Projects or Alternatives Appraisal Techniques

 Present Worth Analysis (PW).

 Annual Worth Analysis (AW).

 Future Worth Analysis (FW).
 Pay Back Period (PBP).
 Discounted Payback Period (DPBP).
 Internal Rate of Return Analysis (IROR).
 External Rate of Return Analysis.
 Capitalized Worth.
 Present Worth Analysis (PW)

1. Present Worth Analysis of Equal-Life Alternatives:

 The PW comparison of alternatives with equal lives is straightforward.

 For one alternative: If PW ≥ 0, the alternative is economically justified.

 For two or more alternatives: Select the alternative with the PW that is
numerically largest, that is, less negative or more positive.

The selections below correctly apply the guideline for two alternatives
A and B:
Example (1):
A piping scheme being developed has two different possible systems of pumps
and pipe work. Details of each scheme are given in the Table. The life of the
scheme is 20 years. Use the present worth analysis to determine which scheme
should be recommended as the most economic, the interest rate is 15 %.
Annual
Pipe diameter Installation
Scheme running
(mm) Cost ($)
cost ($)
A 500 182,500 72,500
B 600 200,000 46,000
Solution:
2. Present Worth Analysis of Different-Life Alternatives:

 The PW of the alternatives must be compared over the same number of

years. by using the following approach:
• Compare the PW of alternatives over a period of time equal to the least
common multiple (LCM) of their estimated lives.
Example (2):
A contractor plans to purchase equipment. Two manufacturers offered the
estimates below.

Determine which vendor should be selected on the basis of a present worth

comparison, if the interest rate is 15% per year.
Solution:
- Since the equipment has different lives, compare them over the LCM of 18
years.
- For life cycles after the first, the first cost is repeated in year 0 of each new
cycle, which is the last year of the previous cycle.
Vendor B is selected, since it costs less in PW.
Example (3):
The director of a company had decided to build a new building, he must
choice between two alternatives. The first one is a reinforced concrete design
has an initial cost of $1,600,000. The second alternative is a steel structural has an
initial cost of $600,000. The useful life of the reinforced concrete building is 60
years, which no need maintenance during the first 10 years, after that it need
maintain of annual cost 10,000 per year.
The steel structure building has useful a life equal to 20 years, with equivalent
annual cost for maintenance of $11,500 from the beginning. The salvage value of
the reinforced concrete at the end of the 60 years is $400,000 and the salvage
value of the steel structure building at the end of the 20 years is $60,000.
Determined which alternative should be selected on the basis of a present worth
comparison, if the interest rate is 10% per year.
Solution:

For the reinforced concrete building:

PW = -1,600,000 + 400,000 (P/F, i =10%, n = 60)

-10,000 (P/A, i=10%, n = 50) (P/F, i=10%, n=10)
= -1,600,000 + 400,000 (0.0033) – 10,000 ( 9.9148) * (0.3855)
= $ - 1,636,901.554
For the steel structural building:

PW = - 600,000 - 600,000 (P/F, i =10%, n = 20) - 600,000 (P/F, i =10%, n = 40)

- 11,500 (P/A, i= 10%, n = 60) + 60,000 (P/F, i =10%, n = 20)
+ 60,000 (P/F, i=10%, n = 40) + 60,000 (P/F, I =10%, n = 60)
= - 600,000 - 600,000 (0.1486) - 600,000 (0.0221) - 11,500 (9.9672)
+ 60,000 (0.1486) + 60,000 (0.0221) + 60,000 (0.0033)
= $ - 806,602.8

Select the steel structural building.

 Future Worth Analysis (FW)

 Future worth analysis over a specified study period is often utilized if the
asset (equipment, a building, etc.) might be sold or traded at some time
before the expected life is reached.

1. Future worth analysis of Equal-Life Alternatives:

 For one alternative: If FW ≥ 0, the alternative is economically justified.

 For two or more alternatives: Select the alternative with the FW that is
numerically largest, that is, less negative or more positive.

2. Future worth analysis of Different-Life Alternatives:

 The FW of the alternatives must be compared over the same number of

years. by using the following approach:
• Compare the FW of alternatives over a period of time equal to the least
common multiple (LCM) of their estimated lives.
 Annual Worth Analysis (AW)

 The AW value determined over one life cycle is the AW for all future life
cycles. Therefore, it is not necessary to use the LCM of lives.

