Investment analysis: Tools for Evaluating Alternatives

Outline
Mutually exclusive and independent projects Use of present, future and annual worth analysis to evaluate alternatives Payback period Rate of return Benefit-cost ratio

Tools for Evaluating Alternatives

There are various tools or methods by which alternatives can be evaluated economically using the factors learned. Purpose
Compare mutually exclusive alternatives Basis: present worth, future worth and annual worth analysis

Category of projects
To help formulate alternatives, a project is categorized as one of the following:
Mutually exclusive: Only one of the viable projects can be selected by the economic analysis Independent: More than one viable project may be selected by the economic analysis.

Tools for Evaluating alternatives

Present Worth Analysis
Formulating Mutually Exclusive Alternatives Present Worth Analysis of Equal-life Alternatives Present worth Analysis of DifferentLife Alternatives Future Worth Analysis Payback Period Analysis

Annual Worth Analysis Rate of Return Analysis Benefit/Cost Ratio Analysis

Present worth Analysis of EqualLife Alternatives

One alternative: Calculate PW at the MARR.
If PW 0, the requested MARR is met or exceeded. The alternative is financially viable.

Two or more alternatives: Calculate the PW of each alternative.

Present worth Analysis of EqualLife Alternatives

Two or more alternatives: Calculate the PW of each alternative at the MARR.
Select the alternative with the largest PW value This means that select the alternative with less negative or more positive.

Selection of alternative following the guideline

PW1 $ -1500 -500 +2500 PW2 $ -500 +1000 -500 Selected alternative 2 2 1

+2500

+1500

Present worth Analysis of EqualLife Alternatives

If the projects are independent, the selection guideline is as follows:
For one or more independent projects, select all projects with PW 0 at the MARR.

Example 5.1
Perform a present worth analysis of equalservice machine with costs shown below, if the MARR is 10% per year. Revenue for all the alternatives are expected to be the same.
Electric powered First cost, $ Annual operating cost (AOC), $ Salvage value S, $ Life, years - 2500 - 900 200 5 Gas powered - 1500 - 700 350 5 Solar powered - 6000 - 50 100 5

Example 5.1
Solution These are service alternatives. The PW of each machine is calculated at i = 10% for n = 5 years.
PWE = -2500 - 900(P/A,10%,5) + 200(P/F,10%,5)= $-5788 PWG = -3500 - 700(P/A,10%,5) + 350(P/F,10%,5)= $-5936 PWS = -6000 - 50(P/A,10%,5) + 100(P/F,10%,5)= $-6127 [See the calculations in excel file] The electric-powered machine is selected since the PW of its costs is the lowest, it has numerically the largest PW value.

Example 5.2
A project engineer with EnvironCare is assigned to start up a new office in a city where a 6-year contract has been finalized to take and to analyze ozone-level readings. Two lease options are available, each with a first cost, annual lease cost, and deposit-return estimates as shown below:
Location A Location B

First cost, $ Annual lease cost, $ per year Deposit return, $ Lease term, years

- 15,000 -3,500 1,000 6

- 18,000 -3,100 2,000 9

Example 5.2
(a) Determine which lease option should be selected on the basis of a present worth comparison, if the MARR is 15% per year. (b) EnvironCare has a standard practice of evaluating all projects over a 5-year period. If a study period of 5 years is used and the deposit returns are not expected to change, which location should be used? (c) Which location should be selected over a 6-year study period if the deposit return at location B is estimated to be $6000 after 6 years.

Break-Even Point
Breakeven Analysis
Single-Product Case Multiproduct Case

Reference: Operations Management, Heizer & Render, 8th ed (p-287)

Learning Objectives
When you complete this topic, you should be able to: Describe or Explain:

Break-even analysis

Assumptions
Graphical and Algebraic Approach

Determining BEP for single and multi-product cases

Break-Even Analysis
A critical tool for determining capacity a facility must have to achieve profitability Objective is to find the point in dollars (or ringgits) and units at which, cost equals revenue Requires estimation of fixed costs, variable costs, and revenue

Break-Even Analysis -The Elements

Fixed costs are costs that continue even if no units are produced Depreciation, taxes, debt, mortgage payments Variable costs are costs that vary with the volume of units produced Labor, materials, portion of utilities Contribution is the difference between selling price and variable cost

Break-Even Analysis -The Elements

Assumptions Costs and revenue are linear functions
(In reality, the case is not so)

There is no time value of money

We actually know that these (variable & fixed) costs are not easy to estimate.

Break-Even Analysis
900 800 Cost in dollars 700 600 Total revenue line

Break-even point Total cost = Total revenue

Total cost line

500
400 300 200 100
|

Variable cost

Fixed cost

| | | | | | | | | | | 0 100 200 300 400 500 600 700 800 900 10001100

Volume (units per period)

Break-Even Analysis
BEPx = Break-even point in units BEP$ = Break-even point in dollars P = Price per unit (after all discounts)
Break-even point occurs when

x = Number of units produced TR = Total revenue = Px F = Fixed costs V = Variable costs per unit TC = Total costs = F + Vx

TR = TC or Px = F + Vx

F BEPx = P-V

Break-Even Analysis
BEPx = Break-even point in units BEP$ = Break-even point in dollars P = Price per unit (after all discounts) x = Number of units produced TR = Total revenue = Px F = Fixed costs V = Variable costs TC = Total costs = F + Vx

