CTC 475 Review

Comparing Alternatives Alternatives can be developed from various

proposals Planning horizons must be the same (LCM,

Shortest Life, Longest Life, predetermined life)

CTC 475

Comparing Alternatives

Objectives

Know how to apply the ranking method Know how to apply the incremental method Know different ways to do a supplementary

analysis Know how to sell your project

Steps for Comparing Alternatives

1. Determine the feasible alternatives

2. Define the planning horizon

3. Develop the cash flow profiles

4. Specify the MARR

5. Compare the alternatives

6. Perform supplementary analyses

7. Select the preferred alternative

Comparing Alternatives – 2 Approaches

Ranking Approach (PW, AW, FW)Compute the value for each alternative and rank the alternatives on the basis of the value you obtain

Incremental Approach (PW, AW, FW, IRR/ERR, SIR)

Comparisons are based on the differences in the cash flows for combinations of alternatives

Why not rank for IRR/ERR/SIR?

Someone borrows $100 from you and pays you back 1 year later with $150– Rate of return = ?

Someone borrows $1 from you and pays you back 1 year later with $2– Rate of return = ?

Which do you prefer?

Three Alternatives (MARR-15%)

EOY A B C

0 $0 -$50K -$75K

1 $4500 $20K $20K

2 $4500 $20K $25K

3 $4500 $20K $30K

4 $4500 $20K $35K

5 $4500 $20K $40K

Ranking Method-PW

Alt A: PW=4,500(P/A15,5)=$15,085

Alt B: PW=-50K+20K(P/A15,5)=$17,044

Alt C: PW=-75K+20K(P/A15,5)+5K(P/G15,5) =$20,920

Rank: Alt C is best

(Alt B is 2nd; Alt A is 3rd)

Steps for Incremental Analysis

1. Order alternatives according to size of initial investment

2. Find the first alternative that is feasible

3. If first alternative is feasible, find the difference in cash flows between the first 2 alternatives (2-1)

4. Determine if 2 is better than 1 (PW/AW/FW/IRR/ERR/SIR)

5. If 2 is better than 1 then compare the next 2 alternatives

Incremental Method (PW)

Step 1-Order alternatives from lowest to highest initial investment

Alt A $0 Alt B $50K Alt C $75K

Incremental Method (PW)

Step 2-Find first alternative that is economically feasible

Alt A PW>0 (feasible)

Compare B-A

EOY Cash Flow (B-A)

0 -50K

1 15.5K

2 15.5K

3 15.5K

4 15.5K

5 15.5K

Calc PW of B-A

PW=-50K+15.5K(P/A15,5)=+1,959

PW>0 therefore Alt B is better than Alt A

Compare C-B

EOY Cash Flow (C-B)

0 -25K (=-75K-(-50K))

1 0K (=20K-20K)

2 5K

3 10K

4 15K

5 20K

Calc PW of C-B

PW=-25K+5K(P/G15,5)=+3,876

PW>0 therefore Alt C is better than Alt B

Incremental Method (IRR)

Compare B-A Compare C to the “winner”

Cashflow of B-A

EOY Cash Flow (B-A)

0 -50K

1 15.5K

2 15.5K

3 15.5K

4 15.5K

5 15.5K

Calc IRR of B-A Cashflow

FW=-50K(F/PIRR,5)+15.5K(F/AIRR,5)=0 IRR=16.5%

IRR>MARR ------Alt B is better than Alt A

Cashflow of C-B

EOY Cash Flow (C-B)

0 -25K

1 0K

2 5K

3 10K

4 15K

5 20K

Calc IRR of 3-2 Cashflow

FW=-25K(F/PIRR,5)+5K(P/GIRR,5) (F/PIRR,5 ) =0 IRR=19.4%

IRR>MARR ------Alt C is better than Alt B

ERR using incremental method

Calc ERR of B-A Cashflow

50K(1+ERR)5=15.5K(F/A15,5) ERR=15.9%

ERR>MARR ------Alt B is better than Alt A

Calc ERR of C-B Cashflow

25K(1+ERR)5=5K (P/G15,5)(F/P15,5) ERR=18.4%

ERR>MARR ------Alt C is better than Alt B

SIR using incremental method

Calc SIR of B-A Cashflow

PW(+)/PW(-) 15.5K(P/A15,5)/50K SIR=1.01

SIR>1 ------Alt B is better than Alt A

Calc SIR of C-B Cashflow

PW(+)/PW(-) 5K(P/G15,5)/25K SIR=1.16

SIR>1 ------Alt C is better than Alt B

PBP

Alt A---PBP is instantaneous Alt B---PBP=2-3 years Alt C---PBP=3 years

If ranked by PBP A,B,C (opposite of other methods)

Supplementary Analyses

Breakeven Sensitivity Risk

Breakeven

Value may not be known for certain but can determine the break even value

Sensitivity

Determine how sensitive the final decision is to values you used.

How far off can the estimates be and still get the same answer?

Risk

Range of values are represented by probabilities

Selling the alternative

Management’s perspective is broad; develop the justification accordingly

Technical aspects should not be oversold Seek support from all parties prior to submission Timing is important Think about what you would want if you were the

boss Support your proposal w/ facts, not fantasy

Next lecture

Benefit/Cost Analyses