 One alternative: If AW ≥ 0, the alternative is economically justified.

 For two or more alternatives: Select the alternative with the AW that is
numerically largest, that is, less negative or more positive.
Example (4):
Two equipments are being considered for purchase. If the interest ate is 7%,
Determined which equipments should be bought on the basis of an annual
worth (AW) comparison?
Equipment A Equipment B
Initial cost $7,000 $5,000
End-of-useful-life salvage value $ 1,500 $1,000
Useful life, in years 12 6
Solution:

 The annual cost for 12 years of equipment A:

Equivalent annual worth (AW) = - 7,000 (A /P, i = 7%, n = 12)

+ 1,500 (A /F, i = 7%, n = 12)
= - 7,000 (0.1259) + 1,500 (0.0559)
= - $797.45

 The annual cost for 6 years of equipment B:

Equivalent annual worth (AW) = - 5,000 (A /P, i = 7%, n = 6)
+ 1,000 (A /F, i = 7%, n = 6)
= - 5,000 (0.2098) + 1,000 (0.1398)
= - $909.20
Select equipment A
 Internal Rate of Return (IROR)

 The internal rate of return is the interest rate that makes the present
worth (PW) or annual worth (AW) of a cash flow series exactly equal to 0.

PW = 0 (i.e., PW of Cash in = PW of Cash out)

AW = 0 (i.e., AW of Cash in = Aw of Cash out)

 The i value that makes the above equations numerically correct is called i*.
If i* ≥ MARR, accept the project as economically viable.
If i* < MARR, the project is not economically viable.
Where:
The Minimum Attractive Rate of Return (MARR) is a reasonable rate of
return established by (financial) managers for the evaluation and selection of
alternatives.
Find i* by Using Trial and Error:
The general procedure of using a PW-based equation is as follows:
1. Draw a cash flow diagram.
2. Set up the rate of return equation (PW = 0 or AW = 0).
3. Select values of i by trial and error until the equation is balanced.

Example (5):
Determine the internal rate of return for the cash flow, if the MARR is 10 % ?

End of Year Cash Flow

0 -10,000
1 +4,000
2 +4,000
3 +4,000
Solution:
Using a net present worth (NPW) of 0, try i = 9%

NPW = - 10,000 + 4,000 (P/F, 9%, 1) + 4,000 (P/F, 9%, 2) + 4,000 (P/F, 9%, 3)
= - 10,000 + 4,000 (0.9174) + 4,000 (0.8417) + 4,000 (0.7722)
= - 10,000 + 3669.6 + 3366.6 + 3088.8
= + 125
The trail interest rate is too low. Select a second trail, i = 11 %
NPW = - 10,000 + 4,000 (P/F,11%,1) + 4,000 (P/F, 11%,2)
+ 4,000 (P/F, 11%, 3)
= - 10,000 + 4,000 (0.9009) + 4,000 (0.8116) + 4,000 (0.7312)
= - 10,000 + 3603.6 + 3246.4 + 2924.8
= - 225.2
From the Figure we can computed the IROR as NPW
125
+ 125
follows: 2-x
0 i%
9 x 11

x = 0.72 % - 225.2
225.2
Then, IROR (i*) = 9 + 0.72 = 9.72 % 2

i* < MARR Project is not economically viable. Plot of NPW versus interest rate i %
Example (6):
An excavator, 1 m3 capacity, is purchased for $ 46,000. Its estimated useful life
is 7 years, with a resale value of $ 4,000 at the end of the 7 years. The total
operating cost is estimated to be $ 3,000 per year, and the total ownership cost
including other company cost is $ 6,500 per year. It is also estimated that its
total operating time will be 2,000 hours per year. If the minimum required
internal rate of return (IROR) is 15%, use the IROR method to calculate the
excavator's minimum hire rate per hour? 4,000
2,000 X
Solution:

Where: X = is the hire rate per hour.

9,500
Using a net present worth (NPW) of 0: i* = 15%
46,000

NPW = 0 = - 46,000 - 9,500 (P/A, 15%,7) + 2,000 X (P/A, 15%,7)

+ 4,000 (P/F, 15%,7)
0 = - 46,000 - 9,500 (4.1604) + 2,000 X (4.1604) + 4,000 (0.3759)
0 = - 46,000 – 39523.8 + 8320.8 X + 1503.6
Then, X = 84020.2 / 8320.8 = 10.10
The excavator's minimum hire rate = $10.10 per hour.
 Pay Back Period Analysis

 Payback period is the period of time required for the profit or other benefits
of an investment to equal the cost of the investment.

