Chapter 2

Methods of Comparing Alternative Proposals

1
 Presentation Outlines
2.1 Present worth method of comparing alternatives
2.2 Annual payment method of comparing alternatives

2.3 Future worth method of comparing alternatives

2.4 Rate of return (ROR) method of comparing alternatives
2.5 Incremental rate of return (IROR) on required investment

2.6 Break-even comparison

2.7 Benefit-cost ratio method of analysis
2.8 payback period Analysis
2
 General
• In general, the decision making process involves the
identification of the best alternative among different
alternatives
• There may initially be many alternatives, nevertheless
only a few will be feasible and actually evaluated
• Therefore, each alternative is a stand-alone option that
involves description and best estimates of parameters
such as first cost (purchase prices, development,
installation), estimated annual incomes and expenses,
salvage value, interest rate, etc.
 …general

 For Purchase of Equipment, for example, alternative

evaluation variables are:
Initial cost; interest rate (rate of return)
Anticipated life of equipment (economic life)
Annual maintenance/operating cost or benefit
Resale or salvage value
 …general
• To select an alternative among different ones, the
measure-of-worth values are compared
• This is simply the result of engineering economy analysis
• Once the alternatives are evaluated and compared, the
best alternative is selected and implemented.
• Keep in mind that the alternatives represent projects that
are economically and technologically viable.
• The Project management team of the client
organization selects the best alternative that involves
less cost and results more revenue.
 …general

To help in formulating alternatives, projects are

categorizes as one of the following:
Mutually exclusive: Only one of the viable projects can
be selected by the economic analysis. Each viable
project is an alternative and compete among each other.

Independent: More than one viable project may be

selected by the economic analysis. They do not compete
among each other.
 …general
• A set of estimates are made based on selection
criteria that is numerically valued and called “Measure
of Worth” such as:
o Present worth: amount of money at the current time
o Future worth: amount of money at some future time
o Payback period: Number of years to recover the
initial investment and a stated rate of return
o Rate of return: Compound interest rate on unpaid or
unrecovered balances
o Benefit/cost ratio
AASTU, Engineering Economics
7
chapter 1
2.1 Present Worth Method of Comparing Alternatives

a) Present Worth Analysis of Equal-Life Alternatives

• If alternatives are used for the same time period, they

are termed equal-service alternatives.
• In present worth analysis, the P value, now called PW, is
calculated at the MARR for each alternative.
• MARR is the Minimum Attractive Rate of Return and is
higher than the rate expected from a bank or some
safe investment.
• The expected rate of return must meet or exceed the
MARR for an alternative to be financially viable.
 …Present Worth Method

• The present worth method:

– converts all cash flows to a single sum equivalent at
time zero using i = MARR over the planning
horizon.
– brings all cash flows back to “time zero” and add
them up.
• That is, all future cash flows are converted into present
birr.
• This makes it easy to determine the economic
advantage of one alternative over another.
 …Present Worth Method
• Comparing Alternatives involves only mutually Exclusive
projects.
• In mutually exclusive alternatives, the following
guidelines are applied to select one alternative:
– One alternative. Calculate PW at the MARR. If PW ≥ 0,
the requested MARR is met or exceeded and the
alternative is financially viable.
– Two or more alternatives. Calculate the PW of each
alternative at the MARR. Select the alternative with the
PW value that is numerically largest (less negative or
more positive), indicating a lower PW of cost cash flows
or larger PW of net cash flows of receipts minus
disbursements.
 …Present Worth Method

• Note that the guideline to select one alternative with

the lowest cost or the highest income uses the criterion
of numerically largest.
• This is NOT the absolute value of the PW amount,
because the sign matters.
• 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

Perform a present worth analysis of equal-service

machines with the costs shown below, if the MARR is 10%
per year. Revenues for all three alternatives are
expected to be the same
Cost Type Electric-Powered Gas- Powered Solar-Powered

First cost, ETB -2,500 -3,500 -6,000

Annual operating -900 -700 -50
Cost, ETB
Salvage Value, ETB 200 350 100
Life, years 5 5 5
 Solution:
• The salvage values are considered a “revenue” not cost, so
a + sign precedes them
• The PW of each machine is calculated at i = 10% for n =
5years
PWE = – 2,500 – 900(P/A,10%,5) + 200(P/F,10%,5) = – 5,788Br
PWG = – 3500 – 700(P/A,10%,5) + 350(P/F,10%,5) = – 5,936Br
PWS = – 6000 – 50(P/A,10%,5) + 100(P/F,10%,5) = – 6,127Br
• The electric-powered machine is selected since the PW of
its costs is the lowest; it has the numerically largest PW
value
b). Present Worth Analysis of Different-life Alternatives

