CTC 475 Review Comparing Alternatives Alternatives can be developed from various proposals Planning horizons must be the same (LCM, Shortest Life, Longest Life, predetermined life)
CTC 475 Review
Comparing Alternatives Alternatives can be developed from various
proposals Planning horizons must be the same (LCM,
Shortest Life, Longest Life, predetermined life)
CTC 475
Comparing Alternatives
Objectives
Know how to apply the ranking method Know how to apply the incremental method Know different ways to do a supplementary
analysis Know how to sell your project
Steps for Comparing Alternatives
1. Determine the feasible alternatives
2. Define the planning horizon
3. Develop the cash flow profiles
4. Specify the MARR
5. Compare the alternatives
6. Perform supplementary analyses
7. Select the preferred alternative
Comparing Alternatives – 2 Approaches
Ranking Approach (PW, AW, FW)Compute the value for each alternative and rank the alternatives on the basis of the value you obtain
Incremental Approach (PW, AW, FW, IRR/ERR, SIR)
Comparisons are based on the differences in the cash flows for combinations of alternatives
Why not rank for IRR/ERR/SIR?
Someone borrows $100 from you and pays you back 1 year later with $150– Rate of return = ?
Someone borrows $1 from you and pays you back 1 year later with $2– Rate of return = ?
Which do you prefer?
Three Alternatives (MARR-15%)
EOY A B C
0 $0 -$50K -$75K
1 $4500 $20K $20K
2 $4500 $20K $25K
3 $4500 $20K $30K
4 $4500 $20K $35K
5 $4500 $20K $40K
Ranking Method-PW
Alt A: PW=4,500(P/A15,5)=$15,085
Alt B: PW=-50K+20K(P/A15,5)=$17,044
Alt C: PW=-75K+20K(P/A15,5)+5K(P/G15,5) =$20,920
Rank: Alt C is best
(Alt B is 2nd; Alt A is 3rd)
Steps for Incremental Analysis
1. Order alternatives according to size of initial investment
2. Find the first alternative that is feasible
3. If first alternative is feasible, find the difference in cash flows between the first 2 alternatives (2-1)
4. Determine if 2 is better than 1 (PW/AW/FW/IRR/ERR/SIR)
5. If 2 is better than 1 then compare the next 2 alternatives
Incremental Method (PW)
Step 1-Order alternatives from lowest to highest initial investment
Alt A $0 Alt B $50K Alt C $75K
Incremental Method (PW)
Step 2-Find first alternative that is economically feasible
Alt A PW>0 (feasible)
Compare B-A
EOY Cash Flow (B-A)
0 -50K
1 15.5K
2 15.5K
3 15.5K
4 15.5K
5 15.5K
Calc PW of B-A
PW=-50K+15.5K(P/A15,5)=+1,959
PW>0 therefore Alt B is better than Alt A
Compare C-B
EOY Cash Flow (C-B)
0 -25K (=-75K-(-50K))
1 0K (=20K-20K)
2 5K
3 10K
4 15K
5 20K
Calc PW of C-B
PW=-25K+5K(P/G15,5)=+3,876
PW>0 therefore Alt C is better than Alt B
Incremental Method (IRR)
Compare B-A Compare C to the “winner”
Cashflow of B-A
EOY Cash Flow (B-A)
0 -50K
1 15.5K
2 15.5K
3 15.5K
4 15.5K
5 15.5K
Calc IRR of B-A Cashflow
FW=-50K(F/PIRR,5)+15.5K(F/AIRR,5)=0 IRR=16.5%
IRR>MARR ------Alt B is better than Alt A
Cashflow of C-B
EOY Cash Flow (C-B)
0 -25K
1 0K
2 5K
3 10K
4 15K
5 20K
Calc IRR of 3-2 Cashflow
FW=-25K(F/PIRR,5)+5K(P/GIRR,5) (F/PIRR,5 ) =0 IRR=19.4%
IRR>MARR ------Alt C is better than Alt B
ERR using incremental method
Calc ERR of B-A Cashflow
50K(1+ERR)5=15.5K(F/A15,5) ERR=15.9%
ERR>MARR ------Alt B is better than Alt A
Calc ERR of C-B Cashflow
25K(1+ERR)5=5K (P/G15,5)(F/P15,5) ERR=18.4%
ERR>MARR ------Alt C is better than Alt B
SIR using incremental method
Calc SIR of B-A Cashflow
PW(+)/PW(-) 15.5K(P/A15,5)/50K SIR=1.01
SIR>1 ------Alt B is better than Alt A
Calc SIR of C-B Cashflow
PW(+)/PW(-) 5K(P/G15,5)/25K SIR=1.16
SIR>1 ------Alt C is better than Alt B
PBP
Alt A---PBP is instantaneous Alt B---PBP=2-3 years Alt C---PBP=3 years
If ranked by PBP A,B,C (opposite of other methods)
Supplementary Analyses
Breakeven Sensitivity Risk
Breakeven
Value may not be known for certain but can determine the break even value
Sensitivity
Determine how sensitive the final decision is to values you used.
How far off can the estimates be and still get the same answer?
Risk
Range of values are represented by probabilities
Selling the alternative
Management’s perspective is broad; develop the justification accordingly
Technical aspects should not be oversold Seek support from all parties prior to submission Timing is important Think about what you would want if you were the
boss Support your proposal w/ facts, not fantasy
Next lecture
Benefit/Cost Analyses