Economic Evaluation

of Alternatives
OBJECTIVES After studying this chapter, you should
be able to understand:
1. What is Economic Evaluation of Alternatives
2. Different Methods in EEA
3. Numerical / Problems
LEARNING
 Introduction

• Alternatives are developed from project proposals to

accomplish a stated purpose.
• Some projects are economically and technologically viable,
and others are not.
• Once the viable projects are defined, it is possible to
formulate the alternatives.
• It is important to classify an alternative’s cash flows as
revenue based or cost-based.
 Types of Projects
• Independent Projects
– These are projects whose economic attractiveness can
be measured , and a decision to accept or reject the
project can be made without reference to any of the
other projects
• Mutually Exclusive
– In a mutually exclusive projects, it is not desirable to
select more than one project in the given context and
the acceptance of one project automatically entails the
rejection of all other projects
 Bases for Comparison of Alternatives
There are several bases for comparing the worthiness of the projects.
These bases are:

i. Present worth method

ii. Future worth method
iii. Annual equivalent method
iv. Capital recovery method
v. Rate of return method
 Present Worth Method
In this method of comparison, the cash flows of each
alternatives will be reduced to time zero by assuming an interest
rate ‘i’. then depending on the type of the decision the best
alternatives will be selected by comparing the present worth of
both the alternatives.
 Present worth criterion
• Determine the interest rate that the firm
wishes to earn on its investment. This
investment is often referred as required Rate
of Return(ROR) or a Minimum Attractive
Rate of Return(MARR).
• Estimate the service life of the project.
• Determine the net cash flow ( Net cash flow
= Cash inflow – Cash outflow)
 Single Project Evaluation
• If PW(i) > 0, accept the project or
investment
• If PW(i) = 0, remain indifferent
• If PW(i) < 0. reject the project or
investment
 Present Worth Method
Cost dominated cash flow diagram:
In the cost dominated cash flow diagram, the costs (out flows) will be
assigned with a positive sign and the profits, revenue and salvage
value (inflows) will be assigned with negative sign.
Revenue dominated cash flow diagram:
In a revenue/ profit dominated cash flow diagram, the profit, the
revenue salvage value (all inflow to an organization) will be assigned
with a positive sign. The costs (outflows) will be assigned with
negative sign.
 Present Worth Method
Cost dominated cash flow diagram:
A generalized cash flow diagram to demonstrate the present worth method of
comparison is shown below.

Where,
P – Represents initial investment
Cj – Net cost of the operation and maintenance at the end of jth year.
S – Represent the salvage value at the end of nth year
 Present Worth Method
Cost dominated cash flow diagram:

To compute the present worth amount of the above cash flow diagram
for a given interest rate i,

In the above formula, expenditure is taken as positive sign and revenue

as negative. The alternative with minimum present worth amount
should be selected as the best alternative.
 Present Worth Method
Revenue dominated cash flow diagram:

Where,
P – Represents initial investment
Rj – Net revenue at the end of jth year.
S – Represent the salvage value at the end of nth year
 Present Worth Method
Revenue dominated cash flow diagram:

To compute the present worth amount of the above cash flow

diagram for a given interest rate i,

In the above formula, expenditure is taken as negative sign and

revenue as positive. The alternative with maximum present worth
amount should be selected as the best alternative.
 Solved Problems
1. A Construction company receives two bids for a elevator to be
installed in their newly constructed apartment, the details of which is
given in the following table.
Bidding Construction Company estimates
Company
Initial Cost (Rs) Service life (years) Annual operations &
maintenance cost (Rs)
1 5,80,000 15 29,000
2 6,40,000 15 30,800

Determine the best bid based on the present worth method of

comparison assuming 12% interest rate, compounded annually.
 Solved Problems
1. Soln: Bidding Company 1
Given data: P= Rs. 5,80,000/- ; A = Rs. 29,000/- ; N = 15 yrs
i = 12% compounded annually
The CFD for the first bid is shown below:
0 1 2 14 15
t

