PRESENT WORTH COMPARISONS INTRODUCTION The most important work of top management in any company is to take decisions Many of these decision-making activities would involve the selection of best alternative from a set of competing alternatives, For example, if there are three designs of a particular car to be manufactured, with each car having different initial outlays and different expected annual revenues, which design to go for ? The C.E.O may have to select the best alternative among the three projects. In order to do so, there are several bases for comparing the worthiness of the projects. In other words, the comparison among the alternatives could be made based on any of the following methods which make use of different economic criteria : 1. Present worth comparison 2. Future worth comparison 3. Equivalent annual worth comparison 4. Rate of retum calculation. We shall be studying the first two methods in this chapter and the remaining two in subsequent chapters. ” PRESENT WORTH METHOD OF COMPARISON In this method of comparison, the cash flows of all the alternatives will be reduced to time zero (i.e., now), by assuming a rate of interest 1. The best alternative is then selected by comparing the present worths of all the alternative: Any given business altemative will always have cash inflows (revenues/income/ete, ) and cash outflows (all types of costs) associated with it. The net Present worth of the business alternative is then calculated by aa Net PW = PW(all revenues) - PWaall costs) When net present worths of all business alternatives are calculated, the one With the highest net PW is chosen. Obviously if the net PW’s of all projects have -ve value, the altemnative with the least negative value is chosen. A general procedure is solving problems in present worth comparison would be as follows:ie OF as Cost. w cash iagram ij ati i 2. a h ae diagram indicating all cash inflows in upward direction and cash ou lows " Ownward direction. Cash inflows are generally - annual revenue, salvage value, annual savings ctc., while cash outflows are generally - initial cost, annual costs, maintenance cos 's, operational costs etc. a cula nt Worth of cach component on the CFD using appropriate compound interest formula, 4. Add the Pri one hand and add the present worths resent Worths of all cash inflows on of all cash outflows on the other hand, en obtained by 5. The net present worth of a business alternative Net Present Worth PWaall cash inflows) - PW(all cash outflows) or NPW = PWaall revenucs) ~ PW(all costs) ives are found. . Like wise, the net PW of all business alte: at . That alternative with the highest algebraic PW value is chosen since Revenue minus Costs indicate profit which has to be maximized. If all net PW values are negative, then the least -Ve value is chosen which indicates the best among the worst i.e., the one with the least cost. . The Present Worths can be calculated either by using formulae or interest tables, although the latter is much easier. But in certain cases where the values of ‘i’ and ‘n’ are not included in the Tables book, it becomes imperative to use the formulae. The student, therefore, should be well versed in both methods. The general steps involved in using Compound Interest tables would be: (i) Go to that page which has the appropriate rate of interest ‘i’ as is given in the problem (i.e., i= 10% , 11% (i) The first column in every page indicates years ‘n’. Select the service life ‘n’ as is given in the problem. (ii). Now, select the value along the given ‘n’ under the type of compound interest problem type. (iv) Please note that the value represents only the corresponding formulae. This value should be multiplied with the appropriate quantity P or A or F.