their individual cash flows are
1.150, 1.158, 1.146 and 1.166 respectively (all greater than 1.0). The
calculation of B/C ratio is shown only for alternative A1. The B/C ratio of
other alternatives can be similarly calculated.

The above incremental B/C ratio analysis was carried out using
conventional B/C ratio. The same analysis can also be carried out by using
modified B/C ratio. As already stated, in modified B/C ratio, the operating
and maintenance cost is subtracted from the benefits in the numerator.
The incremental B/C ratio analysis using modified B/C ratio for the
comparison of above mutually exclusive alternatives is describe below.

The order of alternatives from lowest to highest equivalent cost (present

worth of cost) will depend only on the initial investment as the annual
operating and maintenance cost (considered similar to disbenefits) is
subtracted from the benefits in the numerator of modified B/C ratio. Thus
the order of alternatives from lowest to highest equivalent cost (i.e. initial
investment) is A1, A2, A4 and A3 (same as earlier). Now the incremental
benefit-cost analysis using modified B/C ratio is carried out in the same
manner as that was done using conventional B/C ratio and is presented in
Table 2.9.
Table 2.9 Comparison of alternatives using incremental B/C ratio**
analysis

** Modified B/C ratio

*** Net annual benefit for an alternative is obtained by subtracting the

annual operating and maintenance cost from its annual benefits.
Incremental net annual benefit is the difference in net annual benefits
between two alternatives. Considering the comparison between
alternatives A4 and A2, the calculation of incremental net annual benefit
is shown below.

The net annual benefit of alternative A2 = annual benefits - annual

operating and maintenance cost
= 17200000 - 6450000 = 10750000
The net annual benefit of alternative A4 = annual benefits - annual
operating and maintenance cost
= 17900000 - 6135000 = 11765000
The incremental net annual benefit between A4 and A2 = 11765000 -
10750000 = 1015000

Thus the incremental net annual benefit between two alternatives A4 and
A2 is Rs.1015000, which is shown in Table 2.9.

From Table 2.9, it is observed that the best alternative is A4, which is
same as the outcome obtained from incremental B/C ratio analysis using
the conventional B/C ratio. In other words the same outcome regarding
the best alternative is obtained, however the values of B/C ratios obtained
were different. Similar to present worth, the incremental B/C ratio analysis
can also be carried out by calculating the annual worth (AW) or future
worth (FW) of benefits and costs of alternatives.

Lecture 15 : Breakeven analysis

B reakeven analysis :-

The breakeven analysis is used to calculate the value of a factor (or

variable) at which the expenditures and revenues of a project or
alternative are equal. This value of the variable is known as the breakeven
point. Corresponding to the breakeven point, profit or loss can be
determined if the expected value of the variable is higher or lower than
the breakeven value. In this regard the breakeven point governs the
economic acceptability of the project or the alternative. The breakeven
analysis is also used for comparing two alternatives by determining the
breakeven point i.e. the quantity of a factor (common to both the
alternatives) at which the total equivalent worth of both alternatives are
equal. The examples of some of the factors which are used in the
breakeven analysis are quantities produced per year, hours of operation
per year, rate of return per year and useful life etc. and the breakeven
value of these factors are calculated to find out the economical
acceptability of a single alternative or to select the best one between the
alternatives. The breakeven point between expenditure and revenue for a
single alternative is shown in Fig. 2.32. Here ‘x' is the factor that mainly
affects the expenditure and revenue of the alternative.

Fig. 2.32 Schematic diagram for breakeven point of a single

alternative
In Fig. 2.32, the equivalent worth of expenditure and revenue are plotted
as functions of the quantity of factor ‘x'. The breakeven point corresponds
to that value of the factor ‘x' at which the equivalent worth of expenditure
and revenue of the alternative are equal i.e. the relationships representing
the expenditure and revenue as functions of ‘x' intersect each other
(shown in Fig. 2.32).

The breakeven point between two alternatives is shown in Fig. 2.33.

