ECONOMIC ANALYSIS OF ALTERNATIVES
NET CASH FLOW OF INVESTMENT OPPORTUNITIES
Payments and disbursements need to be determined. Then a net cash flow can be
developed.
PRESENT-WORTH AMOUNT
It is the difference between the equivalent receipts and disbursements at the present.
Assume F_t is a cash flow at time t, the present worth (PW) is
t = n
PW(i) = sum F(t) * [ 1 + i ] ^ -t
t = 0
for any interest -1 < i < infinity.
ANNUAL EQUIVALENT AMOUNT
The annual equivalent amount is the annual equivalent receipts minus the annual
equivalent disbursements of a cash flow. It is used for repeated cash flows per year.
AE (i) = PW (i) * (A/P,i,n)
*- -* *- -*
| t = n | | i(1+i)^n |
= | sum F(t) * [ 1 + i ] ^ -t | * | ------------- |
| t = 0 | | (1+i)^n - 1 |
*- -* *- -*
Example : Given the following cash flow:
=======================================
Year end Receipts Disbursements
=======================================
0 $0.00 -$1000.00
1 $400.00 $0.00
2 $900.00 -$1000.00
3 $400.00 ....
4 $900.00 -$1000.00
... ....... ....
n-2 $900.00 -$1000.00
n-1 $400.00 $0.00
n $900.00 $0.00
Therefore,
AE(10) = [-1000+400(P/F,10,1)+900(P/F,10,2)](A/P,10,2)
for 10%, or
AE(10) = [-$1000+400(0.9091)+900(0.8265)](0.5762)
= $61.93
FUTURE WORTH AMOUNT
It is the difference between the equivalent receipts and disbursements at s ome
common point in the future.
t = n
FW (i) = Sum F_t * [ 1 + i ]^[ n - t ]
t = o
for any interest rate -1 < i < infinity.
PW, AE, and FW differ in the point of time used to compare the equivalent amounts.
INTERNAL RATE OF RETURN
The internal rate of return (IRR) is the interest rate that causes the equi= valent
receipts of a cash flow to be equal to the equivalent disbursements = of the cash flow.
Solve for i* such that
t = n
0 = PW(i*) = sum F(t) * [ 1 + i* ] ^ -t
t = 0
Example : Given the following cash flow:
=======================================
Year end Receipts Disbursements
=======================================
0 $0.00 -$1000.00
1 $0.00 -$800.00
2 $500.00 $0.00
3 $500.00 $0.00
4 $500.00 $0.00
5 $1200.00 $0.00
By trial and error i = 12.8 %.
MEANING OF IRR
It represents the rate of return on the unrecovered balance of an investment (or loan).
The following equation can be developed for loans:
U_t = U_(t-1) * [ 1 + i^* ] + F_t
where
U_o = Initial amount of loan or first cost of asset (F_o),
F_t = Amount received at the end of period t.
i^* = IRR.
It should be noted that the basic equation for i^* requires the solution of the roots of a
nonlinear (polynomial) function. Therefore, more than one root might exist. The
following conditions results in one root (single i*):
1. F_o =< 0 (the first nonzero cash flow is a disbursement).
2. One change in sign in the cash flow (from disbursements to receipts).
3. PW(0) >0 (the sum of all receipts is greater than the sum of all disbursements).
In case of multiple IRR, other methods can be used.
PAYBACK PERIOD
1. Without Interest : The payback period without interest is the length of time
required to recover the first cost of an investment from the cash flow produced
by the investment for an interest rate of zero. It can be computer as the smallest
n that produces
t = n
Sum [ F_t > 0 ]
t = o
2. With Interest : The payback period with interest is the length of time required
to recover the first cost of an investment from the cash flow produced by the
investment for a given interest rate. It can be computer as the smallest n that
produces
t = n
Sum F_t * [1 + i]^[-t] >= 0
t = o
