COMPARISON OF ALTERNATIVES

Col Vivek Mathur, Retd

 Comparison of Alternatives
• The different cost elements and other parameters
to be considered while making the economic
comparison of the alternatives are: -
– Initial cost,
– Annual operating and maintenance cost,
– Annual income or receipts,
– Expected salvage value,
– Income tax benefit and
– Useful life.
• When only one, among the feasible alternatives is
selected, the alternatives are said to be mutually
exclusive.
 Comparison of Alternatives
• In the economic comparison of alternatives, cost or
expenses are considered as negative cash flows. On
the other hand the income or revenues are
considered as positive cash flows.
• Some projects involve initial capital investment i.e.
cash outflow at the beginning and show increased
income or revenue i.e. cash inflow in the
subsequent years. The alternatives having this type
of cash flow are known as investment alternatives.
• While comparing the mutually exclusive investment
alternatives, the alternative showing maximum
positive cash flow is generally selected.
• Eg Dozer procurement
 Comparison of Alternatives
• There are some other projects which involve
only costs or expenses throughout the useful life
except the salvage value if any, at the end of the
useful life. The alternatives having this type of
cash flows are known as cost alternatives.
• Thus while comparing mutually exclusive cost
alternatives, the alternative showing minimum
negative cash flow is generally selected.
• Eg Road alignment
 Comparison of Alternatives
• The economic comparison of mutually exclusive
alternatives can be carried out by different
equivalent worth methods
– Present worth method,
– Future worth method and
– Annual worth method.
• In these methods all the cash flows i.e. cash
outflows and cash inflows are converted into
equivalent present worth, future worth or annual
worth considering the time value of money at a
given interest rate per interest period.
 Comparison of Alternatives
• The different compound interest factors namely
single payment present worth factor, uniform
series present worth factor and present worth
factors for arithmetic and geometric gradient
series etc. will be used to convert the respective
future amounts to the equivalent present worth
values for different alternatives.
• The useful lives of the two alternatives should
be the same. If not, the period considered
should be the LCM of the two useful lives.
 Comparison of Alternatives over a
Specific Period
• The length of the study period may depend on the overall
benefit of the project i.e. it may be shorter or longer (as
compared to useful lives of the individual alternatives).
• The cash flows of the alternatives occurring during the
study period are only considered for the economic
comparison.
• However, if any alternative possesses salvage value at the
end of its useful life and that occurs after the study
period, then its equivalent value must be included in the
economic analysis.
• The values of equivalent present worth of the mutually
exclusive alternatives are calculated over the selected
study period and the alternative showing maximum
positive equivalent present worth or minimum negative
equivalent present worth is selected.
 Question 1
• There are two alternatives for purchasing a concrete mixer.
Both the alternatives have same useful life. The cash flow
details of alternatives are as follows;
• Alternative-1:
– Initial purchase cost = Rs.3,00,000,
– Annual operating and maintenance cost = Rs.20,000,
– Expected salvage value = Rs.1,25,000,
– Useful life = 5 years.
• Alternative-2:
– Initial purchase cost = Rs.2,00,000,
– Annual operating and maintenance cost = Rs.35,000,
– Expected salvage value = Rs.70,000,
– Useful life = 5 years.
• Using present worth method, find out which alternative
should be selected, if the rate of interest is 10% per year.
Summary
 Question 2
• There are two alternatives for purchasing a concrete mixer. Both the
alternatives have same useful life. The cash flow details of alternatives
are as follows;
• Alternative-1:
– Initial purchase cost = Rs.3,00,000,
– Annual operating and maintenance cost = Rs.20,000,
– Expected salvage value = Rs.1,25,000,
– Useful life = 5 years.
– Revenue generated from production = Rs.50,000
• Alternative-2:
– Initial purchase cost = Rs.2,00,000,
– Annual operating and maintenance cost = Rs.35,000,
– Expected salvage value = Rs.70,000,
– Useful life = 5 years.
– Revenue generated from production = Rs.40,000
• Compute the equivalent present worth of the alternatives at the rate
of interest of 10% per year and find out the economical alternative.
 Question 3
• A construction contractor has three options to purchase a dump truck
for transportation and dumping of soil at a construction site. All the
alternatives have the same useful life. The cash flow details of all the
alternatives are provided as follows;
• Option-1: Initial purchase price = Rs.25,00,000, Annual operating cost
Rs.45,000 at the end of 1st year and increasing by Rs.3,000 in the
subsequent years till the end of useful life, Annual income =
Rs.1,20,000, Salvage value = Rs.5,50,000, Useful life = 10 years.
• Option-2: Initial purchase price = Rs.30,00,000, Annual operating cost
= Rs.30,000, Annual income Rs.1,50,000 for first three years and
increasing by Rs.5,000 in the subsequent years till the end of useful
life, Salvage value = Rs.8,00,000, Useful life = 10 years.
• Option-3: Initial purchase price = Rs.27,00,000, Annual operating cost
Rs.35,000 for first 5 years and increasing by Rs.2,000 in the successive
years till the end of useful life, Annual income = Rs.1,40,000, Expected
salvage value = Rs.6,50,000, Useful life = 10 years.
• Using present worth method, find out which alternative should be
selected, if the rate of interest is 8% per year.
 Question 4
• A material testing laboratory has two alternatives for purchasing a
compression testing machine which will be used for determining the
compressive strength of different construction materials. The
alternatives are from two different manufacturing companies. The
cash flow details of the alternatives are as follows;
• Alternative-1: Initial purchase price = Rs.1000000, Annual operating
cost = Rs.10000, Expected annual income to be generated from testing
of different construction materials = Rs.175000, Expected salvage
value = Rs.200000, Useful life = 10 years.
• Alternative-2: Initial purchase price = Rs.700000, Annual operating
cost = Rs.15000, Expected annual income to be generated from testing
of different construction materials = Rs.165000, Expected salvage
value = Rs.250000, Useful life = 5 years.
• Using present worth method, find out the most economical alternative
at the interest rate of 10% per year.
 Question 5
• A construction firm has decided to purchase a dozer to be employed at
a construction site. Two different companies manufacture the dozer
that will fulfill the functional requirement of the construction firm. The
construction firm will purchase the most economical one from one of
these companies. The alternatives have different useful lives. The cash
flow details of both alternatives are presented as follows;
• Company-A Dozer: Initial purchase cost = Rs.3050000, Annual
operating cost Rs.40000 at end of 1st year and increasing by Rs.2000 in
the subsequent years till the end of useful life, Annual income =
Rs.560000, Expected salvage value = Rs.1050000, Useful life = 6 years.
• Company-B Dozer: Initial purchase cost = Rs.4000000, Annual
operating cost = Rs.55000, Annual revenue to be generated Rs.600000
at the end of 1st year and increasing by Rs.5000 in the subsequent
years till the end of useful life, Expected salvage value = Rs.1000000,
Useful life = 12 years.
• Using present worth method, find out the most economical alternative
at the interest rate of 7% per year.