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%) EOYABC 0$0-$50K-$75K 1$4500$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/A 15,5 )=$15,085 Alt B: PW=-50K+20K(P/A 15,5 )=$17,044 Alt C: PW=-75K+20K(P/A 15,5 )+5K(P/G 15,5 ) =$20,920 Rank: Alt C is best (Alt B is 2 nd ; Alt A is 3 rd )

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 APW>0 (feasible)

Compare B-A EOYCash Flow (B-A) 0-50K 115.5K

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 EOYCash Flow (C-B) 0-25K (=-75K-(-50K)) 10K (=20K-20K) 25K 310K 415K 520K

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 EOYCash Flow (B-A) 0-50K 115.5K

Calc IRR of B-A Cashflow FW=-50K(F/P IRR,5 )+15.5K(F/A IRR,5 )=0 IRR=16.5% IRR>MARR Alt B is better than Alt A

Cashflow of C-B EOYCash Flow (C-B) 0-25K 10K 25K 310K 415K 520K

Calc IRR of 3-2 Cashflow FW=-25K(F/P IRR,5 )+5K(P/G IRR,5 ) (F/P IRR,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/A 15,5 ) ERR=15.9% ERR>MARR Alt B is better than Alt A

Calc ERR of C-B Cashflow 25K(1+ERR) 5 =5K (P/G 15,5 )(F/P 15,5 ) 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/A 15,5 )/50K SIR=1.01 SIR> Alt B is better than Alt A

Calc SIR of C-B Cashflow PW(+)/PW(-) 5K(P/G 15,5 )/25K SIR=1.16 SIR> 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