CHAPTER TWO

METHODS OF COMPARING
AND EVALUATING
ALTERNATIVES

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Comparing Alternatives
 In selecting among alternatives, there are two types of data input- those
which can be expressed in economic terms (often called “reducible” or
“tangibles”) and those which cannot be expressed in economic terms (often
called “irreducible” or “intangibles”).
 There are different criterions in comparing mutually exclusive projects. The
cash flows determine whether the alternatives are revenue-based or service-
based.

A. Revenue projects: - are the type of projects which designed for the
purpose of income generating. And each alternative generates cost (or
expense) and revenue (or receipt) cash flow estimates, and possibly
savings.
“Alternatives of revenue projects have different costs and revenues”
B. Service projects: - Each alternative has only cost cash flow estimates. In
these cases the evaluation is based only on cost estimates.
”Alternatives of service projects have different costs but the same
revenue.”
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In comparing alternatives several methods are available including:
A. Initial project screening
Purpose: To eliminate some alternatives that can be easily detected to be
unfit using a simple technique.
Method: Payback period (it is the time required to accumulate a sum of money
from a net cash flow which is equal to the initial investment). This method is simple
but has drawbacks. Such as:-
 It doesn’t consider time value of money(undiscounted
 Fail to measure profitability
 Neglect the return after the payback period
B. Present Worth Analysis
C. Annual payment method
D. Future worth method
E. Rate of return (ROR) method
F. Break-even comparison
G. Benefit-cost ratio method of analysis.

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Present Worth Analysis
• Present worth represents a measure of future cash flow relative to the
time point “now” with the provisions that account for earning
opportunities.

• In this method alternatives are compared on the basis of equivalent

PW.
• In present worth analysis, the P value, now called PW, is calculated at
the MARR (minimum attractive rate of return) for each alternative.
The PW method is popular because future cost and revenue estimates
are transformed into equivalent dollars now; that is, all future cash
flows are converted into present dollars.
• Whether mutually exclusive alternatives involve disbursements only
(service) or receipts and disbursements (revenue), the following
guidelines are applied to select one alternative. 4
 If one alternative
 Calculate PW at the MARR. If PW≥0, the requested MARR is met or
exceeded and the alternative is financially feasible.
 If two or more alternatives
 Calculate the PW of each alternative at the MARR. Select the alternative
with the PW value that is numerically largest, that is, less negative or
more positive, it indicating a lower PW of cost cash flows or larger PW
of net cash flows of receipts minus disbursements.

Steps to do PW analysis for selecting a single alternative

Step 1: Select a desired value of the return on investment (i)
Step 2: Using the compound interest formulas bring all benefits and costs to PW
for each alternative
Step 3: Select the alternative with the largest NPW (PW of benefits–PW of costs)
(i.e. NPW=PWb - PWc ≥ 0)

NB: - The guideline to select one alternative with the lowest cost or the
highest income uses the criterion of numerically largest. This is not the
absolute value of the PW amount, because the sign matters. 5
 Find the present worth of each net cash flow at the MARR. Add up these
present worth figure; their sum is defined as the project’s NPW.

Where:
◦ P(i)= NPW calculated at i
◦ An= net cash flow at period n
◦ i= MARR (or cost of capital) and n= service life of the project
 “A” will be positive if the corresponding period has a net cash inflow or
negative if there is a net cash outflow.
 In this context, a positive NPW means the equivalent worth of the inflows is
greater than the equivalent worth of the outflows, so, the project makes a profit.
 Therefore, if the P(i) is positive for a single project, the project should be
accepted; if negative it should be rejected.
 The decision rule is:

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Merit of Present worth analysis
 It is a criterion for deciding a single project whether to funded
or not;
 It is a criterion of choosing the best alternative among the
mutually exclusive projects.
Demerit of present worth analysis
 It is sensitive to the choice of an interest rate or discounting
rate;
 It is sensitive to the choice of base year;

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Annual Worth Analysis
 It is considered to be the most desirable method because the AW
method is easy to calculate and is easily understood by anyone.
 Some of is assumption is identical with the present worth method
 From the title itself this will determine the equivalent annual
worth and cost.
 It may be used for even the most sophisticated analysis. However,
since the results of this method are intuitively understandable, it
is particularly useful when making presentations to the public or
to other decision-making groups with limited background in time-
value of money.
 Whereas present worth (PW) might be a difficult concept to
present without lengthy preparation, a simple comparison annual
payment is often grasped by even the most casual audience with
relative ease.
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Advantages of AW Method
 The major advantage of the AW method of comparing alternatives on the
basis of periodic payments is that the complication of unequal lives
between alternatives is automatically taken into account without any
extra computations.

