CTC 475 Review

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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)

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CTC 475

• Comparing Alternatives

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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

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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

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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

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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?

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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
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Ranking Method-PW

• Alt A PW4,500(P/A15,5)15,085
• Alt B PW-50K20K(P/A15,5)17,044
• Alt C PW-75K20K(P/A15,5)5K(P/G15,5)
  20,920
• Rank Alt C is best
• (Alt B is 2nd Alt A is 3rd)

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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

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Incremental Method (PW)

• Step 1-Order alternatives from lowest to highest
  initial investment
• Alt A 0
• Alt B 50K
• Alt C 75K

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Incremental Method (PW)

• Step 2-Find first alternative that is
  economically feasible
• Alt A PWgt0 (feasible)

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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
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Calc PW of B-A

• PW-50K15.5K(P/A15,5)1,959
• PWgt0 therefore Alt B is better than Alt A

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Compare C-B
EOY Cash Flow (C-B)
0 -25K (-75K-(-50K))
1 0K (20K-20K)
2 5K
3 10K
4 15K
5 20K
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Calc PW of C-B

• PW-25K5K(P/G15,5)3,876
• PWgt0 therefore Alt C is better than Alt B

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Incremental Method (IRR)

• Compare B-A
• Compare C to the winner

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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
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Calc IRR of B-A Cashflow

• FW-50K(F/PIRR,5)15.5K(F/AIRR,5)0
• IRR16.5
• IRRgtMARR ------Alt B is better than Alt A

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Cashflow of C-B
EOY Cash Flow (C-B)
0 -25K
1 0K
2 5K
3 10K
4 15K
5 20K
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Calc IRR of 3-2 Cashflow

• FW-25K(F/PIRR,5)5K(P/GIRR,5) (F/PIRR,5 ) 0
• IRR19.4
• IRRgtMARR ------Alt C is better than Alt B

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ERR using incremental method
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Calc ERR of B-A Cashflow

• 50K(1ERR)515.5K(F/A15,5)
• ERR15.9
• ERRgtMARR ------Alt B is better than Alt A

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Calc ERR of C-B Cashflow

• 25K(1ERR)55K (P/G15,5)(F/P15,5)
• ERR18.4
• ERRgtMARR ------Alt C is better than Alt B

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SIR using incremental method
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Calc SIR of B-A Cashflow

• PW()/PW(-)
• 15.5K(P/A15,5)/50K
• SIR1.01
• SIRgt1 ------Alt B is better than Alt A

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Calc SIR of C-B Cashflow

• PW()/PW(-)
• 5K(P/G15,5)/25K
• SIR1.16
• SIRgt1 ------Alt C is better than Alt B

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PBP

• Alt A---PBP is instantaneous
• Alt B---PBP2-3 years
• Alt C---PBP3 years
• If ranked by PBP A,B,C (opposite of other methods)

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Supplementary Analyses

• Breakeven
• Sensitivity
• Risk

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Breakeven

• Value may not be known for certain but can
  determine the break even value

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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?

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Risk

• Range of values are represented by probabilities

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Selling the alternative

• Managements 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

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Next lecture

• Benefit/Cost Analyses