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Accept/reject an investment
Comparison of alternative investments
Chapter 5
Chapter 6
Chapter 5
5.1) Describing project cash flows
5.2) Initial project screening method
5.3) Discounted cash flow analysis
5.4) Variations of present worth analysis
5.5) Comparing mutually exclusive alternatives
Example 5.2
Consider the cash flows given in Example 5.1. Determine
the payback period for this computer-process control
system project.
Example 5.3
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Cash Flow
0
1
2
3
4
5
6
-$105,000+$20,000
$15,000
$25,000
$35,000
$45,000
$45,000
$35,000
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13
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Payback
period = 3,6
years
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Net-present-worth criterion
1.Determine the interest rate that the firm wishes to earn on its
investment: the required rate of return or minimum attactive
rate of return (MARR).
2.Estimate the service life of the project.
3.Estimate the cash inflow for each period over the service life.
4.Estimate the cash outflow for each period over the service life.
5.Determine the net cash flows.
6.Find the present worth of each net cash flow at the MARR.
Add up all the present worth figures; their sum is defined as
the projects NPW.
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Decision rule
Single project evaluation
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Example 5.4
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Example 5.5
$35,560
$37,360
$31,850
$34,400
inflow
0
1
outflow
$76,000
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>0
<0
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Figure 5.5 Present-worth profile described in Example 5.5 the machine tool project is acceptable as long as the
firms MARR is less than 30%.
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$34,400
inflow
0
1
outflow
$76,000
MARR = 12%
$34,400
inflow
0
1
outflow
$76,000
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Year
0
1
2
3
4
Interest
Debt
Receipt
Project
Balance
-76,000
27
Year
0
1
2
3
4
Interest
Debt
Receipt
9,120
85,120
35,560
Project
Balance
-76,000
-49,560
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Year
0
1
2
3
4
Interest
Debt
Receipt
9,120
5,947
85,120
55,507
35,560
37,360
Project
Balance
-76,000
-49,560
-18,147
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Year
Interest
Debt
Receipt
0
1
2
3
4
9,120
5,947
2,178
-1,383
85,120
55,507
20,325
-12,908
35,560
37,360
31,850
34,400
Project
Balance
-76,000
-49,560
-18,147
11,525
47,308
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31
32
1.
2.
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35
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After completion:
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Figure 5.9 Cash flow diagram for the Helpmate project (Example 5.6).
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40
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Figure 5.11 Net cash flow diagram for Mr. Bracewells hydroelectric project (Example 5.8).
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Figure 5.12 Diagram illustrating the process of making a choice among mutually exclusive alternatives.
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Scale of investment
The disparity in scale of investment should not be of concern
in comparing mutually exclusive alternatives, as long as:
funds not invested in the project will continue to earn interest
at the MARR.
We will look at mutually exclusive alternatives that require
different levels of investments for both service projects and
revenue projects.
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Scale of investment
Figure 5.13 Comparing mutually exclusive revenue projects requiring different levels of investment.
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Analysis period
If required service period is not specified analysis
period = useful life
If useful life required service period
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Ex. 5.11
Ex. 5.10
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Figure 5.15 (a) Cash flow for model A; (b) cash flow for model B; (Example 5.10).
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NEW salvage
value = 125000 * 2
NEW salvage
value = 45000 * 2
Original salvage
value = 25000 * 2
Original salvage
value = 30000 * 2
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Figure 5.15 (a) Cash flow for model A; (b) cash flow for model B; (c) comparison of service projects with unequal lives
when the required service period is shorter than the individual project life (Example 5.10).
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Example 5.11
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Figure 5.16 Comparison for service projects with unequal lives when the required service period is longer than the
individual project life (Example 5.11).
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Figure 5.17 Comparison of revenue projects with unequal lives when the analysis period coincides with the project
with the longest life in the mutually exclusive group (Example 5.12). In our example, the analysis period is five years,
assuming no cash flow in years 4 and 5 for the lease option.
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Ex. 5.11
Ex. 5.10
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1.
Example 5.13
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Example 5.11
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Figure 5.18
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Do not confuse:
Capitalized equivalent-worth analysis: It is useful
when the proposed project is perpetual or the
planning horizon is extremely long. We invest only
once.
A
PW (i )
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Exercise
Find the capitalized cost of a present cost of $300.000,
annual costs of $35.000, and periodic costs every 5 years
of $75.000. Use an interest rate of 12% per year.
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Model A
-8000
3500
3500
3500
Model B
-15000
10000
10000
-
a)Notice that the models have different service lives. However, model A will be
available in the future with the same cash flows. Model B is available at one time
only. If you select model B now, you will have to replace it with model A at the end
of year 2. If your firm uses the present worth as a decision criterion, which model
should be selected, assuming that the firm will need either model for 3 years?
Salvage Value for Model A, at the end of 1 one year is $6000.
b)Suppose that your firm will need either model for only two years. Determine the
salvage value of model A at the end of year 2 that makes both models indifferent
(equally likely).
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Project A1
-15000
9500
12500
7500
Project A2
-25000
0
X
X
PW (15%) Project A1 = ?
PW (15%) Project A2 = 9300
a)Compute PW (15%) for project A1.
b)Compute the unknown cash flow X in years 2 and 3 for project A2.
c)Compute the project balance (at 15%) of project A1 at the end of period 3.
d)If these two projects are mutually exclusive alternatives, which one would you
select?
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