—_———— WORKED EXAMPLES —— iin: 17An entreprencur owning a small scale industry wants to buy @ mul are machine. He has 3 machines in view, from different ee initial investments, annual revenue, salvage values and the lives of machines are given in the table. Annual _ | Salvage Value | + ife (years Revenue (Rs.) (Rs.) ife (years) Machine 1] 25,000 10,000 4,000 7 Machine? | 45,000 15,000 6,500 7 Machines | _70,000 20,000 9,000 Solution: We have to calculate the Present Worths (PW) of all the machines and then compare them. I. To find PW of Machine 1 Given, Initial Investment, P = Rs. 25,000 — (outflow) Annual Revenue, A= Rs. 10,000 — (inflow) Life of equipment, n = 7 years Rate of interest, i = 14% (compounded annually) Salvage value, S = Rs. 4,000 — (inflow) PW(M/c I) = PW(inflow) — PW(outflow) = [PW(Salvage) + PW(Annual Revenue)] — PW(Initial Cost) = PW(S) + PW(R) — PW(P) ... oo CFD for the above problem would be, A A A A A A A 10000 10000 10000 10000 10000 10000 10000 n=7 i=14% S| wv w z wo o P 25000To find PW(salvage) of M/c 1 Salvage value appears at the end of 7th year. To find its Present Worth means that we have to find P given F. In the given problem the future sum F is nothing but the salvage value S. Therefore ee a+iy" P(S) = S(P/R, i, n) = ‘| ! | P(S) = F(P/F, i, n) or ay 1 . = %, 7) = 4000] 2. P(S) = 4000(P/F, 14%, 7) ica P(S) = 4000(0.3996) = 4000(0.3996) w. P(S) = Rs.1598.54 To find PW(Annual Revenue) of M/c 1 There is a uniform annual revenue at the end each year for 7 years. To find its collective Present Worth means - To find P given A. In the given problem the revenue R is nothing but A. Therefore i a+i’ PW(R) = A(P/A, i, nr afar + | (1+0.14)?-1 = %, 7) =10,000 ————_—— PW(R) = 10,000(P/A, 14%, 7) =10,000 575 PW(R) = 10,000[4.2883] = 10,000(4.2883) = Rs.42883 To find PW(Initial Cost) of M/c 1 Since the initial cost, P is considered at time zero i.e., now its Present Worth will be the same value. Therefore got | PW(P) = Rs.25,000 oe Substituting the values of PW(S), PHA, and PW(P) in equation (1), we have PW(M/c 1) = 1'398 £743,883 - 25,600 PW(M/c 1) = Rs.19,481 pe)Il, To find PW of Machine 2 Given P=Rs, 45,000 - (outflow) A=Rs. 15,000 + (inflow) n= 7 years i= 14% S =Rs, 6,500 -» (inflow) PW(M/e 2) = PW(inflow) ~ PW(outflow) = PW(Salvage) + PW(Annual Revenue) — PW(Initial Cost) = PW(S) + PW(A) - PW(?) «+ ven(2) The cash flow diagram for the above problem would be A A A A A A 15000 15000 15000 15000 15000 15000 15000 i= 14% P 45000 To find PW(S) of Machine 2 PW(S) = F(P/F, i, n) = F/ (S) = F(P/F, i, n) ited PW(S) = S(P/F, i, n) = Satr| (+pPW(S) = 6,500(P/F, 14%, 7) = [ i . 1) = 6,500] To ia? PW(S) = 6,500(0.3996) = 6,500(0.39963) 2. PW(S) = Rs.2,597 To find PW(A) of Machine 2 ‘ (+i -1 = A(P/ =A on p(w) (A) = A(PYA , i, n) [ cD: | RW) A = 15,000(P/A , 14%, 7) = 1so00| Santer | PW = 15,000(4.2883) = 15,000(4.2883) PW = Rs.64,324 To find PW (P) of M/c 2 We have, PW(Initial Cost) = PW(P) = 45,000 Substituting the values of PW(S), PW(A) and PW(P) in equation (2), we have PW(M/c 2) = 2,597 + 64,324 — 45,000 PW(M/c 2) = Rs.21,921 Ill. To find PW of Machine 3 Given data : P=Rs.70,000 -» (outflow) A=Rs.20,000 + (inflow) n=7 years i= 14% S=Rs. 9,000 > (inflow) PW(M/c 3) = PW(inflow) — PW(outflow) = PW(S) + PW(A) - PW(P) ....At The CFD for the