Rs. 29,000
Rs. 5,80,000 i =12 %

The present worth of the bid 1 is given by,

PW (i%) = P + A (P/A, i , n)
= 5,80,000 + 29,000 (P/A, i , n)
= 5,80,000 + 29,000 (P/A, 12 , 15)
= 5,80,000 + 29,000 (6.81086)= Rs. 7,80,920.37/-
 Solved Problems
1. Soln: Bidding Company 2
Given data: P= Rs. 6,40,000/- ; A = Rs. 30,800/- ; N = 15 yrs
i = 12% compounded annually
The CFD for the first bid is shown below:
0 1 2 14 15
t

Rs. 30,800
Rs. 6,40,000 i =12 %

The present worth of the bid 1 is given by,

PW (i%) = P + A (P/A, i , n)
= 6,40,000 + 30,800 (P/A, i , n)
= 6,40,000 + 30,800 (P/A, 12 , 15)
= 6,40,000 + 30,800 (6.81086)= Rs. 8,49,774.49/-
 Practice Problem
2. The following table gives an initial outlay and annual revenue of a
production firm using three different technologies. Find the best
alternative if the interest rate is 20% compounded annually.
Initial Annual Revenue Life (years)
Outlay (Rs) (Rs)
Alternative 1 13,00,000 4,00,000 10
Alternative 2 21,00,000 6,50,000 10
Alternative 3 23,00,000 8,60,000 10

A1 : Salvage of 45000

A2 : Salvage of 55000

A3 : Salvage :nil
 Solved Problems
Soln: Alternative 1
Given data: P= Rs. 13,00,000/- ; A = Rs. 4,00,000/- ; N = 10 yrs
i = 20% compounded annually
The CFD for the first bid is shown below:
A= Rs. 4,00,000
t
0
1 2 9 10
i =20 %

P= Rs. 13,00,000
The present worth of the bid 1 is given by,
PW (20%) = - P + A (P/A, i , n)
= -13,00,000 + 4,00,000 (P/A, i , n) + 45000 (P/F, I, 10)
= -13,00,000 + 4,00,000 (P/A, 20,10)
= -13,00,000 + 4,00,000 (4.19247)
The present worth of the alternative 2:

The present worth of the alternative 3:

 Solved Problems
3. Investment proposals A and B have the net cash flows as follows:
Proposal End of years

0 1 2 3 4
A (Rs) -10,000 3,000 3,000 7,000 6,000
B (Rs) -10,000 6,000 6,000 3,000 3,000

Compare the present worth of A with that of B at i=18%. Which proposal

should be selected ?
 Solved Problems
3. Soln: Proposal A
Given data: P= Rs. 10,000/- ; N = 4 yrs
i = 18% compounded annually
The CFD for the first bid is shown below:
3,000 3,000 7,000 6,000

t
0
1 2 3 4
i =18 %

P= Rs. 10,000
The present worth of proposal A is given by,
PW (18%) = - P + A (P/F, i , n)
= -10,000 + 3,000 (P/F, 18, 1) + 3,000 (P/F, 18, 2) +
7,000 (P/F, 18, 3) + 6,000 (P/F, 18, 4)
= Rs. 2,052.10 /-
 Solved Problems
3. Soln: Proposal B
Given data: P= Rs. 10,000/- ; N = 4 yrs
i = 18% compounded annually
The CFD for the first bid is shown below:
6,000 6,000 3,000 3,000

t
0
1 2 3 4
i =18 %

P= Rs. 10,000
The present worth of proposal A is given by,
PW (18%) = - P + A (P/F, i , n)
= -10,000 + 6,000 (P/F, 18, 1) + 6,000 (P/F, 18, 2) +
3,000 (P/F, 18, 3) + 3,000 (P/F, 18, 4)
= Rs. 2, 767.40/-
4. A granite company is planning to buy a fully automated
granite cutting machine. If it is purchased under down
payment, the cost of the machine is Rs 16,00,000. If it is
purchase under installment basis, the company has to pay
25% of the cost at the time of purchase and the remaining
amount in 10 annual equal installments of Rs 2,00,000
each. Suggest the best alternative for the company using
the present worth basis at i=18%, compounded annually.
 Solved Problems
4. Soln: There are two alternatives available for the company
1. Down payment of Rs 16,00,000
2. Down payment of Rs 4,00,000 and 10 annual equal installments
of Rs 2,00,000 each
The CFD is shown below:
0 1 2 3 10
t

