CHAPTER TWO

Methods of comparison of alternatives

and Decision Analysis
Present worth method of comparing alternatives
Future worth method of comparing alternatives
Annual payment method of comparing alternatives
Rate of return (ROR) method of comparing
alternatives
Incremental rate of return (IROR) on required
investment
 Comparison of alternatives
• For most of the engineering projects,
equipments etc., there are more than one
feasible alternative.
• The Project management team of the client
organization selects the best alternative that
involves less cost and results more revenue.
• For this purpose, the economic comparison
of the alternatives is made.
 Comparison of alternatives
 Alternatives are always present for any
economic decision
 Alternatives evaluation variables are:
Initial cost; interest rate (rate of return)
Anticipated life of equipment (economic life)
Annual maintenance/operating cost or benefit
Resale or salvage value
 Alternative Selection
• To select an alternative among different ones, the
measure-of-worth values are compared
• This is simply the result of engineering economy
analysis

• Once the alternatives are evaluated and compared,

the best alternative is selected and implemented

• Keep in mind that the alternatives represent projects

that are economically and technologically viable
 Project Categories
To help formulate alternatives, projects are
categorizes as one of the following:
• Mutually exclusive. Only one of the viable projects can be
selected by the economic analysis. Each viable project is an
alternative and compete among each other (when an
engineer must select the one best diesel-powered engine
from several competing models)

• Independent. More than one viable project may be selected

by the economic analysis. They do not compete among each
other
1. PRESENT WORTH METHOD OF
COMPARING ALTERNATIVES
 Present Worth Analysis of Equal-Life Alternatives
• In present worth analysis, the P value, now called PW, is
calculated at the MARR for each alternative.
• MARR is the minimum attractive rate of return and is higher
than the rate expected from a bank or some safe investment.
• The expected rate of return must meet or exceed the MARR for
an alternative to be financially viable.
• The present worth method is popular because future cost and
revenue estimates are transformed into equivalent birr now
• Converts all cash flows to a single sum equivalent at time zero
using i = MARR over the planning horizon
• Bring all cash flows back to “time zero” and add them up
 Present Worth Analysis of Equal-Life
Alternatives
• That is, all future cash flows are converted into present birr

• This makes it easy to determine the economic advantage of

one alternative over another

• The PW comparison of alternatives with equal lives is

straightforward

• If alternatives are used for the same time period, they are
termed equal-service alternatives
 Present Worth Analysis of Equal-Life
Alternatives
In mutually exclusive alternatives, the following guidelines
are applied to select one alternative:

• One alternative. Calculate PW at the MARR. If PW ≥ 0, the

requested MARR is met or exceeded and the alternative is
financially viable

• Two or more alternatives. Calculate the PW of each

alternative at the MARR. Select the alternative with the PW
value that is numerically largest (less negative or more
positive), indicating a lower PW of cost cash flows or larger
PW of net cash flows of receipts minus disbursements
 Present Worth Analysis of Equal-Life
Alternatives

• Note that the guideline to select one alternative with the

lowest cost or the highest income uses the criterion of
numerically largest

• This is NOT the absolute value of the PW amount, because the

sign matters

• If the projects are independent, the selection guideline is as

follows:
• For one or more independent projects, select all projects with
PW ≥ 0 at the MARR
 Examples 1
• Perform a present worth analysis of equal-service machines
with the costs shown below, if the MARR is 10% per year.
Revenues for all three alternatives are expected to be the
same

Cost Type Electric- Gas- Solar-

Powered Powered Powered
First cost, ETB -2,500 -3,500 -6,000
Annual operating -900 -700 -50
Cost, ETB
Salvage Value, ETB 200 350 100
Life, years 5 5 5
Solution:
• The salvage values are considered a “revenue” not cost, so a +
sign precedes them
• The PW of each machine is calculated at i = 10% for n = 5years

