UNIT – V

Methods of Comparison of Alternatives–Present Worth Method of Comparison ( Revenue

Dominated Cash flow Diagram, Cost Dominated Cash Flow Diagram),Future Worth Method
Comparison (Revenue Dominated Cash Flow Diagram, Cost Dominated Cash Flow Diagram),
Annual Equivalent Method of Comparison (Revenue Dominated Cash Flow Diagram, Cost
Dominated Cash Flow Diagram), Rate of Return Method, Examples in all the methods.

BASES FOR COMPARISON OF ALTERNATIVES

In most of the practical decision environments, executives will be forced to select the best
alternative from a set of competing alternatives. Let us assume that an organization has a huge
sum of money for potential investment and there are three different projects whose initial
outlay and annual revenues during their lives are known. The executive has to select the best
alternative among these three competing projects
There are several bases for comparing the worthiness of the projects. These bases
are:

1. Present worth method

2. Future worth method
3. Annual equivalent method
4. Rate of return method
PRESENT WORTH METHOD OF COMPARISON
INTRODUCTION
In this method of comparison, the cash flows of each alternative will be reduced to time zero
by assuming an interest rate i. Then, depending on the type of decision, the best alternative
will be selected by comparing the present worth amounts of the alternatives.

The sign of various amounts at different points in time in a cash flow diagram is to be decided
based on the type of the decision problem. In a cost dominated cash flow diagram, the costs
(outflows) will be assigned with positive sign and the profit, revenue, salvage value (all
inflows), etc. will be assigned with negative sign. In a revenue/profit-dominated cash flow
diagram, the profit, revenue, salvage value (all inflows to an organization) will be assigned
with positive sign. The costs (outflows) will be assigned with negative sign.

In case the decision is to select the alternative with the minimum cost, then the alternative with
the least present worth amount will be selected. On the other hand, if the decision is to select
the alternative with the maximum profit, then the alternative with the maximum present worth
will be selected.
 REVENUE-DOMINATED CASH FLOW DIAGRAM
A generalized revenue-dominated cash flow diagram to demonstrate the present worth
method of comparison is presented in Fig. 4.1.

In Fig. 4.1, P represents an initial investment and Rj the net revenue at the end of the jth year.
The interest rate is i, compounded annually. S is the salvagevalue at the end of the nth year.
To find the present worth of the above cash flow diagram for a given Interest rate, the formula is

PW(i) = – P + R1[1/(1 + i)1] + R2[1/(1 + i)2] + ...

+ Rj[1/(1 + i) j] + Rn[1/(1 + i)n] + S[1/(1 + i)n]
In this formula, expenditure is assigned a negative sign and revenues are assigned a positive
sign.
If we have some more alternatives which are to be compared with this alternative, then the
corresponding present worth amounts are to be computed and compared. Finally the alternative
with the maximum present worth amount should be selected as the best alternative.
COST-DOMINATED CASH FLOW DIAGRAM
A generalized cost-dominated cash flow diagram to demonstrate the present worth method of
comparison is presented in Fig. 4.2.
In Fig. 4.2, P represents an initial investment, Cj the net cost of operation and
maintenance at the end of the jth year, and S the salvage value at the end of the nth year.

To compute the present worth amount of the above cash flow diagram for a
given interest rate i, we have the formula

PW(i) = P + C1[1/(1 + i)1] + C2[1/(1 + i)2] + ... + Cj[1/(1 + i) j] +

Cn[1/(1 + i)n] – S[1/(1 + i)n]

In the above formula, the expenditure is assigned a positive sign and the revenue a negative
sign. If we have some more alternatives which are to be compared with this alternative, then
the corresponding present worth amounts are to be computed and compared. Finally, the
alternative with the minimum present worth amount should be selected as the best alternative.

EXAMPLE 4.1 Alpha Industry is planning to expand its production operation.It has identified
three different technologies for meeting the goal. The initialoutlay and annual revenues with
respect to each of the technologies aresummarized in Table 4.1. Suggest the best technology
which is to be implemented based on the present worth method of comparison assuming 20%
interest rate, compounded annually.

Solution In all the technologies, the initial outlay is assigned a negative sign and the
annual revenues are assigned a positive sign.
TECHNOLOGY 1
Initial outlay, P = Rs. 12,00,000

Annual revenue, A = Rs. 4,00,000

Interest rate, i = 20%,

compounded annually Life of this technology, n =
10 years
The cash flow diagram of this technology is as
shown in Fig. 4.3.

The present worth expression for this technology is

PW(20%)1 = –12,00,000 + 4,00,000 x (P/A, 20%, 10)

= –12,00,000 + 4,00,000 x (4.1925)

= –12,00,000 + 16,77,000

= Rs. 4,77,000
TECHNOLOGY 2
Initial outlay, P = Rs. 20,00,000
Annual revenue, A = Rs. 6,00,000
Interest rate, i = 20%, compounded annually

Life of this technology, n = 10 years

The cash flow diagram of this technology is shown in Fig. 4.4.
 The present worth expression for this technology is
PW(20%)2 = – 20,00,000 + 6,00,000 x (P/A, 20%, 10)
= – 20,00,000 + 6,00,000 x (4.1925)
= – 20,00,000 + 6,00,000 x(4.1925)
= – 20,00,000 + 25,15,500
= Rs. 5,15,500

TECHNOLOGY 3
Initial outlay, P = Rs. 18,00,000
Annual revenue, A = Rs. 5,00,000
Interest rate, i = 20%, compounded annually

Life of this technology, n = 10 years

The cash flow diagram of this technology is shown in Fig. 4.5

The present worth expression for this technology is

PW(20%)3 = –18,00,000 + 5,00,000 x (P/A, 20%, 10)

= –18,00,000 + 5,00,000 x(4.1925)

= –18,00,000 + 20,96,250
= Rs. 2,96,250

From the above calculations, it is clear that the present worth of technology 2 is the highest
among all the technologies. Therefore, technology 2 is suggested for implementation to
expand the production.
EXAMPLE 4.2 An engineer has two bids for an elevator to be installed in a new
building. The details of the bids for the elevators are as follows:

Determine which bid should be accepted, based on the present worth method of
comparison assuming 15% interest rate, compounded annually.

Solution
Bid 1: Alpha Elevator Inc.
Initial cost, P = Rs. 4,50,000
Annual operation and maintenance cost, A = Rs. 27,000
Life = 15 years
Interest rate, i = 15%, compounded annually
The cash flow diagram of bid 1 is shown in Fig. 4.6.

The present worth of the above cash flow diagram is computed as follows:

PW(15%) = 4,50,000 + 27,000(P/A, 15%, 15)

= 4,50,000 + 27,000 x 5.8474
= 4,50,000 + 1,57,879.80
= Rs. 6,07,879.80
=
Bid 2: Beta Elevator Inc.
Initial cost, P = Rs. 5,40,000
Annual operation and maintenance cost, A = Rs. 28,500
Life = 15 years

Interest rate, i = 15%, compounded annually.

