Solution: A Rs. 10,000 N 25 Years I 20% F ?

Interest Formulas and Their Applications 31
the next 25 years starting from the end of the next year. The bank gives 20%
interest rate, compounded annually. Find the maturity value of his account when
he is 60 years old.
Solution
A= Rs. 10,000
n= 25 years
i= 20%
F= ?
The corresponding cash flow diagram is shown in Fig. 3.5.
F
i = 20%
0 1 2 3 4 . .
. . 25
10,000 10,000 10,000 10,000 10,000

Fig. 3.5 Cash flow diagram of equal-payment series compound amount.
(1 + i)n − 1
F=A
i
= A(F/A, i, n)
= 10,000(F/A, 20%, 25)
= 10,000 ´ 471.981
= Rs. 47,19,810
The future sum of the annual equal payments after 25 years is equal to
Rs. 47,19,810.
3.3.4 Equal-Payment Series Sinking Fund

In this type of investment mode, the objective is to find the equivalent
amount (A) that should be deposited at the end of every interest period for n
interest periods to realize a future sum (F) at the end of the nth interest period
at an interest rate of i.
F
i%
0 1 2 3 4 . .
. . n
A A A A A
i%
Fig. 3.6 Cash flow diagram of equal-payment series sinking fund.
32 Engineering Economics
In Fig. 3.6,
A = equal amount to be deposited at the end of each interest period
n = No. of interest periods
i = rate of interest
F = single future amount at the end of the nth period
The formula to get F is
i
A=F = F(A/F, i, n)
(1 + i)n − 1
where
(A/F, i, n) is called as equal-payment series sinking fund factor.
EXAMPLE 3.4 A company has to replace a present facility after 15 years at
an outlay of Rs. 5,00,000. It plans to deposit an equal amount at the end of every
year for the next 15 years at an interest rate of 18% compounded annually. Find
the equivalent amount that must be deposited at the end of every year for the
next 15 years.
Solution
F= Rs. 5,00,000
n = 15 years
i= 18%
A= ?
5,00,000
i = 18%
0 1 2 3 4 . .
. . 15
A A A A A
Fig. 3.7 Cash flow diagram of equal-payment series sinking fund.
i
A=F = F(A/F, i, n)
(1 + i)n − 1
= 5,00,000(A/F, 18%, 15)
= 5,00,000 ´ 0.0164
= Rs. 8,200
The annual equal amount which must be deposited for 15 years is Rs. 8,200.
3.3.5 Equal-Payment Series Present Worth Amount

The objective of this mode of investment is to find the present worth of an equal
payment made at the end of every interest period for n interest periods at an
interest rate of i compounded at the end of every interest period.
The corresponding cash flow diagram is shown in Fig. 3.8. Here,
P= present worth
A= annual equivalent payment
i= interest rate
The formula to compute P is
(1 + i)n − 1
P=A = A(P/A, i, n)
i(1 + i)n
where
(P/A, i, n) is called equal-payment series present worth factor.
i%
0 1 2 3 4 . . n
. .
A A A A A
Fig. 3.8 Cash flow diagram of equal-payment series present worth amount.
EXAMPLE 3.5 A company wants to set up a reserve which will help the
company to have an annual equivalent amount of Rs. 10,00,000 for the next 20
years towards its employees welfare measures. The reserve is assumed to grow
at the rate of 15% annually. Find the single-payment that must be made now as
the reserve amount.
Solution
A = Rs. 10,00,000
i = 15%
n = 20 years
P=?
The corresponding cash flow diagram is illustrated in Fig. 3.9.
i = 15%
0 1 2 3 4 . . 20
. .
1,00,00,000
10,00,000 10,00,000 10,00,000 10,00,000 10,00,000
Fig. 3.9 Cash flow diagram of equal-payment series present worth amount.
(1 + i ) n − 1
P =A = A(P/A, i, n)
i (1 + i ) n
= 10,00,000 ´ (P/A, 15%, 20)
= 10,00,000 ´ 6.2593
= Rs. 62,59,300
The amount of reserve which must be set-up now is equal to Rs. 62,59,300.
3.3.6 Equal-Payment Series Capital Recovery Amount

The objective of this mode of investment is to find the annual equivalent
amount (A) which is to be recovered at the end of every interest period for n
interest periods for a loan (P) which is sanctioned now at an interest rate of i
compounded at the end of every interest period (see Fig. 3.10).
P
i%
0 1 2 3 4 . . n
. .
A A A A A
Fig. 3.10 Cash flow diagram of equal-payment series capital recovery amount.
In Fig. 3.10,
P= present worth (loan amount)
A= annual equivalent payment (recovery amount)
i= interest rate
The formula to compute P is as follows:
i(1 + i)n
A=P = P(A/P, i, n)
(1 + i)n − 1
where,
(A/P, i, n) is called equal-payment series capital recovery factor.
EXAMPLE 3.6 A bank gives a loan to a company to purchase an equipment

worth Rs. 10,00,000 at an interest rate of 18% compounded annually. This
amount should be repaid in 15 yearly equal installments. Find the installment
amount that the company has to pay to the bank.
Solution
P= Rs. 10,00,000
i= 18%
n = 15 years
A= ?

10,00,000
i = 18%
0 1 2 3 4 . . 15
. .
A A A A A
Fig. 3.11 Cash flow diagram of equal-payment series capital recovery amount.
i(1 + i)n
A=P = P(A/P, i, n)
(1 + i)n − 1
= 10,00,000 ´ (A/P, 18%, 15)
= 10,00,000 ´ (0.1964)
= Rs. 1,96,400
The annual equivalent installment to be paid by the company to the bank
is Rs. 1,96,400.
3.3.7 Uniform Gradient Series Annual Equivalent Amount

The objective of this mode of investment is to find the annual equivalent amount
of a series with an amount A1 at the end of the first year and with an equal
increment (G) at the end of each of the following n – 1 years with an interest
rate i compounded annually.
0 1 2 3 4 . . 10
. .
A1
A1+G
A1+2G
A1+3G
A1+ (n – 1)G
Fig. 3.12 Cash flow diagram of uniform gradient series annual equivalent amount.
The formula to compute A under this situation is

(1 + i)n − in − 1
A = A1 + G
i(1 + i)n − i
= A1 + G (A/G, i, n)
where
(A/G, i, n) is called uniform gradient series factor.
EXAMPLE 3.7 A person is planning for his retired life. He has 10 more years
of service. He would like to deposit 20% of his salary, which is Rs. 4,000, at
the end of the first year, and thereafter he wishes to deposit the amount
with an annual increase of Rs. 500 for the next 9 years with an interest rate of
15%. Find the total amount at the end of the 10th year of the above series.
Solution Here,
A1 = Rs. 4,000
G= Rs. 500
i= 15%
n= 10 years
A= ?&F=?
The cash flow diagram is shown in Fig. 3.13.
i = 15%
0 1 2 3 4 . . 10
. .
4,000
4,000 + 500
4,000 + 1,000
4,000 + 1,500
4,000 + 4,500
(1 + i)n − in − 1
A = A1 + G
i(1 + i)n − i
= A1 + G(A/G, i, n)
= 4,000 + 500(A/G, 15%, 10)
= 4,000 + 500 ´ 3.3832
= Rs. 5,691.60
This is equivalent to paying an equivalent amount of Rs. 5,691.60 at the end of
every year for the next 10 years. The future worth sum of this revised series at
the end of the 10th year is obtained as follows:
F = A(F/A, i, n)
= A(F/A, 15%, 10)
= 5,691.60(20.304)
= Rs. 1,15,562.25
At the end of the 10th year, the compound amount of all his payments will
be Rs. 1,15,562.25.
EXAMPLE 3.8 A person is planning for his retired life. He has 10 more years
of service. He would like to deposit Rs. 8,500 at the end of the first year and
thereafter he wishes to deposit the amount with an annual decrease of Rs. 500
for the next 9 years with an interest rate of 15%. Find the total amount at the
end of the 10th year of the above series.
Solution Here,
A1 = Rs. 8,500
G = –Rs. 500
i = 15%
n = 10 years
A=?&F=?
The cash flow diagram is shown in Fig. 3.14.
i = 15%
0 1 2 3 4 . . 10
. .
4,000
7,000
7,500
8,000
8,500
(1 + i)n − in − 1
A = A1 – G
i(1 + i)n − i
= A1 – G (A/G, i, n)
= 8,500 – 500(A/G, 15%, 10)
= 8,500 – 500 ´ 3.3832
= Rs. 6,808.40
This is equivalent to paying an equivalent amount of Rs. 6,808.40 at the end of
every year for the next 10 years.
The future worth sum of this revised series at the end of the 10th year is
obtained as follows:
F = A(F/A, i, n)
= A(F/A, 15%, 10)
= 6,808.40(20.304)
= Rs. 1,38,237.75
At the end of the 10th year, the compound amount of all his payments is
Rs. 1,38,237.75.
3.3.8 Effective Interest Rate

