PRESENT WORTH METHOD OF COMPARISON

In this method of comparison, the cash flows of each

alternative will be reduced to time zero by assuming an
interest rate i. Then, depending on the type of decision,
the best alternative will be selected by comparing the
present worth amounts of the alternatives.
The sign of various amounts at different points in time in a
cash flow diagram is to be decided based on the type of the
decision problem.
In a cost dominated cash flow diagram, the costs
(outflows) will be assigned with positive sign and the
profit, revenue, salvage value (all inflows), etc. will
be assigned with negative sign.

In a revenue/profit-dominated cash flow diagram,

the profit, revenue, salvage value (all inflows to an
organization) will be assigned with positive sign.
The costs (outflows) will be assigned with
negative sign.
In case the decision is to select the alternative with
the minimum cost, then the alternative with the
least present worth amount will be selected. On the
other hand, if the decision is to select the alternative
with the maximum profit, then the alternative with
the maximum present worth will be selected.
 REVENUE-DOMINATED CASH FLOW
DIAGRAM
A generalized revenue-dominated cash flow
diagram to demonstrate the present worth method of
comparison is presented in Fig. 4.1.
In Fig. 4.1, P represents an initial investment and Rj the
net revenue at the end of the jth year. The interest rate is i,
compounded annually. S is the salvage value at the end of
the nth year.

To find the present worth of the above cash flow diagram

for a given interest rate, the formula is
PW(i) = – P + R1[1/(1 + i)1] + R2[1/(1 + i)2] + ...
+ Rj[1/(1 + i) j] + Rn[1/(1 + i)n] + S[1/(1 + i)n]

In this formula, expenditure is assigned a negative sign

and revenues are assigned a positive sign.
PW(i) = – P + R (
EXAMPLE 4.1 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 4.1. Suggest the
best technology which is to be implemented based on
the present worth method of comparison assuming
20% interest rate, compounded annually.
Solution In all the technologies, the initial outlay is
assigned a negative sign and the annual revenues are
assigned a positive sign.
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
The cash flow diagram of this technology is as shown
in Fig. 4.3.
The present worth expression for this technology
is
PW(20%)1 = –12,00,000 + 4,00,000 × (P/A, 20%,
10)
= –12,00,000 + 4,00,000 × (4.1925)
= –12,00,000 + 16,77,000
= Rs. 4,77,000
The present worth expression for this
technology is
PW(20%)2 = – 20,00,000 + 6,00,000 × (P/A,
20%, 10)
= – 20,00,000 + 6,00,000 × (4.1925)
= – 20,00,000 + 25,15,500
= Rs. 5,15,500
TECHNOLOGY 3

Initial outlay, P = Rs. 18,00,000 Annual revenue, A =

Rs. 5,00,000
Interest rate, i = 20%, compounded annually Life of this
technology, n = 10 years
The cash flow diagram of this technology is shown in
Fig. 4.5.
The present worth expression for this technology is
PW(20%)3 = –18,00,000 + 5,00,000 × (P/A, 20%, 10)
= –18,00,000 + 5,00,000 × (4.1925)
= –18,00,000 + 20,96,250
= Rs. 2,96,250
From the above calculations, it is clear that the
present worth of technology 2 is the highest
among all the technologies. Therefore, technology
2 is suggested for implementation to expand the
production.
 COST-DOMINATED CASH FLOW DIAGRAM

A generalized cost-dominated cash flow diagram to

demonstrate the present worth method of comparison is
presented in Fig. 4.2.
In Fig. 4.2, P represents an initial investment, Cj the net
cost of operation and maintenance at the end of the jth
year, and S the salvage value at the end of the nth year.
To compute the present worth amount of the above cash
flow diagram for a given interest rate i, we have the
formula
PW(i) = P + C1[1/(1 + i)1] + C2[1/(1 + i)2] + ... + Cj[1/(1 + i) j]
+ Cn[1/(1 + i)n] – S[1/(1 + i)n]

In the above formula, the expenditure is assigned a positive

sign and the revenue a negative sign. If we have some more
alternatives which are to be compared with this alternative,
then the corresponding present worth amounts are to be
computed and compared. Finally, the alternative with the
minimum present worth amount should be selected as the
best alternative
EXAMPLE 4.2 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. 4,50,000
Annual operation and maintenance cost, A = Rs. 27,000 Life
= 15 years
Interest rate, i = 15%, compounded annually.
The cash flow diagram of bid 1 is shown in Fig. 4.6.
 The present worth of the above cash flow diagram is
computed as follows:
PW(15%) = 4,50,000 + 27,000(P/A, 15%, 15)
= 4,50,000 + 27,000 × 5.8474
= 4,50,000 + 1,57,879.80
= Rs. 6,07,879.80

Bid 2: Beta Elevator Inc.

