Engineering Economics & Management

CHAPTER II METHODS OF COMPARING ALTERNATIVE PROPOSALS

The usual goal of engineering economy studies is to minimize costs or maximize profits or
savings. In comparing alternatives several methods are available including:
a) Present worth method of Analysis
b) Annual worth method of Analysis
c) Future worth method of Analysis
d) Rate of return method of Analysis
e) Break-even comparison method or break-even Analysis
f) Benefit-cost Analysis
Each of these methods has advantage and limitations. These are discussed, with examples, to
assist in determining the preferred method in analysing any particular problem.
2.1 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. Very important elements in comparing
mutually exclusive alternatives by using the present worth analysis method are interest rate (i)
and analysis period (N).
Net Present Worth Criteria
We will first summarize the basic procedure for applying the present worth criterion to a typical
investment project.
✓ Determine the interest rate that the firm wishes to earn on its investment. The interest rate
you determine represents the rate at which the firm can always invest the money in its
investment pool. This interest rate is often referred to as either a required rate of return or a
minimum attractive rate of return (MARR). Usually this selection is a policy decision made
by top management. For example, an individual should avoid selecting a MARR that is less
than the interest rates banks are paying on saving accounts.
✓ Estimate the service life of the project.
✓ Estimate the cash outflow over each service period.
✓ Determine the net cash flows, i.e.
Net cash flow = Cash Inflow-Cash Outflow
✓ 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.

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𝐴1 𝐴2 𝐴𝑛
𝑃(𝑖) = 1
+ 2
+⋯+ 𝑊ℎ𝑒𝑟𝑒: 𝑃(𝑖) = 𝑁𝑃𝑊 𝑐𝑎𝑙𝑐𝑢𝑙𝑎𝑡𝑒𝑑 𝑎𝑡 𝑖
(1 + 𝑖) (1 + 𝑖) (1 + 𝑖)𝑛
𝐴𝑛 = 𝑛𝑒𝑡 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑎𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 𝑛
𝑖 = 𝑀𝐴𝑅𝑅 (𝑜𝑟 𝑐𝑜𝑠𝑡 𝑜𝑓 𝑐𝑎𝑝𝑖𝑡𝑎𝑙)
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:
If P(i)>0, accept the investment
If P(i)=0, remain indifference
If P(i)<0 reject the investment
Comparison of Alternatives with Equal Life Span
Example-1: Alternatives with equal life span:
An engineer is in need of an automobile for business purposes and finds that a suitable one can
be obtained by either of two methods: (a) lease a car for Birr 10,000 per month for two years,
paid monthly at the end of each month, or (b) purchase the same type of car for Birr 500,000
now and sell it in two years for Birr 300,000. In either case, the engineer pays all operating
maintenance and insurance costs. He can borrow fund for either alternative from the local bank
at 9% interest. Which is the least costly alternative, assuming interest is compounded monthly?
Solution
Since the life spans of both alternatives are equal, the alternatives can be compared directly by
finding the net present worth of each and selecting the one with least cost.
i. Lease: The NPW of the lease alternative is present worth of the 24 payments of Birr
10,000 per month.
P1 = -Birr 10,000(P/A, i, N) = -Birr 10,000(P/A, 9/12%, 24)
(1+𝑖)𝑁 −1
= -Birr 10,000(P/A, 0.75%, 24), P/A = )
𝑖(1+𝑖)𝑁
24
(1+0.0075) −1
P1 = -Birr 10,000( 24 ) = -Birr 10,000(21.8891) = -Birr 218.891.50
0.0075(1+0.0075)

NPW1 = -Birr 218.891.50

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ii. Purchase: The NPW of the purchase alternative is the present worth of the purchase
price minus the present worth of the income from the resale at the end of two years.
P2 = -Birr 500,000 purchase price
1
P3 = F (P/F, i, N) = Birr 300,000(P/F, 0.75%, 24) P/F = ((1+𝑖)𝑁 )
1 1
P3 = 𝐹((1+𝑖)𝑁 ) = Birr 300,000((1+0.0075)24 ) = Birr 250,749.4212 (resale value)