2,00,000 2,00,000 i =18 % 2,00,000

Rs. 4,00,000

The present worth of the bid 2 is given by, PW (18%) = P + A (P/A, i , n)

= 4,00,000 + 2,00,0000 (P/A, 18 , 10)
= 4,00,000 + 2,00,0000 (4.4941) = Rs. 12,98,820/-
The present worth of this option is Rs. 12,98,820, which is less than the first
option. Hence the company should select the second alternative to buy.
 Solved Problems
5. A small business with an initial outlay of Rs 12,000 yields Rs10,000
during the first year of its operation and the yield increases by Rs 1,000
from its second year of operation up to its 10th year of operation. At the
end of the life of the business, the salvage value is zero. Find the
present worth of the business by assuming an interest rate of 18%,
compounded annually. Explain your Decision
 Solved Problems
5. Soln:
Given data: P= Rs. 12, 000/- ; A= Rs 10,000; n = 10 yrs
G = Rs 1,000 ; i = 18% compounded annually
The CFD for the small business is shown below:
19,000
11,000 12,000
10,000

t
0
1 2 3 10
i =18 %

P= Rs. 12,000

The equation of present worth is given by,

PW (18%) = -12,000 + (10,000 + 1,000*(A/G, 18, 10)) * (P/A, 18, 10)
= -12,000 + (10,000 + 1,000 * 3.1936) * 4.494)
= -12,000 + 59,293.36 = Rs 47,293.36/-
6. A finance company advertises two investment
plans. In plan1, the company pays Rs 12,000 after 15
years for every Rs 1,000 invested now. In plan2, for
every Rs 1,000 invested, the company pays Rs 4,000
at the end of the 10th year and Rs 4,000 at the end of
15th year. Select the best investment plan from the
investor’s point of view at i=12%, compounded
annually.
 Solved Problems
6. Soln: plan 1

The CFD for plan1 is shown below:

12,000

0
1 2 3 15
i =12 %

P= 1,000

The equation of present worth is given by,

PW (12%) = -1,000 + 12,000 (P/F, 12%, 15)
= -1,000 + 12,000 (0.1827)
= Rs 1,192.40/-
 Solved Problems
6. Soln: plan 2

The CFD for plan 2 is shown below:

4,000 4,000

0
1 2 3 10 15
i =12 %

P= 1,000
The equation of present worth is given by,
PW (12%) = -1,000 + 4,000 (P/F, 12%, 10)
+ 4000 (P/F, 12%,15)
= -1,000 + 4,000 (0.3220) + 4,000 (0.1827)
= Rs 1,018.80/-
 Future worth method
• In future worth method of comparison of alternatives, the
future worth of various alternatives will be computed.
• Then, the alternative with the maximum future worth of net
revenue or with the minimum future worth of net cost will be
selected as the best alternative for implementation.
 Future Worth Method
There are two methods in calculating future worth. They are
• Revenue dominated cash flow diagram
• Cost dominated cash flow diagram

Revenue dominated cash flow diagram :

 Future Worth Method
There are two methods in calculating future worth. They are
• Revenue dominated cash flow diagram
• Cost dominated cash flow diagram
Revenue dominated cash flow diagram :

Where,
P – Represents initial investment ; Rj – Net revenue at the end
of jth year ; S – Represent the salvage value at the end of nth year
 Future Worth Method
The formula for the future worth of the revenue based cash flow
diagram for a given interest rate, i is:

FW(i) = - P(1+i)n + R1(1+ i)n-1 + R2(1+i)n-2 + … +Rj(1+i)n-j

+ … + Rn + S
In the above formula, the expenditure is assigned with negative
sign and revenues are assigned with positive sign.
 Future Worth Method
Cost dominated cash flow diagram :