• When the present worth method is used to compare

mutually exclusive alternatives that have different
lives, then the PW of the alternatives must be
compared over the same number of years and end at
the same time.
• A fair comparison can be made only when the PW
values represent costs (and receipts) associated with
equal periods.
• The equal-period requirement can be satisfied by
comparing the alternatives over a period of time
equal to the least common multiple (LCM) of their
lives.
• For example, alternatives with expected lives of 2
and 3 years are compared over a 6-year time period
• Such a procedure requires that some assumptions be
made about subsequent life cycles of the alternatives
• The assumptions of a PW analysis of different-life
alternatives for the LCM method are as follows:
 The service provided by the alternatives will be
needed for at least the LCM of years.
The selected alternative will be repeated over
each life cycle of the LCM in exactly the same
manner
The cash flow estimates will be the same in every
life cycle.
Example:
A project engineer is assigned to start up a new office in a
city where a 6-year contract has been finalized. 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, ETB -15,000 -18,000
Annual lease cost, ETB -3,500 -3,100
Deposit return, ETB 1,000 2,000
Lease term, years 6 9
• Determine which lease option should be selected on the
basis of a present worth comparison, if the MARR is 15%
per year.
Solution
• Since the leases have different lives, compare them
over the LCM of 18 years
• Repeat the first cost in year 0 of each new cycle.
• Calculate PW at 15% over 18 years.
PWA = – 15,000 – 15,000(P/F,15%,6)+1,000(P/F,15%,6)
– 15,000 (P/F,15%,12)+1,000(P/F,15%,12)
+ 1,000(P/F,15%,18) –3,500(P/A,15%,18) = –45,036 ETB
PWB = – 18,000 – 18,000(P/F,15%,9) + 2,000(P/F,15%,9) +
2,000(P/F,15%,18) – 3,100(P/A,15%,18) = –41,384 ETB
 Location B is selected, since it costs less in PW terms;
that is, the PWB value is numerically larger than PWA.
c). Capitalized worth (Cost) method of Analysis

Or CW= AW/i
• Capitalized cost (CC) also called capitalized worth(CW).

• Capitalized worth is the present worth of a perpetuity. A

perpetuity is an investment that has an infinite life.

• The capitalized worth indicates the amount of money

needed “up front” such that the interest earned will cover
the cash flow requirements forever for the investment.

• Used mostly by government.

Example:
A new computer system will be used for the indefinite
future, find the equivalent value now if the system has an
installed cost of 150,000 ETB and an additional cost of
50,000 ETB after 10 years. The annual maintenance cost
is 5,000 ETB for the first 4 years and 8,000 ETB
thereafter. In addition, it is expected to be a recurring
major upgrade cost of 15,000 ETB every 13 years.
Assume that i = 5% per year.
Solution:
• Draw a cash flow diagram for:
Solution:
2.2 Annual worth method of comparing alternatives

• In this method, all receipts and disbursements are

converted into an annualized cost series.
• Annual cost is the cost pattern of each alternative
converted into an equivalent uniform series of annual cost
at a given interest rate.
• The alternative that yields the least cost is chosen.
• 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.
 …annual worth method

Advantages of the Annual Worth Analysis

• Eliminates the LCM problem.
• Only you evaluate one life cycle of a project.
• The result is reported in terms of currency/period.
• If two or more alternatives possess unequal lives then
one need only evaluate the Aw for any given cycle.
Analysis for Different Cycles
6-year project Find the Aw of any 6 – year cycle
9-year project Find the Aw of any 9 – year cycle
 And then compare the Aw6/yr to Aw9/yr
 Examples
1. Consider a project with a $3,000 annual operating cost and a
$5,000 investment required each 5 years. Assume i = 10%
• For one cycle:

Aw = 3,000 + 5,000(A/P,10%,5) = $4,319/yr

• For two cycles:

Aw = 3,000 + 5,000(A/P,10%,10) +5,000(P/F,10%,5)(A/P,10%,10)

= $4,319/yr
 …annual worth method

2. Two pumps are being considered for purchase. If interest is

7%, which pump should be bought?
Pump A B

Initial Cost 7000 5000

Salvage Value 1500 1000

Useful Life, yrs 12 6

AwA = -7,000(A/P,7%,12) + 1,500(A/F,7%,12)