above problem would be s 9000 s A A A A A Sine Eraed 20000 20000 20000 20000 20000 | | 2 3 4 5 6 a P 70000 To find PW(S) of M/c 3 1 PW(S) = S(P/F, i, n) = | 1 PW(S) = 9,000(P/F, 14%, 7) = v000| iar | PW(S) = 9,000(0.3996) = 9,000(0.39963) PW(S) = Rs.3,596 To find PW(A) of M/c 3 a+i" =] PW(A) = A(P/A, i, n) = a] iat (1+0.14)’-1 PW(A) = 20,000(P/A, 14%, 7) = 20,000| {eer | PW(A) = 20,000(4.2883) = 20,000(4.2883) PW(A) = Rs.85,766 To find PW(P) of M/c 3 PW(P) = Rs.70,000substituting the values of PW(S), PW(A) and PW(P) in equation (3), we have, PW(M/c 3) = 3,596 + 85,766 — 70,000 PW(MIC 3) = Rs.19,362 Answer: From the above calculations, it is clear that the present worth of machine 2 is the highest among all the machines. Therefore it is suggested to the entrepreneur to buy machine 2. ° 2A businessman has two investment proposals P and Q in front of him to help him expand his operations. The net cash flows of the proposals are as follows: Proposal End of years 0 eee P (Rs) —20,000 7,000 {9,000 7,000 | 8,000 Q (Rs) —20,000 10,000)6,000 | 7,000| 6,000 Compare the Present Worth of proposal P with that of Q at i= 13%. Which proposal should be selected? Solution: The Present Worths of both proposals should be calculated. Please note that the values in the first column denote investment (cash outflow) since it has —Ve mark. Given data: Initial cost, P =Rs.20,000 —> (outflow) Annual Revenue for 1 year, A,=Rs.7,000 — (inflow) A,= Rs.9,000 —> (inflow) A, = Rs.7,000 (inflow) A,= Rs.8,000 > (inflow) i= 13.5% Salvage value, S = 0 (not given) PW(P) = PW(all inflows) ~ PW(all outflows) or . PW(P) = PW(all revenues), — PW(all costs). PW(P) = PW(A,) +PW(A,) + PW(A,) + PEA) ~ PW)| A, = 7000 A, = 9000 = 7000 A, = 8000 } n=4 2 im 13.5% P= 20000 To find PW of Proposal ‘P* Since the revenue for each year is different, we cannot use (P/A, i, n) but should use (P/F, i, n) for each revenue, In other words, PW of each year-end revenue should be found and then added. Therefore A,, A,, A, and A, are nothing but future amounts whose PW has to be calculated. Note that n='I for ae n= 2 for A, and so on. Using Tables PW(P) = A,(P/F, i, n) + A,(P/F, i, n) + A,(P/F, i, n) + A,(P/F, i, n) - 20,000 PW(P) = 7,000(P/F, 13.5%, 1) + 9,000(P/F, 13.5%, 2) + 7,000(P/F, 13.5%, 3) + 8,000(P/F, 13.5%, 4) — 20,000 From the compound interest tables, PW(P) = 7,000(0.8811) + 9,000(0.7763) + 7,000(0.6839) + 8,000(0.6026) — 20,000 PW(P) = Rs.2762.5 Using Formulae 1 _ —_ | _pwe pw- alate] +A, (ip +A, ds +A, (aiy | 7 (P) 1 1 as PW = 7000] | a 9.000] aaa aa 2 1000| Tsay boy olont hoe F fe ww whlece Phy A 1 3,000 aT — 20,000 PW = 7,000(0.8810) + 9,000(0.7762) + 7,000(0.6839) + 8,000(0. 6025) — 20,000 + PW=Rs.2,761 > (Small changes in value between tables and formulae ar : ” expected) A’. pnTo find PW of Proposal Q Given, P = 20,000 > (Outflow) A, = 10,000 > (Inflow) = 6,000 > (Inflow) A, = 7,000 -> (Inflow) ,000 > (Inflow) 13.5% n= 4 years The CED for the above problem would be A, = 10000 A, = 6000 A,=7000 8, = 6000 P= 20000 Solution: This is similar to previous proposal. Using Tables PW(Proposal Q) = PW(inflows) — PW(outflow) = PW(A,) + PW(A,) + PW(A,) + PW(A))'= PWR) =A(PIF, i, n) + APF, i, n) + APIE, in) + APE, 4, a} ~ 20,000 = 10,000(P/F, 13.5%, 1) + 6,000(P/F, 13.5%, 2) + 7,000(P/F, 13.5%, 3) + 6,000(P/F, 13.5%, 4) — 20,000 PW(Q) = 10,000(0.8811) + 6,000(0.7763) + 7,000(0.6839) + 6,000(0.6026) — 20,000 PW(Q) = Rs.1871.7 Answer: Since the present worth of Proposal P is higher than that of Q, the businessman should select P.