Lesson 6 Application of TVM Concepts in Investment Studies and Comparison of Alternatives

Application of Time Value of
Money Concepts in Investment

Studies and Comparison of
Alternatives
NCE 4103
Four types of evaluation
• Present worth analysis
• Future worth analysis
• Annual worth analysis
• Rate of return analysis
Minimum Attractive Rate of Return
A predetermined rate set by the business to measure the

profitability of an investment or project. It is the interest
rate applied to represent the yield on investment that is
considered minimally accepted by an investor. Acceptable
MARR is one with higher rates than the offer of banks or
other financial institutions.
Present worth analysis
Generally used when placing valuation on future cash flows in an
investment or project, and when comparing investment alternatives.
It is referred to as discounted cash flow method, and the applied
interest rate referred to as the discount rate.
For an investment study with multiple cash flow, total present worth,
PT is
𝑃𝑇 = 𝑃1 + 𝑃2 + 𝑃3
Where,
P1=initial cost
P2=present worth of future series of cash flows
P3=present worth of single cash flow in the future
Sample Problems
A computer is purchased for P 35 000, it is expected to be used
for six years and will be sold for P5000 after that time. Annual
operations, maintenance, and software cost is expected to be P 10
000. For a 9% rate of return, determine the present worth of this
investment.
Sample Problems
A new piece of equipment has been proposed to increase
production. The equipment will cost P 55 000, will last
seven years and will have a salvage value of P5000. With
this investment income is projected to increase by P12 000
each year for the first four years and P 14 000 each year for
the remaining three years. Using present worth analysis
and rate of 14%, determine if the equipment purchase is
justified.
Sample Problems
To increase production output, Mecca Hill, Corp must
adopt one of the following processes, with estimated cash
flow as shown:
A B C
Cost of equipment P 400 000 P 550 000 P 700 000
Annual maintenance 40 000 50 000 55 000
Annual revenue 180 000 230 000 275 000
Salvage value 70 000 70 000 85 000
If the company uses 12% MARR and all equipment life is estimated at 5 years,
determine the best process using present worth analysis
Sample Problems
A plant engineer is considering the adoption of one of two
machines in a production line. Machine A has a first cost of
P 225 000, a yearly operating cost of P 90 000 and a salvage
value of P 25 000 at the end of its 6-year life. Machine B has
a first cost of P 155 000, a yearly operating cost of P 120 000
and a salvage value of P 10 000 at the end of its 4-year life.
Determine which machine should be selected using PW
analysis and an 18% MARR.
Future worth analysis
Alternative method applied in capital investment and alternative
comparison studies, it is based on the concept of finding the
equivalent compound amount of all receipts and disbursements
at the end of the investment or study period. So the future worth,
FT is
𝐹𝑇 = 𝐹1 + 𝐹2 + 𝐹3
Where,
F1=final receipt or disbursement
F2=future worth of any cash flow series
F3=future worth of any single cash flow
Sample Problems
A new equipment that will increase revenue by P 94 500 a
year requires an investment of P 430 000. It is estimated to
have a net salvage value of P 50 000 at end of 12 years, with
annual expenses for repairs and maintenance totaling P 15
000. Determine if the investment is justified using future
worth analysis and an 18% rate of return.
Sample Problems
If the company uses 12% MARR and all equipment life is estimated at 5 years, determine the best
process using future worth analysis. Compare the order ranking of the alternative proposals with that
of PW analysis
Annual worth analysis
A method that converts all cash flows of a project or
investment into an equivalent uniform series, so that the
uniform periodic amount AT is
𝐴 𝑇 = 𝐴1 + 𝐴2 + 𝐴3
Where,
A1=periodic revenues or income
A2=periodic disbursements or expenses
A3=capital recovery amount for invested capital
Sample Problems