NPW2 = P2 - P3 = -500,000 + 250,749.4212

NPW2 = -Birr 249,250.578

Comparing the present worth, it is apparent that the cost of the lease alternative is much less
expensive than the cost of the purchase alternative. So, leasing the car is recommendable.
2.2 The Annual Payments Method of Comparing Alternatives: It is a method of reducing all
cash flows involved in each proposal to an equivalent series of periodic payment. The major
advantage of the annual worth 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.
Example
1. Two roofs are under consideration for a building needed for 20yrs. Their anticipated costs
and life’s are given below in the table. By using Annual worth method, suggest which roof
would you select and why?
Roof C Roof D
Cost new (Birr) 50,000 25,000
Replacement cost (Birr) - Rise 8%/yr
Life of roof (yr.) 20 10
Salvage value (Birr) 0 0
Interest rate (%) 10 10

Solution
0.1(1+0.1)20
Roof C A1 = -Birr 50,000 (A/P, 10%, 20) = -Birr 50,000( ) = -Birr 5,875/yr.
(1+0.1)20 −1

0.1(1+0.1)20
Roof D A2 = -Birr 25,000 (A/P, 10%, 20) = -Birr 25,000( ) = -Birr 2,937/yr.
(1+0.1)20 −1

A3 = -Birr 25,000 (F/P, 8%, 10) (P/F, 10%, 10) (A/P, 10%, 20)

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Let us solve A3 in 3 steps

Step 1. Finding the future worth for replacement cost rising at 8%/yr for 10years.
F = P (F/P, i, N) = -25,000(F/P, 8%, 10) = 25,000(1 + 0.08)10 ) = -Birr 53,973.125
Step 2. Convert to the future worth obtained to present worth discounted at 10%/yr for 10years.
1
P = F (P/F, i, N) = -53,973.125(P/F, 10%, 10) = -53,973.125((1+0.1)10 ) = -Birr 20808.98

Step 3. Convert the present worth obtained into its 20year Annual equivalence
0.1(1+0.1)20
A3 = P (A/P, i, N) = -20,808.98(A/P, 10%, 20) = -20,808.98((1+0.1)20 −1) = -Birr 2,445/yr

(NAW)Net annual worth of roof D = A2 + A3 =-2,937 + -2,445 = -Birr 5,382/yr

Therefore, Roof D alternative is selected because of its least cost.
2. Alternative-1: Initial purchase cost = $300,000, Annual operating and maintenance cost =
$20,000, Expected salvage value = $125,000, Useful life = 5 years.
Alternative-2: Initial purchase cost = $200,000, Annual operating and maintenance cost =
$35,000, Expected salvage value = $70,000, Useful life = 5 years.
The annual revenue to be generated from production of concrete (by concrete mixer) from
Alternative-1 and Alternative-2 are $50000 and $45000 respectively. Compute the equivalent
uniform annual worth of the alternatives at the interest rate of 10% per year and find out the
economical alternative.
Solution:
The cash flow diagram of Alternative-1 i.e. Fig. 2.1 is shown here again for ready reference.

$125,000
$50,000

Time (year) 0 1 2 3 4 5

$300,000 $20,000

Fig. 2.1 Cash flow diagram of Alternative -1

The equivalent uniform annual worth of Alternative-1 i.e. AW1 is computed as follows;

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AW1= -300000(A/P, i, N) -20000+50000 +125000(A/F, i, N)

AW1= -300000(A/P, 10%, 5) -20000+50000 +125000(A/F, 10%, 5)

Here $20000 and $50000 are annual amounts.

Now putting the values of different compound interest factors;

0.1(1+0.1)5 0.1
AW1= -300000((1+0.1)5−1) + (50000-20000) +125000((1+0.1)5−1)

AW1= -300000x0.2638 + (50000-20000) +125000x0.1638 = -79140 + 30000 +20475

AW1= -$28,665

The cash flow diagram of Alternative-2 i.e. Fig. 2.2 is shown here again for ready reference.

