Investment analysis: Tools for

Evaluating Alternatives
Outline
Mutually exclusive and independent
projects
Use of present, future and annual
worth analysis to evaluate
alternatives
Payback period
Rate of return
Benefit-cost ratio

Tools for Evaluating

Alternatives
There are various tools or
methods by which alternatives
can be evaluated economically
using the factors learned.
Purpose
Compare mutually exclusive
alternatives
Basis: present worth, future worth
and annual worth analysis

Category of projects
To help formulate alternatives,
a project is categorized as one
of the following:
Mutually exclusive: Only one of
the viable projects can be
selected by the economic analysis
Independent: More than one viable
project may be selected by the
economic analysis.

Tools for Evaluating alternatives

Present Worth Analysis
Formulating Mutually Exclusive
Alternatives
Present Worth Analysis of Equal-life
Alternatives
Present worth Analysis of DifferentLife
Alternatives
Future Worth Analysis
Payback Period Analysis

Annual Worth Analysis

Rate of Return Analysis
Benefit/Cost Ratio Analysis

Present worth Analysis of EqualLife Alternatives

One alternative: Calculate PW at
the MARR.
If PW 0, the requested MARR is
met or exceeded.
The alternative is financially
viable.

Two or more alternatives:

Calculate the PW of each
alternative.

Present worth Analysis of EqualLife Alternatives

Two or more alternatives:
Calculate the PW of each
alternative at the MARR.
Select the alternative with the
largest PW value
This means that select the
alternative with less negative or
more positive.

Selection of alternative
following the guideline
PW1

PW2

$ -1500

$ -500

Selected
alternative
2

-500

+1000

+2500

-500

+2500

+1500

Present worth Analysis of EqualLife Alternatives

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 5.1
Perform a present worth analysis of equalservice machine with costs shown below,
if the MARR is 10% per year. Revenue for
all the alternatives are expected to be
the same.

First cost, $
Annual operating cost (AOC), $
Salvage value S, $
Life, years

Electric
powered

Gas
powered

Solar
powered

- 2500
- 900
200
5

- 1500
- 700
350
5

- 6000
- 50
100
5

Example 5.1
Solution
These are service alternatives.
The PW of each machine is calculated at
i = 10% for n = 5 years.
PWE = -2500 - 900(P/A,10%,5) + 200(P/F,10%,5)= $-5788
PWG = -3500 - 700(P/A,10%,5) + 350(P/F,10%,5)= $-5936
PWS = -6000 - 50(P/A,10%,5) + 100(P/F,10%,5)= $-6127
[See the calculations in excel file]
The electric-powered machine is selected since the PW
of its costs is the lowest, it has numerically the
largest PW value.

Example 5.2
A project engineer with EnvironCare is assigned to
start up a new office in a city where a 6-year
contract has been finalized to take and to analyze
ozone-level readings. Two lease options are
available, each with a first cost, annual lease
cost, and deposit-return estimates as shown below:

First cost, $
Annual lease cost, $ per year
Deposit return, $
Lease term, years

Location A

Location B

- 15,000
-3,500
1,000
6

- 18,000
-3,100
2,000
9

Example 5.2

(a) Determine which lease option should be selected on

the basis of a present worth comparison, if the MARR
is 15% per year.

(b) EnvironCare has a standard practice of evaluating

all projects over a 5-year period. If a study period
of 5 years is used and the deposit returns are not
expected to change, which location should be used?

(c) Which location should be selected over a 6-year

study period if the deposit return at location B is
estimated to be $6000 after 6 years.

Break-Even Point
Breakeven Analysis
Single-Product Case

Multiproduct Case

Reference: Operations
Management, Heizer &
Render, 8th ed (p-287)

Learning Objectives
When you complete this topic, you
should be able to:
Describe or Explain:

Break-even analysis
Assumptions
Graphical and Algebraic
Approach
Determining BEP for single and
multi-product cases

Break-Even Analysis
A critical tool for determining
capacity a facility must have to
achieve profitability
Objective is to find the point in
dollars (or ringgits) and units at
which, cost equals revenue
Requires estimation of fixed
costs, variable costs, and
revenue

Break-Even Analysis
-The Elements
Fixed costs are costs that continue even if no
units are produced
Depreciation, taxes, debt, mortgage
payments
Variable costs are costs that vary with the
volume of units produced
Labor, materials, portion of utilities
Contribution is the difference between
selling price and variable cost

Break-Even Analysis
-The Elements
Assumptions
Costs and revenue are linear
functions
(In reality, the case is not so)

There is no time value of money

We actually know that these (variable & fixed) costs are not easy to estimate.

Break-Even Analysis

Total revenue line

900

Cost in dollars

800
700

Total cost line

Break-even point
Total cost = Total revenue

600
500
400

Variable cost

300
200
100

Fixed cost

|
|
|
|
|
|
|
|
|
|
|

0 100 200 300 400 500 600 700 800 900 10001100
|

Volume (units per period)

Break-Even Analysis
BEPx = Break-even point in
units
BEP$ = Break-even point in
dollars
P = Price per unit (after
all discounts)

x = Number of units
produced
TR = Total revenue = Px
F = Fixed costs
V = Variable costs per unit
TC = Total costs = F + Vx

Break-even point occurs when

TR = TC
or
Px = F + Vx

F
BEPx =
P-V

Break-Even Analysis
BEPx = Break-even point in
units
BEP$ = Break-even point in
dollars
P = Price per unit (after
all discounts)

x = Number of units
produced
TR = Total revenue = Px
F = Fixed costs
V = Variable costs
TC = Total costs = F + Vx