The present worth of the above cash flow diagram is computed as follows:
PW(15%) = 5,40,000 + 28,500(P/A, 15%, 15)
= 5,40,000 + 28,500 x 5.8474

= 5,40,000 + 1,66,650.90

= Rs. 7,06,650.90
The total present worth cost of bid 1 is less than that of bid 2. Hence, bid 1 is to be selected for
implementation. That is, the elevator from Alpha Elevator Inc. is to be purchased and installed
in the new building.

EXAMPLE 4.3 Investment proposals A and B have the net cash flows as follows:
 Compare the present worth of A with that of B at i = 18%. Which proposal should be
selected?

Solution

Present worth of A at i = 18%. The cash flow diagram of proposal A is shown in Fig. 4.8.

The present worth of the above cash flow diagram is computed as

PWA(18%) = –10,000 + 3,000(P/F, 18%, 1) + 3,000(P/F, 18%, 2)
+ 7,000(P/F, 18%, 3) + 6,000(P/F, 18%, 4)
= –10,000 + 3,000 (0.8475) + 3,000(0.7182) + 7,000(0.6086)
+ 6,000(0.5158)
= Rs. 2,052.10

Present worth of B at i = 18%. The cash flow diagram of the proposal B is shown in Fig.
4.9.

The present worth of the above cash flow diagram is calculated as

PWB(18%) = –10,000 + 6,000(P/F, 18%, 1) + 6,000(P/F, 18%, 2) +3,000(P/F, 18%, 3) +
3,000(P/F, 18%, 4)
= –10,000 + 6,000(0.8475) + 6,000(0.7182) + 3,000(0.6086) +3,000(0.5158)
= Rs. 2,767.40
At i = 18%, the present worth of proposal B is higher than that of proposal A.
Therefore, select proposal B.
EXAMPLE 4.4 A granite company is planning to buy a fully automated granite cutting
machine. If it is purchased under down payment, the cost of the machine is Rs. 16,00,000. If it
is purchased under installment basis, the company has to pay 25% of the cost at the time of
purchase and the remaining amount in 10 annual equal installments of Rs. 2,00,000 each.
Suggest the best alternative for the company using the present worth basis at i = 18%,
compounded annually.
Solution There are two alternatives available for the company:
1. Down payment of Rs. 16,00,000

2. Down payment of Rs. 4,00,000 and 10 annual equal installments of Rs. 2,00,000 each

Present worth calculation of the second alternative. The cash flow diagram of the
second alternative is shown in Fig. 4.10.

The present worth of the above cash flow diagram is computed as

PW(18%) = 4,00,000 + 2,00,000(P/A, 18%, 10)

= 4,00,000 + 2,00,000 x 4.4941

= Rs. 12,98,820
The present worth of this option is Rs. 12,98,820, which is less than the first option of
complete down payment of Rs. 16,00,000. Hence, the company should select the second
alternative to buy the fully automated granite cutting machine.

EXAMPLE 4.5 A finance company advertises two investment plans. In plan 1, the company
pays Rs. 12,000 after 15 years for every Rs. 1,000 invested now. In plan 2, for every Rs. 1,000
invested, the company pays Rs. 4,000 at the end of the 10th year and Rs. 4,000 at the end of
15th year. Select the best investment plan from the investor‘s point of view at i = 12%,
compounded annually.

Solution Plan 1. The cash flow diagram for plan 1 is illustrated in Fig. 4.11.

The present worth of the above cash flow diagram is calculated as

PW(12%) = –1,000 + 12,000(P/F, 12%, 15)

= –1,000 + 12,000(0.1827)

= Rs. 1,192.40
Plan 2. The cash flow diagram for plan 2 is shown in Fig. 4.12.

The present worth of the above cash flow diagram is computed as

PW(12%) = –1,000 + 4,000(P/F, 12%, 10) + 4,000(P/F, 12%, 15)
= –1,000 + 4,000(0.3220) + 4,000(0.1827)

= Rs. 1,018.80
The present worth of plan 1 is more than that of plan 2. Therefore, plan 1 is the best plan
from the investor‘s point of view.

EXAMPLE 4.6 Novel Investment Ltd. accepts Rs. 10,000 at the end of every year for 20 years
and pays the investor Rs. 8,00,000 at the end of the 20th year. Innovative Investment Ltd.
accepts Rs. 10,000 at the end of every year for 20 years and pays the investor Rs. 15,00,000 at
the end of the 25th year. Which is the best investment alternative? Use present worth base with
i = 12%

Solution

Novel Investment Ltd’s plan.

The cash flow diagram of Novel Investment Ltd‘s plan is shown in Fig. 4.13.

The present worth of the above cash flow diagram is computed as

PW(12%) = –10,000(P/A, 12%, 20) + 8,00,000(P/F, 12%, 20)

= –10,000(7.4694) + 8,00,000(0.1037)
= Rs. 8,266

Innovative Investment Ltd’s plan. The cash flow diagram of the Innovative Investment
Ltd‘s plan is illustrated in Fig. 4.14.
The present worth of the above cash flow diagram is calculated as

PW(12%) = –10,000(P/A, 12%, 20) + 15,00,000(P/F, 12%, 25)

= –10,000(7.4694) + 15,00,000(0.0588)

= Rs. 13,506

The present worth of Innovative Investment Ltd‘s plan is more than that of Novel Investment
Ltd‘s plan. Therefore, Innovative Investment Ltd‘s plan is the best from investor‘s point of
view.
EXAMPLE 4.7 A small business with an initial outlay of Rs. 12,000 yields Rs. 10,000 during
the first year of its operation and the yield increases by Rs. 1,000 from its second year of
operation up to its 10th year of operation. At the end of the life of the business, the salvage
value is zero. Find the present worth of the business by assuming an interest rate of 18%,
compounded annually.

Solution
Initial investment, P = Rs. 12,000
Income during the first year, A = Rs. 10,000
Annual increase in income, G = Rs. 1,000 n = 10
years

i = 18%, compounded annually

The cash flow diagram for the small business is depicted in Fig. 4.15 .

The equation for the present worth is

PW(18%) = –12,000 + (10,000 + 1,000 x (A/G, 18%, 10)) x (P/A, 18%, 10)
= –12,000 + (10,000 + 1,000 x 3.1936) x4.4941

= –12,000 + 59,293.36

= Rs. 47,293.36

The present worth of the small business is Rs. 47,293.36.

FUTURE WORTH METHOD

INTRODUCTION
In the future worth method of comparison of alternatives, the future worth of various
alternatives will be computed. Then, the alternative with the maximum future worth of net
revenue or with the minimum future worth of net cost will be selected as the best alternative
for implementation.