Initial cost, P = Rs. 5,40,000
Annual operation and maintenance cost, A = Rs. 28,500 Life =
15 years
Interest rate, i = 15%, compounded annually.
PW(15%) = 5,40,000 + 28,500(P/A, 15%, 15)
= 5,40,000 + 28,500 × 5.8474
= 5,40,000 + 1,66,650.90
= Rs. 7,06,650.90
The total present worth cost of bid 1 is less than that of bid 2. Hence, bid 1 is
to be selected for implementation. That is, the elevator from Alpha
Elevator Inc. is to be purchased and installed in the new building.
EXAMPLE 4.4 A granite company is planning to buy a
fully automated granite cutting machine. If it is
purchased under down payment, the cost of the machine
is Rs. 16,00,000. If it is purchased under installment
basis, the company has to pay 25% of the cost at the
time of purchase and the remaining amount in 10 annual
equal installments of Rs. 2,00,000 each. Suggest the best
alternative for the company using the present worth
basis at i = 18%, compounded annually.
Solution There are two alternatives available for the
company:
Down payment of Rs. 16,00,000
Down payment of Rs. 4,00,000 and 10 annual equal
installments of Rs. 2,00,000 each
Present worth calculation of the second alternative. The cash
flow diagram of the second alternative is shown in Fig. 4.10.
EXAMPLE 4.5 A finance company advertises two investment
plans. In plan 1, the company pays Rs. 12,000 after 15 years for
every Rs. 1,000 invested now. In plan 2, for every Rs. 1,000
invested, the company pays Rs. 4,000 at the end of the 10th year
and Rs. 4,000 at the end of 15th year. Select the best investment
plan from the investor’s point of view at i = 12%, compounded
annually.
Plan 2. The cash flow diagram for plan 2 is shown in Fig. 4.12
 Innovative Investment Ltd’s plan. The cash flow diagram of
the Innovative Investment Ltd’s plan is illustrated in Fig. 4.14.

The present worth of Innovative Investment Ltd’s plan is more than that of Novel Investment
Ltd’s plan. Therefore, Innovative Investment Ltd’s plan is the best from investor’s point of
view.
 FUTURE WORTH METHOD
In the future worth method of comparison of alternatives, the
future worth of various alternatives will be computed. Then, the
alternative with the maximum future worth of net revenue or
with the minimum future worth of net cost will be selected as
the best alternative for implementation.
5.2 REVENUE-DOMINATED CASH FLOW DIAGRAM

A generalized revenue-dominated cash flow diagram to

demonstrate the future worth method of comparison is presented in
Fig. 5.1.
In Fig. 5.1, P represents an initial investment, Rj the net-revenue
at the end of the jth year, and S the salvage value at the end of the
nth year.

The formula for the future worth of the above cash flow diagram
for a given interest rate, i is
FW(i) = –P(1 + i)n + R1(1 + i)n–1 + R2(1 + i)n–2 + ...
+ R j(1 + i)n–j + ... + Rn + S

In the above formula, the expenditure is assigned with negative

sign and the revenues are assigned with positive sign.
If we have some more alternatives which are to be compared with
this alternative, then the corresponding future worth amounts are to
be computed and compared. Finally, the alternative with the
maximum future worth amount should be selected as the best
alternative.
 
F = P × (1 + i)n
COST-DOMINATED CASH FLOW DIAGRAM

A generalized cost-dominated cash flow diagram to demonstrate the

future worth method of comparison is given in Fig. 5.2.
 In Fig. 5.2, P represents an initial investment, Cj the net cost of
operation and maintenance at the end of the jth year, and S the salvage
value at the end of the nth year.
The formula for the future worth of the above cash flow diagram for a
given interest rate, i is

FW(i) = P(1 + i)n + C1(1 + i )n–1 + C2(1 + i)n–2 + ...

