Chapter SIX

Investment Evaluation

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Time Value of Money
 Money has the capacity to generate more money.

 If a sum of money is deposited in a savings account, it

earns interest; if it is used to purchase a share in a
business, it earns profits; if it is used to purchase an
office building, it earns rent.

 The term interest is used to denote the money earned

by the original sum of money regardless of whether
the earned money is referred to as "interests,"
"profits," or "rent" in ordinary commercial jargon.

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Time Value of Money

 The time rate at which a sum of money earns interest

is referred to as the interest rate.

 The interest rate is the ratio of the interest earned

during a given period of time to the sum that earned
this interest during that period.

 For example, if the sum of 10,000 birr earned 860 birr

interest in 1 year, the interest rate was 860/10,000=
8.6% per annum.

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Time Value of Money

 The productive use of money to earn interest is called

an investment.

 The money that earns interest is termed the capital.

 The capacity of money to enlarge itself with the

passage of time is referred to as the time value of
money.

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Time Value of Money

 The term payment will be used to denote any

exchange of money, regardless of whether the
business firm under consideration has received the
fixed sum of money or expended it.

 The two payments are distinguished from each other

by using the term receipt for money that enters the
firm and the term disbursement or expenditure for
money that leaves the firm.

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Cash Flow and Cash-Flow Diagram
 The set of payments associated with an investment is
referred to as its Cash flow.

 A diagram that depicts these payments is known as a

Cash-flow diagram.

 In a cash-flow diagram, time is plotted on a horizontal

axis, and the payments are represented by vertical
bars, the amount of each payments being recorded
directly above or below the bar representing it will be
placed below it.

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Cash Flow and Cash-Flow Diagram

 A project has the following cash flow: a expenditure of

$20,000 now, a receipt of $5,000 three years hence, a
receipt of $12,000 five years hence, and a receipt of
$14,000 eight years hence.

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Cash-flow diagram
 Basic Relationship Between Money and
Time
Consider the simplest form of investment that is
depositing money in a savings account and allowing it to
remain there for a given period of time.

The recurring cycle of events for this investment is

shown diagrammatically
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 Basic Relationship Between Money and
Time
 The sum of money that is earning interest at a given
instant is known as the principal in the account.

 At the expiration of a time interval called the interest

period, the interest that has been earned up to that
date is converted to principal, thereby causing it to
earn interest during the remainder of the investment.

 This process of converting the interest to principal is

referred to as the compounding of interest.

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 Basic Relationship Between Money and
Time

 For Example: At the beginning of a particular year, the sum of

$3000 was deposited in a savings account that earned interest at
6% per annum. The following Table traces the growth of this sum
during a 5-year period.

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 Basic Relationship Between Money and
Time
 Generally, let
 P = sum deposited in savings account at beginning of an interest
period
 F = principal in account at expiration of n interest periods
 i = interest rate

 The principal at the end of the first period is P + Pi = P(1+i). Thus,

the principal is multiplied by the factor (1+i) during each period.
Therefore, the principal at the end of nth period is:

 F = P(1+i)n

 F = P(1+i)5 = 3000(1.06) 5= $4014.68.

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 Significance of Time Value of Money
 Since money grows as time elapses, money and time
are inseparably linked in a two-dimensional
coordinate system.

 Is it preferable to receive $1000 today or $1000 one

year later?

 Is it preferable to expend $1000 now or $1000 one

year later?

 The sooner the money is received, the better; the

longer the expenditure of money delayed the better.

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Notation For Compound Interest Factors

 Each compound interest factor will be represented

symbolically in the following general format:

(A/B, n,i)

 Where, A and B denote two sums of money

 n = the number of interest periods
 i = the interest rate

 However, i can be omitted if it is given elsewhere.

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 Calculation of Future Worth

 In equation F = P(1+i)n , P and F refer to the present

worth and future worth respectively of the given sum
of money.

 The factor (1+i) n is termed the single-payment future-

worth factor. According to the above convention,

 (F/P,n,i) = (1+i)n

 The Equation may now be rewritten as:

 F = P(F/P,n,i)
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 Calculation of Future Worth

 Values of the single-payment future-worth factor are

presented in tables for most frequently encountered
interest rates.

 To specify the timing of payment, select a particular

date as zero time and number the units of time from
that date.