REVENUE-DOMINATED CASH FLOW DIAGRAM

A generalized revenue-dominated cash flow diagram to demonstrate the future worth
method of comparison is presented in Fig. 5.1.

In Fig. 5.1, P represents an initial investment, Rj the net-revenue at the end of the
jth year, and S the salvage value at the end of the nth year.

The formula for the future worth of the above cash flow diagram for a given
interest rate, i is

FW(i) = –P(1 + i)n + R1(1 + i)n–1 + R2(1 + i)n–2 + ...+ Rj(1 + i)n–j + ... + Rn + S
 In the above formula, the expenditure is assigned with negative sign and the revenues are
assigned with positive sign. If we have some more alternatives which are to be compared with
this alternative, then the corresponding future worth amounts are to be computed and compared.
Finally, the alternative with the maximum future worth amount should be selected as the best
alternative.

COST-DOMINATED CASH FLOW DIAGRAM

A generalized cost-dominated cash flow diagram to demonstrate the future worth
method of comparison is given in Fig. 5.2.

In Fig. 5.2, P represents an initial investment, Cj the net cost of operation and maintenance at
the end of the jth year, and S the salvage value at the end of the nth year.The formula for the
future worth of the above cash flow diagram for a given interest rate, i is

FW(i) = P(1 + i)n + C1(1 + i )n–1 + C2(1 + i)n–2 + ...+ Cj(1 + i)n–j + ... + Cn – S

In this formula, the expenditures are assigned with positive sign and revenues with negative
sign. If we have some more alternatives which are to be compared with this alternative, then
the corresponding future worth amounts are to be computed and compared. Finally, the
alternative with the minimum future worth amount should be selected as the best alternative.

5.4 EXAMPLES
In this section, several examples highlighting the applications of the future worth
method of comparison are presented.

At i = 18%, select the best alternative based on future worth method of comparison.
Solution Alternative A
Initial investment, P = Rs. 50,00,000
Annual equivalent revenue, A = Rs. 20,00,000
Interest rate, i = 18%, compounded annually

Life of alternative A = 4 years

The cash flow diagram of alternative A is shown in Fig. 5.3.

The future worth amount of alternative B is computed as

FWA(18%) = –50,00,000(F/P, 18%, 4) + 20,00,000(F/A, 18%, 4) = –

50,00,000(1.939) + 20,00,000(5.215)

= Rs. 7,35,000

Alternative 2—Build soft ice-cream stand

First cost = Rs. 36,00,000
Net annual income = Annual income – Annual property tax

= Rs. 9,80,000 – Rs. 1,50,000

= Rs. 8,30,000
Life = 20 years
Interest rate = 12%, compounded annually
The cash flow diagram for this alternative is shown in Fig. 5.6.
The future worth of alternative 2 is calculated as
FW2(12%) = – 36,00,000(F/P, 12%, 20) + 8,30,000 (F/A, 12%, 20)
= –36,00,000 (9.646) + 8,30,000 (72.052)
= Rs. 2,50,77,560

The future worth of alternative 1 is greater than that of alternative 2. Thus, building the gas
station is the best alternative.

EXAMPLE 5.3 The cash flow diagram of two mutually exclusive alternatives are given in
Figs. 5.7 and 5.8.
(a) Select the best alternative based on future worth method at i = 8%.

(b) Rework part (a) with i = 9% and 20%

(a) Evaluation at i = 8%
Alternative 1—This comes under equal payment gradient series.

P = Rs. 5,00,000
A1 = Rs. 50,000
G = Rs. 50,000
i = 8% n = 6 years
 The formula for the future worth of alternative 1 is
FW1(8%) = –P(F/P, 8%, 6) + [A1 + G(A/G, 8%, 6)] x (F/A, 8%, 6)

= – 5,00,000(1.587) + [50,000 + 50,000(2.2764)] x 7.336

= – 79,35,000 + 1,63,820 x 7.336
= –79,35,000 + 12,01,784
= Rs. 4,08,283.52
Alternative 2—This comes under equal payment gradient series.
P = Rs. 7,00,000
A1 = Rs. 70,000
G = Rs. 70,000

i = 8%

n = 6 years

The formula for the future worth of alternative 2 is

FW2(8%) = –P(F/P, 8%, 6) + [A1 + G(A/G, 8%, 6)] x (F/A, 8%, 6)

FW2(8%) = –7,00,000 x 1.587 + [70,000 + 70,000 x2.2764] x7.336

= –11,10,900 + 16,82,497
= Rs. 5,71,596.93
The future worth of alternative 2 is more than that of alternative 1. Therefore,
alternative 2 must be selected.

(b) (i) Evaluation at i = 9%:

Alternative 1
P = Rs. 5,00,000 A1 = Rs. 50,000 G = Rs. 50,000 n = 6 years

The formula for the future worth of alternative 1 is as follows:

FW1(9%) = – P(F/P, 9%, 6) + [A1 + G(A/G, 9%, 6)] x (F/A, 9%, 6)
= – 5,00,000 (1.677) + [50,000 + 50,000 (2.2498)] x7.523

= – 8,38,500 + 12,22,412.27

= Rs. 3,83,912.27
Alternative 2
P = Rs. 7,00,000 A1 = Rs. 70,000 G = Rs. 70,000 n = 6 years
The formula for the future worth of the alternative 2 is
FW2(9%) = –P(F/P, 9%, 6) + [A1 + G(A/G, 9%, 6)] x(F/A, 9%, 6)

= –7,00,000 x 1.677 + [70,000 + 70,000 x 2.2498] x 7.523

= –11,73,900 + 17,11,377.18
= Rs. 5,37,477.18
The future worth of alternative 2 is more than that of alternative 1. Therefore,
alternative 2 must be selected
(ii) Evaluation at i = 20%: Alternative 1
P = Rs. 5,00,000 A1 = Rs. 50,000 G = Rs. 50,000 n = 6 years
The formula for the future worth of alternative 1 is
FW1(20%) = –P(F/P, 20%, 6) + [A1 + G(A/G, 20%, 6)] x(F/A, 20%, 6)
= –5,00,000(2.986) + [50,000 + 50,000 (1.9788)] x 9.93
= –14,93,000 + 14,78,974.20
= Rs. –14,025.80

The negative sign of the future worth amount indicates that alternative 1 incurs loss.

Alternative 2
P = Rs. 7,00,000 A1 = Rs. 70,000 G = Rs. 70,000 n = 6 years

The formula for the future worth of alternative 2 is

FW2(20%) = – P(F/P, 20%, 6) + [A1 + G(A/G, 20%, 6)] _ (F/A, 20%, 6)

= –7,00,000 _ 2.986 + [70,000 + 70,000 _ 1.9788] _ 9.93

= –20,90,200 + 20,70,563.88

= Rs. –19,636.12

The negative sign of the above future worth amount indicates that alternative 2 incurs loss.
Thus, none of the two alternatives should be selected.
 EXAMPLE 5.4 M/S Krishna Castings Ltd. is planning to replace its annealing furnace.
It has received tenders from three different original manufacturers of annealing furnace.
The details are as follows.