AwB = -5,000(A/P,7%,6) + 1,000(A/F,7%,6)
AwA = -797 & AWB = -909
 Choose Pump A
2.3 Future Worth Method of Comparing Alternatives

• The future worth of an alternative (FW) can be used

to compare alternatives.
• FW analysis is suitable for projects that will not come
online until the end of the investment period.
• Once the FW value is determined, the selection
guidelines are the same as with PW analysis.
– For one alternative, if FW ≥ 0 means the MARR is
met or exceeded.
– For two mutually exclusive alternatives, select the
one with the numerically larger FW value.
Examples:
1. A company purchased a store chain for 75 million ETB
three years ago. There was a net loss of 10 million ETB at
the end of year 1 of ownership. Net cash flow is
increasing with an arithmetic gradient of 5 million ETB per
year starting the second year, and this pattern is
expected to continue for the foreseeable future. Expected
MARR of 25% per year.
a) The company has just been offered 159.5 million ETB to
sell the store. Use FW analysis to determine if the MARR
will be realized at this selling price.
b) If the company continues to own the chain, what selling
price must be obtained at the end of 5 years of
ownership to make the MARR?
Solution:
a). Find the future worth in year 3 at:
i = 25% per year and an offer price of:
159.5 million ETB.
• FW = – 75(F/P,25%,3) –
10(F/P,25%,2) – 5(F/P,25%,1)
+ 159.5
= –168.36 + 159.5
= –8.86 million ETB

• No, the MARR of 25% will not

be realized if the 159.5
million ETB offer is accepted.
b). Determine the future
worth 5 years from
now at 25% per year

• FW = – 75(F/P,25%,5) –
10(F/A,25%,5) +
5(A/G,25%,5)(F/A,25%,5)
= –246.81 million ETB

• The offer must be for at

least 246.81 million ETB to
make the MARR
2.4 Rate of Return (RoR) Method of Comparing Alternatives

• The rate of return technique is also one of the methods

used in selecting an alternative for a project.
• The rate of return (RoR or “ir ”) is the interest rate that
makes the present worth or annual worth of a cash flow
series exactly equal to 0.
• The rate of return is also known by other names namely
Internal Rate of Return (IRR), Profitability index etc.
• IRR, is defined as the interest rate which reduces the
present worth of given cash flow to zero.
• 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.
Calculating Rate of Return
• Convert the various consequences of the investment into a cash
flow.
• Solve the cash flow for the unknown value of the internal rate of
return (IRR).
• Use any of the following forms:
1. (PW)benefits – (PW)costs = 0
2. (PW)benefits/(PW)costs  1
3. Net present worth = 0 Where:
EUAB and EUAC are:
4. EUAB – EUAC = 0 Equivalent Uniform Annual
5. (PW)costs = (PW)benefits Benefits and Costs respectively.

• Any of the previous forms relate costs and benefits with the IRR as
the only unknown.
• It is not possible to calculate the rate of return for the cash flows
involving cost alone or revenue alone.
…RoR Method of Comparing Alternatives
…RoR Method of Comparing Alternatives
 …RoR Method of Comparing Alternatives
OR:
• MARR is the minimum rate of return below which a
company would not be interested in the proposed
investment alternative.
• MARR depends on a number of factors such as
conditions of the market, level of competition and cost
of capital.
• MARR values vary across different companies and
even within the same company.
• A company working for construction of buildings,
bridges, and tunnels, the MARR may be the lowest for
the building business and largest in tunnels, on account
of highest competition in the building sector.
Example 1:
A construction firm is planning to invest 800,000 for the purchase
of a construction equipment which will generate a net profit
of 140,000 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 200,000. 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:
• CFD
• Using the trial and error method, the value of Ir can
be determined as:
Pw= -800,000+140,000(P/A, i,10)+200,000(P/F, i, 10)
0=-800,000+140,000(P/A, i,10)+200,000(P/F, i, 10)
• 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.
i(%) 8% 12% 14%