Where,
P – Represents initial investment
Cj – Net cost of the operation and maintenance at the end of jth year.
S – Represent the salvage value at the end of nth year
 Future Worth Method
The formula for the future worth of the cost based cash flow
diagram for a given interest rate, i is:

FW(i) = P(1+i)n + C1(1+ i)n-1 + C2(1+i)n-2 + … +Cj(1+i)n-j

+ … + Cn - S
In the above formula, the expenditure is assigned with positive
sign and revenues are assigned with negative sign.
 Solved Problems
1. Consider the following two mutually exclusive alternatives:

Alternative End of years

0 1 2 3 4
A (Rs) - 50,00,000 20,00,000 20,00,000 20,00,000 20,00,000
B (Rs) - 45,00,000 18,00,000 18,00,000 18,00,000 18,00,000

At i = 18%, select the best alternative based on future worth method of

comparison.
 Solved Problems
1. Soln: Alternative A
Given data: P= Rs. 50,00,000/- ; A = Rs. 20,00,000/- ; Life = 4 yrs
i = 18% compounded annually
The CFD for the alternative A is shown below:
A= Rs. 20,00,000

0 t
1 2 3 4
i =18 %

Rs. 50,00,000
The future worth of the alternative A is given by,
FW (i%) = - P(F/P, i, n) + A (F/A, i , n)
= -50,00,000 (F/P, 18%,4) + 20,00,000 (F/A, 18%, 4)
= -50,00,000(1.939) + 20,00,000(5.215) = Rs 7,35,000/-
 Solved Problems
1. Soln: Alternative B
Given data: P= Rs. 45,00,000/- ; A = Rs. 18,00,000/- ; Life = 4 yrs
i = 18% compounded annually
The CFD for the alternative A is shown below:
A= Rs. 18,00,000

0 t
1 2 3 4
i =18 %

Rs. 45,00,000
The future worth of the alternative A is given by,
FW (i%) = - P(F/P, i, n) + A (F/A, i , n)
= -45,00,000 (F/P, 18%,4) + 18,00,000 (F/A, 18%, 4)
= -45,00,000(1.939) + 18,00,000(5.215) = Rs 6,61,500/-
 Solved Problems
2. A man owns a corner plot. He must decide which of the several
alternatives to select in trying to obtain a desirable return on his
investment. After much study and calculation, he decides that the two
best alternatives are as given in the following table:
Gas Station Ice Cream Stand

First Cost (Rs) 20,00,000 36,00,000

Annual property taxes (Rs) 80,000 1,50,000
Annual Income (Rs) 8,00,000 9,80,000
Life of building (years) 20 20
Salvage value (Rs) 0 0

Evaluate the alternatives based on the future worth method at i=12%.

 Solved Problems
2. Soln: Alternative 1 – Build gas station
Given data: P= Rs. 20,00,000/- ; Life = 20 yrs; i = 12%
Net annual income = Annual income – Annual property tax
=Rs8,00,000 – Rs80,000 = Rs 7,20,000 /-
The CFD for the alternative 1 is shown below:
A= Rs. 7,20,000
t
0
1 2 19 20
i =12 %
P= Rs. 20,00,000

The present worth of the bid 1 is given by,

FW (12%) = - P (F/P, i, n) + A (F/A, i , n)
= -20,00,000(F/P,12%,20) + 7,20,000(F/A,12%,20)
= - 20,00,000(9.646) + 7,20,000(72.052)
= Rs. 3,25,85,440/-
 Solved Problems
2. Soln: Alternative 2 – Build soft ice cream stand
Given data: P= Rs. 36,00,000/- ; Life = 20 yrs; i = 12%
Net annual income = Annual income – Annual property tax
=Rs 9,80,000 – Rs 1,50,000 = Rs 8,30,000 /-
The CFD for the alternative 2 is shown below:
A= Rs. 8,30,000
t
0
1 2 19 20
i =12 %
P= Rs. 36,00,000

The present worth of the bid 1 is given by,

FW (12%) = - P (F/P, i, n) + A (F/A, i , n)
= -36,00,000(F/P,12,20) + 8,30,000(F/A,12,20)
= -36,00,000(9.646) + 8,30,000(72.052)
= Rs. 2,50,77,560/-
 Solved Problems
3. M/S Krishna Castings Ltd. is planning to replace its annealing furnace. It
has received tenders from three different original manufacturers of
annealing furnace. The details are as follows:
Manufacturer
1 2 3
Initial Cost (Rs) 80,00,000 70,00,000 90,00,000
Life (years) 12 12 12
Annual operation and 8,00,000 9,00,000 8,50,000
maintenance cost (Rs)
Salvage value after 12 5,00,000 4,00,000 7,00,000
years

Which is the best alternative based on future worth method at i=20%?