 Example :- Year 1 starts at zero time and year n

starts at n-l years after zero time.

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Calculation of Future Worth

Numbering of time units

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 Calculation of Future Worth

Example 1

If $2360 is invested at an interest rate of 7

percent per annum, what will be the value of
this sum of money at the end of 6 years?

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Calculation of Future Worth

Solution
F = P(F/P,n,i)
F = 2360(F/P,6,7%) = 2360(1.50073)= $3542

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Calculation of Future Worth

Example 2

Smith loaned Jones the sum of $3000 at the beginning

of year 1 and $5000 at the beginning of year 3. The
loans are to be discharged by a single payment made
at the end of year 6. If the interest rate of the loans is
8 percent per annum, what sum must Jones pay?

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Calculation of Future Worth

Solution

F = 3000(F/P,6,8%) + 5000(F/P,4,8%)
= 3000(1.58687) + 5000(1.36049) = $1l,563 This is the
amount that Jones must pay to discharge the debt.

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Calculation of Future Worth

Exercise 1

If the sum of $1000 is deposited in a fund earning 7.25

percent per annum, what will be the principal at the
end of 9 years?

Solution
F = P(1+i)n
F = 1000(1.0725)9 = $1877

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Calculation of Future Worth
Exercise 2
If $4500 is deposited in an account earning interest at
8 percent per annum compounded quarterly, what will
be the principal at the end of 6 years?

Solution
P = $4500 n = 6 X 4 = 24 i = 8%/4 = 2%
F = 4500(F/P,24,2%) = 4500(1.60844) = $7238
 Where the expression for the interest rate omits the
phrase “per annum,” its presence is understood. Thus,
the statement “interest at 6% compounded
semiannually” means that the interest period is a
half-year and the interest rate for this period is 3%,
i.e. 6%/2=3%.
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Calculation of Present Worth
F n
P  F (1  i )
(1  i ) n

 The factor (1+i)-n is termed the single-payment

present-worth factor.

It can be written as:

(P/F,n,i) = (1+i)-n
Hence, the equation may be rewritten as:
P = F(P/F,n,i)
 When a future sum of money is converted to its
present worth, it is said to be discounted.
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 Calculation of Interest Rate
 Solving equation F = P(1+i)n gives:-
1/ n
F
i   1
 P 

Calculation of Required Investment

Duration
Solving equation F = P(1+i)n gives:-
F = P(1+i)n
F/P = (1+i)n
log(F/P) = log (1+i)n
log(F/P) = n log (1+i)
Hence,
log( F / P)
n
12/3/2020 log(1  i)
Examples

1. A savings account earns interest at the rate of 6

percent per annum compounded quarterly. What sum
of money must be deposited in this account in the
present date if it is to amount to $5000 seven years
hence?

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Examples
Solution
F = $5000 n = 7 X 4 = 28 i = 1.5%
P = 5000(P/F,28,1/5%) = 5000(0.65910) = $3296

2. An individual possesses two promissory notes. The

first note has a maturity value of $1000 and is due 2
years hence. The second note has a maturity value of
$1500 and is due 3 years hence. As this individual
requires cash for his immediate needs, he wishes to
discount these notes (i.e., to assign them to another
individual or organization). If an investor wishes to
earn 7 percent, at what price should she offer to
purchase the notes?

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Examples
Solution
The maturity value of a note is the amount of money
that the holder of the note is entitled to receive at the
specified date. The proposed purchase price is:
P = 1000(P/F,2,7%) + 1500(P/F,3,7%)
= 1000(0.87344) + 1500 (0.81630)
= 873.44 + 1224.45 = 2097.89

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 Examples
3.An individual borrowed $3000 and discharged the
debt by a payment of $4500 four years later. What
annual interest rate did this individual pay, to the
nearest tenth of a percent?

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Examples

Solution
P = $3000 F = $4500 n=4
= 1.107 – 1 = 0.107 = 10.7%

4. If a given sum of money is invested at 13 percent, in

how many years will it treble in value (to the nearest
integer)?

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Examples

Solution

F = 3P
log( F / P)
n
log(1  i )

log( 3P / P) log 3 0.47712

=   9
log(1  0.13) log 1.13 0.05308

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Meaning of Equivalence

 If money is worth 8 percent, the payment of $10,000

at a given date and the payment of $12,597 at a date 3
years later are equivalent to one another.