PW 232,054 55,428 -15,806

Example 2:
An investment resulted in the following cash flow. Compute the rate
of return.
Year Cash Flow
Use the form: EUAB – EUAC = 0 0 -700
100 + 75(A/G, i, 4) – 700(A/P, i, 4) = 0 1 +100
Solve the equation by trial and error since we 2 +175
3 +250
two unknown interest factors.
4 +325
• Try i = 5% ► 100 + 75(1.439) – 700(0.2820) = +11
• Try i = 8% ► 100 + 75(1.404) – 700(0.3019) = – 6
• Try i = 7% ► 100 + 75(1.416) – 700(0.2952) = 0
Therefore the IRR is exactly 7%. (Again, no interpolation was
needed)
Example 3:
Year Cash Flow
Calculate the rate of return on the investment on the 0 -100
cash flow in the table. 1 +20
NPW = –100 + 20(P/F, i, 1) + 30(P/F, i, 2) 2 +30
+ 20(P/F, i, 3) + 40(P/F, i, 4) + 40(P/F, i, 5) 3 +20
4 +40
Assuming a trial rate of return of 12%, 5 +40
NPW = –100 + 20(0.8929) + 30(0.7972) + 20(0.7118)
+40(0.6355) + 40(0.5674) = +4.126
Since it gives positive value of NPW let us assume a higher value of
rate of return, say 15%.
NPW = –100 + 20(0.8969) + 30(0.7561) + 20(0.6575)
+40(0.5718) + 40(0.4972) = – 4.02
Therefore, the IRR lies between 12% and 15%. By linear
interpolation, we find that the IRR is: IRR = 13.5%
 2.5 Incremental Rate of Return (IRoR)
Definition
The incremental rate of return (IROR) is defined as the rate of
return for additional initial investment when comparing against a
lower cost investment.
• When two alternatives have different investment costs, it cannot
simply pick the highest IRR. We must examine the incremental cash
flows.
Two types of investment decision occur:
1. The first type involves costs only
Under such conditions the rate of return for each investment is
negative and, thus need not be calculated.
2. The second type involves both costs and revenues
The question raised to be answered in this type is “which
alternative yields the lowest equivalent cost?”
 …Incremental Rate of Return(IRoR)
To determine, the following procedure should be followed.
Procedures
• list alternatives in order of ascending first cost;
• Step wise determine IROR for each difference in
alternatives compared (the same procedure used as IRR).
Decision Rule of IRoR
The decision of selecting the desirable alternative using
IROR method is based on the MARR.
• If IRoR > MARR, discard the lower cost alternative
(defender)
• If IRoR < MARR, discard the higher initial cost
alternative (challenger)
Example:
Suppose that a cement production company need to
compare five alternatives for equipment purchase.
Assumed that each had the first cost and IROR of each
challenger with respect to their defender are listed below.
Which alternative is best by using MARR=15%.
Alternatives verses First cost
Alternatives First cost
A 1,000,000
B 1,200,000
C 900,000
D 1,150,000
E 1,400,000
IROR values of the incremental values of alternatives
Incremental A-C D-C D-A B-C B-A B-D E-C E-A E-D E-B
IROR , % 24.1% 14% 5.2 20.8 13.9 10.1 11.2 7.9 8.2 9.6
Solution
List the alternatives in order of ascending first cost.
C 900,000
A 1,000,000
D 1,150,000
B 1,200,000
E 1,400,000
Assuming the additional information on operating cost, salvage
value etc. are provided implicitly. From these the term IROR values
are derived list in matrix table as shown below.
Challenger
A D B E
Defender