Let i be the nominal interest rate compounded annually. But, in practice, the
compounding may occur less than a year. For example, compounding may be
monthly, quarterly, or semi-annually. Compounding monthly means that the
interest is computed at the end of every month. There are 12 interest periods in
a year if the interest is compounded monthly. Under such situations, the formula
to compute the effective interest rate, which is compounded annually, is
E J− 1
Effective interest rate, R = 1 + i /C
C
where,
i = the nominal interest rate
C = the number of interest periods in a year.
EXAMPLE 3.9 A person invests a sum of Rs. 5,000 in a bank at a nominal

interest rate of 12% for 10 years. The compounding is quarterly. Find the
maturity amount of the deposit after 10 years.
Solution
P = Rs. 5,000
n = 10 years
i = 12% (Nominal interest rate)
F=?
METHOD 1
No. of interest periods per year = 4
No. of interest periods in 10 years = 10 ´ 4 = 40
Revised No. of periods (No. of quarters), N = 40
Interest rate per quarter, r = 12%/4
= 3%, compounded quarterly.
F = P(1 + r)N = 5,000(1 + 0.03)40
= Rs. 16,310.19
METHOD 2
No. of interest periods per year, C = 4
Effective interest rate, R = (1 + i/C )C – 1
= (1 + 12%/4)4 – 1
= 12.55%, compounded annually.
F = P(1 + R)n = 5,000(1 + 0.1255)10
= Rs. 16,308.91
3.4 BASES FOR COMPARISON OF ALTERNATIVES
In most of the practical decision environments, executives will be forced to

select the best alternative from a set of competing alternatives. Let us assume
that an organization has a huge sum of money for potential investment and there
are three different projects whose initial outlay and annual revenues during their
lives are known. The executive has to select the best alternative among these
three competing projects.
There are several bases for comparing the worthiness of the projects. These
bases are:
1. Present worth method
2. Future worth method
3. Annual equivalent method
4. Rate of return method
These methods are discussed in detail in Chapters 4–7.
QUESTIONS
1. Explain the time value of money.
2. Give practical applications of various interest formulas.
3. A person deposits a sum of Rs. 1,00,000 in a bank for his son’s education
who will be admitted to a professional course after 6 years. The bank pays
15% interest rate, compounded annually. Find the future amount of the
deposited money at the time of admitting his son in the professional
course.
4. A person needs a sum of Rs. 2,00,000 for his daughter’s marriage which
will take place 15 years from now. Find the amount of money that he should
deposit now in a bank if the bank gives 18% interest, compounded annually.
5. A person who is just 30 years old is planning for his retired life. He plans
to invest an equal sum of Rs. 10,000 at the end of every year for the next
30 years starting from the end of next year. The bank gives 15% interest
rate, compounded annually. Find the maturity value of his account when he
is 60 years old.
6. A company is planning to expand its business after 5 years from now. The
expected money required for the expansion programme is Rs. 5,00,00,000.
The company can invest Rs. 50,00,000 at the end of every year for the next
five years. If the assured rate of return of investment is 18% for the
company, check whether the accumulated sum in the account would be
sufficient to meet the fund for the expansion programme. If not, find the
difference in amounts for which the company should make some other
arrangement after 5 years.
7. A financial institution introduces a plan to pay a sum of Rs. 15,00,000 after
10 years at the rate of 18%, compounded annually. Find the annual
equivalent amount that a person should invest at the end of every year for
the next 10 years to receive Rs. 15,00,000 after 10 years from the institution.
8. A company is planning to expand its business after 5 years from now.
The money required for the expansion programme is Rs. 4,00,00,000.
What annual equivalent amount should the company deposit at the end
of every year at an interest rate of 15% compounded annually to get
Rs. 4,00,00,000 after 5 years from now?
9. A company wants to set-up a reserve which will help it to have an annual

equivalent amount of Rs. 15,00,000 for the next 20 years towards its
employees welfare measures. The reserve is assumed to grow at the rate of
15% annually. Find the single-payment that must be made as the reserve
amount now.
10. An automobile company recently advertised its car for a down payment of
Rs. 1,50,000. Alternatively, the car can be taken home by customers without
making any payment, but they have to pay an equal yearly amount of
Rs. 25,000 for 15 years at an interest rate of 18%, compounded annually.
Suggest the best alternative to the customers.
11. A company takes a loan of Rs. 20,00,000 to modernize its boiler section.
The loan is to be repaid in 20 equal installments at 12% interest rate,
compounded annually. Find the equal installment amount that should be
paid for the next 20 years.
12. A bank gives loan to a company to purchase an equipment which is worth
of Rs. 5,00,000, at an interest rate of 18% compounded annually. This
amount should be repaid in 25 yearly equal installments. Find the
installment amount that the company has to pay to the bank.
13. A working woman is planning for her retired life. She has 20 more years
of service. She would like to deposit 10% of her salary which is Rs. 5,000
at the end of the first year and thereafter she wishes to deposit the same
amount (Rs. 5,000) with an annual increase of Rs. 1,000 for the next 14
years with an interest rate of 18%. Find the total amount at the end of the
15th year of the above series.
14. Consider the following cash flow diagram. Find the total amount at the end
of the 10th year at an interest rate of 12%, compounded annually.
i = 15%
0 1 2 3 4 . . 10
. .
8,000
8,000 + 1,000
8,000 + 2,000
8,000 + 3,000
8,000 + 9,000
15. A person is planning for his retired life. He has 10 more years of service.
He would like to deposit 20% of his salary, which is Rs. 10,000, at the end
of the first year and thereafter he wishes to deposit the same amount
(Rs. 10,000) with an annual increase of Rs. 2,000 for the next 9 years with
an interest rate of 20%. Find the total amount at the end of the 10th year
of the above series.
16. A person is planning for his retired life. He has 10 more years of service.
He would like to deposit Rs. 30,000 at the end of the first year and
thereafter he wishes to deposit the same amount (Rs. 30,000) with an
annual decrease of Rs. 2,000 for the next 9 years with an interest rate of
18%. Find the total amount at the end of the 10th year of the above series.
17. A person invests a sum of Rs. 50,000 in a bank at a nominal interest rate
of 18% for 15 years. The compounding is monthly. Find the maturity
amount of the deposit after 15 years.
4
PRESENT WORTH METHOD
OF COMPARISON
4.1 INTRODUCTION
In this method of comparison, the cash flows of each alternative will be reduced
to time zero by assuming an interest rate i. Then, depending on the type of
decision, the best alternative will be selected by comparing the present worth
amounts of the alternatives.
The sign of various amounts at different points in time in a cash flow
diagram is to be decided based on the type of the decision problem.
In a cost dominated cash flow diagram, the costs (outflows) will be assigned
with positive sign and the profit, revenue, salvage value (all inflows), etc. will
be assigned with negative sign.
In a revenue/profit-dominated cash flow diagram, the profit, revenue,
salvage value (all inflows to an organization) will be assigned with positive sign.
The costs (outflows) will be assigned with negative sign.
In case the decision is to select the alternative with the minimum cost, then
the alternative with the least present worth amount will be selected. On the other
hand, if the decision is to select the alternative with the maximum profit, then
the alternative with the maximum present worth will be selected.
4.2 REVENUE-DOMINATED CASH FLOW DIAGRAM
A generalized revenue-dominated cash flow diagram to demonstrate the present

worth method of comparison is presented in Fig. 4.1.
R1 R2 R3 . Rj Rn
0 1 2 3 . j n
P
Fig. 4.1 Revenue-dominated cash flow diagram.
42
Present Worth Method of Comparison 43
In Fig. 4.1, P represents an initial investment and Rj the net revenue at the
end of the jth year. The interest rate is i, compounded annually. S is the salvage
value at the end of the nth year.
To find the present worth of the above cash flow diagram for a given
interest rate, the formula is
PW(i) = – P + R1[1/(1 + i)1] + R2[1/(1 + i)2] + ...
+ Rj[1/(1 + i) j] + Rn[1/(1 + i)n] + S[1/(1 + i)n]
In this formula, expenditure is assigned a negative sign and revenues are
assigned a positive sign.
If we have some more alternatives which are to be compared with this
alternative, then the corresponding present worth amounts are to be computed
and compared. Finally, the alternative with the maximum present worth amount
should be selected as the best alternative.
4.3 COST-DOMINATED CASH FLOW DIAGRAM
A generalized cost-dominated cash flow diagram to demonstrate the present

S
0 1 2 . j . . n
. .
. Cj Cn
C1 C2
P
Fig. 4.2 Cost-dominated cash flow diagram.
In Fig. 4.2, P represents an initial investment, Cj the net cost of operation

and maintenance at the end of the jth year, and S the salvage value at the end
of the nth year.
To compute the present worth amount of the above cash flow diagram for
a given interest rate i, we have the formula
PW(i) = P + C1[1/(1 + i)1] + C2[1/(1 + i)2] + ... + Cj[1/(1 + i) j]
+ Cn[1/(1 + i)n] – S[1/(1 + i)n]
In the above formula, the expenditure is assigned a positive sign and the revenue
a negative sign. If we have some more alternatives which are to be compared
with this alternative, then the corresponding present worth amounts are to be
computed and compared. Finally, the alternative with the minimum present
worth amount should be selected as the best alternative.
4.4 EXAMPLES
In this section, the concept of present worth method of comparison applied to

the selection of the best alternative is demonstrated with several illustrations.
EXAMPLE 4.1 Alpha Industry is planning to expand its production operation.

It has identified three different technologies for meeting the goal. The initial
outlay and annual revenues with respect to each of the technologies are
summarized in Table 4.1. Suggest the best technology which is to be
implemented based on the present worth method of comparison assuming 20%
interest rate, compounded annually.
Table 4.1
Initial outlay Annual revenue Life

(Rs.) (Rs.) (years)
Technology 1 12,00,000 4,00,000 10
Technology 2 20,00,000 6,00,000 10
Technology 3 18,00,000 5,00,000 10
Solution In all the technologies, the initial outlay is assigned a negative sign
and the annual revenues are assigned a positive sign.
TECHNOLOGY 1
Initial outlay, P = Rs. 12,00,000

Annual revenue, A = Rs. 4,00,000
Interest rate, i = 20%, compounded annually
Life of this technology, n = 10 years
The cash flow diagram of this technology is as shown in Fig. 4.3.
4,00,000 4,00,000 4,00,000 . . 4,00,000
0 1 . j
2 3 10
i = 20%
12,00,000
Fig. 4.3 Cash flow diagram for technology 1.
The present worth expression for this technology is

PW(20%)1 = –12,00,000 + 4,00,000 ´ (P/A, 20%, 10)
= –12,00,000 + 4,00,000 ´ (4.1925)
= –12,00,000 + 16,77,000
= Rs. 4,77,000
TECHNOLOGY 2
The cash flow diagram of this technology is shown in Fig. 4.4.
6,00,000 6,00,000 6,00,000
. .
0 1 2 10
i = 20%
20,00,000

PW(20%)2 = – 20,00,000 + 6,00,000 ´ (P/A, 20%, 10)
= – 20,00,000 + 6,00,000 ´ (4.1925)
= – 20,00,000 + 25,15,500
= Rs. 5,15,500
TECHNOLOGY 3
The cash flow diagram of this technology is shown in Fig. 4.5.
5,00,000 5,00,000 5,00,000
. .
0 1 2 10
i = 20%
18,00,000
PW(20%)3 = –18,00,000 + 5,00,000 ´ (P/A, 20%, 10)
= –18,00,000 + 5,00,000 ´ (4.1925)
= –18,00,000 + 20,96,250
= Rs. 2,96,250
From the above calculations, it is clear that the present worth of technology 2
is the highest among all the technologies. Therefore, technology 2 is suggested
for implementation to expand the production.
EXAMPLE 4.2 An engineer has two bids for an elevator to be installed in a

new building. The details of the bids for the elevators are as follows:
Bid Engineer’s estimates

Initial cost Service Annual operations
life (years) & maintenance
(Rs.) cost (Rs.)
Alpha Elevator Inc. 4,50,000 15 27,000
Beta Elevator Inc. 5,40,000 15 28,500
Determine which bid should be accepted, based on the present worth method of
comparison assuming 15% interest rate, compounded annually.
Solution
Bid 1: Alpha Elevator Inc.
Initial cost, P = Rs. 4,50,000
Annual operation and maintenance cost, A = Rs. 27,000
Life = 15 years
Interest rate, i = 15%, compounded annually.
The cash flow diagram of bid 1 is shown in Fig. 4.6.
0 1 2 3 4 15
.. ..
27,000 27,000 27,000 27,000 27,000

4,50,000 i = 15%
Fig. 4.6 Cash flow diagram for bid 1.
The present worth of the above cash flow diagram is computed as follows:
PW(15%) = 4,50,000 + 27,000(P/A, 15%, 15)
= 4,50,000 + 27,000 ´ 5.8474
= 4,50,000 + 1,57,879.80
= Rs. 6,07,879.80
Bid 2: Beta Elevator Inc.