+ Cj(1 + i)n–j + ... + Cn – S

In this formula, the expenditures are assigned with positive sign and
revenues with negative sign. If we have some more alternatives which
are to be compared with this alternative, then the corresponding future
worth amounts are to be computed and compared. Finally, the
alternative with the minimum future worth amount should be selected
as the best alternative.
EXAMPLE 5.1 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 investment, P = Rs. 50,00,000
Annual equivalent revenue, A = Rs. 20,00,000 Interest rate, i = 18%,
compounded annually Life of alternative A = 4 years

The cash flow diagram of alternative A is shown in Fig. 5.3

The future worth amount of alternative B is computed as
FWA(18%) = –50,00,000(F/P, 18%, 4) + 20,00,000(F/A, 18%, 4)
= –50,00,000(1.939) + 20,00,000(5.215)
= Rs. 7,35,000
Alternative B
Initial investment, P = Rs. 45,00,000
Annual equivalent revenue, A = Rs. 18,00,000 Interest rate, i =
18%, compounded annually Life of alternative B = 4 years

F = P × (1 + i)n
 FWB(18%) = – 45,00,000(F/P, 18%, 4) + 18,00,000 (F/A,
18%, 4)
= – 45,00,000(1.939) + 18,00,000(5.215)
= Rs. 6,61,500
The future worth of alternative A is greater than that of alternative B. Thus, alternative A
should be selected.
EXAMPLE 5.2 A man owns a corner plot. He must decide
which of the several alternatives to select in trying to obtain a
desirable return on his investment. After much study and
calculation, he decides that the two best alternatives are as given
in the following table
Alternative 1—Build gas station
First cost = Rs. 20,00,000
Net annual income = Annual income – Annual property tax
= Rs. 8,00,000 – Rs. 80,000
= Rs. 7,20,000
Life = 20 years
Interest rate = 12%, compounded annually
.
The future worth of alternative 1 is computed as
FW1(12%) = –20,00,000 (F/P, 12%, 20) + 7,20,000
(F/A, 12%, 20)
= –20,00,000 (9.646) + 7,20,000 (72.052)
= Rs. 3,25,85,440
Alternative 2—Build soft ice-cream stand
First cost = Rs. 36,00,000
Net annual income = Annual income – Annual property tax
= Rs. 9,80,000 – Rs. 1,50,000
= Rs. 8,30,000
Life = 20 years
Interest rate = 12%, compounded annually
The cash flow diagram for this alternative is shown in Fig. 5.6.
EXAMPLE 5.4 M/S Krishna Castings Ltd. is planning to
replace its annealing furnace. It has received tenders from three
different original manufacturers of annealing furnace. The
details are as follows.
Solution Alternative 1—Manufacturer 1
First cost, P = Rs. 80,00,000 Life, n = 12 years

Annual operating and maintenance cost, A = Rs. 8,00,000 Salvage

value at the end of furnace life = Rs. 5,00,000
The cash flow diagram for this alternative is shown in Fig. 5.9.
The future worth amount of alternative 1 is computed as
FW1(20%) = 80,00,000 (F/P, 20%, 12) + 8,00,000 (F/A, 20%, 12) –
5,00,000
= 80,00,000(8.916) + 8,00,000 (39.581) – 5,00,000
= Rs. 10,24,92,800
Alternative 2— Manufacturer 2
First cost, P = Rs. 70,00,000 Life, n = 12 years
Annual operating and maintenance cost, A = Rs. 9,00,000 Salvage value
at the end of furnace life = Rs. 4,00,000
The cash flow diagram for this alternative is given in Fig. 5.10.
The future worth amount of alternative 2 is computed as
FW2(20%) = 70,00,000(F/P, 20%, 12) + 9,00,000(F/A, 20%,
12) – 4,00,000
= 70,00,000(8.916) + 9,00,000 (39.581) – 4,00,000
= Rs. 9,76,34,900