 Solved Problems
3. Soln: Alternative 1 – Manufacturer 1
Given data: P= Rs. 80,00,000/- ; A = Rs. 8,00,000/- ; n = 12 yrs
S = 5,00,000 ; i = 20% S= Rs. 5,00,000
The CFD for the alternative A is shown below:
1 2 3 4 12
0

i =20 %
A= Rs. 8,00,000 A= Rs. 8,00,000
Rs. 80,00,000

The future worth of the alternative A is given by,

FW (20%) = P(F/P, i, n) + A(F/A, i , n) - S
= 80,00,000 (F/P, 20%,12) + 8,00,000 (F/A, 20%, 12)
– 5,00,000
= 80,00,000(8.916) + 8,00,000(39.581) – 5,00,000
= Rs 10,24,92,800/-
 Solved Problems
3. Soln: Alternative 2 – Manufacturer 2
Given data: P= Rs. 70,00,000/- ; A = Rs. 9,00,000/- ; n = 12 yrs
S = 4,00,000 ; i = 20% S= Rs. 4,00,000
The CFD for the alternative A is shown below:
1 2 3 4 12
0

i =20 %
A= Rs. 9,00,000 A= Rs. 9,00,000
Rs. 70,00,000

The future worth of the alternative A is given by,

FW (20%) = P(F/P, i, n) + A (F/A, i , n) - S
= 70,00,000 (F/P, 20%,12) + 9,00,000 (F/A, 20%, 12)
– 5,00,000
= 70,00,000(8.916) + 9,00,000(39.581) – 4,00,000
= Rs 9,76,34,900/-
 Solved Problems
4. A company must decide whether to buy machine A or machine B:
Machine

A B
Initial Cost (Rs) 4,00,000 8,00,000
Useful Life in years 4 4
Salvage value at the end of 2,00,000 5,50,000
machine life
Annual maintenance cost (Rs) 40,000 0

At 12% interest rate, which machine should be selected? (Use future

worth method of comparison).
 Solved Problems
4. Soln: Machine A
Given data: P= Rs. 4,00,000/- ; A = Rs. 40,000/- ; n = 4 yrs
S = 2,00,000 ; i = 12% S= Rs. 2,00,000
The CFD for Machine A:
1 2 3 4
0
i =12 %

A= Rs. 40,000 A= Rs. 40,000

Rs. 4,00,000

The future worth of the alternative A is given by,

FW (12%) = P(F/P, i, n) + A (F/A, i , n) - S
= 4,00,000 (F/P, 12%,4) + 40,000 (F/A, 12%,4)
– 2,00,000
= 4,00,000(1.574) + 40,000(4.779) – 2,00,000
= Rs 6,20,760/-
 Solved Problems
4. Soln: Machine B
Given data: P= Rs. 8,00,000/- ; n = 4 yrs
S = 5,50,000 ; i = 12% S= Rs. 5,50,000
The CFD for Machine A:
1 2 3 4
0
i =12 %

Rs. 8,00,000
The future worth of the alternative A is given by,
FW (12%) = P(F/P, i, n) - S
= 8,00,000 (F/P, 12%,4) – 5,50,000
= 8,00,000(1.574)– 5,50,000
= Rs 7,09,200/-
The future worth cost of machine A is less than that of machine B.
Therefore, machine A is selected.
 Solved Problems
5. A company must decide whether to select alternative 1 or 2:
2.5L 3L
2L
1.5 L
1,00,000
50,000