C 24.1% 14% 20.8% 11.2%

A 5.2% 13.9% 7.9%
D 10.1% 8.2%
B 9.6%
 Way of selecting the best alternatives
• From the first row of the matrix, take the larger value
of IROR and check whether it exceed MARR or not. If it
is less than MARR accept the defender and the
comparison will over otherwise select challenger
temporarily.
• The IROR values on the row to the right of C are
examined and the largest one is 24.1%. Since it is
greater than the MARR the challenger alternative is
selected temporarily.
• Then when we check the row of A the maximum value is
13.9% which is less than MARR, so the defender
alternative A selected.
 2.6 Break-Even Comparisons
• Breakeven analysis examines the short run relationship
between changes in volume and changes in total sales
revenue, expenses and net profit. Also known as C-V-P
analysis (Cost-Volume-Profit Analysis)
• Break even point-the point, Q, at which a company makes
neither a profit or a loss.
 …Break-Even Comparisons
• The Break-even point may be found by following the
logical three-step procedure, as follows:
i. Find the annual equivalent of the capital costs.
ii. Find the independent variable and set up an
equation for each alternative cost combination. The
equation usually takes in the form of:
iii. Total Annual Cost (TAC) = equivalent capital Cost +
(cost/ variable unit) * (Number of variable units/yr)
TAC= FAC+ VAC
• Find the Break-even point.
 …Break-Even Comparisons
Example
• A contractor is thinking of selling his present dump truck and
buying a new one. The new truck costs 30,000 and is expected to
incur. O&M costs of 0.10 per ton-mile. It has a life of 15 years
with no significant salvage value. The presently owned truck can
be sold now for 10,000. If kept it will cost 0.15 per ton-mile for
O&M, and have an expected life of five years, and no salvage
value. Use i = 10%, find the break-even point in terms of to-miles
per year.
Solution
The annual equivalent to the capital investment cost is
A (new truck) = 30,000 (A/P, 10%, 15)
=30,000 (0.13147) = 3,944/yr
A (present truck) = 10,000 (A/P, 10%, 5)
=10,000 (0.26380)=2,638/yr
 …Break-Even Comparisons
• The total annual cost for each year for each alternative is simply
the annual equivalent capital cost plus the annual O&M cost as
follows:
• Total annual cost (new truck) = A1
A1= 3,944/yr + (0.10/ton-mile) (X ton-mile/yr)
• Total annual cost (present truck) = A2
A2 = 2,638/yr + (0.15/ ton- mile) (X ton-mile/ yr)
• The break- even value to x- may be found by solving the
equations simultaneously.
For new truck y = 0.10x + 3,944
For present truck y = 0.15x + 2,638
X= 3,944-2.638 = 26,120 ton-mile/yr
0.15-0.10
2.7 Benefit Cost Ratio Analysis

• One of the most commonly used criteria to evaluate

public projects is Benefit-Cost Ratio (B/C).
• Benefit-Cost ratio is defined as the ratio of benefit to
public and cost to the Government.
• B/C ratio can be obtained using any one of the PW
analysis, FW Method, AW method.
• B/C ratio of more than one indicates that benefit
outweighs cost and thus the investment is justifiable.
• B/C ratio of less than one indicated that benefit
accrued from the project is less than the cost required to
be invested and thus the investment is not justifiable.
 ...Benefit Cost Ratio Analysis

• The technique to compare two mutually exclusive

alternatives using B/C analysis is to use ΔB/ΔC for
the larger-cost alternative.

If incremental B/C ≥ 1.0, choose the higher-cost

alternative.
If incremental B/C < 1.0, choose the lower-cost
alternative.
 …Benefit-Cost Ratio Analysis
Example:
Analysis of several mutually exclusive road way alignments yield the
following information. (i=7%)
Alternative A Alternative B Alternative C

Annual benefit 375,000 460,000 500,000

Annual cost 150,000 200,000 250,000

B/C 2.5 2.3 2.0

Solution
Comparison of A&B
460,000  375,000 85,000
B/C   1.7 > 1, Discard A(the defender) and accept B
200,000  150,000 50,000
(the challenger) temporally

Comparison of C and B
500,000  460,000 40,000
B/C   0.8 <1, Discard the challenger C
250,000  200,000 50,000
Therefore, B is the better alternative even though the benefit cost ratio is less than that of
A. Alternative A offers a greater benefit for the total expenditure.
 …Benefit-Cost Ratio Analysis

Method of calculating B/C ratio

The most common approaches to compute the benefit-cost
ratio are;
1. The conventional B/C ratio system
2. The modified B/C ratio method
• Both of these methods involve in a comparison of a
proposed facility with an existing facilities.
• For instance, if the proposed facility is a bridge over a
river and there is no existing method of crossing the river
at this point, the present cost is the cost of whatever route
must be taken to reach the other side.
 …Benefit-Cost Ratio Analysis

1. Conventional B/C ratio:- the benefits (usually annual)

are determined for users. Thus the benefits are defined
as;

• Bn=Un= net annual benefit (saving cost = the cost

saved by the implementation of the new project).
• The net benefits are equal to the users cost of the
present facility minus the users cost of the proposed
facility.
 …Benefit-Cost Ratio Analysis

Net Saving to sers

Conventional B / C 
Owners Net apacity  Owner ' s net O & M Cost

1. Modified B/C ratio method:-This method uses the same input data but not
operating and maintenance cost (Mn) is treated as negative benefits they are
placed in the nominator rather than in the denominator.
Un  Mn Bn  Mn
Modified B / C  
Cn Cn
Cn = Net capital cost of replacing the present facility with the future
facility
 …Benefit-Cost Ratio Analysis