 In general, two alternative payments are equivalent

to one another if the monetary worth of the firm will
eventually be the same regardless of which payment
is made.

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Examples

1. An individual invested the following sums at a 7

percent rate of return: $3000 at the beginning of year
1, $2000 at the beginning of year 5, and $1600 at the
beginning of year 8. What was the monetary worth of
this individual at the beginning of year 12 that
resulted from these investments?

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Examples

Solution

The monetary worth is the value of the set of

investments based on an interest rate of 7 percent.
Select the beginning of year 12 as the valuation date.
Monetary worth = 3000(F/P,11) + 2000(F/P,7) + 1600(F/P,4)
= 3000(2.10485) + 2000(1.60578) + 1600(1.31080)
= $11,623
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 Example

2. A business firm contemplating the installation of

labor-saving machinery has a choice of two models.
Model A will cost $36,500 and model B will cost
$36,300. The major repairs required under each model
are estimated to be the following: model A, $1500 at
the end of the fifth year and $2000 at the end of the
tenth year; model B, $3800 at the end of the ninth
year. The models are alike in all other respects. If this
firm is earning 7 percent on its capital, which model is
more economical?

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Example
Solution
Select the purchase date as the valuation date. The
value of the specified expenditures is as follows:

Model A
36,500 + 1500(P/F,5) + 2000(P/F,10) = 36,500 +
1500(0.71299) + 2000(0.50835)
= $38,586

Model B
36,300 + 3800(P/F,9)= 36,300 + 3800(0.54393) = $38,367
Therefore, Model B is more economical.

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Exercise

1. If money is worth 10 percent, what single payment

made at the beginning of year 7 is equivalent to the
following set of payments: $600 at the beginning of
year 1, $3200 at the beginning of year 2, and $4000
at the beginning of year 10?

2. The following set of payments is given: $800 at the

beginning of year 2, and $500 at the beginning of
year 6. On the basis of an 8 percent interest rate, this
set of payments is to be transformed to an equivalent
set consisting of the following: a payment of X at the
beginning of year 5, and a payment of 2X at the
beginning of year 9. Find the payments under the
second set, and verify the values.
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Change of Interest Rate

 If the interest rate changes at a particular date, this

date serves to divide time into two intervals, each
characterized by a specific interest rate.

 If a given sum of money is to be carried from one

interval to the other, it is necessary to find its value at
the boundary point.

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Example

1. The sum of $800 was deposited in a fund that earned

4 percent per annum for the first 3 years and 5
percent per annum thereafter. What was the
principal in the fund 12 years after the date of
deposit?

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Example
Solution
 At the end of the third year, the principal was
800(F/P,3,4%). The principal then grew at the rate of 5
percent per annum for the remaining 9 years, and it
then amounted to:

 800(F/P,3,4%)(F/P,9,5%) = 800(1.12486)(1.55133) =
$1396

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 NPV Method
CF1 CF2 CFT
PV  CF0    ... 
(1  r ) (1  r ) 2
(1  r )T
 1   1   1 
 CF0   CF1   CF2  ...  
2 
CFT
 1  r   (1  r )   (1  r ) T

T
CFt
NPV    I • PV= Total present value
t 1 (1  r ) t
• NPV= Net Present Value
• I = initial investment outlay
• CFt = project cash flow in period t
• r = discount rate (shareholders’ opp. cost)
• T = project termination period
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 NPV Method…..
• Net present value ratio (NPVR) = Profitability index
= PV of cash inflows
PV of investment
The NPV rule:
Accept project if NPV > 0
If we accept a project with NPV > 0
 increase shareholder wealth
If we accept a project with NPV < 0
 decrease shareholder wealth

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 Example
1. Determine the net present value for a project
that costs $86,100 and would yield after-tax
cash flows of $16,000 the first year, $18,000
the second year, $21,000 the third year,
$23,000 the fourth year, $27,000 the fifth
year, and $33,000 the sixth year. The firm's
cost of capital is 12.00%. Is the project
acceptable?