BEP$ = BEPx P
F
=
P
P-V
F
=
(P - V)/P
F
=
1 - V/P

Profit =
=
=
=

TR - TC
Px - (F + Vx)
Px - F - Vx
(P - V)x - F

Break-Even Example
Fixed costs = $10,000
Direct labor = $1.50/unit

BEP$ =

F
=
1 - (V/P)

Material = $.75/unit
Selling price = $4.00 per unit

$10,000
1 - [(1.50 + .75)/(4.00)]

Break-Even Example
Fixed costs = $10,000
Direct labor = $1.50/unit

F
BEP$ = 1 - (V/P) =

BEPx =

Material = $.75/unit
Selling price = $4.00 per unit

$10,000
1 - [(1.50 + .75)/(4.00)]

$10,000
.4375 = $22,857.14

$10,000
F
=
4.00 - (1.50 + .75) = 5,714
P-V

Break-Even Example
50,000

Revenue

Dollars

40,000

Break-even
point

30,000

Total
costs

20,000

Fixed costs

10,000
|

2,000

4,000

6,000
Units

8,000

10,000

Break-Even Example
Multiproduct Case
BEP$ =

where

V
P
F
W
i

=
=
=
=
=

1-

Vi
Pi

x (Wi)

variable cost per unit

price per unit
fixed costs
percent each product is of total dollar sales
each product

Multiproduct BEP Example

Fixed costs = $3,500 per month
Item
Sandwich
Soft drink
Baked potato
Tea
Salad bar

Price
$2.95
.80
1.55
.75
2.85

Cost
$1.25
.30
.47
.25
1.00

Annual Forecasted
Sales Units
7,000
7,000
5,000
5,000
3,000

Multiproduct BEP Example

Fixed costs = $3,500 per month
Item
Price
Sandwich
$2.95
Soft drink
.80
Baked potato
1.55
Selling Variable
Tea
.75
Item (i)
Price (P) Cost (V) (V/P)
Salad bar
2.85

Sandwich $2.95
Soft drink
.80
Baked
1.55
potato
Tea
.75
Salad bar
2.85

$1.25
.30
.47

.42
.38
.30

.25
1.00

.33
.35

Annual Forecasted
Cost
Sales Units
$1.25
7,000
.30
7,000
.47 Annual 5,000 Weighted
Forecasted % of Contribution
.25
5,000
1 - (V/P) Sales $
Sales (col 5 x col 7)
1.00
3,000
.58
.62
.70

$20,650
5,600
7,750

.446
.121
.167

.259
.075
.117

.67
.65

3,750 .081
8,550 .185
$46,300 1.000

.054
.120
.625

Multiproduct Example V
BEP$ =

Fixed costs = $3,500 per month

1Pi

x (Wi)

$3,500 x 12
= Annual Forecasted
= $67,200
.625
Item
Price
Cost
Sales Units
Sandwich
$2.95
$1.25
7,000
Daily $67,200
Soft drink
.80
.30
7,000
=
= $215.38
sales
312
days
Annual
Baked potato
1.55
.47
5,000 Weighted
% of Contribution
Tea Selling Variable .75
.25Forecasted 5,000
Item (i) Price (P)Cost (V) (V/P) 1 - (V/P) Sales $ Sales (col 5 x col
Salad bar
2.85
1.00
3,000
.446 x $215.38
7)
= 32.6 .259
33
Sandwich $2.95 $1.25
.42
.58 $20,650
$2.95 .446
sandwiches
Soft drink
Baked
potato
Tea
Salad bar

.80
1.55

.30
.47

.38
.30

.62
.70

.75
2.85

.25
1.00

.33
.35

.67
.65

5,600
7,750

.121
.075
.167 per day
.117

3,750 .081
8,550 .185
$46,300 1.000

.054
.120
.625

Problems for practice (to be solved in the class)

(1) Given the following data, calculate BEP(x), BEP ($),
and the profit at 100,000 units:
P= $8/unit, V = $4/unit and F =$50,000.
(2) A prolific author is considering starting her own
publishing company. She will call it DSI Publishing,
Inc. DSIs estimated costs are
-----------------------------------------------------------------Fixed
$250,000.00
Variable cost per book
$20.00
Selling price per book
$30.00
How many books must DSI sell to break even? What
is its break-even point in dollars?

Problem #3 (to be solved at home)

As manager of a theatre company you have decided that concession sales

will support themselves. The following Table provides the info you have been
able to put together thus far :

Item

Soft drink

Selling Price

Variable cost

% of revenue

$ 1.00

$o.65

25

Mixed fruit Juice

1.75

0.95

25

Coffee

1.00

0.30

30

Candy

1.00

0.30

20

Last years manager has advised you to be sure to add 10% of

variable cost as a waste allowance for all categories.

Problem #3 (to be solved at home)

You estimate labor cost to be $250.00 (5 booths with 3 people
each). Even if nothing is sold, your labor cost will be $250.00,
so you decide this as fixed cost. Booth rental, which is a
contractual cost at $50.00 for each booth per night, is also a
fixed cost.
(a) What is the break-even volume per evening performance?
(b) How much mixed fruit juice would you expect to sell at the
break-even point?

Problem # 4(to

be solved and submitted with assignment)

Jacks Grocery is manufacturing a store brand item that has a variable cost of $0.75 per unit and a selling
price of $1.25 per unit. Fixed costs are $12,000. Current volume is 50,000 units. The Grocery can substantially
improve the product quality by adding a new piece of equipment at an additional fixed cost of $5,000. Variable
cost would increase to $1.00, but their volume should increase to 70,000 units due to the higher quality product.
Should the company buy the new equipment?
What are the break-even points ($ and units) for the two processes considered in Problem 4?