Solution Alternative 1—Manufacturer 1

First cost, P = Rs. 80,00,000 Life, n = 12 years
Annual operating and maintenance cost, A = Rs. 8,00,000
Salvage value at the end of furnace life = Rs. 5,00,000
The cash flow diagram for this alternative is shown in Fig. 5.9 .

The future worth amount of alternative 1 is computed as

FW1(20%) = 80,00,000 (F/P, 20%, 12) + 8,00,000 (F/A, 20%, 12) – 5,00,000
= 80,00,000(8.916) + 8,00,000 (39.581) – 5,00,000
= Rs. 10,24,92,800
Alternative 2— Manufacturer 2
First cost, P = Rs. 70,00,000
Life, n = 12 years

Annual operating and maintenance cost, A = Rs. 9,00,000

Salvage value at the end of furnace life = Rs. 4,00,000

The future worth amount of alternative 2 is computed as

FW2(20%) = 70,00,000(F/P, 20%, 12) + 9,00,000(F/A, 20%, 12) – 4,00,000

= 70,00,000(8.916) + 9,00,000 (39.581) – 4,00,000

= Rs. 9,76,34,900
Alternative 3—Manufacturer 3
First cost, P = Rs. 90,00,000
Life, n = 12 years
Annual operating and maintenance cost, A = Rs. 8,50,000
Salvage value at the end of furnace life = Rs. 7,00,000
The future worth amount of alternative 3 is calculated as
FW3(20%) = 90,00,000(F/P, 20%, 12) + 8,50,000(F/A, 20%, 12) – 7,00,000
= 90,00,000(8.916) + 8,50,000 (39.581) – 7,00,000
= Rs. 11,31,87,850

The future worth cost of alternative 2 is less than that of the other two alternatives. Therefore,
M/s. Krishna castings should buy the annealing furnace from manufacturer 2.

Solution Machine A
Initial cost of the machine, P = Rs. 4,00,000
Life, n = 4 years
Salvage value at the end of machine life, S = Rs. 2,00,000

Annual maintenance cost, A = Rs. 40,000

Interest rate, i = 12%, compounded annually.
The cash flow diagram of machine A is given in Fig. 5.12.
The future worth function of Fig. 5.12 is
FWA(12%) = 4,00,000 x (F/P, 12%, 4) + 40,000 x (F/A, 12%, 4) – 2,00,000
= 4,00,000 x (1.574) + 40,000 x (4.779) – 2,00,000

= Rs. 6,20,760

Machine B
Initial cost of the machine, P = Rs. 8,00,000
Life, n = 4 years
Salvage value at the end of machine life, S = Rs. 5,50,000
Annual maintenance cost, A = zero.

Interest rate, i = 12%, compounded annually.

The cash flow diagram of the machine B is illustrated in Fig. 5.13.

The future worth function of Fig 5.13 is

FWB(12%) = 8,00,000 x(F/P, 12%, 4) – 5,50,000

= 8,00,000 x (1.574) – 5,50,000

= Rs. 7,09,200

The future worth cost of machine A is less than that of machine B. Therefore, machine A should
be selected.
 ANNUAL EQUIVALENT METHOD
INTRODUCTION
In the annual equivalent method of comparison, first the annual equivalent cost or the revenue of
each alternative will be computed. Then the alternative with the maximum annual equivalent
revenue in the case of revenue-based comparison or with the minimum annual equivalent cost in
the case of costbased comparison will be selected as the best alternative.
REVENUE-DOMINATED CASH FLOW DIAGRAM
A generalized revenue-dominated cash flow diagram to demonstrate the annual equivalent
method of comparison is presented in Fig. 6.1.

In Fig. 6.1, P represents an initial investment, Rj the net revenue at the end
of the jth year, and S the salvage value at the end of the nth year.
The first step is to find the net present worth of the cash flow diagram using
the following expression for a given interest rate, i:
PW(i) = –P + R1/(1 + i)1 + R2/(1 + i)2 + ...
+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n
In the above formula, the expenditure is assigned with a negative sign and
the revenues are assigned with a positive sign.

In the second step, the annual equivalent revenue is computed using the following formula:
where (A/P, i, n) is called equal payment series capital recovery factor.

If we have some more alternatives which are to be compared with this alternative, then the
corresponding annual equivalent revenues are to be computed and compared. Finally, the
alternative with the maximum annual equivalent revenue should be selected as the best
alternative.

COST-DOMINATED CASH FLOW DIAGRAM

A generalized cost-dominated cash flow diagram to demonstrate the annual equivalent method of
comparison is illustrated in Fig. 6.2.

In Fig. 6.2, P represents an initial investment, Cj the net cost of operation and maintenance at the
end of the jth year, and S the salvage value at the end of the nth year.
The first step is to find the net present worth of the cash flow diagram using
the following relation for a given interest rate, i.
PW(i) = P + C1/(1 + i)1 + C2/(1 + i)2 + ...
+ Cj/(1 + i) j + ... + Cn/(1 + i)n – S/(1 + i)n
In the above formula, each expenditure is assigned with positive sign and the salvage value with
negative sign. Then, in the second step, the annual equivalent cost is computed using the
following equation:

where (A/P, i, n) is called as equal-payment series capital recovery factor.

As in the previous case, if we have some more alternatives which are to be compared with this
alternative, then the corresponding annual equivalent costsare to be computed and compared.
Finally, the alternative with the minimum annual equivalent cost should be selected as the best
alternative.
If we have some non-standard cash flow diagram, then we will have to follow the general
procedure for converting each and every transaction to time zero and then convert the net present
worth into an annual equivalent cost/ revenue depending on the type of the cash flow diagram.
Such procedure is tobe applied to all the alternatives and finally, the best alternative is to be
selected.
ALTERNATE APPROACH
Instead of first finding the present worth and then figuring out the annual equivalent
cost/revenue, an alternate method which is as explained below can be used. In each of the cases
presented in Sections 6.2 and 6.3, in the first step, one can find the future worth of the cash flow
diagram of each of the alternatives.
Then, in the second step, the annual equivalent cost/revenue can be obtained by using the
equation:

where (A/F, i, n) is called equal-payment series sinking fund factor.

EXAMPLES
In this section, the application of the annual equivalent method is demonstrated with several
numerical examples.

