Present Worth
Method of
Comparison
Online Lecture
Wednesday, Nov 10 2021
Bases for Comparison of
Alternatives
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
The goal is to convert a series of receipts & disbursements over a period of
time into one equivalent present time value.
• To convert one series of transaction
• To compare two unique investments with given future benefits and other factors
Steps:
i. Define various benefits/costs and period of investment
ii. Specify a rate of return on investments
iii. Specify an appropriate present worth formula
iv. Select best alternative by comparing the present worth amounts of the
alternatives
CASH FLOWS IN PRESENT WORTH METHOD
REVENUE-DOMINATED CASH FLOW COST-DOMINATED CASH FLOW
PW(i) = – P + R1[1/(1 + i)1] + R2[1/(1 + i)2] + ... PW(i) = P + C1[1/(1 + i)1] + C2[1/(1 + i)2] + ... + Cj[1/(1 + i) j]
+ Rj[1/(1 + i) j] + Rn[1/(1 + i)n] + S[1/(1 + i)n] + Cn[1/(1 + i)n] – S[1/(1 + i)n]
Example 1
Alpha Industry is planning to expand its production operation. It
has identified three different technologies for meeting the goal. The
initial outlay and annual revenues with respect to each of the
technologies are summarized in Table. Suggest the best technology
which is to be implemented based on the present worth method of
comparison assuming 20% interest rate, compounded annually.
Solution
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
Example 1
PW(20%)1 = -P +
Example 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.
Annual operation and maintenance cost, A = Rs.
Life = years
Interest rate, i = , compounded annually.
Solution
PW(15%) = P +
Future Worth Method
The goal is to convert a series of receipts & disbursements over a period of time
into one equivalent future time value.
• To convert one series of transaction
• To compare two unique investments with given future benefits and other factors
Steps:
i. Define various benefits & costs and period of investment
ii. Specify a rate of return on investments
iii. Specify an appropriate future worth formula
iv. The alternative with the maximum future worth of net revenue or with the
minimum future worth of net cost will be selected
CASH FLOWS IN FUTURE WORTH METHOD
REVENUE-DOMINATED CASH FLOW COST-DOMINATED CASH FLOW
FW(i) = –P(1 + i)n + R1(1 + i)n–1 + R2(1 + i)n–2 + ... FW(i) = P(1 + i)n + C1(1 + i )n–1 + C2(1 + i)n–2 + ...
+ Rj(1 + i)n–j + ... + Rn + S + Cj(1 + i)n–j + ... + Cn – S
Example 1
Consider the following two mutually exclusive alternatives. At i =
18%, select the best alternative based on future worth method of
comparison.
Solution
Alternative A
Initial outlay, P = Rs. 50,00,000
Annual revenue, A = Rs. 20,00,000
Interest rate, i = 18%, compounded annually
Life of this technology, n = 4 years
Solution
Alternative A
FW = -P x (1 + i)n + A x [(1+i)n −1]/i
(1 + i)n is Single Payment Compound Amount Factor (F/P,i,n)
[(1+i)n −1]/i is Equal Payment Compound Amount Factor (F/A,i,n)
FWA(18%) =
Solution
Alternative B
Initial outlay, P = Rs. 45,00,000
Annual revenue, A = Rs. 18,00,000
Interest rate, i = 18%, compounded annually
Life of this technology, n = 4 years
Solution
Alternative B
FW = -P x (1 + i)n + A x [(1+i)n −1]/i
FWB(18%) =
Example 2
A firm is planning to replace its furnace. It has received tenders
from three different original manufacturers of furnace. The details are
as follows:
Which is the best alternative based on future worth method at i
= 20%?
Solution
Manufacturer 1
Initial cost, P = Rs. 80,00,000
Annual operation and maintenance cost, A = Rs. 8,00,000
Life = 12 years
Salvage Value = 5,00,000
Interest rate, i = 20%, compounded annually