Initial cost, P = Rs. 5,40,000
Annual operation and maintenance cost, A = Rs. 28,500
Life = 15 years
The cash flow diagram of bid 2 is shown in Fig. 4.7.

0 1 2 3 4 .. 15
..
28,500 28,500 28,500 28,500 28,500

i = 15%
5,40,000
Fig. 4.7 Cash flow diagram for bid 2.
The present worth of the above cash flow diagram is computed as follows:
PW(15%) = 5,40,000 + 28,500(P/A, 15%, 15)
= 5,40,000 + 28,500 ´ 5.8474
= 5,40,000 + 1,66,650.90
= Rs. 7,06,650.90
The total present worth cost of bid 1 is less than that of bid 2. Hence, bid 1 is
to be selected for implementation. That is, the elevator from Alpha Elevator
Inc. is to be purchased and installed in the new building.
EXAMPLE 4.3 Investment proposals A and B have the net cash flows as
follows:
Proposal End of years

0 1 2 3 4
A (Rs.) –10,000 3,000 3,000 7,000 6,000
B (Rs.) –10,000 6,000 6,000 3,000 3,000
Compare the present worth of A with that of B at i = 18%. Which proposal

should be selected?
Solution
Present worth of A at i = 18%. The cash flow diagram of proposal A is
shown in Fig. 4.8.
3,000 3,000 7,000 6,000
0 1 2 3 4
i = 18%
10,000
Fig. 4.8 Cash flow diagram for proposal A.
The present worth of the above cash flow diagram is computed as
PWA(18%) = –10,000 + 3,000(P/F, 18%, 1) + 3,000(P/F, 18%, 2)

+ 7,000(P/F, 18%, 3) + 6,000(P/F, 18%, 4)
= –10,000 + 3,000 (0.8475) + 3,000(0.7182)
+ 7,000(0.6086) + 6,000(0.5158)
= Rs. 2,052.10
Present worth of B at i = 18%. The cash flow diagram of the proposal

B is shown in Fig. 4.9.
6,000 6,000 3,000 3,000
0 1 2 3 4
i = 18%
10,000
Fig. 4.9 Cash flow diagram for proposal B.
The present worth of the above cash flow diagram is calculated as
PWB(18%) = –10,000 + 6,000(P/F, 18%, 1) + 6,000(P/F, 18%, 2)

+ 3,000(P/F, 18%, 3) + 3,000(P/F, 18%, 4)
= –10,000 + 6,000(0.8475) + 6,000(0.7182)
+ 3,000(0.6086) + 3,000(0.5158)
= Rs. 2,767.40
At i = 18%, the present worth of proposal B is higher than that of proposal A.

Therefore, select proposal B.
EXAMPLE 4.4 A granite company is planning to buy a fully automated

granite cutting machine. If it is purchased under down payment, the cost of the
machine is Rs. 16,00,000. If it is purchased under installment basis, the
company has to pay 25% of the cost at the time of purchase and the remaining
amount in 10 annual equal installments of Rs. 2,00,000 each. Suggest the best
alternative for the company using the present worth basis at i = 18%,
compounded annually.
Solution There are two alternatives available for the company:

1. Down payment of Rs. 16,00,000
2. Down payment of Rs. 4,00,000 and 10 annual equal installments of
Rs. 2,00,000 each
Present worth calculation of the second alternative. The cash flow diagram
of the second alternative is shown in Fig. 4.10.
0 1 2 3 10
. . .
2,00,000 2,00,000 2,00,000 2,00,000

4,00,000 i = 18%
Fig. 4.10 Cash flow diagram for the second alternative.

PW(18%) = 4,00,000 + 2,00,000(P/A, 18%, 10)
= 4,00,000 + 2,00,000 ´ 4.4941
= Rs. 12,98,820
The present worth of this option is Rs. 12,98,820, which is less than the first
option of complete down payment of Rs. 16,00,000. Hence, the company should
select the second alternative to buy the fully automated granite cutting machine.
EXAMPLE 4.5 A finance company advertises two investment plans. In plan 1,

the company pays Rs. 12,000 after 15 years for every Rs. 1,000 invested now.
In plan 2, for every Rs. 1,000 invested, the company pays Rs. 4,000 at the end
of the 10th year and Rs. 4,000 at the end of 15th year. Select the best investment
plan from the investor’s point of view at i = 12%, compounded annually.
Solution Plan 1. The cash flow diagram for plan 1 is illustrated in Fig. 4.11.
12,000
0 1 2 3 . . . . 15
i = 12%
1,000
Fig. 4.11 Cash flow diagram for plan 1.

PW(12%) = –1,000 + 12,000(P/F, 12%, 15)
= –1,000 + 12,000(0.1827)
= Rs. 1,192.40
Plan 2. The cash flow diagram for plan 2 is shown in Fig. 4.12.
4,000 4,000
0 1 2 3 . . 10 . 15
i = 12%
1,000
Fig. 4.12 Cash flow diagram for plan 2.

PW(12%) = –1,000 + 4,000(P/F, 12%, 10) + 4,000(P/F, 12%, 15)
= –1,000 + 4,000(0.3220) + 4,000(0.1827)
= Rs. 1,018.80
The present worth of plan 1 is more than that of plan 2. Therefore, plan 1 is the
best plan from the investor’s point of view.
.
EXAMPLE 4.6 Novel Investment Ltd. accepts Rs. 10,000 at the end of
every year for 20 years and pays the investor Rs. 8,00,000 at the end of the
20th year. Innovative Investment Ltd. accepts Rs. 10,000 at the end of
every year for 20 years and pays the investor Rs. 15,00,000 at the end of
the 25th year. Which is the best investment alternative? Use present worth
base with i = 12%.
Solution Novel Investment Ltd’s plan. The cash flow diagram of Novel
Investment Ltd’s plan is shown in Fig. 4.13.
8,00,000
i = 12%
0 1 2 3 20
. . .
10,000 10,000 10,000 10,000
Fig. 4.13 Cash flow diagram for Novel Investment Ltd.

PW(12%) = –10,000(P/A, 12%, 20) + 8,00,000(P/F, 12%, 20)
= –10,000(7.4694) + 8,00,000(0.1037)
= Rs. 8,266
Innovative Investment Ltd’s plan. The cash flow diagram of the Innovative
Investment Ltd’s plan is illustrated in Fig. 4.14.
15,00,000
i = 12%
0 1 2 3 20 25
.
10,000 10,000 10,000 10,000

Fig. 4.14 Cash flow diagram for Innovative Investment Ltd.

PW(12%) = –10,000(P/A, 12%, 20) + 15,00,000(P/F, 12%, 25)
= –10,000(7.4694) + 15,00,000(0.0588)
= Rs. 13,506
The present worth of Innovative Investment Ltd’s plan is more than that of
Novel Investment Ltd’s plan. Therefore, Innovative Investment Ltd’s plan is the
best from investor’s point of view.
EXAMPLE 4.7 A small business with an initial outlay of Rs. 12,000 yields
Rs. 10,000 during the first year of its operation and the yield increases by
Rs. 1,000 from its second year of operation up to its 10th year of operation. At
the end of the life of the business, the salvage value is zero. Find the present
worth of the business by assuming an interest rate of 18%, compounded
annually.
Solution
Initial investment, P = Rs. 12,000
Income during the first year, A = Rs. 10,000
Annual increase in income, G = Rs. 1,000
n = 10 years
i = 18%, compounded annually
The cash flow diagram for the small business is depicted in Fig. 4.15.
19,00,000
19,000
12,000
11,000
10,000
. .
0 1 2 3 . . 10
i = 18%
12,000
Fig. 4.15 Cash flow diagram for the small business.
The equation for the present worth is

PW(18%) = –12,000 + (10,000 + 1,000 ´ (A/G, 18%, 10)) ´ (P/A, 18%, 10)
= –12,000 + (10,000 + 1,000 ´ 3.1936) ´ 4.4941
= –12,000 + 59,293.36
= Rs. 47,293.36
The present worth of the small business is Rs. 47,293.36.
QUESTIONS
1. A project involves an initial outlay of Rs. 30,00,000 and with the following
transactions for the next five years. The salvage value at the end of the life
of the project after five years is Rs. 2,00,000. Draw a cash flow diagram of
the project and find its present worth by assuming i = 15%, compounded
annually.
End Maintenance and Revenue

of year operating expense
(Rs.) (Rs.)
1 2,00,000 9,00,000
2 2,50,000 10,00,000
3 3,00,000 12,00,000
4 3,00,000 13,00,000
5 4,00,000 12,00,000
2. Find the present worth of the following cash flow series. Assume i = 15%,
End of year 0 1 2 3 4 5
Cash flow
(Rs.) –10,000 30,000 30,000 30,000 30,000 30,000
3. Consider the following cash flow series over a 20-year period. Assuming
the interest rate as 18% compounded annually, compute the present worth
of the series; give your comments.
End of year Cash flow (Rs.)