EXAMPLE 6.1 A company provides a car to its chief executive. The owner of the company is
concerned about the increasing cost of petrol. The cost per litre of petrol for the first year of
operation is Rs. 21. He feels that the cost of petrol will be increasing by Re.1 every year. His
experience with his company car indicates that it averages 9 km per litre of petrol. The executive
expects to drive an average of 20,000 km each year for the next four years. What is the annual
equivalent cost of fuel over this period of time?. If he is offered similar service with the same
quality on rental basis at Rs. 60,000 per year, should the owner continue to provide company car
for his executive or alternatively provide a rental car to his executive? Assume i = 18%. If the
rental car is preferred, then the company car will find some other use within the company
Solution
Average number of km run/year = 20,000 km
Number of km/litre of petrol = 9 km
Therefore,
Petrol consumption/year = 20,000/9 = 2222.2 litre
Cost/litre of petrol for the 1st year = Rs. 21
Cost/litre of petrol for the 2nd year = Rs. 21.00 + Re. 1.00
= Rs. 22.00
Cost/litre of petrol for the 3rd year = Rs. 22.00 + Re. 1.00
= Rs. 23.00
Cost/litre of petrol for the 4th year = Rs. 23.00 + Re. 1.00
= Rs. 24.00
Fuel expenditure for 1st year = 2222.2 _ 21 = Rs. 46,666.20
Fuel expenditure for 2nd year = 2222.2 _ 22 = Rs. 48,888.40
Fuel expenditure for 3rd year = 2222.2 _ 23 = Rs. 51,110.60
Fuel expenditure for 4th year = 2222.2 _ 24 = Rs. 53,332.80

The annual equal increment of the above expenditures is Rs. 2,222.20 (G).
In Fig. 6.3, A1 = Rs. 46,666.20 and G = Rs. 2,222.20
A = A1 + G(A/G, 18%, 4)
= 46,666.20 + 2222.2(1.2947)
= Rs. 49,543.28
The proposal of using the company car by spending for petrol by the company will cost an
annual equivalent amount of Rs. 49,543.28 for four years. This amount is less than the annual
rental value of Rs. 60,000. Therefore, the company should continue to provide its own car to its
executive.
EXAMPLE 6.2 A company is planning to purchase an advanced machine centre. Three original
manufacturers have responded to its tender whose particulars are tabulated as follows:

Determine the best alternative based on the annual equivalent method by assuming i = 20%,
compounded annually.

Solution Alternative 1
Down payment, P = Rs. 5,00,000
Yearly equal installment, A = Rs. 2,00,000
n = 15 years
i = 20%, compounded annually
The cash flow diagram for manufacturer 1 is shown in Fig. 6.4.

The annual equivalent cost expression of the above cash flow diagram is
AE1(20%) = 5,00,000(A/P, 20%, 15) + 2,00,000
= 5,00,000(0.2139) + 2,00,000
= 3,06,950
Alternative 2
Down payment, P = Rs. 4,00,000
Yearly equal installment, A = Rs. 3,00,000
n = 15 years
i = 20%, compounded annually
The cash flow diagram for the manufacturer 2 is shown in Fig. 6.5 .

The annual equivalent cost expression of the above cash flow diagram is
AE2(20%) = 4,00,000(A/P, 20%, 15) + 3,00,000
= 4,00,000(0.2139) + 3,00,000
= Rs. 3,85,560.
Alternative 3
Down payment, P = Rs. 6,00,000
Yearly equal installment, A = Rs. 1,50,000
n = 15 years
i = 20%, compounded annually
The cash flow diagram for manufacturer 3 is shown in Fig. 6.6.

The annual equivalent cost expression of the above cash flow diagram is
AE3(20%) = 6,00,000(A/P, 20%, 15) + 1,50,000
= 6,00,000(0.2139) + 1,50,000
= Rs. 2,78,340.
The annual equivalent cost of manufacturer 3 is less than that of manufacturer 1 and
manufacturer 2. Therefore, the company should buy the advanced machine centre from
manufacturer 3.
EXAMPLE 6.3 A company invests in one of the two mutually exclusive alternatives. The life of
both alternatives is estimated to be 5 years with the following investments, annual returns and
salvage values.

Determine the best alternative based on the annual equivalent method by assuming i = 25%.

Solution Alternative A
Initial investment, P = Rs. 1,50,000 , Annual equal return, A = Rs. 60,000
Salvage value at the end of machine life, S = Rs. 15,000
Life = 5 years, Interest rate, i = 25%, compounded annually
The cash flow diagram for alternative A is shown in Fig. 6.7.

The annual equivalent revenue expression of the above cash flow diagram
is as follows:
AEA(25%) = –1,50,000(A/P, 25%, 5) + 60,000 + 15,000(A/F, 25%, 5)
= –1,50,000(0.3718) + 60,000 + 15,000(0.1218)
= Rs. 6,057
Alternative B
Initial investment, P = Rs. 1,75,000
Annual equal return, A = Rs. 70,000
Salvage value at the end of machine life, S = Rs. 35,000
Life = 5 years
Interest rate, i = 25%, compounded annually
The cash flow diagram for alternative B is shown in Fig. 6.8.
The annual equivalent revenue expression of the above cash flow diagram is
AEB(25%) = –1,75,000(A/P, 25%, 5) + 70,000 + 35,000(A/F, 25%, 5)
= –1,75,000(0.3718) + 70,000 + 35,000(0.1218)
= Rs. 9,198
The annual equivalent net return of alternative B is more than that of alternative A. Thus, the
company should select alternative B.

EXAMPLE 6.4 A certain individual firm desires an economic analysis to determine which of the
two machines is attractive in a given interval of time. The minimum attractive rate of return for
the firm is 15%. The following data are to be used in the analysis:

Which machine would you choose? Base your answer on annual equivalent cost.

Solution Machine X
First cost, P = Rs. 1,50,000
Life, n = 12 years
Estimated salvage value at the end of machine life, S = Rs. 0.
Annual maintenance cost, A = Rs. 0.
Interest rate, i = 15%, compounded annually.

The annual equivalent cost expression of the above cash flow diagram is
AEX(15%) = 1,50,000(A/P, 15%, 12)
= 1,50,000(0.1845)
= Rs. 27,675
Machine Y
First cost, P = Rs. 2,40,000
Life, n = 12 years
Estimated salvage value at the end of machine life, S = Rs. 60,000
Annual maintenance cost, A = Rs. 4,500
Interest rate, i = 15%, compounded annually.
The cash flow diagram of machine Y is depicted in Fig. 6.10.
The annual equivalent cost expression of the above cash flow diagram is
AEY(15%) = 2,40,000(A/P, 15%, 12) + 4,500 – 6,000(A/F, 15%, 12)
= 2,40,000(0.1845) + 4,500 – 6,000(0.0345)
= Rs. 48,573
The annual equivalent cost of machine X is less than that of machine Y. So, machine X is the
more cost effective machine.