 This automatic feature is predicated on the assumption of equal

replacement cost. With this assumption, the Aw technique will yield the
same decision as the PW technique.
AW = PW(A/P, i, n) = FW(A/F, i, n)
 The n in the factors is the number of years for equal-service comparison. This is
the LCM or the stated study period of the PW or FW analysis.

 The AW value has to be calculated for only one life cycle. Therefore it is
not necessary to use LCM of lives compared to PW and FW method.
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Assumptions of AW Method
 When alternatives being compared have different lives, the
AW method makes the assumption that:
1. The services provided are needed for at least the LCM of the lives
of the alternatives.
2. The selected alternative will be repeated for succeeding life cycle
in exactly the same manner as for the first life cycle.
3. All cash flow will have the same estimated values in every life
cycle.

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Capital Recovery and AW Values
 Assume the potential purchase of any productive asset
 One needs to know or estimate
◦ Initial investment, P
◦ Estimated future salvage value, S
◦ Estimated life of the asset, N
◦ Estimated operating cost and timing
◦ Operative interest rate, i%

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Annual Worth Values
1. Initial Investment (P) – Total first cost of all assets and
services required to initiate the alternative.
2. Salvage Value (S) – This is the terminal estimated value
of the assets at the end of their useful life.
3. Annual Amount (A) – This is the equivalent annual
amount, sometimes referred as annual operating cost.

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AW of an Alternative
 It is comprised of two components: Capital recovery for the initial
investment P at a stated interest rate, usually MARR and the
equivalent annual amount A.
 In equation;
AW = -CR + (– A)
 Both CR and A have minus signs because they represent costs.

 Capital recovery is the equivalent annual cost of owning the asset

plus the return of the initial investment.
CR = -[P(A/P, i, n) + (- S(A/F, i, n)])

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 Evaluating Alternatives by AW Analysis
 The alternatives selected, when the MARR is specified, has the lowest
equivalent annual cost, or the highest equivalent income.
 For a mutually exclusive alternatives, calculate AW at the MARR
One alternative
AW ≥0, MARR is met or exceeded
Two or more alternatives
Choose the lowest cost or highest income in AW value method.

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Rate of Return Analysis
 Rate of return (ROR) is the rate paid on the unpaid balance of borrowed
money, or the rate earned on the unrecovered balance of an investment,
so that the final payment or receipt brings the balance to exactly zero
with interest considered.
 In order to apply the ROR method each alternative investment must have
a numerically measurable return of income or some equivalent value.
 Then the ROR is calculated as the percent interest at which the present
worth of the cost equals the present worth of the income. This, of course,
is also the percent interest at which the equivalent annual cost equals the
annual income, as well as the percent interest at which the future worth of
cost equals future worth of income.
%interest PW cost= %interest PW income
 Single alternative case
 In this method all revenues and costs of the alternative are reduced to a
single percentage number
 This percentage number can be compared to other investment returns and
interest rates inside and outside the organization 15
 Step-by-step procedure for finding ROR.

Step 1. Make a guess at a trial rate of return.

Step 2. Count the costs as negative (-) and the income or savings as positive (+).
 Then find the equivalent net worth of all costs and income. Use present worth,
annual worth or future worth.

Step 3. If the equivalent net worth is positive, then the income from the
investment is worth more than the cost of the investment and the actual present
return is higher than the trial rate, (i).

Step 4. adjust the estimates of the trial rate, of return and proceed with steps 2
and 3 again until one of (i) is found that results in a positive (+)equivalent net
worth , and another higher value of (i) is found with a negative (-) equivalent net
worth.

Step 5. Solve for the correct value of (i) by interpolation.