0 –50,00,000
1 6,00,000
2 6,00,000
. .
. .
. .
20 6,00,000
4. The cost of erecting an oil well is Rs. 1,50,00,000. The annual equivalent
yield from the oil well is Rs. 30,00,000. The salvage value after its useful
life of 10 years is Rs. 2,00,000. Assuming an interest rate of 18%,
compounded annually, find out whether the erection of the oil well is
financially feasible, based on the present worth method.
5. The details of the feasibility report of a project are as shown below. Check
the feasibility of the project based on present worth method, using i = 20%.
Initial outlay = Rs. 50,00,000
Life of the project = 20 years.
Annual equivalent revenue = Rs. 15,00,000
Modernizing cost at the end of the 10th year = Rs. 20,00,000
Salvage value at the end of project life = Rs. 5,00,000.
6. Consider the following cash flow diagram. Find the present worth using an
interest rate of 15%, compounded annually.
0 1 2 3 4 .. .. 10
7,000
7,000 + 1,000
7,000 + 2,000
7,000 + 3,000
7,000 + 9,000
7. An automobile company recently advertised its car for a down payment of
Rs. 1,50,000. Alternatively, the car can be taken home by customers without
making any payment, but they have to pay an equal yearly amount of
Rs. 25,000 for 15 years at an interest rate of 18%, compounded annually.
You are asked to advise the best alternative for the customers based on
the present worth method of comparison.
8. The cash flows of two project proposals are as given below. Each of the
project has an expected life of 10 years. Select the best project based on
present worth method of comparison using an interest rate of 18%,
Initial Annual Salvage

outlay equivalent value after
revenue 10 years
(Rs.) (Rs.) (Rs.)
Project 1 –7,50,000 2,00,000 50,000
Project 2 –9,50,000 2,25,000 1,00,000
9. A company has two alternatives for satisfying its daily travel requirements
of its employees for the next five years:
Alternative 1: Renting a vehicle at a cost of Rs. 10,00,000 per year.

Alternative 2: Buying a vehicle for Rs. 5,00,000 with an operating and
maintenance cost of Rs. 3,50,000 per year. The salvage value of the vehicle
after five years is Rs. 1,00,000.
Select the best alternative based on the present worth method of comparison
using the interest rate of 20%, compounded annually.
10. A working woman is planning for her retired life. She has 20 more years
of service. She would like to have an annual equivalent amount of
Rs. 3,00,000, starting from the end of the first year of her retirement. Find
the single amount that should be deposited now so that she receives the
above mentioned annual equivalent amount at the end of every year for
20 years after her retirement. Assume i = 15%, compounded annually.
5
FUTURE WORTH METHOD
5.1 INTRODUCTION
In the future worth method of comparison of alternatives, the future worth of

various alternatives will be computed. Then, the alternative with the maximum
future worth of net revenue or with the minimum future worth of net cost will
be selected as the best alternative for implementation.
A generalized revenue-dominated cash flow diagram to demonstrate the future

S
R1 R2 R3 . Rj Rn
0 1 2 3 . j n
P
In Fig. 5.1, P represents an initial investment, Rj the net-revenue at the end

of the jth year, and S the salvage value at the end of the nth year.
The formula for the future worth of the above cash flow diagram for a given
interest rate, i is
FW(i) = –P(1 + i)n + R1(1 + i)n–1 + R2(1 + i)n–2 + ...
+ R j(1 + i)n–j + ... + Rn + S
In the above formula, the expenditure is assigned with negative sign and the
revenues are assigned with positive sign.
55
alternative, then the corresponding future worth amounts are to be computed and
compared. Finally, the alternative with the maximum future worth amount
should be selected as the best alternative.
A generalized cost-dominated cash flow diagram to demonstrate the future

worth method of comparison is given in Fig. 5.2.
S
. j . .
0 1 2 . . n
.
C1 C2 Cj Cn
P

of the nth year.
The formula for the future worth of the above cash flow diagram for a given
interest rate, i is
FW(i) = P(1 + i)n + C1(1 + i )n–1 + C2(1 + i)n–2 + ...
+ Cj(1 + i)n–j + ... + Cn – S
In this formula, the expenditures are assigned with positive sign and revenues
with negative sign. If we have some more alternatives which are to be compared
with this alternative, then the corresponding future worth amounts are to be
computed and compared. Finally, the alternative with the minimum future worth
amount should be selected as the best alternative.
5.4 EXAMPLES
In this section, several examples highlighting the applications of the future

worth method of comparison are presented.
EXAMPLE 5.1 Consider the following two mutually exclusive alternatives:
End of year
Alternative 0 1 2 3 4
A (Rs.) – 50,00,000 20,00,000 20,00,000 20,00,000 20,00,000
B (Rs.) – 45,00,000 18,00,000 18,00,000 18,00,000 18,00,000
Future Worth Method 57
At i = 18%, select the best alternative based on future worth method of

comparison.
Solution Alternative A
Initial investment, P = Rs. 50,00,000
Annual equivalent revenue, A = Rs. 20,00,000
Life of alternative A = 4 years
The cash flow diagram of alternative A is shown in Fig. 5.3.
20,00,000 20,00,000 20,00,000 20,00,000
0 1 2 3 4
i = 18%
50,00,000
Fig. 5.3 Cash flow diagram for alternative A.
The future worth amount of alternative B is computed as

FWA(18%) = –50,00,000(F/P, 18%, 4) + 20,00,000(F/A, 18%, 4)
= –50,00,000(1.939) + 20,00,000(5.215)
= Rs. 7,35,000
Alternative B
Annual equivalent revenue, A = Rs. 18,00,000
Life of alternative B = 4 years
The cash flow diagram of alternative B is illustrated in Fig. 5.4.
18,00,000 18,00,000 18,00,000 18,00,000
0 1 2 3 4
i = 18%
45,00,000
Fig. 5.4 Cash flow diagram for alternative B.
The future worth amount of alternative B is computed as

FWB(18%) = – 45,00,000(F/P, 18%, 4) + 18,00,000 (F/A, 18%, 4)
= – 45,00,000(1.939) + 18,00,000(5.215)
= Rs. 6,61,500
The future worth of alternative A is greater than that of alternative B. Thus,

alternative A should be selected.
EXAMPLE 5.2 A man owns a corner plot. He must decide which of the
several alternatives to select in trying to obtain a desirable return on his
investment. After much study and calculation, he decides that the two best
alternatives are as given in the following table:
Build Build soft

gas station ice-cream stand
First cost (Rs.) 20,00,000 36,00,000
Annual property taxes (Rs.) 80,000 1,50,000
Annual income (Rs.) 8,00,000 9,80,000
Life of building (years) 20 20
Salvage value (Rs.) 0 0
Evaluate the alternatives based on the future worth method at i = 12%.
Alternative 1—Build gas station

First cost = Rs. 20,00,000
Net annual income = Annual income – Annual property tax
= Rs. 8,00,000 – Rs. 80,000
= Rs. 7,20,000
Life = 20 years
Interest rate = 12%, compounded annually
The cash flow diagram for this alternative is depicted in Fig. 5.5.
7,20,000 7,20,000 7,20,000
0 1 2 . 20
i = 12%
20,00,000
Fig. 5.5 Cash flow diagram for alternative 1.
The future worth of alternative 1 is computed as

FW1(12%) = –20,00,000 (F/P, 12%, 20) + 7,20,000 (F/A, 12%, 20)
= –20,00,000 (9.646) + 7,20,000 (72.052)
= Rs. 3,25,85,440
Alternative 2—Build soft ice-cream stand

First cost = Rs. 36,00,000
Net annual income = Annual income – Annual property tax
= Rs. 9,80,000 – Rs. 1,50,000
= Rs. 8,30,000
Life = 20 years
The cash flow diagram for this alternative is shown in Fig. 5.6.
8,30,000 8,30,000 8,30,000
0 1 2 . 20
i = 12%
36,00,000
The future worth of alternative 2 is calculated as

FW2(12%) = – 36,00,000 (F/P, 12%, 20) + 8,30,000 (F/A, 12%, 20)
= – 36,00,000 (9.646) + 8,30,000 (72.052)
= Rs. 2,50,77,560
The future worth of alternative 1 is greater than that of alternative 2. Thus,
building the gas station is the best alternative.
EXAMPLE 5.3 The cash flow diagram of two mutually exclusive alternatives
are given in Figs. 5.7 and 5.8.
3,00,000
2,50,000
2,00,000
1,50,000
1,00,000
50,000
0 1 2 3 4 5 6
35,00,000
4,20,000
3,50,000
2,80,000
2,10,000
1,40,000
70,000
0 1 2 3 4 5 6
7,00,000
(a) Select the best alternative based on future worth method at i = 8%.
(b) Rework part (a) with i = 9% and 20%
(a) Evaluation at i = 8%
Alternative 1—This comes under equal payment gradient series.
P = Rs. 5,00,000
A1 = Rs. 50,000
G = Rs. 50,000
i = 8%
n = 6 years
The formula for the future worth of alternative 1 is
FW1(8%) = – P(F/P, 8%, 6) + [A1 + G(A/G, 8%, 6)] ´ (F/A, 8%, 6)

= – 5,00,000(1.587) + [50,000 + 50,000(2.2764)] ´ 7.336
= – 79,35,000 + 1,63,820 ´ 7.336
= – 79,35,000 + 12,01,784
= Rs. 4,08,283.52
Alternative 2—This comes under equal payment gradient series.
P = Rs. 7,00,000
A1 = Rs. 70,000
G = Rs. 70,000
i = 8%
n = 6 years
FW2(8%) = – P(F/P, 8%, 6) + [A1 + G(A/G, 8%, 6)] ´ (F/A, 8%, 6)

FW2(8%) = –7,00,000 ´ 1.587 + [70,000 + 70,000 ´ 2.2764] ´ 7.336
= –11,10,900 + 16,82,497
= Rs. 5,71,596.93
The future worth of alternative 2 is more than that of alternative 1. Therefore,
alternative 2 must be selected.
(b) (i) Evaluation at i = 9%: Alternative 1
P = Rs. 5,00,000
A1 = Rs. 50,000
G = Rs. 50,000
n = 6 years
The formula for the future worth of alternative 1 is as follows:
FW1(9%) = – P(F/P, 9%, 6) + [A1 + G(A/G, 9%, 6)] ´ (F/A, 9%, 6)
= – 5,00,000 (1.677) + [50,000 + 50,000 (2.2498)] ´ 7.523
= – 8,38,500 + 12,22,412.27
= Rs. 3,83,912.27
Alternative 2
P = Rs. 7,00,000
A1 = Rs. 70,000
G = Rs. 70,000
n = 6 years
The formula for the future worth of the alternative 2 is
FW2(9%) = –P(F/P, 9%, 6) + [A1 + G(A/G, 9%, 6)] ´ (F/A, 9%, 6)
= –7,00,000 ´ 1.677 + [70,000 + 70,000 ´ 2.2498] ´ 7.523
= –11,73,900 + 17,11,377.18
= Rs. 5,37,477.18
The future worth of alternative 2 is more than that of alternative 1. Therefore,
alternative 2 must be selected.
(ii) Evaluation at i = 20%: Alternative 1
P = Rs. 5,00,000
A1 = Rs. 50,000
G = Rs. 50,000
n = 6 years