EXAMPLE 6.5 Two possible routes for laying a power line are under study.Data on the routes
are as follows:

If 15% interest is used, should the power line be routed around the lake or under the lake?
Solution Alternative 1— Around the lake
First cost = 1,50,000 x 15 = Rs. 22,50,000
Maintenance cost/yr = 6,000 x15 = Rs. 90,000
Power loss/yr = 15,000 x 15 = Rs. 2,25,000
Maintenance cost and power loss/yr = Rs. 90,000 + Rs. 2,25,000
= Rs. 3,15,000
Salvage value = 90,000 x 15 = Rs. 13,50,000
The cash flow diagram for this alternative is shown in Fig. 6.11

The annual equivalent cost expression of the above cash flow diagram is
AE1(15%) = 22,50,000(A/P, 15%, 15) + 3,15,000 – 13,50,000(A/F, 15%, 15)
= 22,50,000(0.1710) + 3,15,000 – 13,50,000(0.0210)
= Rs. 6,71,400

Alternative 2—Under the lake

First cost = 7,50,000 x 5 = Rs. 37,50,000
Maintenance cost/yr = 12,000 x5 = Rs. 60,000
Power loss/yr = 15,000 x5 = Rs. 75,000
Maintenance cost and power loss/yr = Rs. 60,000 + Rs. 75,000
= Rs. 1,35,000
Salvage value = 1,50,000 x 5 = Rs. 7,50,000
The cash flow diagram for this alternative is shown in Fig. 6.12.
The annual equivalent cost expression of the above cash flow diagram is
AE2(15%) = 37,50,000(A/P, 15%, 15) + 1,35,000 – 7,50,000(A/F, 15%, 15)
= 37,50,000(0.1710) + 1,35,000 – 7,50,000(0.0210)
= Rs. 7,60,500

The annual equivalent cost of alternative 1 is less than that of alternative 2. Therefore, select the
route around the lake for laying the power line.
EXAMPLE 6.6 A suburban taxi company is analyzing the proposal of buying cars with diesel
engines instead of petrol engines. The cars average 60,000 km a year with a useful life of three
years for the petrol taxi and four years for the diesel taxi. Other comparative details are as
follows:

Determine the more economical choice if interest rate is 20%, compounded annually.
Solution Alternative 1— Purchase of diesel taxi
Vehicle cost = Rs. 3,90,000
Life = 4 years
Number of litres/year 60,000/30 = 2,000 litres
Fuel cost/yr = 2,000 x 8 = Rs. 16,000
Fuel cost, annual repairs and insurance premium/yr
= Rs. 16,000 + Rs. 9,000 + Rs. 15,000 = Rs. 40,000
Salvage value at the end of vehicle life = Rs. 60,000
The annual equivalent cost expression of the above cash flow diagram is
AE(20%) = 3,90,000(A/P, 20%, 4) + 40,000 – 60,000(A/F, 20%, 4)
= 3,90,000(0.3863) + 40,000 – 60,000(0.1863)
= Rs. 1,79,479
Alternative 2— Purchase of petrol taxi
Vehicle cost = Rs. 3,60,000
Life = 3 years, Number of litres/year 60,000/20 = 3,000 litres
Fuel cost/yr = 3,000 x 20 = Rs. 60,000
Fuel cost, annual repairs and insurance premium/yr
= Rs. 60,000 + Rs. 6,000 + Rs. 15,000 = Rs. 81,000
Salvage value at the end of vehicle life = Rs. 90,000

The cash flow diagram for alternative 2 is shown in Fig. 6.14.

The annual equivalent cost expression of the above cash flow diagram is
AE(20%) = 3,60,000(A/P, 20%, 3) + 81,000 – 90,000(A/F, 20%, 3)
= 3,60,000(0.4747) + 81,000 – 90,000(0.2747)
= Rs. 2,27,169
The annual equivalent cost of purchase and operation of the cars with diesel engine is less than
that of the cars with petrol engine. Therefore, the taxi company should buy cars with diesel
engine. (Note: Comparison is done on common multiple lives of 12 years.)

EXAMPLE 6.7 Ramu, a salesman, needs a new car for use in his business. He expects that he
will be promoted to a supervisory job at the end of third year and so his concern now is to have a
car for the three years he expects to be “on the road”. The company will reimburse their
salesman each month the fuel cost and maintenance cost. Ramu has decided to drive a low-priced
automobile. He finds, however, that there are two different ways of obtaining the automobile. In
either case, the fuel cost and maintenance cost are borne by the company.
(a) Purchase for cash at Rs. 3,90,000.
(b) Lease a car. The monthly charge is Rs. 10,500 on a 36-month lease payable at the end of each
month. At the end of the three-year period, the car is returned to the leasing company. Ramu
believes that he should use a 12% interest rate compounded monthly in determining which
alternative to select. If the car could be sold for Rs. 1,20,000 at the end of the third year, which
option should he use to obtain it?
Alternative 1—Purchase car for cash
Purchase price of the car = Rs. 3,90,000
Life = 3 years = 36 months
Salvage value after 3 years = Rs. 1,20,000
Interest rate = 12% (nominal rate, compounded annually)
= 1% compounded monthly
The monthly equivalent cost expression [ME(1%)] of the above cash flow
diagram is
ME(1%) = 3,90,000(A/P, 1%, 36) – 1,20,000(A/F, 1%, 36)
= 3,90,000(0.0332) – 1,20,000(0.0232)
= Rs. 10,164
Alternative 2—Use of car under lease
Monthly lease amount for 36 months = Rs. 10,500

Monthly equivalent cost = Rs.10,500.

The monthly equivalent cost of alternative 1 is less than that of alternative 2. Hence, the
salesman should purchase the car for cash.
EXAMPLE 6.8 A company must decide whether to buy machine A or machine B.

Solution Machine A
Initial cost = Rs. 3,00,000
Useful life (years) = 4
Salvage value at the end of machine life = Rs. 2,00,000
Annual maintenance = Rs. 30,000
Interest rate = 15%, compounded annually
The cash flow diagram of machine A is depicted in Fig. 6.17.

The annual equivalent cost expression of the above cash flow diagram is
AE(15%) = 3,00,000(A/P, 15%, 4) + 30,000 – 2,00,000(A/F, 15%, 4)
= 3,00,000(0.3503) + 30,000 – 2,00,000(0.2003)
= Rs. 95,030
Machine B
Initial cost = Rs. 6,00,000
Useful life (years) = 4
Salvage value at the end of machine life = Rs. 3,00,000
Annual maintenance = Rs. 0.
Interest rate = 15%, compounded annually
The cash flow diagram of machine B is illustrated in Fig. 6.18.