PWE = – 2,500 – 900(P/A,10%,5) + 200(P/F,10%,5) = – 5,788Br

PWG = – 3500 – 700(P/A,10%,5) + 350(P/F,10%,5) = – 5,936Br
PWS = – 6000 – 50(P/A,10%,5) + 100(P/F,10%,5) = – 6,127Br

• The electric-powered machine is selected since the PW of its

costs is the lowest; it has the numerically largest PW value
 Examples 2
• A firm is considering which of two mechanical devices to
install to reduce costs in a particular situation. Both devices
cost $1000 and have useful lives of 5 years and no salvage
value. Device A can be expected to result in $300 savings
annually. Device B will provide cost savings of $400 the first
year but will decline $50 annually, making the second-year
savings $350, the third-year savings $300, and so forth. With
interest at 7%, which device should the firm purchase?
 Examples 3
• X County will build an aqueduct to bring water in from the
upper part of the state. It can be built at a reduced size now
for $300 million and be enlarged 25 years hence for an
additional $350 million. An alternatives to construct the full-
sized aqueduct now for $400 million. Both alternatives would
provide the needed capacity for the 50-year analysis period.
Maintenance costs are small and may. Be ignored. At 6%
interest, which alternative should be selected?
I. For the two stage construction
PW = 300 million + 350 million(P/F, 6%, 25)
II. For the one stage construction
PW = 400 million
Since the two stage construction have smaller PW, it is preferred
to invest in the form 300 million now and enlarge after 25 year.
 Present Worth Analysis of Different-life
Alternatives

• When the present worth method is used to compare mutually

exclusive alternatives that have different lives, then the PW of
the alternatives must be compared over the same number of
years and end at the same time

• A fair comparison can be made only when the PW values

represent costs (and receipts) associated with equal periods

• The equal-period requirement can be satisfied by comparing

the alternatives over a period of time equal to the least
common multiple (LCM) of their lives.
 Present Worth Analysis of Different-life
Alternatives – The LCM Approach
• The LCM approach automatically makes the cash flows for all
alternatives extend to the same time period
• For example, alternatives with expected lives of 2 and 3 years
are compared over a 6-year time period
• Such a procedure requires that some assumptions be made
about subsequent life cycles of the alternatives
• The assumptions of a PW analysis of different-life alternatives
for the LCM method are as follows:
 The service provided by the alternatives will be needed for at
least the LCM of years
 The selected alternative will be repeated over each life cycle of
the LCM in exactly the same manner
 The cash flow estimates will be the same in every life cycle
 Examples

1. A project engineer is assigned to start up a new office in a

city where a 6-year contract has been finalized
Two lease options are available, each with a first cost, annual
lease cost, and deposit-return estimates shown below
Location A Location B
First cost, ETB -15,000 -18,000
Annual lease cost, ETB -3,500 -3,100
Deposit return, ETB 1,000 2,000
Lease term, years 6 9
• Determine which lease option should be selected on the basis
of a present worth comparison, if the MARR is 15% per year
Solution
Solution:
• Since the leases have different lives, compare them over the
LCM of 18 years
• Repeat the first cost in year 0 of each new cycle
• Calculate PW at 15% over 18 years
• PWA = – 15,000 – 15,000(P/F,15%,6)+1,000(P/F,15%,6)
– 15,000 (P/F,15%,12)+1,000(P/F,15%,12)
+ 1,000(P/F,15%,18) –3,500(P/A,15%,18) = –45,036 ETB
• PWB = – 18,000 – 18,000(P/F,15%,9) + 2,000(P/F,15%,9) +
2,000(P/F,15%,18) – 3,100(P/A,15%,18) = –41,384 ETB

 Location B is selected, since it costs less in PW terms;

that is, the PWB value is numerically larger than PWA
 Examples

• Two processes can be used for producing a polymer that

reduces friction loss in engines. Process K will have a first cost
of $160,000, an operating cost of $7000 per quarter, and a
salvage value of $40,000 after its 2-year life. Process L will
have a first cost of $210,000, an operating cost of $5000 per
quarter, and a $26,000 salvage value after its 4-year life.
Which process should be selected on the basis of a present
worth analysis at an interest rate of 8% per year, compounded
quarterly?
Capitalized worth (Cost) method of Analysis
Cont…

Or CW= AW/i
 Cont…
• Capitalized cost (CC) called also capitalized worth(CW)
• A perpetuity is an investment that has an infinite life
• And capitalized worth is the present worth of a perpetuity
• The capitalized worth indicates the amount of money needed
“up front” such that the interest earned will cover the cash
flow requirements forever for the investment
• Used mostly by government
 Examples
1. A new computer system will be used for the
indefinite future, find the equivalent value now if
the system has an installed cost of 150,000 ETBand
an additional cost of 50,000 ETB after 10 years. The
annual maintenance cost is 5,000 ETB for the first 4
years and 8,000 ETB thereafter. In addition, it is
expected to be a recurring major upgrade cost of
15,000 ETB every 13 years. Assume that i = 5% per
year.
Solution:
• Draw a cash flow diagram for
Solution
 Examples:
1. Two sites are currently under consideration for a bridge over a small river. The
north site requires a suspension bridge. The south site has a much shorter span,
allowing for a truss bridge, but it would require new road construction. The
suspension bridge will cost $500 million with annual inspection and maintenance
costs of $350,000. In addition, the concrete deck would have to be resurfaced
every 10 years at a cost of $1,000,000.