Fig. 2.33 Schematic diagram of breakeven point between two

alternatives

In this figure the total equivalent worth i.e. equivalent worth of net cash
flow (i.e. expenditures and revenues) of the alternatives are plotted at
various values of the common factor ‘x'. The intersection of the total
equivalent worth of two alternatives gives the breakeven point i.e. the
value of the common factor ‘x' at which the values of total equivalent
worth of the two alternatives are equal. If the expected value of ‘x' is less
than the breakeven value, Alternative-1 is selected as its total equivalent
worth (assuming it as negative cash flow i.e. cost greater than revenue) is
less than that of Alternative-2 as evident from Fig. 2.33. Similarly when
the expected value of ‘x' is greater than the breakeven value, Alternative-
2 is selected as it shows lower equivalent worth (i.e. lower cost) compared
to Alternative-1. In Fig. 2.32 the variations of equivalent worth of
expenditure and revenue of the single alternative and in Fig. 2.33 the
variations of total equivalent worth of two alternatives are considered as
linear functions of the value of factor ‘x'. Sometimes these relationships
may also be non-linear. In the breakeven analysis, the equivalent worth of
expenditures and revenues can be calculated either by present worth
method, future worth method or annual worth method by taking into
account the time value of money. The annual worth method is normally
used when the quantities of the variable (on which the expenditures and
the revenues mostly depend) are expressed on annual basis.

The following example will illustrate the breakeven analysis for a single
alternative.

Example -22

A concrete mixer has the following cash flow details;

Initial purchase price = Rs.750000,

Annual operating and maintenance cost = Rs.45000

Salvage value = Rs.210000,

Useful life = 10 years

In addition one operator is required to operate the concrete mixer at cost

of Rs.30 per hour. The production (preparation) rate of concrete of the
mixer is 0.1 m3 per hour. The revenue to be generated from production of
1 m3 of concrete is Rs.1000. The interest rate is 11% per year. How many
‘m3' of concrete need to be produced per year so that the revenue
generated breakevens with the expenditure?

Solution:

In order to find out the breakeven value of the concrete volume (in ‘m 3' )
per year, the equivalent uniform annual worth of expenditure will be
equated to that of revenue.

Let ‘x' m3 is the volume of concrete produced by the concrete mixer per
year.

The operator cost is Rs.30 per hour.

The operator cost (Rs.) per year is given by;

Now the equivalent uniform annual worth (Rs.) of expenditure is given by;
The equivalent uniform annual worth (Rs.) of revenue is calculated as
follows;

Now equating equivalent uniform annual worth of expenditure with that of

revenue;

Thus the volume of concrete to be produced by the concrete mixer per

year i.e. the breakeven quantity at which the expenditure incurred is equal
to the revenue generated is 228.274 m3. If the volume of concrete
produced per year is different from the breakeven value, then there will
change in the net cash flow as shown below;

If x is equal to 200 m3 (i.e. less than breakeven value), the equivalent

uniform annual worth of expenditure and revenue are given by;

Expenditure

Revenue

AWe > AWr

If x is equal to 250 m3 (i.e. greater than breakeven value), the equivalent

uniform annual worth of expenditure and revenue are given by;

Expenditure
Revenue

AWr > AWe

Thus from above calculations it is observed that, equivalent annual worth

of revenue is less than that of expenditure, when the volume of concrete
produced per year is less than the breakeven value and on the other
hand, equivalent annual worth of revenue is more than that of
expenditure, when the volume of concrete produced per year is greater
than the breakeven value.

The breakeven point is also graphically shown in Fig. 2.34.

Fig. 2.34 Equivalent uniform annual worth of expenditure and

revenue and breakeven point

The equivalent uniform annual worth of expenditure and revenue are

calculated at different values of volume of concrete produced per year
using the respective expressions as mentioned earlier and are shown in
the above figure.

The breakeven point can also be calculated by equating the equivalent

present worth of expenditures to that of revenues as shown below.

Present worth of expenditure:

Present worth of revenue:

Now equating equivalent present worth of expenditure with that of

revenue;

Thus the breakeven value of volume of concrete to be produced by the

concrete mixer per year is 228.275 m3 which is same as the value
obtained by annual worth method stated earlier.

Lecture 16 :
Breakeven analysis for two and more than
two alternatives
Breakeven analysis between two alternatives

The breakeven analysis between two alternatives is carried out by

equating the equivalent worth of cash flows of both the alternatives. For
determining the breakeven point between the alternatives, a factor or
variable (as required) must be common to both the alternatives and the
corresponding cost or revenue element is expressed in terms of this
common variable. As already stated, the total equivalent worth of
alternatives can be calculated either by present worth method, future
worth method or annual worth method by considering the time value of
money. The breakeven analysis between two alternatives is presented in
the following example.