BEP$ = BEPx P F = P P-V F = (P - V)/P F = 1 - V/P

Profit = = = =

TR - TC Px - (F + Vx) Px - F - Vx (P - V)x - F

Break-Even Example
Fixed costs = $10,000 Direct labor = $1.50/unit Material = $.75/unit Selling price = $4.00 per unit

BEP$ =

F = 1 - (V/P)

$10,000 1 - [(1.50 + .75)/(4.00)]

Break-Even Example
Fixed costs = $10,000 Direct labor = $1.50/unit Material = $.75/unit Selling price = $4.00 per unit

BEP$ =

F 1 - (V/P) =

$10,000 1 - [(1.50 + .75)/(4.00)]

$10,000 .4375 = $22,857.14

BEPx =

$10,000 F = 4.00 - (1.50 + .75) = 5,714 P-V

Break-Even Example
50,000

40,000
30,000 20,000 10,000
| 0 | | | |

Revenue Break-even point Total costs

Dollars

Fixed costs

2,000

4,000

6,000 Units

8,000

10,000

Break-Even Example
Multiproduct Case
BEP$ = F

where V P F W i = = = = =

1-

Vi Pi

x (Wi)

variable cost per unit price per unit fixed costs percent each product is of total dollar sales each product

Multiproduct BEP Example

Fixed costs = $3,500 per month Item Sandwich Soft drink Baked potato Tea Salad bar Price $2.95 .80 1.55 .75 2.85 Cost $1.25 .30 .47 .25 1.00 Annual Forecasted Sales Units 7,000 7,000 5,000 5,000 3,000

Multiproduct BEP Example

Fixed costs = $3,500 per month Item Price Sandwich $2.95 Soft drink .80 Baked potato 1.55 Selling Variable Tea .75 Item (i) Price (P) Cost (V) (V/P) Salad bar 2.85
$1.25 .30 .47 .25 1.00

Sandwich $2.95 Soft drink .80 Baked 1.55 potato Tea .75 Salad bar 2.85

.42 .38 .30 .33 .35

Annual Forecasted Cost Sales Units $1.25 7,000 .30 7,000 .47 Annual 5,000 Weighted Forecasted % of Contribution .25 5,000 1 - (V/P) Sales $ Sales (col 5 x col 7) 1.00 3,000
.58 .62 .70 .67 .65 $20,650 5,600 7,750 .446 .121 .167 .259 .075 .117 .054 .120 .625

3,750 .081 8,550 .185 $46,300 1.000

Multiproduct Example V
BEP$ =

F
i

Fixed costs = $3,500 per month

1Pi

x (Wi)

$3,500 x 12 = Annual Forecasted = $67,200 .625 Item Price Cost Sales Units Sandwich $2.95 $1.25 7,000 Daily $67,200 Soft drink .80 .30 7,000 = = $215.38 sales 312 days Annual Baked potato 1.55 .47 5,000 Weighted Forecasted 5,000 % of Contribution Tea Selling Variable .75 .25 Item (i) Price (P)Cost (V) (V/P) 1 - (V/P) Sales $ Sales (col 5 x col Salad bar 2.85 1.00 3,000 .446 x $215.38 7) = 32.6 .259 33 Sandwich $2.95 $1.25 .42 .58 $20,650 $2.95 .446 sandwiches
Soft drink Baked potato Tea Salad bar .80 1.55 .75 2.85 .30 .47 .38 .30 .33 .35 .62 .70 .67 .65 5,600 7,750 .121 .075 .167 per day .117 .054 .120 .625 .25 1.00 3,750 .081 8,550 .185 $46,300 1.000

Problems for practice (to be solved in the class)

(1) Given the following data, calculate BEP(x), BEP ($), and the profit at 100,000 units: P= $8/unit, V = $4/unit and F =$50,000. (2) A prolific author is considering starting her own publishing company. She will call it DSI Publishing, Inc. DSIs estimated costs are -----------------------------------------------------------------Fixed $250,000.00 Variable cost per book $20.00 Selling price per book $30.00 How many books must DSI sell to break even? What is its break-even point in dollars?

Problem #3 (to be solved at home)

As manager of a theatre company you have decided that concession sales will support themselves. The following Table provides the info you have been able to put together thus far :

Item Soft drink Mixed fruit Juice Coffee Candy

Selling Price $ 1.00 1.75 1.00 1.00

Variable cost $o.65 0.95 0.30 0.30

% of revenue 25 25 30 20

Last years manager has advised you to be sure to add 10% of variable cost as a waste allowance for all categories.

Problem #3 (to be solved at home)

You estimate labor cost to be $250.00 (5 booths with 3 people each). Even if nothing is sold, your labor cost will be $250.00, so you decide this as fixed cost. Booth rental, which is a contractual cost at $50.00 for each booth per night, is also a fixed cost. (a) What is the break-even volume per evening performance?

(b) How much mixed fruit juice would you expect to sell at the break-even point?

Problem # 4(to

be solved and submitted with assignment)

Jacks Grocery is manufacturing a store brand item that has a variable cost of $0.75 per unit and a selling price of $1.25 per unit. Fixed costs are $12,000. Current volume is 50,000 units. The Grocery can substantially improve the product quality by adding a new piece of equipment at an additional fixed cost of $5,000. Variable cost would increase to $1.00, but their volume should increase to 70,000 units due to the higher quality product. Should the company buy the new equipment? What are the break-even points ($ and units) for the two processes considered in Problem 4?