The truss bridge and approach roads are expected to cost $250 million and have
annual maintenance costs of $200,000. This bridge would have to be painted
every 3 years at a cost of $400,000. In addition, the bridge would have to be
sandblasted every 10 years at a cost of $1,900,000. The cost of purchasing right-
of-way is expected to be $20 million for the suspension bridge and $150 million
for the truss bridge. Compare the alternatives on the basis of their capitalized cost
if the interest rate is 6% per year.
Solution:
I. Capitalized cost of suspension bridge
CC1 = Capitalized cost initial cost
= -500 – 20 = $ -520 million
The recurring operating cost A1 = $ -350,000 and the annual equivalence resurfacing every
10
A2 = $ -1,000,000(A/F, 6%, 10) = $ -1,000,000(0.07587) = $ -75,870
CC2 = (A1+A2)/I
= (-350,000 – 75, 870)/0.06
= $-7,097,833
CC of suspension bridge is = -520,000,000 – 7,097,833
= $ - 527.1 million Build Truss bridge
II. Capitalized cost of truss bridge
CC1 = Capitalized cost initial cost
= -250 – 150 = $ -400 million
A1 = $-200,000
A2= Annual cost of painting = $ -400,000( A/F, 6%, 3) = -400,000( 0.31411) = $ -125,644
A3 = Annual cost of sandblasting = $ - 1,900,000 (A/F, 6%, 10) = $ -144,153
CC2 = ( A1 + A2 + A3 )/0.06 = $ -7,829,950
CC of truss bridge is = -400,000,000 – 7,829,950
= $ - 407.3 million
2. FUTURE WORTH METHOD OF COMPARING
ALTERNATIVES
• The future worth of an alternative (FW) can be used to
compare alternatives
• FW analysis is suitable for projects that will not come online
until the end of the investment period
• Once the FW value is determined, the selection guidelines
are the same as with PW analysis
• For one alternative, if FW ≥ 0 means the MARR is met or
exceeded
• For two mutually exclusive alternatives, select the one with
the numerically larger FW value
Examples:
1. A company purchased a store chain for 75 million ETB three
years ago. There was a net loss of 10 million ETB at the end
of year 1 of ownership. Net cash flow is increasing with an
arithmetic gradient of +5 million ETB per year starting the
second year, and this pattern is expected to continue for the
foreseeable future. Expected MARR of 25% per year

a) The company has just been offered 159.5 million ETB to sell
the store. Use FW analysis to determine if the MARR will be
realized at this selling price
b) If the company continues to own the chain, what selling price
must be obtained at the end of 5 years of ownership to make
the MARR?
 Solution
• Find the future worth in year
3 at i = 25% per year and an
offer price of 159.5 million ETB

• FW = – 75(F/P,25%,3) –
10(F/P,25%,2) – 5(F/P,25%,1)
+ 159.5 = –168.36 + 159.5
= –8.86 million ETB

• No, the MARR of 25% will not

be realized if the 159.5
million ETB offer is accepted
 Solution
2) Determine the future
worth 5 years from
now at 25% per year

• FW = – 75(F/P,25%,5) –
10(F/A,25%,5) +
5(A/G,25%,5)(F/A,25%,5)
= –246.81 million ETB

• The offer must be for at

least 246.81 million ETB to
make the MARR
3. Annual worth method of comparing
alternatives
• The mutually exclusive alternatives are compared on the
basis of equivalent uniform annual worth(EUAW).
• The EUAW represents the annual equivalent value of all the
cash inflows and cash outflows
• The equivalent uniform annual worth of all expenditures and
incomes of the alternatives are determined
• Compound interest factors namely capital recovery factor,
sinking fund factor and annual worth factors for arithmetic
and geometric gradient series
• Since equivalent uniform annual worth of the alternatives over
the useful life are determined, same procedure is followed
irrespective of the life spans of the alternatives.
 Cont…
• Advantages of the Annual Worth Analysis
• Eliminates the LCM problem
• Only you evaluate one life cycle of a project
• The result is reported in terms of birr/period
• If two or more alternatives possess unequal
lives then one need only evaluate the AW for
any given cycle
 Examples
1. There are two alternatives for purchasing a concrete mixer.
Both the alternatives have same useful life. The cash flow
details of alternatives are as follows;
Costs Alternative-1 Alternative-2
Initial purchase cost (ETB) 300,000 200,000
Annual operating and maintenance 20,000 35,000
cost (ETB)
Expected salvage value (ETB) 125,000 70,000
Useful life 5 years 5 years
The annual revenue to be generated from production of
concrete (by concrete mixer) from Alternative-1 and Alternative-2
are 50,000 and 45,000 respectively. find out the economical
alternative using equivalent uniform annual worth of the
alternatives at the interest rate of 10% per year.
• CFD

