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EE - L9 To L10 - Economic Evaluation of Alternatives - Present Worth Method
EE - L9 To L10 - Economic Evaluation of Alternatives - Present Worth Method
EE - L9 To L10 - Economic Evaluation of Alternatives - Present Worth Method
of Alternatives
OBJECTIVES After studying this chapter, you should
be able to understand:
1. What is Economic Evaluation of Alternatives
2. Different Methods in EEA
3. Numerical / Problems
LEARNING
Introduction
Where,
P – Represents initial investment
Cj – Net cost of the operation and maintenance at the end of j th year.
S – Represent the salvage value at the end of n th year
Present Worth Method
Cost dominated cash flow diagram:
To compute the present worth amount of the above cash flow diagram
for a given interest rate i,
Where,
P – Represents initial investment
Rj – Net revenue at the end of jth year.
S – Represent the salvage value at the end of nth year
Present Worth Method
Revenue dominated cash flow diagram:
0 1 2 3 4
A (Rs) -10,000 3,000 3,000 7,000 6,000
B (Rs) -10,000 6,000 6,000 3,000 3,000
Rs. 29,000
Rs. 5,80,000 i =12 %
Rs. 30,800
Rs. 6,40,000 i =12 %
P= Rs. 13,00,000
The present worth of the bid 1 is given by,
PW (20%) = - P + A (P/A, i , n)
= -13,00,000 + 4,00,000 (P/A, i , n)
= -13,00,000 + 4,00,000 (P/A, 20,10)
= -13,00,000 + 4,00,000 (4.19247) = Rs. 3,76,988/-
Solved Problems
3. Soln: Proposal A
Given data: P= Rs. 10,000/- ; N = 4 yrs
i = 18% compounded annually
The CFD for the first bid is shown below:
3,000 3,000 7,000 6,000
t
0
1 2 3 4
i =18 %
P= Rs. 10,000
The present worth of proposal A is given by,
PW (18%) = - P + A (P/F, i , n)
= -10,000 + 3,000 (P/F, 18, 1) + 3,000 (P/F, 18, 2) +
t
0
1 2 3 4
i =18 %
P= Rs. 10,000
The present worth of proposal A is given by,
PW (18%) = - P + A (P/F, i , n)
= -10,000 + 6,000 (P/F, 18, 1) + 6,000 (P/F, 18, 2) +
t
0
1 2 3 10
i =18 %
P= Rs. 12,000
0
1 2 3 15
i =12 %
P= 1,000
0
1 2 3 10 15
i =12 %
P= 1,000
The equation of present worth is given by,
PW (12%) = -1,000 + 4,000 (P/F, 12%, 10)
+ 4000 (P/F, 12%,15)
= -1,000 + 4,000 (0.3220) + 4,000 (0.1827)
= Rs 1,018.80/-
Present Worth Method – Unequal Lives
• When the assets have unequal lives, there must be comparison between
the alternatives based on equivalent outcomes.
• For example, a magazine offers the subscription for 3 years for Rs. 325
and for 5 years Rs 500. In this case comparison base on Rs 325 and Rs
500 will be inappropriate, because paying extra Rs 175 buys 2 more
years of issues.
• The following two methods are most commonly used to make comparison of
assets having unequal lives:
1. Common multiple method
2. Study period method
1. Common Multiple Method
• In this method, alternatives are co-terminated by selecting an analysis period
which is the Least Common Multiple (LCM) of the lives of the involved assets.
• For example, if the assets had lives of 3 and 4 years, then the Least Common
Multiple (LCM) is 12 years, which means the asset with 3 years life will be
replaced 4 times and that with life of 4 years will be replaced 3 times respectively.
Problem 7: Two types of trucks are available for transportation use. They are
needed for 10 years. The details are,
Details Truck A Truck B
First Cost Rs 10,00,000 Rs 15,00,000
Estimated annual Rs 20,000 Rs 15,000
maintenance cost
Estimated life 5 years 10 years
Estimated salvage value Rs 2,00,000 Rs 5,00,000
Both the truck deliver same amount of work. Assume interest rate of 7%. Which
truck is to be preferred on present worth basis?
Solved Problems
7.Soln: This is a problem with unequal lives. We can use common multiple
method for making a comparison. In this case the LCM is 10 years.
Truck 1: Given data: P= Rs. 10,00,000/- ; A = Rs. 20,000/- ; N = 5 yrs
i = 7% ; S = Rs. 2,00,000
The CFD for Truck A is shown below: S=Rs. 2,00,000
S=Rs. 2,00,000
0 1 2 3 4 5 6 7 8 9 10
t
Rs. 20,000 i =7 %
0 1 2 3 8 9 10
t
P=Rs. 15,00,000
required function. Asset A2 has an initial cost of Rs 32,000 and an expected salvage
value of Rs 4000 at the end of its 4 year service life. Asset A 1 costs 9000 less
initially, with an economic life 1 year shorter than that of A 2 ; but A1 has no salvage
value, and its annual operating costs exceed those of A 2 by Rs 2500. When the
required rate of return is 15% state which alternative is preferred when comparison
is by,
b)A2 year study period assuming the assets are needed for only 2 years.
Solved Problems
8. Soln: a) The repeated – project method
We can use common multiple method for making a comparison. In this
case the LCM is 12 years.
Asset A1
Given data: P= Rs. 23,000/- ; A = Rs. 2500/- ; n = 3 yrs ; i = 15%
i =15 %
0 1 2 3 4 5 6 7 8 9 10 11 12
years
A= Rs. 2500
Asset A2
0 4 8 12
years
i =15 %
How much will be left for the initial construction costs, after funds are allocated
for perpetual upkeep? Deposited funds can earn 6% annual interest and these
returns are not subject to taxes.
Solved Problems
Soln: The cash flow diagram for the given case is shown below.
0 1 10 20
years
A = 25,000 A = 25,000
i =6 %
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
years