Chapter 6

Bases for Comparison of

Alternatives
(Hand-out + the Text book)

If we have to choose between two or more

alternatives, we must conduct an economic
analysis.
We will study the following different methods:
9
9
9
9
9
9
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9
9

Present Value (PV)

Annual Equivalent (AE)
Future Value (FV)
Payback Period (PBP)
Internal Rate of Return (IRR)
Capitalized Equivalent Amount (CE(i))
Capital Recovery with Return (CR(i))
Project Balance (PB(i))
Plus, the hand out.

6.1 Present worth method

The following guidelines are applied to select an alternative
using the present worth method at a selected interest rate i.

When dealing with one alternative: If PW > 0, the requested rate of

return is met and the alternative is financially viable.

When dealing with two or more alternatives. When only one can be
chosen, select the alternative with the PW that is Max positive value.
The relationship between i and PW is
n

PW (i ) = Ft (1 + i )
t =0

Example
Make a present worth comparison of the service
machines for which the costs are shown below,
if i =10% per year.
Machine A Machine B
First cost

2500

3500

Annual operating cost

900

700

Salvage value

200

350

Life, years

Solution
The PW of each machine is calculated as follows:
PWA= -2500 - 900(P/A,10,5) + 200(P/F,10,5) = -5788
PWB= -3500 - 700(P/A,10,5) + 350(P/F,10,5) = - 5936
Machine A is selected, since th e summation of PW of
costs is less.
Also let's discuss table 6.1
The question is: Up to what interest rate during the cash
flow we still be able to make money (profit) out of this
project????
We must have a positive PW(i).

6.2 Annual Equivalent

(not commonly used)
Here you are comparing the annual equivalent of different
cash flows, where the annual equivalent is defined as:
The annual equivalent receipts less the annual equivalent
disbursements of a cash flow.

AE (i ) = PW (i )( A / P, i, n )
t
i (1 + i )n
n
AE (i ) = Ft (1 + i )

n
(1 + i ) 1
t =0

Example
Help the manager of a canning plant to decide
what tomato peeling machine to buy if the
required rate of return is 15%.
Machine A Machine B
First cost
Annual maintenance cost
Annual labor cost
Extra annual income tax
Salvage value
Life, years

26,000
800
11,000
2,000
6

36,000
300
7,000
2,600
3,000
10

Solution
The AE of each machine is calculated as follows:
AEA= -26,000(A/P,15,6) + 2,000(A/F,15,6) 11,800
= -18,442
AEB= -36,000(A/P,15,10) + 3,000(A/F,15,10) 9,900
= -16,925
Machine B is selected, since th e AE of costs are less.

6.3 Future Worth

The future worth represents the difference between the equivalent
receipts and disbursements at some common point in the future.
Where:
n

FW (i ) = Ft (1 + i )

n t

t =0

Or you could find the present worth first then convert it to its future
equivalent n years hence at a certain i.
Also notice that if you are comparing alternative A to alternative B
you will find that PW, AE and FW are all inter related and all provide
consistence basis for comparison:

PW (i ) A AE (i ) A FW (i ) A
=
=
PW (i )B AE (i )B FW (i )B

6.4 Internal Rate of Return

Internal Rate of Return (i*) is the rate of interest paid on
the unpaid balance of borrowed money, or the rate of
interest earned on the un-recovered balance of an
investment, so that the final payment or receipt brings
the balance to exactly zero with interest concerned.

So in terms of investments (projects), an internal rate

of return of -100% means the entire amount is lost.
****Notice that i* is between -100 and infinity****
To determine the rate of return of a projects cash flow,
we must set the rate of return equations to zero thus:
PW(i) = 0

or

AE(i) =0

This is how to find i*:

1.
2.
3.

Draw cash flow diagram

Set up the rate of return equation
Select values of i* by trial and error until the equation is
balanced
Question: How to get close to correct answer from the first
trial?

1.

2.
3.

Answer: follow these steps:

Convert all disbursements into either single amount (P or
F) or uniform annual payments (A) by neglecting the time
value of money.
Convert receipts to either single or uniform values
Find i at given n as your first i* trial value.

Example
If $5,000 is invested now in common stock that is expected to
yield 100 per year for 10 years and $7,000 at the end of 10
years, what is the rate of return?