The annual equivalent cost expression of the above cash flow diagram is
AE(15%) = 6,00,000(A/P, 15%, 4) – 3,00,000(A/F, 15%, 4)
= 6,00,000(0.3503) – 3,00,000(0.2003)
= Rs. 1,50,090
Since the annual equivalent cost of machine A is less than that of machine B, it is advisable to
buy machine A.
EXAMPLE 6.9 Jothi Lakshimi has arranged to buy some home recording equipment. She
estimates that it will have a five year useful life and no salvage value at the end of equipment
life. The dealer, who is a friend has offered Jothi Lakshimi two alternative ways to pay for the
equipment.
(a) Pay Rs. 60,000 immediately and Rs. 15,000 at the end of one year.
(b) Pay nothing until the end of fourth year when a single payment of
Rs. 90,000 must be made.
If Jothi Lakshimi believes 12% is a suitable interest rate, which alternative
is the best for her?
Solution Alternative 1
Down payment = Rs. 60,000
Payment after one year = Rs. 15,000
The cash flow diagram for alternative 1 is shown in Fig. 6.19.

The present worth equation of the above cash flow diagram is

PW(12%) = 60,000 + 15,000(P/F, 12%, 1)
= 60,000 + 15,000(0.8929)
= 73,393.50

The annual equivalent expression of the above cash flow diagram is

AE(12%) = 73,393.5(A/P, 12%, 4)
= 73,393.5(0.3292)
= Rs. 24,161.14
Alternative 2
Payment after four years = Rs. 90,000
The annual equivalent cost expression of the above cash flow diagram is
AE(12%) = 90,000(A/F, 12%, 4)
= 90,000(0.2092)
= Rs. 18,828
The annual equivalent cost of alternative 2 is less than that of alternative 1. Hence, Jothi
Lakshimi should select alternative 2 for purchasing the home equipment.

EXAMPLE 6.10 A transport company has been looking for a new tyre for its truck and has
located the following alternatives:

If the company feels that the warranty period is a good estimate of the tyre life and that a
nominal interest rate (compounded annually) of 12% is appropriate, which tyre should it buy?
Solution In all the cases, the interest rate is 12%. This is equivalent to 1% per
month.
Brand A
Tyre warranty = 12 months
Price/tyre = Rs. 1,200
The annual equivalent cost expression of the above cash flow diagram is
AE(1%) = 1,200(A/P, 1%, 12)
= 1,200(0.0888)
= Rs. 106.56
Brand B
Tyre warranty = 24 months
Price/tyre = Rs. 1,800

The annual equivalent cost expression of the above cash flow diagram is
AE(1%) = 1,800(A/P, 1%, 24)
= 1,800(0.0471)
= Rs. 84.78
Brand C
Tyre warranty = 36 months
Price/tyre = Rs. 2,100
The annual equivalent expression of the above cash flow diagram is
AE(1%) = 2,100(A/P, 1%, 36)
= 2,100(0.0332)
= Rs. 69.72

Brand D
Tyre warranty = 48 months
Price/tyre = Rs. 2,700

The annual equivalent cost expression of the above cash flow diagram is
AE(1%) = 2,700(A/P, 1%, 48)
= 2,700 (0.0263)
= Rs. 71.01
Here, minimum common multiple lives of tyres are considered. This is 144 months. Therefore,
the comparison is made on 144 month’s basis. The annual equivalent cost of brand C is less than
that of other brands. Hence, it should be used in the vehicles of the trucking company. It should
be replaced four times during the 144-month period.
 RATE OF RETURN METHOD
INTRODUCTION
The rate of return of a cash flow pattern is the interest rate at which the present worth of that cash
flow pattern reduces to zero. In this method of comparison, the rate of return for each alternative
is computed. Then the alternative which has the highest rate of return is selected as the best
alternative. In this type of analysis, the expenditures are always assigned with a negative sign
and the revenues/inflows are assigned with a positive sign.

A generalized cash flow diagram to demonstrate the rate of return method of comparison is
presented in Fig. 7.1.

In the above cash flow diagram, P represents an initial investment, Rj the

net revenue at the end of the jth year, and S the salvage value at the end of the
nth year.
The first step is to find the net present worth of the cash flow diagram using
the following expression at a given interest rate, i.
PW(i) = – P + R1/(1 + i)1 + R2/(1 + i)2 + ...
+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n

Now, the above function is to be evaluated for different values of i until the present worth
function reduces to zero, as shown in Fig. 7.2.
In the figure, the present worth goes on decreasing when the interest rate is increased. The value
of i at which the present worth curve cuts the X-axis is the rate of return of the given
proposal/project. It will be very difficult to find the exact value of i at which the present worth
function reduces to zero.

So, one has to start with an intuitive value of i and check whether the present worth function is
positive. If so, increase the value of i until PW(i) becomes negative. Then, the rate of return is
determined by interpolation method in the range of values of i for which the sign of the present
worth function changes from positive to negative.
EXAMPLES
In this section, the concept of rate of return calculation is demonstrated with
suitable examples.
EXAMPLE 7.1 A person is planning a new business. The initial outlay and cash flow pattern for
the new business are as listed below. The expected life of the business is five years. Find the rate
of return for the new business.

Solution
Initial investment = Rs. 1,00,000
Annual equal revenue = Rs. 30,000
Life = 5 years

The cash flow diagram for this situation is illustrated in Fig. 7.3.

The present worth function for the business is

PW(i) = –1,00,000 + 30,000(P/A, i, 5)
When i = 10%,
PW(10%) = –1,00,000 + 30,000(P/A, 10%, 5)
= –1,00,000 + 30,000(3.7908)
= Rs. 13,724.
When i = 15%,
PW(15%) = –1,00,000 + 30,000(P/A, 15%, 5)
= –1,00,000 + 30,000(3.3522)
= Rs. 566.
When i = 18%,
PW(18%) = –1,00,000 + 30,000(P/A, 18%, 5)
= –1,00,000 + 30,000(3.1272)
= Rs. – 6,184

Therefore, the rate of return for the new business is 15.252%.

EXAMPLE 7.2 A company is trying to diversify its business in a new product line. The life of
the project is 10 years with no salvage value at the end of its life. The initial outlay of the project
is Rs. 20,00,000. The annual net profit is Rs. 3,50,000. Find the rate of return for the new
business.
Solution
Life of the product line (n) = 10 years
Initial outlay = Rs. 20,00,000
Annual net profit = Rs. 3,50,000
Scrap value after 10 years = 0
The cash flow diagram for this situation is shown in Fig. 7.4.

The formula for the net present worth function of the situation is
PW(i) = –20,00,000 + 3,50,000(P/A, i, 10)
When i = 10%,
PW(10%) = –20,00,000 + 3,50,000(P/A, 10%, 10)
= –20,00,000 + 3,50,000(6.1446)
= Rs. 1,50,610.
When i = 12%,
PW(12%) = –20,00,000 + 3,50,000(P/A, 12%, 10)
= –20,00,000 + 3,50,000(5.6502)
= Rs. –22,430.