Alternative-1 Alternative-2
• AW1= -300,000(A/P,i,n)-20,000+50,000+125,000(A/F,i,n)
• AW1= -300,000(A/P,10%,5)-20,000+50,000+125,000(A/F,10%,5)
AW1= -28,655 ETB
• AW2= -200,000(A/P,i,n)-35,000+45,000+70,000(A/F,i,n)
• AW2= -200,000(A/P,10%,5)-20,000+45,000+70,000(A/F,10%,5)
AW2= -31,294 ETB
Alternative-1 will be selected
Examples:
2. Using the annual worth method, compare the following
machines having different life spans at an interest rate of
11.5% per year.
Costs Machine-1 Machine-2
Initial purchase cost (ETB) 1,200,000 1,400,000
Annual operating cost (ETB) 38,000 26,000
Expected salvage value (ETB) 320,000 450,000
Annual Revenue (ETB) * 290,000
Useful life 14 years 7 years

* The Annual revenue of Machine-1 is 210,000 for first 6 years

and then 225,000 afterwards till the end of useful life.
Soln:
Draw the cash flow diagrams
• CFD of:
Machine-1

Machine-2
Examples:
For Machine-1
• Annual revenue is in the form of two uniform annual amount
series(210,000 from beginning till end of year 6 and 225,000
from end of year 7 till the end of useful life).
• The annual revenue in the CFD can be 210,000 from
beginning till the end of useful life and the annual amount
of 15,000 from end of year 7 till the end of useful life.
• For the annual revenue of 15,000 from end of year 7 till the
end of useful life, first the equivalent future worth is
calculated followed by the calculation of the equivalent
annual worth.
 The equivalent uniform annual worth of Machine-1 is computed
as follows;
 AW1= -1,200,000 (A/P,11.5%,14)-38,000+210,000+15,000
(F/A,11.5%,8) (A/F,11.5%,14)+320,000(A/F,11.5%,14)
 AW1= -1,200,000x0.14703-38,000+210,000+
15,000x12.07744*0.03203 +320,000x0.03203
 AW1= -176,436-38,000+210,000+ 5803+10250
AW1= 11,617 ETB
 The equivalent uniform annual worth of Machine-2 is calculated
as follows;
 AW2= -1,400,000 (A/P,11.5%,7)-
26,000+290,000+450,000(A/F,11.5%,7)
 AW2= -1,400,000x0.21566-26,000+290,000+450,000x0.010066
 AW2= -301,924-26,000+290,000+45,297
AW2= 7,373 ETB
• The equivalent uniform annual worth of Machine-2 can be
determined as follows also;

• AW2= -1,400,000 (A/P,11.5%,14)-26,000+290,000+ 450,000

x(P/F,11.5%,7)(A/P,11.5%,14)-1,400,000x(P/F,11.5%,7)
(A/P,11.5%,14)+450,000(A/F,11.5%,14)
• AW2= -1,400,000 x0.14703-26,000+290,000+ (450,000 -
1,400,000)*0.46674*0.14703+ 450,000*0.03203
AW2=7,378 , so select Machine -1
• The calculated EUAW of Machine-2 for two cycles of cash flow is
same as that with only one cycle i.e. first cycle.
• The minor difference is due to the effect of decimal points
2.4 RATE OF RETURN (ROR)

• The rate of return technique is one of the methods used in

selecting an alternative for a project.

• The rate of return is the interest rate that makes the present
worth or annual worth of a cash flow series exactly equal to 0

• The rate of return is also known by other names namely

internal rate of return (IRR), Profitability index etc.