0 6 t
1 2 3 4 5

a) i =8 % b) i =9% c) i =20%
Rs. 35,00,000
Use future worth method of comparison 3.5L 4.2L
2.8 L
2.1 L
1,40,000
70,000

0 6 t
1 2 3 4 5

a) i =8 % b) i =9% c) i =20%
Rs. 7,00,000
 Solved Problems
5. The future worth of the alternative 1 is given by,

1) a) FW (8%) = - P(F/P, 8%, 6) + [A1+ G(A/G,i,n)] * (F/A,i,n)

1) b) FW(9%) = - P(F/P, 9%, 6) + [A1+ G(A/G,i,n)] * (F/A,i,n)

1) c) FW(20%) = - P(F/P, 20%, 6) + [A1+ G(A/G,i,n)] * (F/A,i,n)

The future worth of the alternative 2 is given by,

2) a) FW (8%) = - P(F/P, i, n) + [A1+ G(A/G,i,n)] * (F/A,i,n)

2) b) FW(9%) = - P(F/P, i, n) + [A1+ G(A/G,i,n)] * (F/A,i,n)

2) c) FW(20%) = - P(F/P, i, n) + [A1+ G(A/G,i,n)] * (F/A,i,n)

• Ilkal Corporation requires a chemical finishing process for a product under
contract for a period of six years. Three options are available. Neither Option 1
nor Option 2 can be repeated after its process life. However, Option 3 will
always be available from K&K Chemical Corporation at the same cost during
the period that the contract is operative. Here are the options:
• Option 1. Process device A, which costs $100,000, has operating and labor
costs of $60,000 per quarter and a useful service life of four years with an
estimated salvage value of $10,000.
• Option 2. Process device B, which costs $150,000, has operating and labor
costs of $50,000 per quarter and a useful service life of six years with an
estimated salvage value of $30,000.
• Option 3. Subcontract out the process at a cost of $100,000 per Quarter.
• According to the present-worth criterion, which option would you recommend
at i=12% compounded Quarterly
 Solution hint
• Ieffective = (1+12%/4)1 – 1 = 3%
• Pw1 = -100000 - 60000(P/A, 3%, 16) - 100000(P/A,3%,8)(P/F, 3%,
16) +10000(p/f, 3%,16)
• =-100000 - 60000*12.5611 - 100000*7.0197*0.6232 +10000*0.6232
• = -12,84,902
• Pw2 = -150000 -50000(P/A, 3%, 24) +30000(P/f, 3%,24)
• = -150000 -50000*16.9355+30000*16.9355
• = - 48,8710
• Pw3 = -100000(P/A, 3%, 24)
• = -100000*16.9355
• = -16,93,550
 Present Worth Method – Unequal Lives
• When the assets have unequal lives, there must be comparison between
the alternatives based on equivalent outcomes.
• For example, a magazine offers the subscription for 3 years for Rs. 325
and for 5 years Rs 500. In this case comparison base on Rs 325 and Rs
500 will be inappropriate, because paying extra Rs 175 buys 2 more
years of issues.
• The following two methods are most commonly used to make comparison of
assets having unequal lives:
1. Common multiple method
2. Study period method
 1. Common Multiple Method
• In this method, alternatives are co-terminated by selecting an analysis period
which is the Least Common Multiple (LCM) of the lives of the involved assets.
• For example, if the assets had lives of 3 and 4 years, then the Least Common
Multiple (LCM) is 12 years, which means the asset with 3 years life will be
replaced 4 times and that with life of 4 years will be replaced 3 times respectively.
– Problem 1: Two types of trucks are available for transportation use.
They are needed for 10 years. The details are,

– Both the truck deliver same amount of work. Assume interest rate of
7%. Which truck is to be preferred on present worth basis?
 Solved Problems
Soln: This is a problem with unequal lives. We can use common multiple
method for making a comparison. In this case the LCM is 10 years.
Truck 1: Given data: P= Rs. 10,00,000/- ; A = Rs. 20,000/- ; N = 5 yrs
i = 7% ; S = Rs. 2,00,000
The CFD for Truck A is shown below: S=Rs. 2,00,000
S=Rs. 2,00,000