 There are two types of payback analysis as determined by the required return.

(1) Simple Payback Period.

(2) Discounted Payback Period.

(1) Simple Payback Period:

 This method also called No return; i = 0%, this is the recovery of only the
initial investment.

 Simple payback neglects the time value of money, since no return on an

investment is required.
 Simple payback disregards all cash flows occurring after the payback
period.
Example (7):
For the investment project represented by the net cash flow shown in the table
below, calculate the simple payback period.
Solution:
End of Year Cash Flow
The cost of the investment = - 4,000 0 -4,000
 Calculate the cumulative cash in (benefits): 1 +900
At year 1: 2 +1,000
Cash in = + 900 3 +1,200
At year 2: 4 +1,000
Cash in = 900 + 1,000 = 1,900 5 +900
At year 3:
6 +15,00
Cash in = 1,900 + 1,200 = 3,100
At year 4:
Cash in = 3,100 + 1,000 = 4,100
The payback period is between year 3 and 4:

By using the interpolation, Payback period = 3.9 years

Example (8):
For the investment project represented by the net cash flow shown in the table
below, calculate the simple payback period.
End of Year Cash Flow
0 - 4,000
1 + 900
2 + 900
3 + 900
4 + 900
5 + 900
6 + 900
Solution:

The investment Cost = - 4,000

Uniform Annual Benefit = + 900
Payback Period = Cost of Investment / Uniform Annual Benefit
The payback period = 4,000 / 900 = 4.444 years.
(2) Discounted Payback Period i > 0 %:
 The time value of money is considered in that some return, for example,
10% per year, must be realized in addition to recovering the initial investment
 Discounted payback period disregards all cash flows occurring after the
payback period.
For net cash flow (NCF) varies annually: 0 = - P + ∑ NCF (P/F, i%, n)
For net cash flow (NCF) annual uniform : 0 = - P + NCF (P/A, i%, n)
Example (9):
For the investment project represented by the net cash flow shown in the table
below, if the interest rate is 10 % calculate the discounted payback period?

End of Year Cash Flow

0 -10,000
1 +4,000
2 +3,000
3 +3,500
4 +3,500
Solution:
The investment Cost = - 10,000
The net cash flow (NCF) is varies annually:

0 = - P + ∑ NCF (P/F, i%, n)

0 = - 10,000 + 4,000 (P/F, 10%, 1) = - 10,000 + 4000 (0.9091) = - 6363.6

0 = -10,000 + 4000 (0.9091) + 3000 (P/F, 10%, 2)

= - 10,000 + 4000 (0.9091) + 3000 (0.8264) = - 3884.4

0 = -10,000 + 4000 (0.9091) + 3000 (0.8264) + 3,500(P/F,10%,3)

= -10,000 + 4000 (0.9091) + 3000 (0.8264) + 3,500(0.7513) = - 1254.85

0 = -10,000 + 4000 (0.9091) + 3000 (0.8264) + 3,500(0.7513) + 3,500(P/F,10%, 4)

= -10,000 + 4000 (0.9091) + 3000 (0.8264) + 3,500(0.7513) + 3,500(0.6830)
= 1135.65
Then the discounted pay back period is between year 3 and 4:

Discounted pay back period = 3.52 years.

Example (10):
For the investment project represented by the net cash flow shown in the table
below, if the interest rate is 15 % calculate the discounted payback period?
Solution: End of Year Cash Flow
The net cash flow (NCF) annual uniform: 0 -20,0000
1 +5,000
0 = - P + NCF (P/A, i%, n) 2 +5,000
0 = -20,000 + 5,000 (P/F, 15%, 6)
3 +5,000
= - 20,000 + 5,000 (3.7845) = - 1077.5
4 + 5,000
0 = - 20,000 + 5,000 (P/F, 15%, 7) 5 + 5,000
= - 20,000 + 5,000 (4.1604) = 802 6 +5,000
7 + 5,000
Then the discounted pay back period is between year 6 and 7:
Discounted pay back period = 6.57 years.