A construction company is considering the acquisition of a
transport mixer to save manpower requirements. The
mixer will cost P 1.5M, will be used for seven years, then
sold for an estimated P 50 000. Annual savings and
maintenance cost estimates are P 375 000 and P 40 000,
respectively. If the company uses a 12% MARR, determine
the annual worth of the mixer.
Sample Problems
If the company uses 12% MARR and all equipment life is estimated at 5 years, determine the best
process using annual worth analysis. Compare the order ranking of the alternative proposals with
that of PW analysis
Sample Problems
A contractor can buy trucks for P 800 000 each, or rent them
for P1200 per truck per day. The truck has a salvage value
of P 100 000 at the end of its useful life of five years. The
annual maintenance cost is P 20 000 per truck. Using
annual cost method and 14% interest rate, determine the
number of days per year that each truck must be used to
warrant its purchase.
Evaluation of alternatives using PW, FW, or AW analysis
Select alternative with highest value indicating lower costs
or higher profits in comparing proposals or alternatives.
Compare the alternatives for the same time span. If
alternatives have different lives, it is necessary to extend
cash flow to the same period which is the least common
multiple of their lives.
Following relationships apply:
𝑃𝑇1 𝐹𝑇1 𝐴𝑇1
𝑃𝑇2
= 𝐹𝑇2
= 𝐴𝑇2
Rate of return analysis
Method used by investors to realize the interest in terms of
percentage. Without no external factors involved, rate of return
described is refer to as Internal rate of return (IRR).
In setting up ROR equation to determine the IRR, apply
equivalence concept. In using PW approach, use PW receipts
equals to PW disbursement. That is,
𝑃𝑊𝑅 = 𝑃𝑊𝐷 , 𝑃𝑇 = 𝑃𝑊𝑅 − 𝑃𝑊𝐷 = 0
For FW and AW analysis,
𝐹𝑊𝑅 = 𝐹𝑊𝐷 , 𝐹𝑇 = 𝐹𝑊𝑅 − 𝐹𝑊𝐷 = 0
𝐴𝑊𝑅 = 𝐴𝑊𝐷 , 𝐴 𝑇 = 𝐴𝑊𝑅 − 𝐴𝑊𝐷 = 0
Rate of return evaluation of alternatives
1. Rank order alternatives on the basis of increasing investment as A
and B
2. Tabulate the incremental cash flows for B minus A
3. If alternatives have different lives, tabulate their incremental cash
flows using their least common multiple
4. If necessary draw an incremental cash flow program
5. Solve for iB-A
6. If iB-A>MARR, the extra cost is justified, select alternative B. If iB-
A<MARR, the smaller investment is justified, select alternative A
7. For three or more alternatives, pair comparisons must be made
until the best alternative is found.
Sample Problems
Determine the rate of return on a P 20 501 investment that
has an annual revenue of P 5000 over a five year period.
Sample Problems
Determine the acceptability of a ten-year project using IRR
method. The project requires an initial investment of
P15.35M and yearly expenditures of P1M for the next four
years. The expected income generated from this project is
P10M per year from the fifth to the tenth year. The required
MARR is 10%.
Sample Problems
Asia Toolkit Corp is considering an expansion proposal to
increase production. The proposal will require P18.1M for
additional equipment and space requirements. The net
receipts from this expansion are expected to be P4.5M per
year for the next eight years, after which, the equipment
will be sold for P0.78M. Using the IRR method, determine
the acceptability of this proposal. The company’s MARR is
16%.
Sample Problems
If the company uses 12% MARR and all equipment life is estimated at 5 years, Using the rate of return
analysis, determine the best alternative for the processes described. Compare the order ranking of the
alternative proposals with that of PW analysis

Lesson 6 Application of TVM Concepts in Investment Studies and Comparison of Alternatives

Uploaded by

Copyright:

Available Formats

Lesson 6 Application of TVM Concepts in Investment Studies and Comparison of Alternatives

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lesson 6 Application of TVM Concepts in Investment Studies and Comparison of Alternatives

Uploaded by

Copyright:

Available Formats

Application of Time Value of

Money Concepts in Investment

A predetermined rate set by the business to measure the

You might also like