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 Project Cash Discount
Years flow factor PV
0 -86,100 1 -86100
1 16,000 0.892857 14285.71
2 18,000 0.797194 14349.49
3 21,000 0.71178 14947.39
4 23,000 0.635518 14616.92
5 27,000 0.567427 15320.53
6 33,000 0.506631 16718.83
NPV
4138.857
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Net Present Value
The advantages of using NPV are:
 It introduces the time value of money.
 It expresses all future cash-flows in today's values,
which enables direct comparisons.
 It allows for inflation and escalation.
 It looks at the whole project from start to finish.
 It can simulate project what-if analysis using
different values.
 It gives a more accurate profit and loss forecast than
non DCF calculations.

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Net Present Value
The disadvantages are:-
 Its accuracy is limited by the accuracy of the
predicted future cash-flows and interest rates.
 It is biased towards short run projects.
 It excludes non financial data e.g. market potential.
 It uses a fixed interest rate over the duration of the
project.

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 Internal rate of return (IRR)
 The IRR is the value of the discount factor when
the NPV is zero. It is assumed that the costs are
committed at the end of the year and these are
the only costs during the year.
Decision Rule
A project should only be accepted if its IRR is NOT less
than the target internal rate of return.
T
CFt
0 I
t 1 (1  IRR)
t

IRR = I1 + PV (i2 – i1 ) , where

PV + /NV/
PV= positive NPV
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NV= negative NPV
 IRR calculation
• Guess the value of r and calculate the NPV of the
project at that value
• If NPV is close to zero then IRR is equal to r.
Or
Apply the formula for the determination of IRR.

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 Example
1. Determine the IRR value for a project that costs
$86,100 and would yield after-tax cash flows of
$16,000 the first year, $18,000 the second year,
$21,000 the third year, $23,000 the fourth year,
$27,000 the fifth year, and $33,000 the sixth year.
The firm's cost of capital is assumed to be 12.00%.
Determine also whether the project is accepted or
not.

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 Years Project Cash flow
Discount factor
PV
0 -86,100 1 -86100
1 16,000 0.88106 14096.9
2 18,000 0.77626 13972.7
3 21,000 0.68393 14362.5
4 23,000 0.60258 13859.4 IRR= 13.46
5 27,000 0.53091 14334.5
6 33,000 0.46776 15436.1
NPV -37.777
r NPV
14 -1364.9343
13.5 -37.7770
13.49 -10.8200
13.458 -2.8302
13.48 16.1468
13 1321.4090
12 4138.857

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Opportunity Costs

 Opportunity cost is the cost related to the next-best

choice available to someone who has picked between
several mutually exclusive choices.

 the cost expressed in terms of the next best

alternative sacrificed

 Helps us view the true cost of decision making

 Implies valuing different choices

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12/3/2020
Examples

 A person who decides to quit his job and go back to

school to increase his future earning potential has an
opportunity cost equal to his lost wages for the period
of time he is in school.

 Conversely, if the person elect to remain employed

and not return to school then the opportunity cost of
that action is the lost potential wage increase.

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Sunk Cost

 A sunk cost is an expenditure that was made in the

past and that exerts no direct influence on future cash
flows.

 Therefore, it is irrelevant in an economy analysis.

 Sunk costs are costs that must be paid whether or not

you do something.

 Unfortunately, sunk costs are like continual weeds;

it's often hard to yank them out of a problem.

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Example

 For example, let's say you designed a banner ad for a

certain website (cost: $1000) and paid to run the ad for
three months (cost: $2000). At the end of the three
months, you look at the results and they're horrible —
barely anyone clicked the ad and none of those people
made a purchase.

 Clearly you won't spend any more time or money on

that ad. Yes you spent $3000, but that's a "sunk cost"
— you cannot get that money back. Whether you had
spent $30 or $30,000, it still wouldn't be worth
continuing this project.

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Example

 A company is building a new $20 million

manufacturing plant. They burn through the $20m,
but it now it's clear that it will take another $10m to
complete the project. In the meantime, an opportunity
has appeared where they could take over a different
manufacturing plant for only $2m.

 From a completely rational perspective, they should

abandon the original project. The $20m they've spent
can't be recovered (Sunk Cost), so it's now just a
choice between spending $2m or $10m.

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Inflation

 The rate at which the general level of prices for goods

and services is rising, and, subsequently, purchasing
power is falling.

 Inflation affects you directly when you go to market

but find that a hundred birr doesn’t get you the same
amount did last five years.