Alternative 3—Manufacturer 3
First cost, P = Rs. 90,00,000 Life, n
= 12 years
Annual operating and maintenance cost, A
= Rs. 8,50,000 Salvage value at the end of
furnace life = Rs. 7,00,000
The future worth amount of alternative 3 is calculated as
FW3(20%) = 90,00,000(F/P, 20%, 12) + 8,50,000(F/A, 20%, 12) – 7,00,000
= 90,00,000(8.916) + 8,50,000 (39.581) – 7,00,000
= Rs. 11,31,87,850
The future worth cost of alternative 2 is less than that of the other two
alternatives. Therefore, M/s. Krishna castings should buy the annealing furnace
from manufacturer 2.
Solution Machine A
Initial cost of the machine, P = Rs. 4,00,000
Life, n = 4 years
Salvage value at the end of machine life, S = Rs. 2,00,000
Annual maintenance cost, A = Rs. 40,000
Interest rate, i = 12%, compounded annually.
The cash flow diagram of machine A is given in Fig. 5.12.
FWA(12%) = 4,00,000 × (F/P, 12%, 4) + 40,000 × (F/A, 12%, 4) – 2,00,000
= 4,00,000 × (1.574) + 40,000 × (4.779) – 2,00,000
= Rs. 6,20,760
Machine B
Initial cost of the machine, P = Rs. 8,00,000 Life, n = 4 years
Salvage value at the end of machine life, S = Rs. 5,50,000 Annual
maintenance cost, A = zero.
Interest rate, i = 12%, compounded annually.
The cash flow diagram of the machine B is illustrated in Fig. 5.13.
 ANNUAL EQUIVALENT METHOD
In the annual equivalent method of comparison, first the annual
equivalent cost or the revenue of each alternative will be computed.
Then the alternative with the maximum annual equivalent revenue
in the case of revenue-based comparison or with the minimum
annual equivalent cost in the case of cost- based comparison will
be selected as the best alternative.
6.2 REVENUE-DOMINATED CASH FLOW
DIAGRAM

A generalized revenue-dominated cash flow diagram to

demonstrate the annual equivalent method of comparison is
presented in Fig. 6.1.
In Fig. 6.1, P represents an initial investment, Rj the net
revenue at the end of the jth year, and S the salvage
value at the end of the nth year.
The first step is to find the net present worth of the cash
flow diagram using the following expression for a given
interest rate, i:
PW(i) = –P + R1/(1 + i)1 + R2/(1 + i)2 + ...
+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n
In the above formula, the expenditure is assigned with a
negative sign and the revenues are assigned with a
positive sign.
EXAMPLE 6.1 A company provides a car to its chief executive.
The owner of the company is concerned about the increasing cost of
petrol. The cost per litre of petrol for the first year of operation is Rs.
21. He feels that the cost of petrol will be increasing by Re.1 every
year. His experience with his company car indicates that it averages
9 km per litre of petrol. The executive expects to drive an average of
20,000 km each year for the next four years. What is the annual
equivalent cost of fuel over this period of time?. If he is offered
similar service with the same quality on rental basis at Rs. 60,000
per year, should the owner continue to provide company car for his
executive or alternatively provide a rental car to his executive?
Assume i = 18%. If the rental car is preferred, then the company car
will find some other use within the company.
Solution
Average number of km run/year = 20,000 km
Number of km/litre of petrol = 9 km
Therefore,
Petrol consumption/year = 20,000/9 = 2222.2 litre
Cost/litre of petrol for the 1st year = Rs. 21
Cost/litre of petrol for the 2nd year = Rs. 21.00 + Re. 1.00
= Rs. 22.00
Cost/litre of petrol for the 3rd year = Rs. 22.00 + Re. 1.00
= Rs. 23.00
Cost/litre of petrol for the 4th year = Rs. 23.00 + Re. 1.00
= Rs. 24.00
Fuel expenditure for 1st year = 2222.2 21 = Rs. 46,666.20
Fuel expenditure for 2nd year = 2222.2 22 = Rs. 48,888.40
Fuel expenditure for 3rd year = 2222.2 23 = Rs. 51,110.60
Fuel expenditure for 4th year = 2222.2 24 = Rs. 53,332.80
The annual equal increment of the above expenditures is Rs. 2,222.20 (G).
The cash flow diagram for this situation is depicted in Fig. 6.3.
The proposal of using the company car by spending for petrol by the company will
cost an annual equivalent amount of Rs. 49,543.28 for four years. This amount is less
than the annual rental value of Rs. 60,000. Therefore, the company should continue to
provide its own car to its executive.
 EXAMPLE 6.2 A company is planning to purchase an advanced machine
centre. Three original manufacturers have responded to its tender whose
particulars are tabulated as follows:

Determine the best alternative based on the annual equivalent method by

assuming i = 20%, compounded annually.
 