FW1(20%) = –P(F/P, 20%, 6) + [A1 + G(A/G, 20%, 6)] ´ (F/A, 20%, 6)
= –5,00,000 (2.986) + [50,000 + 50,000 (1.9788)] ´ 9.93
= –14,93,000 + 14,78,974.20
= Rs. –14,025.80
The negative sign of the future worth amount indicates that alternative 1
incurs loss.
Alternative 2
P = Rs. 7,00,000
A1 = Rs. 70,000
G = Rs. 70,000
n = 6 years
FW2(20%) = – P(F/P, 20%, 6) + [A1 + G(A/G, 20%, 6)] ´ (F/A, 20%, 6)
= –7,00,000 ´ 2.986 + [70,000 + 70,000 ´ 1.9788] ´ 9.93
= –20,90,200 + 20,70,563.88
= Rs. –19,636.12
The negative sign of the above future worth amount indicates that alternative 2
incurs loss. Thus, none of the two alternatives should be selected.
EXAMPLE 5.4 M/S Krishna Castings Ltd. is planning to replace its annealing
furnace. It has received tenders from three different original manufacturers of
annealing furnace. The details are as follows.
Manufacturer
1 2 3
Initial cost (Rs.) 80,00,000 70,00,000 90,00,000
Life (years) 12 12 12
Annual operation and
maintenance cost (Rs.) 8,00,000 9,00,000 8,50,000
Salvage value after
12 years 5,00,000 4,00,000 7,00,000
Which is the best alternative based on future worth method at i = 20%?
Solution Alternative 1—Manufacturer 1

First cost, P = Rs. 80,00,000
Life, n = 12 years
Annual operating and maintenance cost, A = Rs. 8,00,000

Salvage value at the end of furnace life = Rs. 5,00,000
5,00,000
i =20%
20%
0 1 2 3 . . 12
. .
8,00,000 8,00,000 8,00,000 8,00,000
80,00,000
Fig. 5.9 Cash flow diagram for manufacturer 1.
The future worth amount of alternative 1 is computed as

FW1(20%) = 80,00,000 (F/P, 20%, 12) + 8,00,000 (F/A, 20%, 12) – 5,00,000
= 80,00,000(8.916) + 8,00,000 (39.581) – 5,00,000
= Rs. 10,24,92,800
Alternative 2— Manufacturer 2
Life, n = 12 years
The cash flow diagram for this alternative is given in Fig. 5.10.
4,00,000
i = 20%
0 1 2 3 . . 12
9,00,000 9,00,000 9,00,000 . . 9,00,000
70,00,000
The future worth amount of alternative 2 is computed as

FW2(20%) = 70,00,000(F/P, 20%, 12) + 9,00,000(F/A, 20%, 12) – 4,00,000
= 70,00,000(8.916) + 9,00,000 (39.581) – 4,00,000
= Rs. 9,76,34,900
Alternative 3—Manufacturer 3
Life, n = 12 years

The cash flow diagram for this alternative is illustrated in Fig. 5.11.
7,00,000
i = 20%
0 1 2 3 . . 12
8,50,000 8,50,000 8,50,000 . . 8,50,000
90,00,000
The future worth amount of alternative 3 is calculated as

FW3(20%) = 90,00,000(F/P, 20%, 12) + 8,50,000(F/A, 20%, 12) – 7,00,000
= 90,00,000(8.916) + 8,50,000 (39.581) – 7,00,000
= Rs. 11,31,87,850
The future worth cost of alternative 2 is less than that of the other two
alternatives. Therefore, M/s. Krishna castings should buy the annealing furnace
from manufacturer 2.
EXAMPLE 5.5 A company must decide whether to buy machine A or

machine B:
Machine A Machine B
Initial cost Rs. 4,00,000 Rs. 8,00,000
Useful life, in years 4 4
Salvage value at the end
of machine life Rs. 2,00,000 Rs. 5,50,000
Annual maintenance cost Rs. 40,000 0
At 12% interest rate, which machine should be selected? (Use future worth
method of comparison).
Solution Machine A
Initial cost of the machine, P = Rs. 4,00,000
Life, n = 4 years
Salvage value at the end of machine life, S = Rs. 2,00,000
Annual maintenance cost, A = Rs. 40,000
The cash flow diagram of machine A is given in Fig. 5.12.
2,00,000
i = 20%
0 1 2 3 4
40,000 40,000 40,000 .

40,000
4,00,000
Fig. 5.12 Cash flow diagram for machine A.
The future worth function of Fig. 5.12 is

FWA(12%) = 4,00,000 ´ (F/P, 12%, 4) + 40,000 ´ (F/A, 12%, 4) – 2,00,000
= 4,00,000 ´ (1.574) + 40,000 ´ (4.779) – 2,00,000
= Rs. 6,20,760
Machine B
Initial cost of the machine, P = Rs. 8,00,000
Life, n = 4 years
Salvage value at the end of machine life, S = Rs. 5,50,000
Annual maintenance cost, A = zero.
The cash flow diagram of the machine B is illustrated in Fig. 5.13.
5,50,000
i = 12%
0 1 2 3 4
8,00,000
Fig. 5.13 Cash flow diagram for machine B.
The future worth function of Fig 5.13 is

FWB(12%) = 8,00,000 ´ (F/P, 12%, 4) – 5,50,000
= 8,00,000 ´ (1.574) – 5,50,000
= Rs. 7,09,200
The future worth cost of machine A is less than that of machine B.
Therefore, machine A should be selected.
QUESTIONS
1. A suburban taxi company is considering buying taxis with diesel engines

instead of petrol engines. The cars average 50,000 km a year, with a useful
life of three years for the taxi with the petrol engine and four years for the
diesel taxi. Other comparative information are as follows:
Diesel Petrol
Vehicle cost Rs. 5,00,000 Rs. 4,00,000
Fuel cost per litre Rs. 9.00 Rs. 24.00
Mileage, in km/litre 30 20
Annual insurance premium Rs. 500 Rs. 500
of vehicle life Rs. 70,000 Rs. 1,00,000
Determine the more economical choice based on the future worth method
of comparison if the interest rate is 15%, compounded annually.
2. A motorcycle is sold for Rs. 50,000. The motorcycle dealer is willing to sell
it on the following terms:
(a) Make no down payment but pay Rs. 1,500 at the end of each of the first
four months and Rs. 3,000 at the end of each month after that for 18
continuous months.
(b) Make no down payment but pay a total amount of Rs. 90,000 at the end
of the 22nd month; till that time the buyer should mortgage property
worth of Rs. 50,000, at present.
Based on these terms and a 12% annual interest rate compounded monthly,
find the best alternative for the buyer based on the future worth method of
comparison.
3. Consider the following two mutually exclusive alternatives.
A B
Cost Rs. 4,000 Rs. 6,000
Uniform annual benefit Rs. 640 Rs. 960
Useful life (years) 20 20
Using a 15% interest rate, determine which alternative should be selected
based on the future worth method of comparison.
4. A company must decide whether to buy machine A or machine B:
Machine A Machine B
Initial cost Rs. 4,00,000 Rs. 8,00,000
Useful life, (years) 5 5
of machine life Rs. 2,00,000 Rs. 5,50,000
Annual maintenance cost Rs. 40,000 0
At 15% interest rate, which machine should be selected? (Use the future
worth method of comparison.)
5. Due to increasing awareness of customers, two different television
manufacturing companies started a marketing war. The details of
advertisements of the companies are as follows:
Brand X Brand Y
Selling price of a TV set Rs. 15,000 Rs. 10,000
Amount returned to buyer after 5 years Rs. 8,000 –
Select the most economical brand from the customer’s point of view using
the future worth method of comparison, assuming an interest rate of 15%,
6. Alpha Finance Company is coming with an option of accepting
Rs. 10,000 now and paying a sum of Rs. 1,60,000 after 20 years. Beta
Finance Company is coming with a similar option of accepting Rs. 10,000
now and paying a sum of Rs. 3,00,000 after 25 years. Compare and select
the best alternative based on the future worth method of comparison with
15% interest rate, compounded annually.
7. An insurance company gives an endowment policy for a person aged 30
years. The yearly premium for an insured sum of Rs. 1,00,000 is Rs. 4,000.
The policy will mature after 25 years. Also, the person is entitled for a
bonus of Rs. 75 per thousand per year at the end of the policy. If a person
survives till the end of the 25th year:
(a) What will be the total sum that he will get from the insurance company
at that time?
(b) Instead of paying the premiums for the insurance policy, if the person
invests an equal sum of Rs. 4,000 at the end of each year for the next
25 years in some other scheme which is having similar tax benefit, find
the future worth of the investment at 15% interest rate, compounded
annually.
(c) Rate the above alternatives assuming that the person is sure of living
for the next 25 years.
6
ANNUAL EQUIVALENT METHOD
6.1 INTRODUCTION
In the annual equivalent method of comparison, first the annual equivalent cost
or the revenue of each alternative will be computed. Then the alternative with
the maximum annual equivalent revenue in the case of revenue-based
comparison or with the minimum annual equivalent cost in the case of cost-
based comparison will be selected as the best alternative.
A generalized revenue-dominated cash flow diagram to demonstrate the annual

equivalent method of comparison is presented in Fig. 6.1.
R1 R2 R3 . Rj Rn
0 1 2 3 . j n
P
In Fig. 6.1, P represents an initial investment, Rj the net revenue at the end
of the jth year, and S the salvage value at the end of the nth year.
The first step is to find the net present worth of the cash flow diagram using
the following expression for a given interest rate, i:
PW(i) = –P + R1/(1 + i)1 + R2/(1 + i)2 + ...
+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n
In the above formula, the expenditure is assigned with a negative sign and
the revenues are assigned with a positive sign.
68
Annual Equivalent Method 69
In the second step, the annual equivalent revenue is computed using the
following formula:
i(1 + i)n
A = PW(i)
(1 + i)n − 1
= PW(i) (A/P, i, n)
where (A/P, i, n) is called equal payment series capital recovery factor.
alternative, then the corresponding annual equivalent revenues are to be
computed and compared. Finally, the alternative with the maximum annual
equivalent revenue should be selected as the best alternative.
A generalized cost-dominated cash flow diagram to demonstrate the annual