 Many people hang on their money and stop spending

on many non-essential items because of fear.

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 Inflation

 For a given commodity, let

Cr-1 = cost of commodity at beginning of first year
Cr = cost of commodity at end of rth year
q = (effective) rate of inflation for rth year

 The rate of inflation for a given year is the ratio of the

increase in cost of the commodity during that year to
the cost at the beginning of the year, that is:

C r  C r 1
q
C r 1

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Inflation

For example,
If the cost of the commodity is $20 at the beginning of
a particular year and the rate of inflation for that year
is 10%, the cost of the commodity at the end of the
year would be:
C r  C r 1
q
C r 1
20 + 20(0.1) = $22

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Inflation

 If the annual rate of inflation q remains constant for n

years, the cost of the commodity at the end of that
period is:

C n  C o (1  q ) n

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 Example

1. A commodity cost $30 per unit at the beginning of the

first year. The annual rate of inflation was 2 percent
for the first 3 years, 5 percent for the fourth year and
8 percent for the fifth year. What did the commodity
cost the end of the fifth year?

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Inflation

Solution
C3 = 30(1.02)3 C4 = C3(1.05) C5 = C4(1.08)
Then, C5 = 30(1.02)3(1.05)(1.08) = $36.10/unit

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Example

2. A newly acquired machine is expected to last 7 years

and to be replaced at that time with another machine
of identical type. The cost of the machine was $12,000
and its scrap value at the end of 7 years is estimated
as $3000 on the basis of current prices. If the inflation
rate during this 7-year period is expected to be 4
percent per annum, what will be the next expenditure
to replace the machine?

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Example

Solution
As a result of inflation, the cost of the second machine
will exceed $12,000, and the income that accrues from
scrapping the first machine will exceed $3000. By
Equation C n  C o (1  q) n , we have:
Net expenditure = (12,000-3000)(1.04)7 = $11,843

Usually the inflation rate varies from year to year, but

it is often advantageous to calculate an equivalent
uniform inflation rate qe for a given period.

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Example
3. The inflation rate was 5.6 percent for the first year,
4.9 percent for the second year and 8.7 percent for the
third year. Find the value of qe for this three-year
period, to three significant figures.

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Example

Solution
(1 + qe)3 = (1.056)(1.049)(1.087)
(1 + qe) = (1.056)(1.049)(1.087) 1/3 = 1.0639
Then, qe = 6.39%
This equivalent rate is a geometric mean of the true
rates.

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Exercise
1. On April 1 of year 1, a bank account had a balance
of $8000. A deposit of $1600 was made on January
1 of year 2, a withdrawal of $2900 was made on
April 1 of year 4 and a deposit of $700 was made
on October 1 of year 7. If the interest rate of the
account was 4 percent compounded quarterly, what
was the principal on July 1 of year 8? Ans. $10,035

2. A firm borrowed $10,000 at the beginning of year 1

and $9000 at the beginning of year 3. It discharged
the debt by making a payment of $43,000 at the
end of year 8. What annual interest rate did the
firm pay? Ans. 12.2 percent

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Exercise
3. The parents of a newborn child wish to have the sum
of $50,000 available at the child’s seventeenth
birthday. What sum must they set aside at the
present time if it is expected to earn interest at 7
percent per annum for the first 10 years and 8 percent
per annum thereafter? Ans. $14,831

4. A firm invested $50,000 in a venture that lasted 1

year, and it received the sum of $72,000 when the
venture terminated. Of the $22,000 profit, $16,000
was taxed at the rate of 46 percent and the remainder
was taxed at the rate of 22 percent. What was the
after-tax investment rate? Ans. 26.64

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Exercise
5. An individual’s current income is $42,000 per year.
If the inflation rate is expected to be 4.5 percent per
annum through the foreseeable future, what must
this individual’s income be 5 years hence if it is
merely to keep pace with inflation? Ans. $52,340
per year

6. The cost of a commodity underwent the following

variations: year 1, an increase of 18.6 percent; year
2, an increase of 7.8 percent; year 3, a decrease of
2.6 percent; year 4, an increase of 5.3 percent. What
was the equivalent uniform rate of increase of the
cost of this commodity during this four-year period?
Ans. 7.01 percent per annum
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Introduction

 Businesses must make a profit to survive

 To make a profit, income must be higher than

expenditure (or costs)

Income $50,000 Income $50,000

Costs $40,000 Costs $60,000
Profit $10,000 Loss $10,000

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Break-even Analysis

 One of the most common tools used in evaluating the

economic feasibility of a new enterprise or product is
the break-even analysis.