Example -23
A construction company has two alternatives to purchase an excavator
which is to be employed at a construction site for excavation of earth. The
cash flow details of the two alternatives are presented as follows;

Alternative-1: Initial purchase cost = Rs.4865000

Salvage value = Rs.1250000

Useful life = 12 years

Operating cost:

The operating cost for excavating 1m3 of earth is Rs.11.0. The excavator
(Alternative-1) can excavate 52 m3 of earth in one hour.

Alternative-2: Initial purchase cost = Rs.5350000

Salvage value = Rs.1410000

Useful life = 12 years

Operating cost:

The operating cost for excavating 1m3 of earth is Rs.8.0. The excavator
(Alternative-2) can excavate 60 m3 of earth in one hour.

The company's minimum attractive rate of return (MARR) is 10.5% per

year. How many hours the excavators have to operate per year, for the
equivalent uniform annual worth of cash flows of both the alternatives to
be equal?

Solution:

Let ‘y' is the number of operating hours per year.

The annual operating cost (Rs.) for Alternative-1 is given by;

Now the equivalent uniform annual worth (Rs.) of Alternative-1 is given

by;

The annual operating cost (Rs.) for Alternative-2 is given by;

The equivalent uniform annual worth (Rs.) of Alternative-2 is given by;

Now equating equivalent uniform annual worth Alternative-1 to that of

Alternative-2;

Thus the breakeven value of number of operating hours per year is 713.9
hours, at which the equivalent uniform annual worth of Alternative-1 is
equal to that of Alternative-2.

The breakeven point is also shown in Fig. 2.35. The equivalent uniform
annual worth of both the alternatives are determined at different values of
annual operating hours and are shown in Fig. 2.35.

Fig. 2.35 Equivalent uniform annual worth and breakeven point

between Alternative-1 and Alternative-2
The equivalent uniform annual worth of both the alternatives is negative
as cash outflows (i.e. expenditures) are greater than the cash inflows (i.e.
revenues). Thus the equivalent uniform annual worth of both the
alternatives shown in Fig. 2.35 can also be stated as equivalent uniform
annual cost. The line representing the equivalent uniform annual cost of
Alternative-1 has greater slope than Alternative-2 as observed from this
figure. In other words Alternative-1 has higher annual variable cost
(Rs.572y) as compared to Alternative-2 (Rs.480y). Similarly Alternative-2
has higher constant equivalent annual cost (Rs.740626) than Alternative-1
(Rs.674946), as observed from expressions of equivalent uniform annual
worth of both the alternatives and also from the above figure. If the
expected annual operating hours are less than the breakeven value (i.e.
713.9 hours), then the construction company should select Alternatives-1
as its equivalent annual cost is less than that of Alternative-2 (as evident
from Fig. 2.35). Similarly if the expected annual operating hours are
greater than breakeven value, then Alternative-2 should be selected as it
shows lower equivalent annual cost as compared to Alternative-1.

Breakeven analysis for more than two alternatives

The breakeven analysis can also be carried out for more than two
alternatives. Similar to the case of two alternatives, the required factor or
variable must be common to all the alternatives. In this analysis the pair-
wise comparison between the alternatives is carried out to determine the
corresponding breakeven point. The schematic diagram of breakeven
analysis between three alternatives ( A1, A2 and A3 ) is shown in Fig.
2.36. In this figure the lines represent the total equivalent worth (i.e.
equivalent worth of net cash flow) of the alternatives at different values of
the common variable ‘ x '.
Fig. 2.36 Schematic diagram of breakeven points for three
alternatives