$70,000
$45,000

Time (year) 0 1 2 3 4 5

$200,000 $35,000

Fig. 2.2 Cash flow diagram of Alternative -2

Now the equivalent uniform annual worth of Alternative-2 i.e. AW2 is calculated as follows;

AW2= -200000(A/P, i, N)-35000+45000+70000(A/F, i, N)

AW2= -200000(A/P, 10%, 5) -35000+45000+70000(A/F, 10%, 5)

For alternative-2, $35000 and $45000 are annual amounts.

Now putting the values of different compound interest factors in the above expression;

0.1(1+0.1)5 0.1
AW2= -200000((1+0.1)5−1)+ (45000-35000) +70000((1+0.1)5−1)

AW2= -200000x0.2638+ (45000-35000) +70000x0.1638 = -52760+10000+11466

AW2= -$31,294

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From this comparison, it is observed that Alternative-1 will be selected as it shows lower
negative equivalent uniform annual worth compared to Alternative-2.
2.3 Future worth Method of Computing Alternative.
Future worth (FW) comparisons of alternative investments or projects are frequently used when
the owner or manager expects to sell or otherwise liquidate the investment at some future date
and wants to estimate of net worth at that future date.
Example
1. An Engineering consultant reviewed records of the expenditure from year zero to 5 which is
as shown in the figure. Out of that he selected only the 3 largest amounts. What return can he
expect at the 10th year at an interest rate of 5% per year. Calculate the future worth by both
present and future worth analysis. Construct a cash flow diagram for the same.

year 1, 175
year 0, 600 year 2, 300
year 3, 135
year 5, 400 year 4, 250

Solution: 3 Largest amounts are 600[year 0], 400[year 5], and 300[year 2]
1. By Future worth analysis
F = 600 (F/P, 5%, 10) + 300 (F/P, 5%, 8) + 400 (F/P, 5%, 5)
F = 600(1 + 0.05)10 + 300(1 + 0.05)8 + 400(1 + 0.05)5 = 977.34+443.24+510.51
F= 1931.11
2. By Present worth analysis
First let us find the present worth and then convert it in to the future worth.
P= 600 (P/F, 5%, 0) + 300 (P/F, 5%, 2) + 400 (P/F, 5%, 5)
1 1 1
P= 600((1+0.05)0) + 300((1+0.05)2) + 400((1+0.05)5) = 600+272.11+313.41

P= 1185.50
F= 1185.50 (F/P, 5%, 10) = 1185.50(1 + 0.05)10

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F= 1931.11
Both the calculations give the same future worth value.
Cash flow diagram
+ 1931.11

i=5%

0 1 2 3 4 5 6 7 8 9 10

300
400
- 600

2. A construction company is considering the purchase of one of the two new front-end loaders
whose data are listed below. Use Future worth analysis to find which loader is preferred.
Front End Loader A Front End Loader B
First cost (Birr) -100,000 -40,000
Annual net income +16,000 +13,000
Useful life (yrs.) 10 5
Replacement cost escalation NA 10%/yr. compounded
Salvage value (Birr) +10,000 +10,000
Interest rate (%) 8 8

FW (A) = -100,000 (F/P, 8%, 10) +16,000 (F/A, 8%, 10) + 10,000
(1+0.08)10 −1
= -100,000(1 + 0.08)10 + 16,000( ) + 10,000 = -215,900 + 231,792 +10,000
0.08

= +Birr 25,886
FW (B) = -40,000 (F/P, 8%, 10) -40,000 (F/P, 10%, 5) (F/P, 8%, 5) +13,000 (F/A, 8%, 10)
+10,000 + 10,000 (F/P, 8%, 5)
(1+0.08)10 −1
= -40,000(1 + 0.08)10-40,000(1 + 0.1)5 (1 + 0.08)5+13,000( 0.08
)+10,000+10,000(1 + 0.08)5

= -86,357 - 94,654.7 + 188,325.3 + 10,000 + 14,693.3

= +Birr 32,050
Comparing the future worth of loader, A and B, Loader B, with greater positive FW (revenue),
is preferred.

