EVALUATING ALTERNATIVES( Projects) BY

EQUIVALENCE of:
1. Present Worth Comparison
2. Future Worth Comparison
3. Annual Cost and Worth Method
4. Rate of Return (IRR) Method
5. Pay back period method
6. Benefit-cost Ratio Analysis
Introduction
➢For most of the engineering projects, equipment
etc., there are more than one feasible
alternative.
➢ It is the duty of the project management
team of the client organization to select the best
alternative that involves less cost and results
more revenue
1. Present Worth Comparison
ASSUMPTIONS
 Cash flows are known.

 Cash flows do not include effect of inflation.

 The interest rate (discounting rate) is known.

 Comparisons are made with before tax cash flows.

✓ General in nature such that:

PW = AW(P/A, i%, n)
PW = FW(P/F, i% ,n)
1.1 Alternatives with equal lives

 The competing alternatives have equal lives.

 The alternative with the maximum present worth is

the most economical alternative.

 For cost dominated cash flow diagrams the alternative

with the lowest present cost is chosen.

 In case of cash flow diagrams involving both costs and

revenues the net or difference of present worth of
revenues and costs are found. This is referred to as net
present worth or net present value (NPV).
1.1 Alternatives with equal lives(cont……)

 The method of comparison of NPV is quite popular for

evaluation of alternatives.
 NPV is also used to calculate profitability for an
investment alternative.
Example
Compare an alternative
 Project A, costing 500,000 Birr and
requiring cash outlays of 250,000 Birr a
year for 10 years,
 Project B, costing 750,000 and requiring
prospective cash outlays of 200,000 Birr a
year for 10 years, if interest is 10%.
Calculation of present worth
 Present worth of Alternate A
= 500000+250000(P/A, 10%, 10yrs) =
500000+250000(6.1446) =
2,036,150.00
 Present worth of Alternate B
= 750000+200000(P/A, 10%, 10yrs) =
750000+200000(6.1446)
=1,978,920.00

Decision:
➢ In this case, since the present worth of cost for alternative
B is less than that of alternative A,
➢ It is preferable to choose alternative B.
1.2 Alternatives with unequal lives
➢ the alternatives do not have an equal life period of service
(they are not co-terminal).
➢ decision to choose between two batching plants, which
may have different service lives – say 5 years and 10 years.

➢ The common multiple method and the study period

method are two approaches to solve this class of problems.
Common multiple method
➢ In this method a coterminous life period is chosen for
the alternatives using the least common multiples of
the different life periods.
➢ For example if the alternatives have life period of 2, 3, 4
and 6 years, they will be put in use for a period equal to
the least common multiple of their life periods.
➢ In the case above it is 12 years.
➢ This means that the alternative with two year life period
shall be replaced 6 times; the one with three years shall
be replaced four times and so on for achieving
coterminous life period for all the alternatives.
➢ It is assumed here that the alternatives shall be replaced
after their service life with same cost characteristics.
➢ This assumption stands valid if the common multiple of
alternative life periods is small
Example
 Assets A1 and A2 have the capability of performing a
required function.
 Asset A2 has an initial cost of 160,000 and expected salvage
value of 20,000 Birr at the end of its 4 year service life.
 Asset A1 costs 45,000 less initially, with an economic life 1
year shorter than that of A2; but A1 has no salvage value,
and its annual operating costs exceed those of A2 by 12,500.
 When the required rate of return is 15%; state which
alternative is preferred when comparison is made by the
common multiple method
Common multiple method

Asset-A2

Net present worth = -160,000 –(160,000/1.154)-

(160,000/1.158 )+(20,000/1.154) + (20,000/1.158 +
( 20,000/1.1512)= -282,074.00
Solution

A1

Net present worth= -115,000 –(115,000/1.153)-

(115,000/1.156 )-(115,000/1.159)-12,500*[(1.1512-
1)/(0.15*1.1512)]
= -340,779.50
1.3 Alternatives with infinite lives---
➢ when the alternatives involved have long lives or long-term
projects for example the appraisal of different alternatives in
construction of civil engineering structures – dams, power
projects, tunnel projects etc., which have a reasonably long life.
➢ Capitalized equivalent method is used
➢ Capitalized equivalent (CE) is the present (at time zero) worth
of cash inflows and outflows.
➢ In other words, CE is a single amount determined at time zero,
which at a given rate of interest, will be equivalent to the net
difference of receipts and disbursements if the given cash flow
pattern is repeated in infinity.

