Chapter 9

Other Analysis Techniques
 Future Worth Analysis (FWA)

 Benefit-Cost Ratio Analysis (BCRA)
 Payback Period
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Techniques for Cash Flow Analysis
 Present Worth Analysis  Chapter 5

 Annual Cash Flow Analysis  Chapter 6
 Rate of Return Analysis  Chapter 7
 Incremental Analysis  Chapter 8
 Other Techniques:  Chapter 9
 Future Worth Analysis
 Benefit-Cost Ration Analysis
 Payback Period Analysis
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Future worth analysis
Future worth analysis is equivalent to present worth analysis;
the best alternative one way is also best the other way. There are many
situations where we want to know what a future situation will be, if we take
some particular course of action now. This is called future worth analysis.
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Example 9-1
Ron Jamison, a 20-year-old college student, consumes about a carton of
cigarettes a week. He wonders how much money h~ could accumulate by
age 65 if he quit smoking now and put his cigarette money into a savings
account. Cigarettes cost $35 per carton. Ron expects that a savings
account would earn 5% interest, compounded semiannually. Compute
Ron's future worth at age 65.
Semiannual saving $35/carton x 26 weeks = $910

Future worth (FW)= A(FjA,2.5%,90) = 910(329.2) = $299,572
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Benefit-cost ratio analysis
Since we can write
PW of cost  PW of benefit or
EUAC  EUAB we can equivalently write
(PW of benefit)/PW of cost  1, or
EUAB/EUAC  1.
Economic analysis based on these ratios is called benefit-
cost ratio analysis.
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Benefit-cost ratio comparison criteria
Situation Criterion
Fixed input Amount of money or other input Maximize B/C
resources are fixed
Fixed output Fixed benefit Maximize B/C
Neither input nor Neither amount of money or other Compute incremental benefit-
output fixed inputs not amount of benefits or cost ratio (∆B/∆C) on the
other outputs are fixed increment of investment
between the alternatives. If
∆B/∆C ≥ 1, choose the higher-
cost alternative; otherwise,
choose the lower-cost
alternative.
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Example 9-3
Using an interest rate of 7%, choose the best alternative using the
benefit-cost ratio analysis
Year Device A Device B
0 –$1000 –$1000
1 +300 +400
2 +300 +350
3 +300 +300
4 +300 +250
5 +300 +200
We have solved this problem using the present worth analysis, the
annual cash flow analysis, and the rate of return analysis. Now, we
will use the Benefit-Cost Ratio analysis.
Since this is a fixed cost case, the criterion is to maximize the B/C
ratio.
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Example 9-4
Using an interest rate of 10%, choose the best machine using the
benefit-cost ratio analysis
Machine X Machine Y
Initial cost $200 $700
Uniform annual benefit 95 120
End of Useful live salvage value 50 150
Useful life (years) 6 12
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Example 9-5
Example
Each of the five mutually exclusive alternatives presented below will last for 20 years
and has no salvage value. MARR = 6%.
A B C D E F
Cost $4000 $2000 $6000 $1000 $9000 $10000
PWB $7330 $4700 $8730 $1340 $9000 $9500
B/C 1.83 2.35 1.46 1.34 1.00 0.95
NPV
3330 2700 1730 340 0 -500
(to check)
The steps are the same as in incremental ROR, except that the criterion is now B/C, and
the cutoff is 1 instead of the MARR:
1) Be sure you identify all alternatives.

2) (Optional) Compute the B/C ratio for each alternative. Discard any with a B/C < 1.
(We can discard F).
3) Arrange the remaining alternatives in ascending order of investment.
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…Example 9-5
D B A C E F
Cost $1000 $2000 $4000 $6000 $9000 $10000
PWB $1340 $4700 $7330 $8730 $9000 $9500
B/C 1.34 2.35 1.83 1.46 1.00 0.95
NPV 340 2700 3330 1730 0 -500
4) Comparing B/C with 1 for consecutive alternatives select the best

alternative.
B-D A-B C-A E-A
Incremental Cost $1000 $2000 $2000 $5000
Incremental Benefit $3360 $2630 $1400 $1670
B/C 3.36 1.32 0.76 0.33
Comparison result B A A A
preferred preferred preferred preferred
Increment B-D is attractive; therefore B is preferred to D.