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3. A Computer company has invested 50,000 Birr now. Find its equivalence value 3 years
earlier with a discount rate of 20% / year. Draw the cash flow diagram.
Solution:
F = 50,000 Birr, i = 20%, N = 3 years
P = F (P/F, i, N)
1
P = 50,000 (P/F, 20%, 3) =50,000((1+0.2)3)

P = 28,935 Birr
+
P = 28,935

i = 20 %

-3 -2 -1 0 1 2 3

- F = 50,000
2.4 Rate of return method of comparing alternative
A return of Birr 6 interest per year on a deposit of birr 100 is easily understood to imply a rate of
return of 6%
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.
Example
1. Assume a bond sells for Birr 950. The bond holder will receive Birr 60 per year interest as
well as Birr 1,000 (the face amount of this bond) at the end of ten years. Find ROR.
Solution

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Find the interest rate at which the present worth of the income equals the present worth of the
cost.
Step 1. Let trial i = 7%
10
(1+0.07) −1
Step 2. Income P1 = Birr 60 (P/A, 7%, 10) = Birr 60 ( 10 ) = Birr 421.44
0.07(1+0.07)
1
Income P2 = Birr 1000 (P/F, 7%, 10) = Birr 1000((1+0.07)10)= Birr 508.30

Cost P3 = -Birr 950

Net present worth = 421.44 + 508.30 - 950 = -Birr 20.26
Step 3. The present worth is negative so the trial rate, 7% is too high
Step 4. Adjust the estimate downward to, say, 6%. Then,
Assume trial ROR as 6%
(1+0.06)10 −1
P1 = Birr 60(P/A, 6%, 10) = 𝐵𝑖𝑟𝑟 60 (0.07(1+0.06)10 ) = Birr 441.60
1
Income P2 = Birr 1000 (P/F, 6%, 10) = 𝐵𝑖𝑟𝑟 1000((1+0.06)10) = Birr 558.40

Cost P3 = -Birr 950

Net present worth = 441.60 + 558.40 - 950 = +Birr 50.00
By Trial and error rate of return i = 6.7 %
2.5 Break Even Comparisons
The break-even point: It is the point at which costs or expenses and revenue are equal: there is
no net loss or gain." A profit or a loss has not been made, In short, all costs that need to be paid
are paid by the firm but the profit is equal to 0.
The break-even point may be found by following the logical three-step procedure, as follows:
1. Find the annual equivalent of the capital costs.
2. Find the independent variable and set up an equation for each alternative cost combination.
The equation usually takes the form of
Total annual cost = Equivalent capital Cost + (Cost/variable unit) * (Number of variable units/yr)
TAC= FAC+ VAC
3. Find the breakeven point.
Example
1. A contractor is thinking of selling his present dump truck and buying a new one. The new
truck costs 30,000 and is expected to incur. O&M costs of 0.10 per ton-mile. It has a life of

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15 years with no significant salvage value. The presently owned truck can be sold now for
10,000. If it is kept, it will cost 0.15 per ton-mile for O&M, and have an expected life of five
years, and no salvage value. Use i = 10%, find the break-even point in terms of ton miles per
year.
Solution
The annual equivalent to the capital investment cost is
0.1(1+0.1)15
A (new truck) = 30,000 (A/P, 10%, 15) = 30,000((1+0.1)15 −1) =3,944/yr
0.1(1+0.1)5
A (present truck) = 10,000 (A/P, 10%, 5) =10,000((1+0.1)5−1) = 2,638/yr

The total annual cost for each year for each alternative is simply the annual equivalent capital
cost plus the annual O&M cost as follows:
Total annual cost (new truck) = A1
A1= 3,944/yr + (0.10/ton-mi) (X ton-mi/yr)
Total annual cost (present truck) = A2
A2 = 2,638/yr + (0.15/ ton- mi) (X ton-mi/ yr)
The break- even value to x- may be found by solving the equations simultaneously.
For new truck y = 0.10X + 3,944
For present truck y = 0.15X + 2,638
X= 3,944-2.638=26,120 ton-mi/yr
Graphical solution is also possible by drawing the graphs of the two equations; see the result in
the graph below.