Solution
Lets follow a systematic approach:
1. Plot the cash flow diagram
2. Set up the rate of return equation
0 = -5,000 + 100(P/A, i*, 10) + 7,000(P/F,i*,10)
3. Use the first approximation procedure we just described:
Here we could either choose the P/F factor or P/A factor. We
select P/F since most of the cash flow ($7,000) already fits this
factor and errors created by neglecting the time value of the
remaining annual payments. Thus for the first estimation of i*
we can write:

5,000 = {10(100) + 7,000}(P/F,i,10)

5,000 = 8,000(P/F,i,10)
0.625 = (P/F,i,10)
You will find that your initial i estimation is near 5.
Thus for a first trial use i* = 5%
0 = -5,000 + 100(P/A,5,10) + 7,000(P/F,5,10)
0 < 69.46
We are too large on the positive side, go to 6%
0 = -5,000 + 100(P/A,6,10) + 7,000(P/F,6,10)
0 > -355.19
We are between 5 and 6, do interpolation to get:
i* = 5.16%

Important Note: A cash flow could have multiple i*.

How could we know that there are more than one i*
for each cash flow.
Answer:
By solving the equation and getting two roots!!
Or a smarter approach (follow this rule)
Only one sign change in series of cumulative cash
flows (no time considered), which starts negatively,
indicates that there is one positive root to the
polynomial relation.

Example
For the cash flow diagram below, is there a single or multiple i*???

Year
Cash Flow

0
+2,000

1
-500

2
-8,100

3
+6,800

Solution
S0 = +2,000
S1 = +1,500
S2 = -6,600
S3 = +200
According to the rule; the first sign is + and there are two sign
changes. These facts indicate that there are multiple i*.
Notice that you could get two or three values for i* but only one is
practical since some could be very unrealistic (like 750%!!!!!)

So how could we find this realistic value among the different

values of i* for a cash flow???
It is up to your judgment and you could always use other
methods of choosing alternatives if the IRR method gets
complicated.
Lets say you have 3 different values of i* (mainly because of
sign changes as a first indication) One of them is correct if it
satisfy the following:
1.

Make sure that the first item in the cash flow is a disbursement
(i.e. F0<0), if not, multiply every component in the cash flow by
(-1), if the first cash flow item is zero, move to the first non-zero
item to Uo.

2.

Apply the following relation:

Ut = Ut-1 (1+i*) + Ft

Where,

t = 1,2,..,n
n = number of years in project
you must have Uo, U1, .., Un-1 < 0

Example
For the following cash flow, show that i* = 20% is the single (realistic) IRR.

Year
$

0
0

1
2
-3000 1000

3
1900

Solution
t = 1 is assumed to be t = 0 assuring that Fo < 0 then,
Uo = -3000
U1 = -3000(F/P,20,1) + 1000 = -2600
U2 = -2600(F/P,20,1) + 1900 = -1220
U3 = -1220(F/P,20,1) 800 = -2264
U4 = -2264(F/P,20,1) + 2717 = 0
Since Fo < 0, and
Since the values for t = 0, 1, 2,3 are < 0
i* = 20% is the single realistic IRR

4
-800

5
2700

6.5 Payback Period

The payback period (np) for an asset or alternative is the
estimated time, usually in years, it will take for revenues
and other economic benefits to recover the initial
investment and a stated interest.
The payback period should never be used as the sole
measure of worth to select an alternative.

Payback Period with Interest

To find the payback period with interest use the following
expression:
t = nt

0 = P + NCFt (P / F , i, t )
t =1

Where NCFt is the estimated Net Cash flow at the end of

each year.
If the net cash flows are expected to be the same each year
then use the expression:

0 = P + NCFt (P / A, i, t )
Notice that payback analysis could be very bias since it
does not take into consideration of any cash flow after the
payback period

Payback Period Without Interest

You may run into the common practice of neglecting the effects of
interest, that is use i = 0%. The relation would be
t = nt

0 = P + NCFt
t =1

If the net cash flows are expected to be the same each year
then use the expression:

P
np =
NCFt
Notice: Using the payback without interest analysis to
make alternative selection is wrong since:
1.
2.
3.

It does not take into consideration of interest

It does not take into consideration of any cash flow after nt.
Selected alternative may be different from the one selected by
PW, AE and FW analysis methods.

Example
A company approved an $18 million worldwide financial
service contract. The services are expected to generate
net annual revenues of $3 millions. The contract has a
clause, which states that a repayment of $3 millions
should be made if the client cancels the contract during
the 10 years of the contract.
a.

Compute the payback period if the interest rate is 15%

per year.

b.

Compute the no interest payback period.

Solution
a.

0 = -P + NCFt(P/A.i,n)
0 = -18 + 3(P/A,15,n) + 3(P/F,15,n)
np = 15.3 years
Therefore, during the period of 10 years, the revenues will
not deliver the required return.

b.

0 = -18 + 3 (n) + 3
np = 5 years
Notice that in part b the value of money is not considered
when no interest is considered, thus causing a very
significant difference in the results upon which you have to
make your decision.