Increment A-B is attractive; therefore B is preferred to A.
Increment C-A is not attractive, as B/C = 0.76 < 1 ; therefore A is preferred to C.
Increment E-A is not attractive, as B/C = 0.33 < 1 ; therefore A is preferred to E.
►►Finally A is the best project.
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Benefit/Cost Ratio Analysis – Graphical representation
 A, B, C, and D are above the

45-degree line; their B/C ratio is > 1.
 F is below the line: B/C ratio is < 1. PWB F
 We can discard F if we wish.
C E
A
Examine each separable increment of PWB/PWC = 1
investment.
B
B/C < 1  increment is not attractive
B/C  1  increment is desirable.
Compare D to B: Slope or B/C > 1. ►►B preferred

D
Compare B to A: Slope or B/C > 1. ►►A preferred
Compare A to C: Slope or B/C < 1; discard C.
Compare A to E: Slope or B/C < 1; discard E.
PWC
F was discarded earlier since its B/C is less than 1
B-D A-B C-A E-A
Therefore A is the best alternative.
Note: Despite the fact that Alt. B has the highest B/C Incremental Cost $1000 $2000 $2000 $5000
ratio, we should not make the mistake of choosing B
Incremental Benefit $3360 $2630 $1400 $1670
since the economic criterion here should be based on
B/C (since neither input nor output is fixed) Incr.B/Incr. C 3.36 1.32 0.76 0.33
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Payback Period
Payback period is an approximate analysis method. For example, if a $1000 investment today
generates $500 of benefits per year, we say its payback period is 1000/500 = 2 years.
Four important points about the payback period

1. Payback period is an approximate, rather than an exact, analysis calculation.
2. All costs and all profits, or savings of the investment prior to payback, are included
without considering differences in their timing.
3. All the economic consequences beyond the payback period are completely ignored.
4. Payback period may or may not select the same alternative as an exact economic analysis
method.
Payback period is used because

1. the concept can be readily understood,
2. the calculations can be readily made and understood by people unfamiliar with the use of
the time value of money.
The rate of return only measures the speed of return of the investment. The other analysis
techniques we studied before measure the economic efficiency or the overall profitability of
the investment.
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Lesson from Example 9-8: liquidity and profitability can be very different criteria. We discussed the
definitions of liquidity and profitability in class.
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Summary
Future Worth.
A future worth calculation occurs when the point in time at which the comparison between alternatives will be made
is in the future. The best alternative according to future worth should also be best according to present worth.
Benefit-Cost Ratio Analysis.

We compute a ratio of benefits to costs, using either PW or ACF calculations. Graphically, the method is similar to
PW analysis. When neither input nor output is fixed, we use incremental benefit-cost analysis (B/C).
Payback Period.
The payback period is the period of time needed for the profit or other benefits of an investment to equal its cost.
This method is simple to use and understand, but is a poor analysis technique for ranking alternatives. It
provides a measure of the speed of return of the investment, but is not an accurate measure of its profitability.
Sensitivity and Breakeven analysis will not be covered in this course
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Other Analysis Techniques

 Future Worth Analysis (FWA)

 Present Worth Analysis  Chapter 5

Semiannual saving $35/carton x 26 weeks = $910

1) Be sure you identify all alternatives.

4) Comparing B/C with 1 for consecutive alternatives select the best

Increment B-D is attractive; therefore B is preferred to D.

 A, B, C, and D are above the

Compare D to B: Slope or B/C > 1. ►►B preferred

Four important points about the payback period

Payback period is used because

Benefit-Cost Ratio Analysis.

Sensitivity and Breakeven analysis will not be covered in this course

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