 The break-even point is the point at which revenue is

exactly equal to costs.

 At this point, no Profit is made and no losses are

incurred. The break-even point can be expressed in
terms of unit sales or dollar sales.

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Break-even Analysis

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Break-even Analysis

 The break-even units indicate the level of sales that

are required to cover costs.

 Profit region : the out put level of the variable Q

grater than the break even point , where total revenue
is greater than total costs.

 Loss region : the output level of the variable Q less

than the break even point, where total costs are
greater than total revenue.

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 Use Break-even Analysis in Engineering
Economy
 Break-even analysis can be very helpful in the
evaluation of a new venture.
 Many new enterprises and products actually operate
at a loss (at a point below break-even) in the early
stages of development.
 Knowing the price or volume necessary to break-even
is critical to evaluating the time-frame in which losses
are acceptable.
 The break-even is also an excellent benchmark by
which a company’s short-term goals can be
measured/tracked.

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Costs Related to Break-even Analysis

 Break-even analysis is based on two types of costs:

fixed costs and variable costs.

 Fixed costs (FC) are constant and do not change as

the level of output changes.

 Variable costs (VC) are not constant and do change

with the level of output. Because of this, variable
expenses are often stated on a per unit basis.

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Costs Related to Break-even Analysis

 For example in a production environment fixed costs

such as factory floor space and equipment ,remain the
same even though production quantity number of
employees and level of work in process may vary.

 Labor costs are classified as a variable cost because

they depend on the number of employees in the
factory .

 Thus fixed costs level or constant regardless of output

or activity, and variable costs are changing and
related to the level of out put or activity.

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Costs Related to Break-even Analysis

Total Costs = Total Variable Costs + Total Fixed Costs

TC=VC+FC

When total costs = Total Revenue, this is called the break-

even point,
Total Expenses=Total Sales
TC=TR
Example
 total costs = $5,000

 total sales revenue = $5,000

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 Notational System for Break Even
Analysis
 TC = total cost
 TR = Total Revenue
 FC = Fixed Cost
 VC = Variable Cost per unit
 P = Selling price per unit
 QB = Break even point

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Equations of break even analysis
Equate total revenue and total cost functions and solve
for QB
TR = P x Q
TC = FC + (VC x Q)
TR = TC
P x QB = FC + VC x QB
(P x QB) – (VC x QB) = FC
QB (P – VC) = FC
QB = FC/(P – VC) , break even units
PQ = (FCxP)/(P-VC)
= ((FCxP)/P)/((P-VC)/P)
= FC/((P/P) – (VC/P))
12/3/2020 = FC/(1-VC/P), break even sales
Break-even Analysis

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Example
1. A local livestock producer utilizes compost waste to
develop an organic fertilizer product. The fertilizer is
prepared for retail sale in 50 pound bags. The retail
sales price is $5.00 per bag. The average variable cost
per bag is $2.80 and average annual fixed costs are
$60,000. Calculate the number of bags that must be
sold in order to break-even as well as the total dollar
of sales needed to break-even?

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Example
Solution
 Using the formulas explained earlier, the following
calculations can be made:
QB = FC/(P – VC)
 Break-Even Units: $60,000.00 ÷ ($5.00 - $2.80) =
27,273 bags
Break even sales=FC/(1-(VC/P))
 Break-Even Sales: $60,000.00 ÷ 1 - ($2.80 ÷ $5.00) =
$136,365

 Therefore, no profits are made from the sale of this

product until more than 27,273 bags are sold or more
than $136,365 in gross sales is generated.
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Exercise
Tom can rent candy machine for an afternoon
at a summer celebration. The machine rent will be $100
and the variable cost will $50 per candy. Tom thinks a
sensible selling price will be $1.50.
At this price, how many candy must he sell to cover his
costs? Calculating this will help Tom to decide if the idea
is worthwhile.

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Break Even Point Between Two Alternatives

Two production methods to accomplish

same task

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Break Even Point Between Two Alternatives
 To find the break even point the variable must be
common to both alternatives.