equivalent method of comparison is illustrated in Fig. 6.2.
S
0 1 2 . j . . n
. .
.
C1 C2 Cj Cn
P

of the nth year.
the following relation for a given interest rate, i.
PW(i) = P + C1/(1 + i)1 + C2/(1 + i)2 + ...
+ Cj/(1 + i) j + ... + Cn/(1 + i)n – S/(1 + i)n
In the above formula, each expenditure is assigned with positive sign and
the salvage value with negative sign. Then, in the second step, the annual
equivalent cost is computed using the following equation:
i(1 + i)n
A = PW(i)
(1 + i)n − 1
= PW(i) (A/P, i, n)
where (A/P, i, n) is called as equal-payment series capital recovery factor.
As in the previous case, if we have some more alternatives which are to be

compared with this alternative, then the corresponding annual equivalent costs
are to be computed and compared. Finally, the alternative with the minimum
annual equivalent cost should be selected as the best alternative.
If we have some non-standard cash flow diagram, then we will have to
follow the general procedure for converting each and every transaction to time
zero and then convert the net present worth into an annual equivalent cost/
revenue depending on the type of the cash flow diagram. Such procedure is to
be applied to all the alternatives and finally, the best alternative is to be selected.
6.4 ALTERNATE APPROACH
Instead of first finding the present worth and then figuring out the annual
equivalent cost/revenue, an alternate method which is as explained below can be
used. In each of the cases presented in Sections 6.2 and 6.3, in the first step, one
can find the future worth of the cash flow diagram of each of the alternatives.
Then, in the second step, the annual equivalent cost/revenue can be obtained by
using the equation:
i
A =F
(1 + i )n − 1
= F(A/F, i, n)
where (A/F, i, n) is called equal-payment series sinking fund factor.
6.5 EXAMPLES
In this section, the application of the annual equivalent method is demonstrated

with several numerical examples.
EXAMPLE 6.1 A company provides a car to its chief executive. The owner
of the company is concerned about the increasing cost of petrol. The cost per
litre of petrol for the first year of operation is Rs. 21. He feels that the cost of
petrol will be increasing by Re.1 every year. His experience with his company
car indicates that it averages 9 km per litre of petrol. The executive expects to
drive an average of 20,000 km each year for the next four years. What is the
annual equivalent cost of fuel over this period of time?. If he is offered similar
service with the same quality on rental basis at Rs. 60,000 per year, should the
owner continue to provide company car for his executive or alternatively
provide a rental car to his executive? Assume i = 18%. If the rental car is
preferred, then the company car will find some other use within the company.
Solution
Average number of km run/year = 20,000 km
Number of km/litre of petrol = 9 km
Therefore,
Petrol consumption/year = 20,000/9 = 2222.2 litre
Cost/litre of petrol for the 1st year = Rs. 21
Cost/litre of petrol for the 2nd year = Rs. 21.00 + Re. 1.00
= Rs. 22.00
Cost/litre of petrol for the 3rd year = Rs. 22.00 + Re. 1.00
= Rs. 23.00
Cost/litre of petrol for the 4th year = Rs. 23.00 + Re. 1.00
= Rs. 24.00
Fuel expenditure for 1st year = 2222.2 ´ 21 = Rs. 46,666.20
Fuel expenditure for 2nd year = 2222.2 ´ 22 = Rs. 48,888.40
Fuel expenditure for 3rd year = 2222.2 ´ 23 = Rs. 51,110.60
Fuel expenditure for 4th year = 2222.2 ´ 24 = Rs. 53,332.80
The annual equal increment of the above expenditures is Rs. 2,222.20 (G).
The cash flow diagram for this situation is depicted in Fig. 6.3.
0 1 2 3 4
A1
A1 + G
A1 + 2G
A1 + 3G
Fig. 6.3 Uniform gradient series cash flow diagram.
In Fig. 6.3, A1 = Rs. 46,666.20 and G = Rs. 2,222.20

A = A1 + G(A/G, 18%, 4)
= 46,666.20 + 2222.2(1.2947)
= Rs. 49,543.28
The proposal of using the company car by spending for petrol by the
company will cost an annual equivalent amount of Rs. 49,543.28 for four years.
This amount is less than the annual rental value of Rs. 60,000. Therefore, the
company should continue to provide its own car to its executive.
EXAMPLE 6.2 A company is planning to purchase an advanced machine

centre. Three original manufacturers have responded to its tender whose
particulars are tabulated as follows:
Manufacturer Down payment Yearly equal No. of

installment installments
(Rs.) (Rs.)
1 5,00,000 2,00,000 15
2 4,00,000 3,00,000 15
3 6,00,000 1,50,000 15
Determine the best alternative based on the annual equivalent method by

assuming i = 20%, compounded annually.
Solution Alternative 1
Down payment, P = Rs. 5,00,000
Yearly equal installment, A = Rs. 2,00,000
n = 15 years
The cash flow diagram for manufacturer 1 is shown in Fig. 6.4.
0 1 2 3 4 15
. .
2,00,000 2,00,000 2,00,000 2,00,000 2,00,000
5,00,000
The annual equivalent cost expression of the above cash flow diagram is
AE1(20%) = 5,00,000(A/P, 20%, 15) + 2,00,000
= 5,00,000(0.2139) + 2,00,000
= 3,06,950
Alternative 2
n = 15 years
The cash flow diagram for the manufacturer 2 is shown in Fig. 6.5.
0 1 2 3 4 15
. .
3,00,000 3,00,000 3,00,000 3,00,000 3,00,000
4,00,000
AE2(20%) = 4,00,000(A/P, 20%, 15) + 3,00,000
= 4,00,000(0.2139) + 3,00,000
= Rs. 3,85,560.
Alternative 3
n = 15 years
The cash flow diagram for manufacturer 3 is shown in Fig. 6.6.
0 1 2 3 4 15
. .
1,50,000 1,50,000 1,50,000 1,50,000 1,50,000
6,00,000
AE3(20%) = 6,00,000(A/P, 20%, 15) + 1,50,000
= 6,00,000(0.2139) + 1,50,000
= Rs. 2,78,340.
The annual equivalent cost of manufacturer 3 is less than that of
manufacturer 1 and manufacturer 2. Therefore, the company should buy the
advanced machine centre from manufacturer 3.
EXAMPLE 6.3 A company invests in one of the two mutually exclusive

alternatives. The life of both alternatives is estimated to be 5 years with the
following investments, annual returns and salvage values.
Alternative
A B
Investment (Rs.) – 1,50,000 – 1,75,000
Annual equal return (Rs.) + 60,000 + 70,000
Salvage value (Rs.) + 15,000 + 35,000
Determine the best alternative based on the annual equivalent method by

assuming i = 25%.
Solution Alternative A
Annual equal return, A = Rs. 60,000
Salvage value at the end of machine life, S = Rs. 15,000
Life = 5 years
The cash flow diagram for alternative A is shown in Fig. 6.7.

60,000 + 15,000
60,000 60,000 60,000 60,000
0 1 2 3 4 5
1,50,000
Fig. 6.7 Cash flow diagram for alternative A.
The annual equivalent revenue expression of the above cash flow diagram
is as follows:
AEA(25%) = –1,50,000(A/P, 25%, 5) + 60,000 + 15,000(A/F, 25%, 5)
= –1,50,000(0.3718) + 60,000 + 15,000(0.1218)
= Rs. 6,057
Alternative B
Annual equal return, A = Rs. 70,000
Salvage value at the end of machine life, S = Rs. 35,000
Life = 5 years
The cash flow diagram for alternative B is shown in Fig. 6.8.
70,000 + 35,000
70,000 70,000 70,000 70,000
0 1 2 3 4 5
1,75,000
Fig. 6.8 Cash flow diagram for alternative B.
The annual equivalent revenue expression of the above cash flow diagram is
AEB(25%) = –1,75,000(A/P, 25%, 5) + 70,000 + 35,000(A/F, 25%, 5)
= –1,75,000(0.3718) + 70,000 + 35,000(0.1218)
= Rs. 9,198
The annual equivalent net return of alternative B is more than that of
alternative A. Thus, the company should select alternative B.
EXAMPLE 6.4 A certain individual firm desires an economic analysis to

determine which of the two machines is attractive in a given interval of time.
The minimum attractive rate of return for the firm is 15%. The following data
are to be used in the analysis:
Machine X Machine Y
First cost Rs. 1,50,000 Rs. 2,40,000
Estimated life 12 years 12 years
Salvage value Rs. 0 Rs. 6,000
Annual maintenance cost Rs. 0 Rs. 4,500
Which machine would you choose? Base your answer on annual equivalent
cost.
Solution Machine X
Life, n = 12 years
Estimated salvage value at the end of machine life, S = Rs. 0.
Annual maintenance cost, A = Rs. 0.
The cash flow diagram of machine X is illustrated in Fig. 6.9.
0 12
1,50,000
Fig. 6.9 Cash flow diagram for machine X.
AEX(15%) = 1,50,000(A/P, 15%, 12)
= 1,50,000(0.1845)
= Rs. 27,675
Machine Y
Life, n = 12 years
Estimated salvage value at the end of machine life, S = Rs. 60,000
Annual maintenance cost, A = Rs. 4,500
The cash flow diagram of machine Y is depicted in Fig. 6.10.
60,000
6,000
0 1 2 3 . . 12
. .
4,500 4,500 4,500 4,500
2,40,000
Fig. 6.10 Cash flow diagram for machine Y.
AEY(15%) = 2,40,000(A/P, 15%, 12) + 4,500 – 6,000(A/F, 15%, 12)

= 2,40,000(0.1845) + 4,500 – 6,000(0.0345)
= Rs. 48,573
The annual equivalent cost of machine X is less than that of machine Y. So,
machine X is the more cost effective machine.
EXAMPLE 6.5 Two possible routes for laying a power line are under study.
Data on the routes are as follows:
Around the lake Under the lake

Length 15 km 5 km
First cost (Rs.) 1,50,000/km 7,50,000/km
Maintenance cost (Rs.) 6,000/km/yr 12,000/km/yr
Salvage value (Rs.) 90,000/km 1,50,000/km
Yearly power loss (Rs.) 15,000/km 15,000/km
If 15% interest is used, should the power line be routed around the lake or
under the lake?
Solution Alternative 1— Around the lake