Note:

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If the contractor’s annual production is below 26,120 mile-tone, the old truck is more economical
and if it is greater than 26,120, the new truck is economical. At the break-even point both truck
have the same economical value.
2.6 Benefit-cost analysis (BCA) is a technique for evaluating a project or investment by
comparing the economic benefits with the economic costs of the activity. Benefit-cost analysis
has several objectives. First, BCA can be used to evaluate the economic merit of a project.
Second the results from a series of benefit-cost analysis can be used to compare competing
projects.
Discounting is a technique that converts all benefits and costs into their value in the present.
Discounting is based on the premise that a Birr received today is worth more than a Birr received
in the future. Another way of saying this is that a dollar received in the future is not worth as
much as that same dollar received in the present. That is, the future value of the dollar is
discounted. Discounting is the opposite of compounding. Not surprisingly, the rate at which a
future value is discounted is closely related to the rate at which present values are compounded,
namely the interest rate.
Whenever the benefits and costs used in a benefit-cost analysis occur in the future, it is important
to discount these future values to account for their present value. If the interest rate is r, then the
following formula can be used to find the present value (PV) of an amount (Pt) received at some
time t in the future:
𝑃𝑡
𝑃𝑉 =
(1 + 𝑟)𝑡
To apply the formula, remember:
PV is the present value of the amount invested; Pt is the value of the future amount in time t;
r is the discount rate; and t is the year in which Pt is realized.
Example
1. Suppose you are given the choice of two investments. The first pays you $210 today, but
nothing thereafter. The second investment pays $100 today and $115 next year (for a total of
$215). If the discount rate is 5%, which is the better investment? Find out by applying the
present value formula:
$210 $0
PV of investment 1 = (1+0.05)0 + (1+0.05)1 = $210
$100 $115
PV of investment 2 = (1+0.05)0 + (1+0.05)1 = $209.5

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Even though the second investment pays out a greater sum, after discounting the first deal looks
like a better choice.

Net present value (NPV): The net present value (NPV) is the current value of all project net
benefits. Net benefits are simply the sum of benefits minus costs. The sum is discounted at the
discount rate. Using this method, if the project has a NPV greater than zero then it appears to be
a good candidate for implementation. The formula used to calculate the NPV is:
𝑇
(𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑡 − 𝐶𝑜𝑠𝑡𝑡 )
𝑁𝑃𝑉 = ∑
(1 + 𝑟)𝑡
𝑡=1

[Or]
(𝐵1 − 𝐶1 ) (𝐵2 − 𝐶2 ) (𝐵3 − 𝐶3 ) (𝐵𝑁 − 𝐶𝑁 )
NPV =[(𝐵0 − 𝐶0 )] + [ ]+[ ]+[ ] + ……… + [ ]
(1+𝑟) (1+𝑟)2 (1+𝑟)3 (1+𝑟)𝑁

Benefit-cost ratio (BCR)

The benefit-cost ratio (BCR) is calculated as the NPV of benefits divided by the NPV of costs: Where, Bt
is the benefit in time t and Ct is the cost in time t. If the BCR exceeds one, then the project might be a
good candidate for acceptance.
𝐵𝑡
∑𝑇𝑡=1
(1+𝑟)𝑡
𝐵𝐶𝑅 = 𝐶𝑡
∑𝑇𝑡=1
(1+𝑟)𝑡