In this figure the total equivalent worth is assumed as the equivalent

annual cost of the alternatives. Further ‘x1', ‘x2' and ‘x3' represent the
breakeven points between alternatives A1 and A3,
between A2 and A3 and between A1 and A2 respectively. As already
mentioned, the breakeven points ‘x1', ‘x2' and ‘x3' can be calculated by
equating the equivalent worth of the corresponding pair of the
alternatives. If the expected or estimated value of common variable ‘x' is
less than ‘x1' (i.e. the breakeven value between A1 and A3), then
alternative A3 is selected as it shows lowest equivalent annual cost as
evident from Fig. 2.36. Similarly if the expected value of common variable
‘x' lies in between ‘x1' and ‘x3', then alternative A1 is selected as its
equivalent annual cost is lowest within this range of the common variable.
Further if the expected value of common variable is greater than ‘x3', then
alternative A2 is preferred over other alternatives as it shows lowest
equivalent annual cost as compared to other alternatives. In this analysis,
‘x2' (the breakeven point between alternatives A2 and A3 ) lies between
the breakeven points ‘x1' and ‘x3' and alternative A1 has lowest
equivalent annual cost between breakeven points ‘x1' and ‘x2' and
between ‘x2' and ‘x3' (i.e. between ‘x1' and ‘x3' as already stated).
The breakeven analysis between three alternatives is presented in the
following example.

Example -24 (Using data of Example-23)

In this example, details about third alternative are mentioned along with
the two alternatives stated in Example-23 for carrying out breakeven
analysis between three alternatives.

A construction company has three alternatives to purchase an excavator

which is to be employed at a construction site for excavation of earth. The
cash flow details of all the three alternatives are presented as follows;

Alternative-1: Initial purchase cost = Rs.4865000

Salvage value = Rs.1250000

Useful life = 12 years

Operating cost:

The operating cost for excavating 1m3 of earth is Rs.11.0. The excavator
(Alternative-1) can excavate 52 m3 of earth in one hour.

Alternative-2: Initial purchase cost = Rs.5350000

Salvage value = Rs.1410000

Useful life = 12 years

Operating cost:

The operating cost for excavating 1m3 of earth is Rs.8.0. The excavator
(Alternative-2) can excavate 60 m3 of earth in one hour.

Alternative-3: Initial purchase cost = Rs.5975000

Salvage value = Rs.1500000

Useful life = 12 years

Operating cost:

The operating cost for excavating 1m3 of earth is Rs.6.0. The excavator
(Alternative-3) can excavate 67 m3 of earth in one hour.

The company's minimum attractive rate of return (MARR) is 10.5% per

year. Determine the economical alternative at different values of annual
operating hours.

Solution:

In this case the pair-wise comparison between the alternatives is carried

out to determine the corresponding breakeven point.
Let ‘y' is the number of operating hours per year.

As already determined in Example-23, the equivalent uniform annual

worth of Alternative-1 and Alternative-2 are as follows;

The annual operating cost (Rs.) for Alternative-3 is given by;

Now the equivalent uniform annual worth (Rs.) of Alternative-3 is given

by;

The equivalent uniform annual worth of all the alternatives can also be
stated as equivalent uniform annual cost, as it is negative. Now the
equivalent uniform annual worth of all the three alternatives are
determined at different values of annual operating hours and are shown in
Fig. 2.37.
Fig. 2.37 Equivalent uniform annual worth and breakeven points
between the alternatives

From this figure, it is observed that there are three breakeven points
i.e. P1 between Alternative-1 and Alternative-2, P2 between Alternative-1
and Alternative-3 and P3 between Alternative-2 and Alternative-3. The
breakeven points are determined by equating the equivalent uniform
annual worth of the corresponding alternatives.

For breakeven point P1 , equating the equivalent uniform annual worth

Alternative-1 to that of Alternative-2;

For breakeven point P2 , equating the equivalent uniform annual worth

Alternative-1 to that of Alternative-3;

For breakeven point P3 , equating the equivalent uniform annual worth

Alternative-2 to that of Alternative-3;

If the expected annual operating hours are less than the 713.9 hours
(breakeven point P1), then the construction company should select
Alternatives-1 as it shows lowest equivalent annual cost as compared to
other alternatives as observed from Fig. 2.37. Similarly Alternative-2
should be selected, if the expected annual operating hours lie between
713.9 and 1152.7 hours (between breakeven points P1 and P3) as its
equivalent annual cost is lowest than other alternatives. Further,
Alternative-3 should be selected, if the expected annual operating hours
are greater than 1152.7 hours (breakeven point P3), as it shows lowest
equivalent annual cost as compared to other alternatives as evident from
Fig. 2.37.
It is to be noted here that, similar to Example-1 (Lecture-2 of this module),
commas at appropriate places for the numbers can be placed in other
examples presented in different lectures.