 The intersection of the two TC lines locates the break

even point

 If the number of units of the common variables is

expected to greater than the breakeven amount
alternative 1 is selected , since the total cost of the
operation will be lower

 on the other hand, an anticipated level of operation

below the breakeven point favors alternative 2
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Break Even Point Between Two Alternatives

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Example

2. Two companies, A and B, manufacture the same

commodity. Company A uses a mechanized process,
and company B relies mainly on manual labor. The
fixed cost is $40,000 per month for A and $15,000 per
month for B. The directly varying cost is $14 per unit
for A and $52 per unit for B. The selling price is $85
per unit for each company.
a) At what volume of production are the total costs of
the two companies identical?
b) How many units must each company sell each month
merely to avoid a loss?

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Example
Solution
FCA=$40,000 per month
FCB=$15,000 per month
VCA=$14 per unit
VCB =$52 per unit
PA=PB=$85 per unit
X= number of units produced and sold per month
TCA=TCB=total cost of producing X units

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Example

Solution
The total costs are equal at the point where
TCA =TCB

 TCA=FCA+VCA=40,000+14X
 TCB=FCB + VCB= 15,OOO + 52X
40,000+ 14X = 15,000+ 52X
X = 658 units/month

This break-even point reveals that the minimum

production that is needed to justify use of the
mechanized process.
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Example

Solution
By Applying the following equation, we obtain
Q = FC/(P – VC)

QA= 40,000/(85-14)=40,000/71=563 units/month

QB=15,000/(85-52)=15,000/33=455 units/month

 Thus, companies A and B must sell 563 and 455 units

per month, respectively, merely to avoid a loss.

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Payback Period
 The pay back period is defined as the length of
time required to recover one’s investment.

 The time period is usually expressed in years and

months.

Net investment
Pay back Period =
Net annual income from investment

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  To calculate the pay back period, simply work out
how long it will take to recover the initial outlay.
Decision Rule

 Accept the project only if its payback period is

LESS than the target payback period.

 In multi-projects evaluations, select the least

payback period project

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 Cash flow of two alternative machines

Year 0 1 2 3 4
Machine A
Cash flow (Birr) -35,000 +20,000 +15,000 +10,000 +10,000
Machine B
Cash flow (Birr) -35,000 +10,000 +10,000 +15,000 +20,000

 Pay back period for machine A is two years where as

for machine B it is three years.
 That is machine A will recover its investment cost one
year sooner than machine B.
 Where project’s are ranked by the shortest pay back
period, machine A is selected in preference to machine
B.
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 Example

Company C is planning to undertake an expansion

project requiring initial investment of Birr 50 million
and is expected to generate Birr 10 million in Year 1,
Birr 13 million in Year 2, Birr 16 million in year 3, Birr
19 million in Year 4 and Birr 22 million in Year 5.
a)Calculate the payback value of the project.
b)If the target pay back period is 3.5 years, can the
project be accepted?

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The advantages of the payback method are:
 It is simple and easy to use.
 It uses readily available accounting data to
determine cash-flows.
 It reduces the project's exposure to risk and
uncertainty by selecting the project that has the
shortest payback period.
 Faster payback has a favorable short-term effect on
earnings per share.
Disadvantages of the Pay back Period:
 It ignores the life of the project beyond the pay
back period.
 It does not consider the profitability of the projects.
 It dose not consider the time value of money.
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Return on Investment (ROI)
 This method first calculates the average annual profit,
which is simply the project outlay deducted from the
total gains, divided by the number of years the
investment will run.

 The profit is then converted into a percentage of the

total outlay using the following equations:

Average Annual = (Total gains)-(Total outlay)

Profit Number of years

Return on Investment= Average Annual Profit

X 100%
Original Investment
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Using the machine selection project

Profit (A & B) = $55,000 - $35,000

Annual Profit= 20,000 = $5,000 per year (same for both
4 machines)

Return on Investment= 5,000 X 100% = 14%

35,000
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 The return on investment method has the advantage
of also being a simple technique like pay back period,
but further, it considers the cash-flow over the whole
project.

 The main criticism of return on investment is that it

averages out the profit over successive years. An
investment with high initial profits would be ranked
equally with a project with high profits later if the
average profit was the same.

 It does not consider the time value of money

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