Return of Investment (ROI): A performance measure used to evaluate the efficiency of an

investment or to compare the efficiency of a number of different investments. To calculate ROI,
the benefit (return) of an investment is divided by the cost of the investment; the result is
expressed as a percentage or a ratio.
ROI = (net benefits/total cost).
If the ROI is positive, the benefits exceed the costs and the investment should be considered. A
negative ROI means that the costs outweigh the benefits. An ROI of 0 means the benefits equal
the costs.
Example:
1. Analysis of several mutually exclusive road way alignments yield the following information.
(i=7%)
Alternative A Alternative B Alternative C
Annual Benefit 375,000 460,000 500,000

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Annual Cost 150,000 200,000 250,000

B/C 2.5 2.3 2.0

Solution
Comparison of A and B
𝐵⁄ = (460,000−375,000) 85,000
𝐶 = 50,000 = 1.7 > 1. Discard A (the defender) and accept B
(200,000−150,000)

(the challenger) temporally

Comparison of C and B
𝐵⁄ = (500,000−460,000) 40,000
𝐶 = 50,000 = 0.8 < 1. Discard the challenger C
(250,000−200,000)

Therefore, B is the better alternative even though the benefit cost ratio is less than that of A. Alternative A
offers a greater benefit for the total expenditures.
2. Perform CBA with the application of NPV and ROI for a project with cost of 50,000 Birr.
Out of the total cost of the project of 50,000 Birr, 35,000 Birr is the initial investment. The
costs allotted for year 1, 2 and 3 are 5,000 Birr each. Assume the total benefits as 25,000
Birr/year and the Discounting factor as 2.5 %.

Initial Cost Year 1 Year 2 Year 3 Cumulative total

Total Cost 35,000 5,000 5,000 5,000 50,000
Total Benefit 0 25,000 25,000 25,000 75,000
Net Benefit - 35,000 20,000 20,000 20,000 25,000

To find NPV

𝑦0 = 𝐵0 − 𝐶0 = 0 − 35000 = −35,000 𝐵𝑖𝑟𝑟

𝐵1 − 𝐶1 25,000 − 5,000 20,000
𝑦1 = = = = 19,512 𝐵𝑖𝑟𝑟
(1 + 𝑖) (1 + 0.025) (1.025)
𝐵2 − 𝐶2 25,000 − 5,000 20,000
𝑦2 = 2
= 2
= = 19,036 𝐵𝑖𝑟𝑟
(1 + 𝑖) (1 + 0.025) (1.025)2
𝐵3 − 𝐶3 25,000 − 5,000 20,000
𝑦3 = = = = 18,572 𝐵𝑖𝑟𝑟
(1 + 𝑖)3 (1 + 0.025)2 (1.025)2
NPV = -35000+19512+19036+18572 = 22,120 Birr

If ROI is calculated without considering Discount rate, ROI = (25,000/50,000) = 0.5 =50%

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By adding a discount factor and calculating NPV, ROI = (22,120/50,000) = 0.4424 =44.24%, but is still
positive, and more meaningful because it accounts for the time value of money. Since ROI is positive in
both the case, the investment is worthwhile.
Benefit-cost analysis: -
The benefit-cost analysis method is mainly used for economic evaluation of public projects
which are mostly funded by government organizations. In addition, this method can also used for
economic evaluation of alternatives for private projects. The main objective of this method is
used to find out desirability of public projects as far as the expected benefits on the capital
investment are concerned. As the name indicates, this method involves the calculation of ratio of
benefits to the costs involved in a project.
In benefit-cost analysis method, a project is considered to be desirable, when the net benefit
(total benefit less disbenefits) associated with it exceeds its cost.

Conventional B/C ratio

The conventional benefit-cost ratio of a project is mentioned as follows;

𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜

𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
=
𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝐸𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑤𝑜𝑟𝑡ℎ 𝑜𝑓 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

Thus, the expression for conventional benefit-cost ratio (B/C ratio) is mentioned as follows;

𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜

𝑃𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑃𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
=
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 + 𝑃𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑛𝑑 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑐𝑜𝑠𝑡 − 𝑃𝑊 𝑜𝑓 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜

𝐴𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐴𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
=
𝐴𝑊 𝑜𝑓 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 + 𝐴𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑛𝑑 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑐𝑜𝑠𝑡 − 𝐴𝑊𝑜𝑓 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