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Cost- Benefit Analysis
 It is a systematic process for calculating and comparing benefits and cost
of a project, decision or policy.
 Present and future benefits (income) and costs need to be estimated to
determine the attractiveness (worthiness) of a new product investment
alternative
 It has two purposes:
◦ To determine if it is a sound investment/decision
◦ To provide basis for comparing projects
 Costs- estimated expenditures to the government entity for construction,
operation, and maintenance of the project, less any expected salvage
value.
 Benefits- advantages to be experienced by the owners, the public.
 Dis-benefits- expected undesirable or negative consequences to the
owners if the alternative is implemented. Dis-benefits may be indirect
economic disadvantages of the alternative.
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Benefit/Cost Ratio
 Initially used in the economic analysis of public sector
evaluation by reducing the effect of politics and special
interest
 It can use equivalency computation based on PW, AW
and FW values.

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Benefit Cost Analysis of a Single Project
 The B/C ratio is calculated using one of these relations:
B/C=PW of benefits/PW of costs
B/C=AW of benefits/AW of costs
B/C=FW of benefits/FW of benefits
If B/C≥ 1.0, accept the project as economically acceptable
for the estimates and discount rate applied.
If B/C <1.0, the project is not economically acceptable.

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Conventional B/C Ratio
 It is the most widely use B/C ratio in public and private
sector.
benefits  disbenefits
B/C 
cos ts

 The dis-benefits are subtracted from the benefits and not

added to the cost

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Modified B/C ratio
 In this method the maintenance and operation (M&O)is
in the numerator and treated as dis-benefits

benefits  disbenefits  M & O cos t

ModefiedB / C 
initial investment
 Salvage value is included in the denominator as a negative
cost

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Benefit and Cost Difference

 It is a measure of worth which does not involve ratio,

and is based on the difference between the PW, AW or
FW of benefits and cost.
 If B – C is ≥0; the project is acceptable

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Breakeven Analysis
 It is performed to determine the value of the variable or
a parameter of a project or alternative that makes two
element equal.
 Samples of breakeven analysis:
◦ Equating revenue and cost
◦ Make or buy decision
◦ Deciding source of manufactured components

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Breakeven Analysis of a Single Projects
 Three methods used in determining the quantity
required for breakeven analysis:
◦ Direct Solution-used if only one factor is given or single
amount is estimated
◦ Trial and Error- used when multiple factors are present.
◦ Computer Spreadsheet

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Breakeven Point, QBE
 This can be determine using relations for revenue and
cost at different values of the variable, Q
 This may happen by designing the element to minimize
the cost, or the production level to realize the revenue
 It can be measured using units/year, percentage of
capacity, hours per month and many other dimensions

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Revenue Relation TC = FC + VC

Total cost, TC
TC = FC + VC

Cost per year

Variable Cost, VC
Total cost, TC
Cost per year

Fixed Cost, FC

Variable Cost, VC Q, units per year

Fixed Cost, FC Nonlinear relation

Q, units per year

Linear Relation 26
Fixed Cost and Variable Cost
 Fixed Cost- includes cost such as building, insurance,
fixed overhead, some minimum level of labor, equipment
capital recovery and information systems
 Variable Cost – includes cost such as direct labor,
materials, indirect cost, contractors, marketing
advertisement and warranty

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Effect of breakeven point when VC is reduced
R

TC

Breakeven

Lowered
Variable cost

Profit

Loss

QBE
Profit = Revenue( R ) – Total Cost (TC)
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Breakeven Point, QBE
 When Q>QBE, there is a predictable
profit
 When Q<QBE, there is a loss

When R  TC, then it is breakeven

FC
then QBE 
r v

where : r  revenue per unit

v  variable cost
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Breakeven Analysis Between Two Alternatives
 It involves the determination of a common variable or
economic parameter between two alternatives.
 The parameter can be interest rate, first cost, annual
operating cost or any parameter.

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Steps to Determine the Break-even Point
1. Define the common variable and its dimensional units
2. Use AW or PW analysis to express the total cost of
each alternative as a function of the common variable
3. Equate the two relations and solve for the break-even
value of the variable
4. If the anticipated level is below the break-even value,
select the alternative with the higher variable cost. If
the level is above the break-even point, select the
alternative with the lower variable cost.
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Limitations
 It is only a supply side analysis
 It assumes that fixed cost are constant
 It assume average variable cost per unit of the output.
 It assumes that the quantity produced is equal to the
quantity sold
 In multi-product company it is assumes that the product
sold and produced is constant

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