Solution Alternative 1
Down payment, P = Rs. 5,00,000
Yearly equal installment, A = Rs. 2,00,000
n = 15 years
i = 20%, compounded annually
The cash flow diagram for manufacturer 1 is shown in Fig. 6.4.
= Rs. 3,85,560.
Alternative 3
Down payment, P = Rs. 6,00,000
Yearly equal installment, A = Rs. 1,50,000
n = 15 years
i = 20%, compounded annually
The cash flow diagram for manufacturer 3 is shown in Fig. 6.6.
EXAMPLE 6.4 A certain individual firm desires an economic
analysis to determine which of the two machines is attractive in a
given interval of time. The minimum attractive rate of return for
the firm is 15%. The following data are to be used in the analysis:
 
Solution Machine X
First cost, P = Rs. 1,50,000 Life, n = 12 years
Estimated salvage value at the end of machine life, S =
Rs. 0. Annual maintenance cost, A = Rs. 0.
Interest rate, i = 15%, compounded annually.
Machine Y
First cost, P = Rs. 2,40,000 Life, n = 12 years
Estimated salvage value at the end of machine life, S = Rs.
6,000 Annual maintenance cost, A = Rs. 4,500
Interest rate, i = 15%, compounded annually.
The cash flow diagram of machine Y is depicted in Fig. 6.10.
EXAMPLE 6.6 A suburban taxi company is analyzing the
proposal of buying cars wi th diesel engines instead of petrol
engines. The cars average 60,000 km a year with a useful life
of three years for the petrol taxi and four years for the diesel
taxi. Other comparative details are as follows
The annual equivalent cost expression of the above cash flow
diagram is
AE(20%) = 3,90,000(A/P, 20%, 4) + 40,000 – 60,000(A/F,
20%, 4)
= 3,90,000(0.3863) + 40,000 – 60,000(0.1863)
= Rs. 1,79,479
Alternative 2— Purchase of petrol taxi
Vehicle cost = Rs. 3,60,000 Life = 3 years
Number of litres/year 60,000/20 = 3,000 litres Fuel cost/yr =
3,000 × 20 = Rs. 60,000

Fuel cost, annual repairs and insurance premium/yr

= Rs. 60,000 + Rs. 6,000 + Rs. 15,000 = Rs. 81,000
Salvage value at the end of vehicle life = Rs. 90,000
The cash flow diagram for alternative 2 is shown in Fig.
6.14.
The annual equivalent cost of purchase and operation of the cars with diesel engine is less
than that of the cars with petrol engine. Therefore, the taxi company should buy cars with
diesel engine. (Note: Comparison is done on common multiple lives of 12 years.)
 RATE OF RETURN METHOD

The rate of return of a cash flow pattern is the interest rate at which the present
worth of that cash flow pattern reduces to zero. In this method of comparison,
the rate of return for each alternative is computed. Then the alternative which
has the highest rate of return is selected as the best alternative.
In this type of analysis, the expenditures are always assigned with a negative
sign and the revenues/inflows are assigned with a positive sign.
A generalized cash flow diagram to demonstrate the rate of return method of
comparison is presented in Fig. 7.1.
The first step is to find the net present worth of the cash flow
diagram using the following expression at a given interest rate,
i.
PW(i) = – P + R1/(1 + i)1 + R2/(1 + i)2 + ...
+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n
Now, the above function is to be evaluated for different values
of i until the present worth function reduces to zero, as shown
in Fig.
In the figure, the present worth goes on decreasing when
the interest rate is increased. The value of i at which the
present worth curve cuts the X-axis is the rate of return of the
given proposal/project. It will be very difficult to find the
exact value of i at which the present worth function reduces
to zero.
7.2.
So, one has to start with an intuitive value of i and check
whether the present worth function is positive. If so, increase the
value of i until PW(i) becomes negative. Then, the rate of return
is determined by interpolation method in the range of values of i
for which the sign of the present worth function changes from
positive to negative.
EXAMPLE 7.1 A person is planning a new business. The initial outlay and
cash flow pattern for the new business are as listed below. The expected life
of the business is five years. Find the rate of return for the new business .