• The rate of return is denoted by ROR or “ir ”

 Calculating Rate of Return
• Convert the various consequences of the investment into a cash
flow.
• Solve the cash flow for the unknown value of the internal rate of
return (IRR).
• Use any of the following forms: Where:
• EUAB and EUAC are the
1. PW of benefits – PW of costs = 0 Equivalent
Uniform
2. (PW of benefits)/(PW of costs)  1 Annual
3. Net present worth = 0 Benefits and
Costs
4. EUAB – EUAC = 0
5. PW of costs = PW of benefits
• Any of the previous forms relate costs and benefits with the IRR
as the only unknown.
• Rate of Return: It is the interest rate at which the benefits are
equivalent to the costs
Rate of Return
Rate of Return
Examples:
1. A construction firm is planning to invest 800,000 for the
purchase of a construction equipment which will generate
a net profit of 140,000 per year after deducting the
annual operating and maintenance cost. The useful life of the
equipment is 10 years and the expected salvage value of
the equipment at the end of 10 years is 200,000.
Compute the rate of return using trial and error method
based on present worth, if the construction firm’s minimum
attractive rate of return (MARR) is 10% per year.
Solution:
• CFD
Examples:
• For determination of rate of return Ir of the construction
equipment, first the equation for net present worth of cash
inflows and cash outflows is equated to zero.
• Then using the trial and error method the value of Ir is
determined.
Pw= -800,000+140,000(P/A, i,10)+200,000(P/F, i, 10)
• For the determining the value of Ir the net present worth is
equated to zero.
• 0=-800,000+140,000(P/A, i,10)+200,000(P/F, i, 10)
• Since MARR is 10%, first assume a value of Ir equal to 8% and
compute the net present worth.
• Now putting the values of different compound interest factors
in the expression for net present worth at Ir equal to 8%
results in the following;
i(%) 8% 12% 14%
PW 232,054 55,428 -15,806
Examples:
2. An investment resulted in the following cash flow. Compute the
rate of return.
Year Cash Flow
Use the form: EUAB – EUAC = 0 0 -700
100 + 75(A/G, i, 4) – 700(A/P, i, 4) = 0 1 +100
• Solve the equation by trial and error 2 +175
3 +250
4 +325

• Try i = 5% ► 100 + 75(1.439) – 700(0.2820) = +11

• Try i = 8% ► 100 + 75(1.404) – 700(0.3019) = – 6
• Try i = 7% ► 100 + 75(1.416) – 700(0.2952) = 0
• Therefore the IRR is exactly 7%. (Again, no interpolation was
needed)
Examples:
3. Calculate the rate of return on the investment on the
following cash flow. Year Cash Flow
0 -100
Use the form: NPW = 0
1 +20
NPW = –100 + 20(P/F, i, 1) + 30(P/F, i, 2)
2 +30
+ 20(P/F, i, 3) + 40(P/F, i, 4) + 40(P/F, i, 5) 3 +20
Try i = 12% ► 4 +40
NPW = –100 + 20(0.8929) + 30(0.7972) + 20(0.7118) 5 +40

+40(0.6355) + 40(0.5674) = +4.126

Try i = 15% ►
NPW = –100 + 20(0.8969) + 30(0.7561) + 20(0.6575)
+40(0.5718) + 40(0.4972) = – 4.02
Therefore, the IRR lies between 12% and 15%. By linear
interpolation, we find that the IRR is: IRR = 13.5%
Examples:
4. For the cash flow of the two alternatives shown in the table
Which alternative would you select?
Year Alt. 1 Alt. 2
0 -10 -20
a) Using PW analysis 1 +15 +28
b) Using rate of return
Use a Minimum Attractive Rate of Return (MARR) of 6%.
Solution:
a) Using PW analysis
Alt.1: NPW = 15(P/F, 6%, 1) – 10 = 15(0.9434) – 10 = 4.15
Alt. 2: NPW = 28(P/F, 6%, 1) – 20 = 28(0.9434) – 20 = 6.415
Based on the PW analysis one should select Alt. 2.
Examples:
b) Using rate of return
Alt. 1:
PW of cost of Alt.1 = PW of benefit of Alt.1
10 = 15(1+ i )-1 ► i = 50%
i.e. the rate of return for Alt. 1 is 50%
Alt. 2:
PW of cost of Alt.2 = PW of benefit of Alt.2
20 = 28(1+ i)-1 ► i = 40%
i.e. the rate of return for Alt. 2 is 40%
Based on the rate of return results one should select alternative 1,
which contradicts with the PW analysis results.
What should we follow; the PW analysis or the rate of return?
• Since we know that the PW analysis is correct, the previous
example tells us that something went wrong in the rate of
return approach.