𝐹𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐹𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
𝐹𝑊 𝑜𝑓 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 + 𝐹𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑛𝑑 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑐𝑜𝑠𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

In the above expressions, PW, AW, and FW refer to equivalent present worth, annual worth and
future worth respectively.
Modified B/C ratio

In the modified benefit-cost ratio method, the operating and maintenance cost is subtracted from
the benefits in the numerator of the ratio. In other words, operating and maintenance cost is

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considered similar to the disbenefits. The expression for modified benefit-cost ratio using PW,
AW or FW is given as follows;
𝑃𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑃𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑃𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑛𝑑 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑐𝑜𝑠𝑡
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑃𝑊 𝑜𝑓 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

𝐴𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐴𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐴𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑛𝑑 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑐𝑜𝑠𝑡

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
𝐴𝑊 𝑜𝑓 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝐴𝑊𝑜𝑓 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

𝐹𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐹𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐹𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑎𝑛𝑑 𝑚𝑎𝑖𝑛𝑡𝑒𝑛𝑎𝑛𝑐𝑒 𝑐𝑜𝑠𝑡

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
𝐹𝑊 𝑜𝑓 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
A project is considered to be acceptable when the conventional or modified B/C ratio is greater
than or equal to 1.0. The illustration of conventional and modified B/C ratio methods is
described in the following example.

Example 1. The cash flow details of a public project is as follows

Initial cost = $21,000,000

Annual operating cost = $1,600,000
Worth of annual benefits = $5,000,000
Worth of annual disbenefits = $1,100,000
Salvage value = $4,000,000
Interest rate per year = 8% and useful lie = 30 Years
Using benefit-cost ratio method (both conventional and modified), find out the economical
acceptability of the public project. Use PW, AW and FW methods to find out the equivalent
worth of costs, benefits and disbenefits.
Solution:
First the conventional benefit-cost ratio (B/C ratio) of the project is computed.
Conventional B/C ratio using Present worth:
The conventional benefit-cost ratio of the public project is calculated as follows;
𝑃𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑃𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 + 𝑃𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 − 𝑃𝑊 𝑜𝑓 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

5000000(𝑃/𝐴 , 𝑖, 𝑛) − 1100000(𝑃/𝐴 , 𝑖, 𝑛)
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000 + 1600000(𝑃/𝐴 , 𝑖, 𝑛) − 4000000(𝑃/𝐹 , 𝑖, 𝑛)

5000000(𝑃/𝐴 ,8%, 30) − 1100000(𝑃/𝐴 ,8%, 30)

𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000 + 1600000(𝑃/𝐴 ,8%, 30) − 4000000(𝑃/𝐹 ,8%, 30)

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5000000𝑋11.2578 − 1100000𝑋11.2578
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000 + 1600000𝑥11.2578 − 4000000𝑥0.0994

Conventional B/C ratio = 1.137

Conventional B/C ratio using Annual worth:

𝐴𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐴𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
𝐴𝑊 𝑜𝑓 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 + 𝐴𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 − 𝐴𝑊 𝑜𝑓 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

5000000 − 1100000
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000(𝐴/𝑃, 𝑖, 𝑛) + 1600000 − 4000000(𝐴/𝐹, 𝑖, 𝑛)

5000000 − 1100000
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000(𝐴/𝑃, 8%, 30) + 1600000 − 4000000(𝐴/𝐹, 8%, 30)

5000000 − 1100000
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000𝑥0.0888 + 1600000 − 4000000𝑥0.0088
Conventional B/C ratio = 1.137

Conventional B/C ratio using Future worth:

𝐹𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐹𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
𝐹𝑊 𝑜𝑓 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 + 𝐹𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

5000000(𝐹/𝐴, 𝑖, 𝑛) − 1100000(𝐹/𝐴, 𝑖, 𝑛)
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000(𝐹/𝑃, 𝑖, 𝑛) + 1600000(𝐹/𝐴, 𝑖, 𝑛) − 4000000

5000000(𝐹/𝐴, 8%, 30) − 1100000(𝐹/𝐴, 8%, 30)

𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000(𝐹/𝑃, 8%, 𝑛) + 1600000(𝐹/𝐴, 8%, 30) − 4000000

5000000𝑥113.2832 − 1100000𝑥113.2832
𝐶𝑜𝑛𝑣𝑒𝑛𝑡𝑖𝑜𝑛𝑎𝑙 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000𝑥10.0627 + 1600000𝑥113.2832 − 4000000
Conventional B/C ratio = 1.137
As calculated above, the conventional benefit-cost ratio is found to be the same by using any of
the equivalent worth methods i.e. PW method, AW method or FW method. As the benefit-cost
ratio of the public project is 1.137 (i.e. greater than 1.0), the project is acceptable.
Now the modified benefit-cost ratio (B/C ratio) of the project is calculated.
Modified B/C ratio using Present worth:
The modified benefit-cost ratio of the public project is calculated as follows;
𝑃𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑃𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑃𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑃𝑊 𝑜𝑓 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

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5000000(𝑃/𝐴, 𝑖, 𝑛) − 1100000(𝑃/𝐴, 𝑖, 𝑛) − 1600000(𝑃/𝐴, 𝑖, 𝑛)

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
2100000 − 4000000(𝑃/𝐹, 𝑖, 𝑛)
5000000(𝑃/𝐴, 8%, 30) − 1100000(𝑃/𝐴, 8%, 30) − 1600000(𝑃/𝐴, 8%, 30)
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
2100000 − 4000000(𝑃/𝐹, 8%, 30)
5000000𝑥11.2578 − 1100000𝑥11.2578 − 1600000𝑥11.2578
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
2100000 − 4000000𝑥0.0994
Modified B/C ratio = 1.257
Modified B/C ratio using Annual worth:
𝐴𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐴𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐴𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
𝐴𝑊 𝑜𝑓 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝐴𝑊𝑜𝑓 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒
5000000 − 1100000 − 1600000
𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000(𝐴/𝑃, 𝑖, 𝑛) − 4000000(𝐴/𝐹, 𝑖, 𝑛)

5000000 − 1100000 − 1600000

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000(𝐴/𝑃, 8%, 30) − 4000000(𝐴/𝐹, 8%, 30)

5000000 − 1100000 − 1600000

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000𝑥0.0888 − 4000000𝑥0.0088

Modified B/C ratio = 1.257

Modified B/C ratio using Future worth:

𝐹𝑊 𝑜𝑓 𝐵𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐹𝑊 𝑜𝑓 𝐷𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝐹𝑊 𝑜𝑓 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑐𝑜𝑠𝑡

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
𝐹𝑊 𝑜𝑓 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑐𝑜𝑠𝑡 − 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

5000000(𝐹/𝐴, 𝑖, 𝑛) − 1100000(𝐹/𝐴, 𝑖, 𝑛) − 1600000(𝐹/𝐴, 𝑖, 𝑛)

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000(𝐹/𝑃, 𝑖, 𝑛) − 4000000

5000000(𝐹/𝐴, 8%, 𝑛) − 1100000(𝐹/𝐴, 8%, 𝑛) − 1600000(𝐹/𝐴, 8%, 𝑛)

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000(𝐹/𝑃, 𝑖, 𝑛) − 4000000

5000000𝑥113.2832 − 1100000𝑥113.2832 − 1600000𝑥113.2832

𝑀𝑜𝑑𝑖𝑓𝑖𝑒𝑑 𝐵/𝐶 𝑟𝑎𝑡𝑖𝑜 =
21000000𝑥10.0627 − 4000000
Modified B/C ratio = 1.257
The modified benefit-cost ratio of the public project is found to be 1.257.
As observed from above calculations, the B/C ratio of the project from both methods
(conventional and modified) is greater than 1.0, although the value is different. It may be noted
here that, although the magnitude of benefit-cost ratio differs between two methods i.e.
conventional B/C ratio and modified B/C ratio, but the decision to select or not a project is not
changed by use of any of the two methods.

G5WSEEF- E 17