0 1 2 3 4 5 6 7 8 9 10
t

Rs. 20,000 i =7 %

P=Rs. 10,00,000 P=Rs. 10,00,000

 Solved Problems
The present worth of the truck A is given by,
PWA (7%) = 10,00,000 + A (P/A, i , 10) + 8,00,000 (P/F, i , 5)
- 2,00,000 (P/F, i , 10)
= 10,00,000 + 20,000 (7.02358) + 8,00,000 (0.71299)
- 2,00,000 (0.50835)
= Rs. 16,09,193.85 /-
Truck B: Given data
P = Rs. 15,00,000
A = Rs. 15,000
N = 10 years
S = Rs. 5,00,000
i = 7% compounded annually
 Solved Problems
S=Rs. 5,00,000

0 1 2 3 8 9 10
t

Rs. 15,000 i =7 % Rs. 15,000

P=Rs. 15,00,000

The present worth of the truck A is given by,

PWB (7%) = 15,00,000 + A (P/A, 7 , 10) - 5,00,000 (P/F, 7 , 10)
= 15,00,000 + 15,000 (7.02358) - 5,00,000 (0.50835)
= Rs. 13,51,178.7 /-
Comparing the present worth of truck A and truck B, truck B is chosen.
 Solved problems
Problem 2: Assets A1 and A2 have the capability of satisfactorily performing a
required function. Asset A2 has an initial cost of Rs 32,000 and an expected salvage
value of Rs 4000 at the end of its 4 year service life. Asset A1 costs 9000 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 Rs 2500. When the
required rate of return is 15% state which alternative is preferred when comparison
is by,

a) The repeated – project method

b) A 2 year study period assuming the assets are needed for only two
years.
 Solved Problems
Soln: a) The repeated – project method
We can use common multiple method for making a comparison. In this
case the LCM is 12 years.
Asset A1
Given data: P= Rs. 23,000/- ; A = Rs. 2500/- ; n = 3 yrs ; i = 15%
i =15 %

0 1 2 3 4 5 6 7 8 9 10 11 12
years

A= Rs. 2500

P=Rs. 23,000 P=Rs. 23,000 P=Rs. 23,000 P=Rs. 23,000

 Solved Problems
The present worth of A1 is given by,
PW (15%) = P + P(P/F,i,3) + P(P/F,i,6) + P(P/F,i,9) + A(P/A,i,12)
= 23,000 + 23,000 (P/F, i , 3) + 23,000(P/F, i , 6)
+ 23,000(P/F, i , 9) + 2500(P/A, i, 12)
= 23,000 + 23,000 (0.65752) + 23,000 (0.43233)
+ 23,000 (0.28426) + 2500 (5.42062)
= Rs. 68,156.08 /-

Asset A2

Given data: P= Rs. 32,000/- ;

S = Rs. 4000/- ;
n = 4 yrs ;
i = 15%
 Solved Problems
Asset A2
S=Rs. 4,000 S=Rs. 4,000 S=Rs. 4,000

0 4 8 12
years
i =15 %

P=Rs. 32,000 P=Rs. 32,000 P=Rs. 32,000

The present worth of A2 is given by,

PW (15%) = P + P-S(P/F,i,4) + P-S(P/F,i,8) - S(P/F,i,12)
= 32,000 + 28,000(P/F, i, 4) +28,000(P/F, i, 8) – 4000(P/F,i,12)
= 32,000 + 28,000(0.57175) +28,000(0.32691) – 4000(0.18691)
= Rs. 56,414.84/-
 Solved Problems
b) Study period method:
In this case during the study period of two years the
assets will be disposed off after their service for 2 years. Hence it is
essential to find the salvage value of the assets. The minimum resale
value can be calculated in this case to make the alternatives equivalent.
After this, only a judgment is necessary to decide whether the market
value is above or below this level.
Assuming a minimum salvage value of S=0 for assets A1 and A2 after
two years of service, we have the present worth,
PW(A1) = 23,000 + 2500 (P/A,i,2) = 23,000 + 2500 (1.62571)
= Rs. 27064.275/-
PW(A2) = 32,000/-
This means A1 has the lower PW costs for a 2 year period for zero
salvage value
 Solved Problems
The salvage value of A2 which makes
PW(A2) = PW(A1) is
32000 – S (P/F,i,2) = Rs. 27064.275
S = 32000 – 27062.275
(P/F, 15 ,2)