6.6 Capitalized Equivalent Amount CE(i)

It is a special case of the present worth method.
Definition
The Capitalized Equivalent CE(i) represents the
basis for comparison that consists of finding a
single amount at the present which, at a given
interest rate, will be equivalent to the net
difference of receipts and disbursements if a given
cash flow pattern is repeated forever.
Here we are dealing with investments represented
in cash flows that goes from the present to infinity.

Here, convert the original cash flow to an

equivalent cash flow of equal payments extending
from the present to infinity.

A
CE (i ) =
i
If you invest a present worth P at a certain i, then
if you withdraw an amount A equal to the interest
earned, then these withdrawals will continue
forever as long as the original investment is intact.

Example:
Suppose ABC foundation is considering a gift to a
city to build a park and to maintain it forever.
Suppose that the annual interest rate is 8% and
annual maintenance cost is expected to be
$16,000 per year for the first 15 years, increasing
to $25,000 per year after 15 years. What is the
amount of the gift received at the present that will
be required to assure continuing maintenance of
the park forever?

Solution:
The interest rate is 8% per year
They will need $16,000 in the first 15 years and the cost of
maintenance will increase by $9,000 and will stay at $ 25,000.
So $16,000 will be needed forever
And after 15 years from the present we will need an extra $9,000
forever
CE(i) consists of two parts.

16,000 9,000(P / F ,8,15)

CE (8) =
+
0.08
0.08
CE (8) = 200,000 + 35,471 = $235,471
Therefore, we need $200,000 now to pay 16,000 a year forever
and $35,471 now to pay the extra $9,000 a year forever
starting 15 years from now for park maintenance

6.7 Capital Recovery With Return

This method is used to calculate the AE(i) of an investment
having a salvage value F. The general equation for this
method is:
CR(i) = (P-F) (A/P, i, n) + (F i)
Subtracting the salvage value F from the investment
cost P, (P-F), before multiplying by the A/P factor,
recognizes that the salvage value will not be recovered
for n years is taken into account by charging the
interest lost (F i) during the asset life. Failure to
include this term assumes that the salvage value was
obtained in year 0 instead of year n.

Example
Calculate the capital recovery with return CR(i) for a tractor
attachment that has an initial cost of $8,000 and a salvage
value of $500 after 8 years. Annual operating costs for this
machine are estimated to be $900, and interest rate of
20% per year is applicable.
Solution
Applying the equation we get
CR(i)

= (8000-500)(A/P, 20, 8) + (500 0.2)

= $2054.5 (in annual expenditures, i.e. annual
disbursements, i.e. ve)
AE(20%) = -2054.5 - 900 = $-2955

6.8 Project Balance

One of the recent methods to measures the economic
worth of an alternative.

6.8.1 The Concept of Project Balance

In the previous methods, we reduce the basis of
comparison to a single index. (for example: PW, FW,
AE, CE(i), CR(i), IRR, Payback period, etc.).
The project balance method describes the equivalent
loss or profit as a function of time.
Project Balance PB(i) is the time profile that measures
the net equivalent amount of dollars tied up (or
committed to) the project at each point in time during
life of the cash flow.

At any time t, the project balance is expressed as:

PB(i)t = (I = i) PB(i)t-1 + Ft
Where
PB(i)0 = F0
and Ft is the cash receipts and disbursements
at time t
Our aim is to plot the project balance diagram which
tells us our financial status on the project every year
and what happens if we terminate the project before
the end of the project life)
Solve example on page 173

Example:

8,000
5,000

6,000
3,000

1,000

Discounted
PBP

Interest rate 20%

FW

PB(20)
-10,000
PB(20)0= -10,000
PB(20)1= -10,000(1.20)+1000 = -11,000
PB(20)2= -11,000(1.20)+5000 = -8,200
PB(20)3= -8,200(1.20)+8000 = -1,840

Profit
++
0

PB(20)4= -1,840(1.20)+6000 = 3,792

PB(20)5= 3,792(1.20)+3000 = 7,550
To confirm, FV(20)=-10,000(F/P,20,5)+1,000(F/P,20,4)
+ 5,000(F/P,20,3)+ 8,000(F/P,20,2)+ 6,000(F/P,20,1)
+3,000 = 7,550

Loss

6.8.2 Four Elements of Project Balance

The following important information could be devised
from a project balance diagram
1.
2.
3.
4.

Net future worth

The payback period
The exposure to risk of loss
The profit potential
[Check Figure 6.11 page 178]

6.8.3 Project Balance and Inflation

Use i and f according to the concept we discussed in
chapter 5.