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CTC 475 Review

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

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CTC 475 Review

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  1. 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)

  2. CTC 475 Comparing Alternatives

  3. 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

  4. Steps for Comparing Alternatives • Determine the feasible alternatives • Define the planning horizon • Develop the cash flow profiles • Specify the MARR • Compare the alternatives • Perform supplementary analyses • Select the preferred alternative

  5. 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

  6. 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?

  7. Three Alternatives (MARR-15%)

  8. Ranking Method-PW • Alt A: PW=4,500(P/A15,5)=$15,085 • Alt B: PW=-50K+20K(P/A15,5)=$17,044 • Alt C: PW=-75K+20K(P/A15,5)+5K(P/G15,5) =$20,920 Rank: Alt C is best (Alt B is 2nd; Alt A is 3rd)

  9. Steps for Incremental Analysis • Order alternatives according to size of initial investment • Find the first alternative that is feasible • If first alternative is feasible, find the difference in cash flows between the first 2 alternatives (2-1) • Determine if 2 is better than 1 (PW/AW/FW/IRR/ERR/SIR) • If 2 is better than 1 then compare the next 2 alternatives

  10. Incremental Method (PW) • Step 1-Order alternatives from lowest to highest initial investment • Alt A $0 • Alt B $50K • Alt C $75K

  11. Incremental Method (PW) • Step 2-Find first alternative that is economically feasible • Alt A PW>0 (feasible)

  12. Compare B-A

  13. Calc PW of B-A • PW=-50K+15.5K(P/A15,5)=+1,959 • PW>0 therefore Alt B is better than Alt A

  14. Compare C-B

  15. Calc PW of C-B • PW=-25K+5K(P/G15,5)=+3,876 • PW>0 therefore Alt C is better than Alt B

  16. Incremental Method (IRR) • Compare B-A • Compare C to the “winner”

  17. Cashflow of B-A

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

  19. Cashflow of C-B

  20. Calc IRR of 3-2 Cashflow • FW=-25K(F/PIRR,5)+5K(P/GIRR,5) (F/PIRR,5 )=0 • IRR=19.4% • IRR>MARR ------Alt C is better than Alt B

  21. ERR using incremental method

  22. Calc ERR of B-A Cashflow • 50K(1+ERR)5=15.5K(F/A15,5) • ERR=15.9% • ERR>MARR ------Alt B is better than Alt A

  23. Calc ERR of C-B Cashflow • 25K(1+ERR)5=5K (P/G15,5)(F/P15,5) • ERR=18.4% • ERR>MARR ------Alt C is better than Alt B

  24. SIR using incremental method

  25. Calc SIR of B-A Cashflow • PW(+)/PW(-) • 15.5K(P/A15,5)/50K • SIR=1.01 • SIR>1 ------Alt B is better than Alt A

  26. Calc SIR of C-B Cashflow • PW(+)/PW(-) • 5K(P/G15,5)/25K • SIR=1.16 • SIR>1 ------Alt C is better than Alt B

  27. 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)

  28. Supplementary Analyses • Breakeven • Sensitivity • Risk

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

  30. 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?

  31. Risk • Range of values are represented by probabilities

  32. 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

  33. Next lecture • Benefit/Cost Analyses

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