For one alternative:

 To determine the desirability of one alternative:

1. Compute the IRR from the cash flow

2. Compare the computed IRR with a preselected minimum

attractive rate of return (MARR). The project is desirable if
IRR≥MARR.
2.5 INCREMENTAL RATE OF RETURN(DROR)
 When there are two alternatives,

 It cannot simply pick the highest IRR if alternatives have different investment
costs

 Must examine the incremental cash flows

 rate of return analysis is performed by computing the incremental rate of

return DROR on the difference between the alternatives. The difference can
be:

1. Increments of Investment:

 Compute the cash flow for the difference between the alternatives, which is
computed by subtracting the cash flows for the “Lower First Cost”
alternative from the cash flows of the “Higher First Cost” alternative to
obtain the “Incremental Cash Flow” or D.
 Incremental Rate of return(DROR)
Compute the IRR on the incremental cash flow. This is the
DROR.
 Choose the higher-cost alternative if DROR ≥ MARR
 Choose the lower-cost alternative if DROR < MARR
2. Increments of Borrowing:
• The reverse is done.
• For the above Year Alt. 1 Alt. 2 Alt. 2- Alt.1
example 0 -10 -20 -10
1 +15 +28 +13

• For the cost of differences cash flow (Alt.2 – Alt.1), compute

the DROR :
 Incremental Rate of return(DROR)
PW of cost of (Alt.2 – Alt.1) = PW of benefit of (Alt.2 – Alt.1)
10 = 13(P/F, i , 1)
(P/F, i , 1) = 10/13= 0.7692
• From the compound interest tables i = 30%. (OR you can just
say an increase of 10 to 13 is 30% increase)
• Since DROR ≥ MARR, choose Alternative 2.
• What happened was that the 30% rate of return on the
difference between the alternatives is far higher than the 6%
MARR.
• In other words, the additional 10 ETB investment (at 30%
DROR) is superior to investing the 10 ETB elsewhere at 6%.
Examples:
5. Consider the cash flow for Alternative A and Alternative B as
shown below. which alternatives will acceptable? Assume
MARR(6%)
Cash flow of Cash flow of
Year
Alternative A Alternative B
0 -1000 -2783
1 200 1200
2 200 1200
3 1200 1200
4 1200 1200
5 1200 1200
 Solution:
• Must examine the incremental cash flows!!
• Obtain the “Incremental Cash Flow” or D.
• Compute the IRR on the incremental cash flow, DROR.
Cont…
• The DROR is Cash flow of Cash flow of Cash flow of
Year Alternative Alternative Alternative
8.01% which is A B B-A
0 -1000 -2783 -1783
> MARR=6%, 1 200 1200 1000
Therefore, 2 200 1200 1000
3 1200 1200 0
choose the 4 1200 1200 0
higher cost 5 1200 1200 0

alternative. IRR 48.72% 32.60% 8.01%

 Q. Why did we do this?

Cont…
• Ans. Both alternatives were acceptable compared only to the
MARR.
• Since either alternative will work, the question is whether we
want to spend the additional 1783 ETB to go from the lower
cost to the higher cost alternative.
• The benefit for doing so is the savings of two years of 1000
ETB payments.
• Essentially we are getting an 8.01% return on that 1783 ETB
investment.
• The company can get 10% ROR on its money elsewhere, so
reject the increment.
• That is, spend 1000 ETB now on lower cost (Alternative A) and
invest the other 1783 ETB for a higher return.
Cont…
• The following information is provided for five mutually
exclusive alternatives that have 20-year useful lives. If the
minimum attractive rate of return is 6%, which alternatives
should be selected?
 Rate of Return by by Spreadsheet
• Ir (IRR) by Spreadsheet
• The fastest way to determine an Ir value when there is a series
of equal cash flows (A series) is to apply the RATE function.
• This is a powerful one-cell function, where it is acceptable to
have a separate P value in year 0 and a separate F value in
year n. The format is
=RATE (n,A,P,F)

• When cash flows vary from year to year (period to period),

the best way to find Ir is to enter the net cash flows into
contiguous cells (including any 0 amounts) and apply the IRR
function in any cell. The format is

=IRR(first cell:last cell)

Examples:
1.An investor spent an investment of 1,145,000 ETB now for the
construction of G+1 commercial building. He planned to gain an
estimated savings of 150,000 ETB per year from rental for each of
the next 10 years and to sale the building by 300,000 at the end of
year 10 . Determine the rate of return using hand and spreadsheet
solutions.
Solution:
Assignment: 2

1. An investment resulted in the following cash

flow. Compute the rate of return.
Year Cash flow

0 -7,000
1 1,000
2 1,500
3 2,500
4 3,250