First cost = 1,50,000 ´ 15 = Rs. 22,50,000
Maintenance cost/yr = 6,000 ´ 15 = Rs. 90,000
Power loss/yr = 15,000 ´ 15 = Rs. 2,25,000
Maintenance cost and power loss/yr = Rs. 90,000 + Rs. 2,25,000
= Rs. 3,15,000
Salvage value = 90,000 ´ 15 = Rs. 13,50,000
13,50,000
i = 15%
0 1 2 3 . . 15
. .
3,15,000 3,15,000 3,15,000 3,15,000
22,50,000
AE1(15%) = 22,50,000(A/P, 15%, 15) + 3,15,000 – 13,50,000(A/F, 15%, 15)
= 22,50,000(0.1710) + 3,15,000 – 13,50,000(0.0210)
= Rs. 6,71,400
Alternative 2— Under the lake
First cost = 7,50,000 ´ 5 = Rs. 37,50,000
Maintenance cost/yr = 12,000 ´ 5 = Rs. 60,000
Power loss/yr = 15,000 ´ 5 = Rs. 75,000
Maintenance cost and power loss/yr = Rs. 60,000 + Rs. 75,000
= Rs. 1,35,000
Salvage value = 1,50,000 ´ 5 = Rs. 7,50,000
7,50,000
i = 15%
0 1 2 3 . . 15
. .
1,35,000 1,35,000 1,35,000 1,35,000
37,50,000
AE2(15%) = 37,50,000(A/P, 15%, 15) + 1,35,000 – 7,50,000(A/F, 15%, 15)
= 37,50,000(0.1710) + 1,35,000 – 7,50,000(0.0210)
= Rs. 7,60,500
The annual equivalent cost of alternative 1 is less than that of alternative 2.
Therefore, select the route around the lake for laying the power line.
EXAMPLE 6.6 A suburban taxi company is analyzing the proposal of buying

cars with diesel engines instead of petrol engines. The cars average 60,000 km
a year with a useful life of three years for the petrol taxi and four years for the
diesel taxi. Other comparative details are as follows:
Diesel Petrol
Vehicle cost (Rs.) 3,90,000 3,60,000
Fuel cost per litre (Rs.) 8 20
Mileage in km/litre 30 20
Annual repairs (Rs.) 9,000 6,000
Annual insurance premium (Rs.) 15,000 15,000
Resale value at the end of vehicle life (Rs.) 60,000 90,000
Determine the more economical choice if interest rate is 20%, compounded

annually.
Solution Alternative 1— Purchase of diesel taxi
Vehicle cost = Rs. 3,90,000
Life = 4 years
Number of litres/year 60,000/30 = 2,000 litres
Fuel cost/yr = 2,000 ´ 8 = Rs. 16,000
Fuel cost, annual repairs and insurance premium/yr
= Rs. 16,000 + Rs. 9,000 + Rs. 15,000 = Rs. 40,000
Salvage value at the end of vehicle life = Rs. 60,000
The cash flow diagram for alternative 1 is shown in Fig. 6.13.
60,000
0 1 2 3 4
40,000 40,000 40,000 40,000
3,90,000
AE(20%) = 3,90,000(A/P, 20%, 4) + 40,000 – 60,000(A/F, 20%, 4)
= 3,90,000(0.3863) + 40,000 – 60,000(0.1863)
= Rs. 1,79,479
Alternative 2— Purchase of petrol taxi
Vehicle cost = Rs. 3,60,000
Life = 3 years
Number of litres/year 60,000/20 = 3,000 litres
Fuel cost/yr = 3,000 ´ 20 = Rs. 60,000
Fuel cost, annual repairs and insurance premium/yr

= Rs. 60,000 + Rs. 6,000 + Rs. 15,000 = Rs. 81,000
Salvage value at the end of vehicle life = Rs. 90,000
90,000
0 1 2 3
81,000 81,000 81,000
3,60,000
AE(20%) = 3,60,000(A/P, 20%, 3) + 81,000 – 90,000(A/F, 20%, 3)
= 3,60,000(0.4747) + 81,000 – 90,000(0.2747)
= Rs. 2,27,169
The annual equivalent cost of purchase and operation of the cars with diesel
engine is less than that of the cars with petrol engine. Therefore, the taxi
company should buy cars with diesel engine. (Note: Comparison is done on
common multiple lives of 12 years.)
EXAMPLE 6.7 Ramu, a salesman, needs a new car for use in his business. He
expects that he will be promoted to a supervisory job at the end of third year
and so his concern now is to have a car for the three years he expects to be “on
the road”. The company will reimburse their salesman each month the fuel cost
and maintenance cost. Ramu has decided to drive a low-priced automobile. He
finds, however, that there are two different ways of obtaining the automobile. In
either case, the fuel cost and maintenance cost are borne by the company.
(a) Purchase for cash at Rs. 3,90,000.
(b) Lease a car. The monthly charge is Rs. 10,500 on a 36-month lease
payable at the end of each month. At the end of the three-year period,
the car is returned to the leasing company.
Ramu believes that he should use a 12% interest rate compounded monthly
in determining which alternative to select. If the car could be sold for
Rs. 1,20,000 at the end of the third year, which option should he use to obtain it?
Alternative 1—Purchase car for cash
Purchase price of the car = Rs. 3,90,000
Life = 3 years = 36 months
Salvage value after 3 years = Rs. 1,20,000
Interest rate = 12% (nominal rate, compounded annually)

= 1% compounded monthly
1,20,000
0 1 2 3 . . 36
3,90,000
The monthly equivalent cost expression [ME(1%)] of the above cash flow
diagram is
ME(1%) = 3,90,000(A/P, 1%, 36) – 1,20,000(A/F, 1%, 36)
= 3,90,000(0.0332) – 1,20,000(0.0232)
= Rs. 10,164
Alternative 2—Use of car under lease

Monthly lease amount for 36 months = Rs. 10,500
The cash flow diagram for alternative 2 is illustrated in Fig. 6.16.
0 1 2 3 . . 36
10,500 10,500 10,500 10,500

Monthly equivalent cost = Rs.10,500.

The monthly equivalent cost of alternative 1 is less than that of alternative
2. Hence, the salesman should purchase the car for cash.
EXAMPLE 6.8 A company must decide whether to buy machine A or

machine B.
Machine A Machine B
Initial cost (Rs.) 3,00,000 6,00,000
Salvage value at the end of machine life (Rs.) 2,00,000 3,00,000
Annual maintenance (Rs.) 30,000 0
At 15% interest rate, which machine should be purchased?

Solution Machine A
Initial cost = Rs. 3,00,000
Useful life (years) = 4
Salvage value at the end of machine life = Rs. 2,00,000
Annual maintenance = Rs. 30,000
The cash flow diagram of machine A is depicted in Fig. 6.17.
2,00,000
0 1 2 3 4
30,000 30,000 30,000 30,000
3,00,000
Fig. 6.17 Cash flow diagram for machine A.
AE(15%) = 3,00,000(A/P, 15%, 4) + 30,000 – 2,00,000(A/F, 15%, 4)
= 3,00,000(0.3503) + 30,000 – 2,00,000(0.2003)
= Rs. 95,030
Machine B
Initial cost = Rs. 6,00,000
Useful life (years) = 4
Salvage value at the end of machine life = Rs. 3,00,000
Annual maintenance = Rs. 0.
The cash flow diagram of machine B is illustrated in Fig. 6.18.
3,00,000
0 1 2 3 4
6,00,000
Fig. 6.18 Cash flow diagram for machine B.
AE(15%) = 6,00,000(A/P, 15%, 4) – 3,00,000(A/F, 15%, 4)
= 6,00,000(0.3503) – 3,00,000(0.2003)
= Rs. 1,50,090
Since the annual equivalent cost of machine A is less than that of
machine B, it is advisable to buy machine A.
EXAMPLE 6.9 Jothi Lakshimi has arranged to buy some home recording
equipment. She estimates that it will have a five year useful life and no salvage
value at the end of equipment life. The dealer, who is a friend has offered Jothi
Lakshimi two alternative ways to pay for the equipment.
(a) Pay Rs. 60,000 immediately and Rs. 15,000 at the end of one year.
(b) Pay nothing until the end of fourth year when a single payment of
Rs. 90,000 must be made.
If Jothi Lakshimi believes 12% is a suitable interest rate, which alternative
is the best for her?
Solution Alternative 1
Down payment = Rs. 60,000
Payment after one year = Rs. 15,000
0 1
15,000
60,000
The present worth equation of the above cash flow diagram is

PW(12%) = 60,000 + 15,000(P/F, 12%, 1)
= 60,000 + 15,000(0.8929)
= 73,393.50
The above present worth is represented in Fig. 6.20.
0 1 2 3 4
73,393.5
Fig. 6.20 Resultant cash flow diagram.
The annual equivalent expression of the above cash flow diagram is

AE(12%) = 73,393.5(A/P, 12%, 4)
= 73,393.5(0.3292)
= Rs. 24,161.14
Alternative 2
Payment after four years = Rs. 90,000
0 1 2 3 4
90,000
Fig. 6.21 Cash flow diagram of alternative 2.
AE(12%) = 90,000(A/F, 12%, 4)
= 90,000(0.2092)
= Rs. 18,828
The annual equivalent cost of alternative 2 is less than that of alternative 1.
Hence, Jothi Lakshimi should select alternative 2 for purchasing the home
equipment.
EXAMPLE 6.10 A transport company has been looking for a new tyre for its
truck and has located the following alternatives:
Brand Tyre warranty Price per tyre

(months) (Rs.)
A 12 1,200
B 24 1,800
C 36 2,100
D 48 2,700
If the company feels that the warranty period is a good estimate of the tyre
life and that a nominal interest rate (compounded annually) of 12% is
appropriate, which tyre should it buy?
Solution In all the cases, the interest rate is 12%. This is equivalent to 1% per
month.
Brand A
Tyre warranty = 12 months
Price/tyre = Rs. 1,200
The cash flow diagram for brand A is shown in Fig. 6.22.