= 11.74 %
Therefore, the rate of return of the new product line is 11.74%
EXAMPLE 7.3 A firm has identified three mutually exclusive investment proposals whose
details are given below. The life of all the three alternatives is estimated to be five years with
negligible salvage value. The minimum attractive rate of return for the firm is 12%.

Find the best alternative based on the rate of return method of comparison.
Solution
Calculation of rate of return for alternative A1
Initial outlay = Rs. 1,50,000
Annual profit = Rs. 45,570
Life = 5 years
The cash flow diagram for alternative A1 is shown in Fig. 7.5.

The formula for the net present worth of alternative A1 is given as

PW(i) = –1,50,000 + 45,570(P/A, i, 5)
When i = 10%,
PW(10%) = –1,50,000 + 45,570(P/A, 10%, 5)
= –1,50,000 + 45,570(3.7908)
= Rs. 22,746.76
When i = 12%,
PW(12%) = –1,50,000 + 45,570(P/A, 12%, 5)
= –1,50,000 + 45,570(3.6048)
= Rs. 14,270.74
When i = 15%,
PW(15%) = –1,50,000 + 45,570(P/A, 15%, 5)
= –1,50,000 + 45,570(3.3522)
= Rs. 2,759.75
When i = 18%,
PW(18%) = –1,50,000 + 45,570(P/A, 18%, 5)
= –1,50,000 + 45,570(3.1272)
= Rs. –7,493.50
Therefore, the rate of return of the alternative A1 is

Calculation of rate of return for alternative A2

Initial outlay = Rs. 2,10,000
Annual profit = Rs. 58,260
Life of alternative A2 = 5 years
The cash flow diagram for alternative A2 is shown in Fig. 7.6.

The formula for the net present worth of this alternative is

PW(i) = –2,10,000 + 58,260 (P/A, i, 5)
When i = 12%,
PW(12%) = –2,10,000 + 58,260(P/A, 12%, 5)
= –2,10,000 + 58,260(3.6048)
= Rs. 15.6
When i = 13%,
PW(13%) = –2,10,000 + 58,260(P/A, 13%, 5)
= –2,10,000 + 58,260 (3.5172)
= Rs. –5,087.93
Therefore, the rate of return of alternative A2 is

Calculation of rate of return for alternative A3

Initial outlay = Rs. 2,55,000
Annual profit = Rs. 69,000
Life of alternative A3 = 5 years
The cash flow diagram for alternative A3 is depicted in Fig. 7.7.

The formula for the net present worth of this alternative A3 is

PW(i) = –2,55,000 + 69,000(P/A, i, 5)
When i = 11%,
PW(11%) = – 2,55,000 + 69,000(P/A, 11%, 5)
= –2,55,000 + 69,000 (3.6959)
= Rs. 17.1
When i = 12%,
PW(12%) = – 2,55,000 + 69,000(P/A, 12%, 5)
= –2,55,000 + 69,000 (3.6048)
= Rs. – 6,268.80
Therefore, the rate of return for alternative A3 is

The rates of return for the three alternatives are now tabulated

From the above data, it is clear that the rate of return for alternative A3 is less than the minimum
attractive rate of return of 12%. So, it should not be considered for comparison. The remaining
two alternatives are qualified for consideration. Among the alternatives A1 and A2, the rate of
return of alternative A1 is greater than that of alternative A2. Hence, alternative A1 should be
selected.

EXAMPLE 7.4 For the cash flow diagram shown in Fig. 7.8, compute the rate of return. The

amounts are in rupees.

Solution For the positive cash flows of the problem,

A1 = Rs. 150, G = Rs. 150
The annual equivalent of the positive cash flows of the uniform gradient
series is given by
A = A1 + G(A/G, i, n)
= 150 + 150(A/G, i, 5)
The formula for the present worth of the whole diagram
= –1,275 + [150 + 150(A/G, i, 5)] _ (P/A, i, 5)
PW(10%) = –1,275 + [150 + 150(A/G, 10%, 5)] __ (P/A, 10%, 5)
= –1,275 + [150 + 150(1.8101)] _ (3.7908)
= Rs. 322.88
PW(12%) = –1,275 + [150 + 150(A/G, 12%, 5)] _ (P/A, 12%, 5)
= –1,275 + [150 + 150(1.7746)] _ (3.6048)
= Rs. 225.28
PW(15%) = –1,275 + [150 + 150(A/G, 15%, 5)] _ (P/A, 15%, 5)
= –1,275 + [150 + 150(1.7228)] _ (3.3522)
= Rs. 94.11
PW(18%) = –1,275 + [150 + 150(A/G, 18%, 5)] _ (P/A, 18%, 5)
= –1,275 + [150 + 150(1.6728)] _ (3.1272)
= Rs. –21.24
Therefore, the rate of return for the cash flow diagram is

EXAMPLE 7.5 A company is planning to expand its present business activity. It has two
alternatives for the expansion programme and the corresponding cash flows are tabulated below.
Each alternative has a life of five years and a negligible salvage value. The minimum attractive
rate of return for the company is 12%. Suggest the best alternative to the company.

Solution Alternative 1
Initial outlay = Rs. 5,00,000
Annual revenue = Rs. 1,70,000
Life of alternative 1 = 5 years
The cash flow diagram for alternative 1 is illustrated in Fig. 7.9 .

The formulae for the net present worth of alternative 1 are as follows:
PW1(i) = –5,00,000 + 1,70,000(P/A, i, 5)
PW1(15%) = –5,00,000 + 1,70,000(P/A, 15%, 5)
= –5,00,000 + 1,70,000(3.3522)
= Rs. 69,874
PW1(17%) = –5,00,000 + 1,70,000(P/A, 17%, 5)
= –5,00,000 + 1,70,000(3.1993)
= Rs. 43,881
PW1(20%) = –5,00,000 + 1,70,000(P/A, 20%, 5)
= –5,00,000 + 1,70,000(2.9906)
= Rs. 8,402
PW1(22%) = –5,00,000 + 1,70,000(P/A, 22%, 5)
= –5,00,000 + 1,70,000(2.8636)
= Rs. –13,188

Therefore, the rate of return of alternative 1 is

Alternative 2

Initial outlay = Rs. 8,00,000

Annual revenue = Rs. 2,70,000
Life = 5 years
The cash flow diagram for alternative 2 is depicted in Fig. 7.10.

The formula for the net present worth of alternative 2 is:

PW2(i) = – 8,00,000 + 2,70,000(P/A, i, 5)
PW2(20%) = – 8,00,000 + 2,70,000(P/A, 20%, 5)
= – 8,00,000 + 2,70,000(2.9906)
= Rs. 7,462

PW2(22%) = –8,00,000 + 2,70,000 (P/A, 22%, 5)

= – 8,00,000 + 2,70,000 (2.8636)
= Rs. –26,828

Thus, the rate of return of alternative 2 is

Since the rate of return of alternative 1 is greater than that of the alternative 2, select alternative
1.