Example: A flood control project is proposed for a certain

area. There is a question as to the location of the dam
and the numbers of alternative sites have been narrowed
down to two, site A and site B. Estimate of the costs
associated with each of the site are listed below. The
funds to construct the projects are available from bonds
bearing interest rate of 6%. The expected life of the
project at either site is 40 years and no salvage value is
expected.
 …Benefit-Cost Ratio Analysis
Cash Flow descriptions
Description Existing Situation Site A Site B
Cost of construction 0 3,000,000 8,000,000
Annual O&M cost 0 56,000 94,000
Annual cost of flood damages 620,000 Birr 290,000 120,000
Annual loss due to land is lost to 0 20,000 46,000
reservoir Engineering Economics
Solution
Site A

Un = 620,000-290,000-20,000
= 310,000
Mn = 56,000
Cn = 3, 000, 000 (A/P,6%,40)
=199,384.6

Un  Mn
Modified B / C 
Cn
310,000  56,000

199,384.6
=1.274
 …Benefit-Cost Ratio Analysis

Site B
Un = 620,000-120,000-46,000
= 454,000
Mn = 94,000
Cn = 8, 000,000 (A/P,6%,40)
= 531,692.3

Un  Mn
Modified B / C 
Cn
454,000  94,000

531,692.3
= 0.677

Therefore, Site A is selected because of its higher value of B/C

ratio.
 Limitations of B/C Analysis

• The monetary estimation of benefits, particularly

intangible ones such as recreation and the saving of
human lives continue to cause problems.

• The determination of the proper interest rate and time

horizon for discounting future benefits and costs has
long been a source of controversy.
2.8 Payback Period Analysis
• The payback period (PBP or np) for an investment may be taken as
the number of years it takes to repay the original invested capital.
• Payback period is the time required to accumulate a sum of money
from a net cash flow which is equal to the initial investment.
• It is understood that the shorter the payback period, the higher the
likelihood of the project being profitable.
• The payback period analysis should provide initial screening or
supplemental information in conjunction with an analysis performed
using present worth or another method.
• In order to find np, the initial investment should equal the present
worth of net present value of all estimated cash flows.
• How many years are required to get my money back?
Why the Payback Period Method?

• Does not require interest rate calculations

• Does not require a decision concerning the MARR
• Easily explained and understood
• Reflects a manager’s attitudes when capital is limited
• Hedge against uncertainty of future cash flows
• Provides a rough measure of the liquidity of an
investment

63
Drawbacks

• Nowadays it only employed in the initial screening of

projects as a result of its significant drawbacks.

• This method is simple but has drawbacks. Such as:

• It doesn’t consider time value of money
(undiscounted)
• Fail to measure profitability
• Neglect the return after the payback period

64
 Example 1
• An engineering firm has just approved an $18 million
design contract. The services are expected to generate
new annual net cash flows of $3 million; Contract period
is 10 years. If i = 15%, compute the payback period
Solution
• The initial investment = $18 million
• The present value of the expected return = A(P/A,i,n)
when considering that A = $3 million
 3(P/A,15%,n)
• The two amounts ought to be equal
 18 = 3(P/A,15%,n) this gives a value of np = 16.47 years
Example 2:
Two machines are being considered for purchase by a company.
Machine 2 is expected to be versatile and technologically
advanced enough to provide net income longer than machine 1.

The quality manager used a return of 15% per year and a PC-
based economic analysis package. The manager recommended
machine 1 because it has a shorter payback period of 6.57 years
at i = 15%. Is this right?
Solution
For Machine 1
• 12,000 = 3,000(P/A,15%,np) which gives a payback period of 6.57
years
For Machine 2
• 8,000 = 1,000(P/A,15%,5) + 3,000(P/A,15%,np-5)х(P/F,15%,5) which
gives a payback period of 9.52 years
• If we would like to use PW analysis to compare the machines, then
the following procedure ought to be considered:
For Machine 1
• PW1 = -12,000 – 12,000(P/F,15%,7) + 3,000(P/A,15%,14) = $663
For Machine 2
• PW2 = -8,000 + 1,000(P/A,15%,5) + 3,000(P/A,15%,9)(P/F,15%,5)
• = $2,470
 Machine 2 is selected since its PW value is larger
Chapter 2 Ends!
Thank You!!

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