Economics Module No. 07 Present Worth Method of Comparison
By Muhammad Shahid Iqbal
Introduction
In this method of comparison, the cash flows of each
alterative will be reduced to time zero by assuming an interest rate i. The best alternative will be selected depending on the type of decision by comparing the present worth amounts of the alternatives. The alternatives being considered may require different amounts of capital investment The alternatives may have different useful lives The subject of this section will help: Analyze and compare feasible alternatives Select the preferred alternative
Cash Flow Analysis Methods
The cash-flow analysis methods (PW) used in this process.
The alternative that requires the minimum investment and produces satisfactory functional results will be chosen unless the incremental capital associated with an alternative having a larger investment can be justified with respect to its incremental savings (or benefits ). The sign of various amounts in a cash flow is decided on the type of decision problem. In Revenue dominated cash flows, the profit, revenue, salvage value (all inflows) will be assigned positive sign while the all costs (outflows) will be assigned with negative sign. In cost dominated cash flows the cost will be assigned with positive signs and all inflows will be assigned negative sign.
Rule For Choosing Among Alternatives
In case the decision to select the alternative with the
minimum cost, the alternative with the least present worth amount will be selected. In the decision is to select the alternative with the maximum profit, the alternative with the maximum present worth will be selected.
Revenue-Dominated cash flow analysis
Revenue-dominated cash flow analysis is given as:
PW = - P + R1[1/(1 +i)1] + R2[1/(1 +i)2] + .+ Rn[1/(1 +i)n] + S [1/(1 +i)n] P = Initial investment Rn = Net revenue at the end of nth year. S = Salvage value at the end of nth year.
In this formula expenditures are assigned negative sign and
revenues are assigned positive signs. If there are more alternatives which are to be compared, the alternative with the maximum present worth amount should be selected as the best alternative.
Cost-Dominated cash flow analysis
Cost-dominated cash flow analysis is given as:
PW = P + C1[1/(1 +i)1] + C2[1/(1 +i)2] + .+ Cn[1/(1 +i)n] - S [1/(1 +i)n] P = Initial investment Cn = cost of operation at the end of nth year. S = Salvage value at the end of nth year.
In this formula expenditures are assigned positive sign
and revenue a negative sign. If there are more alternatives which are to be compared, comparing PW, the alternative with the minimum present worth amount should be selected as the best alternative.