➢ If n is not infinitive, we use this formula

➢ If n is infinitive, Mathematically, CE = A x (P/A, i, n=∞)

P(CE) = A x [((1+i)∞-1)/ i(1+i)∞]= A/i
Example
 Dam A initially costs 160,000 Birr to construct and cost
750,000 Birr a year to operate and maintain.
 Another dam design B costs 7,500,000 Birr to build and
cost 500,000 a year to operate and maintain.
 Both installations are felt to be permanent.
 The minimum required rate of return is 5%.
 Which alternative should be preferred?
Dam A
 NPV = -160,000-750,000/0.05
= -15,160,000
Dam B

 NPV = -7,500,000 - 500,000/0.05

= -17,500,000

The cost of dam A is less, so Construct Dam A.

2.Future Worth Comparison
➢ the future worth of each component of cash flow is
evaluated
➢ there is no discounting of each component of cash
flow to the present
➢ there is no special advantage over the present worth
method,
➢ frequently used in cases when the owner wants an
estimate of net worth at some future date such as
planning for retirement.
➢ comparison and evaluation seems to be more
meaningful as it provides some insight into future
receipts.
Example
Compare an alternative
 A, costing 500,000 Birr and requiring cash
outlays of 250,000 Birr a year for 10 years,
 B, costing 750,000 and requiring
prospective cash outlays of 200,000 Birr a
year for 10 years, if interest is 10%.
3. Annual Cost and Worth Comparison
➢ Popular Analysis Technique.
➢ Easily understood–results are reported in money/time period.
➢ All payments and disbursements are converted into an annual cost
series at a given interest rate
➢ The alternative that yields the least cost is chosen.
➢ The method could be used to compare alternatives with equal and
unequal lives
➢ Eliminates the LCM problem associated with the present worth
method for unequal period.
➢ Only have to evaluate one life cycle of a project.
➢ Cash-Flow analysis approach where the cash flows are converted to
their respective equal, end-of-period amounts.
➢ The result is reported in terms of Birr/period.
➢ Variant of the present worth approach.
➢ Popular with some managers who tend to think in terms of
“ETB/year”, “ETB/month”, etc.
Annual worth method----
✓ General in nature such that:
✓ AW = PW(A/P, i%, n)
✓ AW = FW(A/F, i% ,n)
✓ Convert all cash flows to their end-of-period equivalent
amounts
✓ AW is known by other titles.
✓ EAW (Equivalent Annual Worth),
✓ EAC (Equivalent Annual Cost),
✓ AE (Annual Equivalent), and
✓ EUAC (Equivalent Uniform Annual Cost)
Example
Compare an alternative
 Project ‘A’ initially costs 500,000 Birr
and requiring cash outlays of 250,000
Birr a year for 10 years,
 B, costs 750,000 and requiring
prospective cash outlays of 200,000 Birr
a year for 10 years, if interest is 10%.
Compare using the annual worth method
Home Assignment-1
Compare the following alternatives
using PW,AW and FW method

EOY 0 1 2 3 4
Project X -50,000 5000 17,500 30,000 42,500

Project Y -50,000 50,000 10,000 10,000 10,000

Home Assignment-2
Home Assinment-3
Compare the following Equipments using present
worth Comparison

Year 0 1 2 3
Operation and
Initial cost maintenance
cost

Equipment A 450,000 225,000 450,000 -

Equipment B 725,000 300,000 300,000 400,000