S = Rs. 4935.725 = Rs. 6527.53/-

0.75614

This means A2 is preferred to A1 if the resale value of A2 at the end

of year 2 is more than Rs. 6527.53/-. This is greater than the resale
value of A1 at the same time.
Types of Compound Interest Formulas

5. Equal Payment Series Present Worth:

•Objective is to the find present worth of an equal payment made at end
of every interest period for n periods.
• As n approaches infinity, We replace the
symbols P and PW with CC as a reminder
that this is a capitalized cost equivalence.
Since the A value can also be termed
• AW for annual worth, the capitalized cost
formula is simply
 Assets having Infinite Lives – A Comparison
• The evaluation of assets assumed to have infinite lives is done by
calculating the capitalized cost.
Capitalized cost = First cost + PIN of disbursements for a period N= ∞
•If P is the first cost, then
•Capitalized cost = P + A (P/A, i, ∞) = P + A 1 = P + A
i i
where A is the uniform difference between annual receipts and
disbursements.
• When there is no revenue, capitalized cost is given by,
Capitalized cost = P + Annual worth
i
• This type of comparison is used to study dams, tunnels and similar
structures that provide extended service.
Steps in computing Capitalized Cost
1. Draw a cash flow diagram showing all non
recurring and recurring cash flows for two life
cycles.
2. Find the present worth of all non recurring
amounts.
3. Find the equivalent uniform annual worth
(Aw)through one life cycle of all recurring amount.
4. Divide the Aw obtained by the given interest rate.
5. Add the values obtained in step 2 and step 4
• The Haverty County Transportation Authority (HCTA) has just
installed new software to charge and track toll fees. The director
wants to know the total equivalent cost of all future costs
incurred to purchase the software system. If the new system will
be used for the indefinite future, find the equivalent cost ( a )
now, a CC value, and ( b ) for each year hereafter, an AW value.
The system has an installed cost of $150,000 and an additional
cost of $50,000 after 10 years. The annual software maintenance
contract cost is $5000 for the fi rst 4 years and $8000 thereafter.
In addition, there is expected to be a recurring major upgrade
cost of $15,000 every 13 years. Assume that i 5% per year for
county funds.
• Non recurring = +150,000 + 50,000(P/F,5%,10)
=$180,695
• CC1= 15,000(A/F,5%,13)/i = $16,940
• CC2= 5000/i = $100,000
• CC3={3000/i }(P/F,5%,4)= $49,362
• Final CC=$180,695+ $16,940+ $100,000+
$49,362
• = $346,997
 Solved problems
Problem : A music academy has received a gift cheque of Rs 5,00,000 for the
construction and continuous upkeep of a music shell. Annual maintenance for a
shell is estimated to be Rs15,000. In addition, Rs 25,000 will be needed every
10 years for painting and major repairs.

How much will be left for the initial construction costs, after funds are allocated
for perpetual upkeep? Deposited funds can earn 6% annual interest and these
returns are not subject to taxes.
 Solved Problems
Soln: The cash flow diagram for the given case is shown below.
0 1 10 20
years

A = 25,000 A = 25,000
i =6 %
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
years

A=Rs. 15,000+25000 ( A/F , 6 , 10 )

 Solved problems
The annual disbursements include Rs 15,000 for maintenance and annual
payments necessary to accumulate Rs 25,000 every 10 years. We have,

Capitalized cost = First cost + Annual disbursements

i

Or First cost = Capitalized cost - A

i
= Rs 5,00,000 - Rs 15000 + 25000 (A/F, 6 , 10)
0.06

= Rs 5,00,000 - Rs 15000 + 25000 ( 0.0759)

0.06
= Rs 2,18,387.50 /-
 Recap

1. What is Economic Evaluation of

Alternatives
2. Different Methods in EEA
3. Numerical / Problems