0 1 2 3 . . . 12
1,200
Fig. 6.22 Cash flow diagram of brand A.
AE(1%) = 1,200(A/P, 1%, 12)
= 1,200(0.0888)
= Rs. 106.56
Brand B
The cash flow diagram for brand B is shown in Fig. 6.23.
0 1 2 3 . . . 24
1,800
Fig. 6.23 Cash flow diagram of brand B.
AE(1%) = 1,800(A/P, 1%, 24)
= 1,800(0.0471)
= Rs. 84.78
Brand C
The cash flow diagram for brand C is shown in Fig. 6.24.
0 1 2 3 . . . 36
2,100
Fig. 6.24 Cash flow diagram of brand C.
The annual equivalent expression of the above cash flow diagram is

AE(1%) = 2,100(A/P, 1%, 36)
= 2,100(0.0332)
= Rs. 69.72
Brand D
The cash flow diagram for brand D is shown in Fig. 6.25.
0 1 2 3 . . . 48
2,700
Fig. 6.25 Cash flow diagram of brand D.
AE(1%) = 2,700 (A/P, 1%, 48)
= 2,700 (0.0263)
= Rs. 71.01
Here, minimum common multiple lives of tyres is considered. This is 144
months. Therefore, the comparison is made on 144 month’s basis.
The annual equivalent cost of brand C is less than that of other brands.
Hence, it should be used in the vehicles of the trucking company. It should be
replaced four times during the 144-month period.
QUESTIONS
1. A company has three proposals for expanding its business operations. The
details are as follows:
Alternative Initial cost Annual revenue Life

(Rs.) (Rs.) (years)
A1 25,00,000 8,00,000 10
A2 20,00,000 6,00,000 10
A3 30,00,000 10,00,000 10
Each alternative has insignificant salvage value at the end of its life.
Assuming an interest rate of 15%, compounded annually, find the best
alternative for expanding the business operations of the company using the
annual equivalent method.
2. An automobile dealer has recently advertised for its new car. There are
three alternatives of purchasing the car which are explained below.
Alternative 1 The customer can take delivery of a car after making a down
payment of Rs. 25,000. The remaining money should be paid in 36 equal
monthly installments of Rs. 10,000 each.
Alternative 2 The customer can take delivery of the car after making a
down payment of Rs. 1,00,000. The remaining money should be paid in 36
equal monthly installments of Rs. 7,000 each.
Alternative 3 The customer can take delivery of the car by making full
payment of Rs. 3,00,000.
Suggest the best alternative of buying the cars for the customers by
assuming an interest rate of 20% compounded annually. Use the annual
equivalent method.
3. A small-scale industry is in the process of buying a milling machine. The
purchase value of the milling machine is Rs. 60,000. It has identified two
banks for loan to purchase the milling machine. The banks can give only
80% of the purchase value of the milling machine as loan. In Urban Bank,
the loan is to be repaid in 60 equal monthly installments of Rs. 2,500 each.
In State Bank, the loan is to be repaid in 40 equal monthly installments of
Rs. 4,500 each. Suggest the most economical loan scheme for the company,
based on the annual equivalent method of comparison. Assume a nominal
rate of 24%, compounded monthly.
4. There are two alternatives of replacing a machine. The details of the
alternatives are as follows:
Alternative 1
Purchase value of the new machine : Rs. 2,00,000
Life of the machine : 10 years
Salvage value of the new machine at
the end of its life : Rs. 20,000
Annual operation and maintenance cost : Rs. 40,000
Buyback price of the existing machine : Rs. 25,000
Alternative 2
Purchase value of the new machine : Rs. 3,00,000
Life of the machine : 10 years
Salvage value of the new machine at
the end of its life : Rs. 15,000
Annual operation and maintenance cost : Rs. 35,000
Buyback price of the existing machine : Rs. 5,000
Suggest the best replacement option for the company using the annual
equivalent cost method of comparison by assuming 20% interest rate,
5. A company receives two options for purchasing a copier machine for its
office.
Option 1 Make a down payment of Rs. 30,000 and take delivery of the
copier machine. The remaining money is to be paid in 24 equal monthly
installments of Rs. 4,500 each.
Option 2 Make a full payment of Rs. 1,00,000 and take delivery of the
copier machine.
Suggest the best option for the company to buy the copier machine based
on the annual equivalent method of comparison by assuming 15% interest
rate, compounded annually.
6. Find the best alternative using the annual equivalent method of comparison.
Assume an interest rate of 15% compounded annually.
Alternative A B C
Initial cost (Rs.) 5,00,000 8,00,000 6,00,000
Annual receipt (Rs.) 2,00,000 1,50,000 1,20,000
Life (years) 10 10 10
Salvage value (Rs.) 1,00,000 50,000 30,000
7
RATE OF RETURN METHOD
7.1 INTRODUCTION
The rate of return of a cash flow pattern is the interest rate at which the present
worth of that cash flow pattern reduces to zero. In this method of comparison,
the rate of return for each alternative is computed. Then the alternative which
has the highest rate of return is selected as the best alternative.
In this type of analysis, the expenditures are always assigned with a
negative sign and the revenues/inflows are assigned with a positive sign.
A generalized cash flow diagram to demonstrate the rate of return method
of comparison is presented in Fig. 7.1.
R1 R2 R3 . Rj Rn
0 . j n
1 2 3
P
Fig. 7.1 Generalized cash flow diagram.
In the above cash flow diagram, P represents an initial investment, Rj the

net revenue at the end of the jth year, and S the salvage value at the end of the
nth year.
the following expression at a given interest rate, i.
PW(i) = – P + R1/(1 + i)1 + R2/(1 + i)2 + ...
+ Rj/(1 + i) j + ... + Rn/(1 + i)n + S/(1 + i)n
Now, the above function is to be evaluated for different values of i until the
present worth function reduces to zero, as shown in Fig. 7.2.
In the figure, the present worth goes on decreasing when the interest
rate is increased. The value of i at which the present worth curve cuts the
X-axis is the rate of return of the given proposal/project. It will be very
difficult to find the exact value of i at which the present worth function
reduces to zero.
88
Rate of Return Method 89
Positive
Present
worth
Rate of return
PWi()
0
2 4 6 8 10 12 14 16 18 . .
Interest rate (i%)
Negative
Fig. 7.2 Present worth function graph.
So, one has to start with an intuitive value of i and check whether the
present worth function is positive. If so, increase the value of i until PW(i)
becomes negative. Then, the rate of return is determined by interpolation
method in the range of values of i for which the sign of the present worth
function changes from positive to negative.
7.2 EXAMPLES
In this section, the concept of rate of return calculation is demonstrated with
suitable examples.
EXAMPLE 7.1 A person is planning a new business. The initial outlay and
cash flow pattern for the new business are as listed below. The expected life of
the business is five years. Find the rate of return for the new business.
Period 0 1 2 3 4 5
Cash flow –1,00,000 30,000 30,000 30,000 30,000 30,000
(Rs.)
Solution
Initial investment = Rs. 1,00,000
Annual equal revenue = Rs. 30,000
Life = 5 years
The cash flow diagram for this situation is illustrated in Fig. 7.3.
30,000 30,000 30,000 30,000 30,000
0 1 2 3 4 5
1,00,000
Fig. 7.3 Cash flow diagram.
The present worth function for the business is

PW(i) = –1,00,000 + 30,000(P/A, i, 5)
When i = 10%,
PW(10%) = –1,00,000 + 30,000(P/A, 10%, 5)
= –1,00,000 + 30,000(3.7908)
= Rs. 13,724.
When i = 15%,
PW(15%) = –1,00,000 + 30,000(P/A, 15%, 5)
= –1,00,000 + 30,000(3.3522)
= Rs. 566.
When i = 18%,
PW(18%) = –1,00,000 + 30,000(P/A, 18%, 5)
= –1,00,000 + 30,000(3.1272)
= Rs. – 6,184
566 − 0
i = 15% + ´ (3%)
566 − (− 6184)
= 15% + 0.252%
= 15.252%
Therefore, the rate of return for the new business is 15.252%.
EXAMPLE 7.2 A company is trying to diversify its business in a new product

line. The life of the project is 10 years with no salvage value at the end of its
life. The initial outlay of the project is Rs. 20,00,000. The annual net profit is
Rs. 3,50,000. Find the rate of return for the new business.
Solution
Life of the product line (n) = 10 years
Annual net profit = Rs. 3,50,000
Scrap value after 10 years = 0
The cash flow diagram for this situation is shown in Fig. 7.4.
3,50,000 3,50,000 3,50,000 3,50,000
1 2 3 . 10
0
20,00,000
Fig. 7.4 Cash flow diagram.
Rate of Return Method 91
The formula for the net present worth function of the situation is
PW(i) = –20,00,000 + 3,50,000(P/A, i, 10)
When i = 10%,
PW(10%) = –20,00,000 + 3,50,000(P/A, 10%, 10)
= –20,00,000 + 3,50,000(6.1446)
= Rs. 1,50,610.
When i = 12%,
PW(12%) = –20,00,000 + 3,50,000 (P/A, 12%, 10)
= –20,00,000 + 3,50,000 (5.6502)
= Rs. –22,430.
1,50, 610 − 0
i = 10% + ´ (2%)
1,50,610 − ( −22 , 430)
= 11.74 %
Therefore, the rate of return of the new product line is 11.74%
EXAMPLE 7.3 A firm has identified three mutually exclusive investment

proposals whose details are given below. The life of all the three alternatives is
estimated to be five years with negligible salvage value. The minimum attractive
rate of return for the firm is 12%.
Alternative
A1 A2 A3
Investment Rs. 1,50,000 Rs. 2,10,000 Rs. 2,55,000
Annual net income Rs. 45,570 Rs. 58,260 Rs. 69,000
Find the best alternative based on the rate of return method of comparison.
Solution Calculation of rate of return for alternative A1

Annual profit = Rs. 45,570
Life = 5 years
The cash flow diagram for alternative A1 is shown in Fig. 7.5.
45,570 45,570 45,570 45,570 45,570
0 1 2 3 4 5
1,50,000
Fig. 7.5 Cash flow diagram for alternative A1.

Solution: A Rs. 10,000 N 25 Years I 20% F ?

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Interest Formulas and Their Applications 31

10,000 10,000 10,000 10,000 10,000

3.3.4 Equal-Payment Series Sinking Fund

3.3.5 Equal-Payment Series Present Worth Amount

3.3.6 Equal-Payment Series Capital Recovery Amount

EXAMPLE 3.6 A bank gives a loan to a company to purchase an equipment

The corresponding cash flow diagram is shown in Fig. 3.11.

3.3.7 Uniform Gradient Series Annual Equivalent Amount

The formula to compute A under this situation is

3.3.8 Effective Interest Rate

EXAMPLE 3.9 A person invests a sum of Rs. 5,000 in a bank at a nominal

3.4 BASES FOR COMPARISON OF ALTERNATIVES

In most of the practical decision environments, executives will be forced to

9. A company wants to set-up a reserve which will help it to have an annual

4.2 REVENUE-DOMINATED CASH FLOW DIAGRAM

A generalized revenue-dominated cash flow diagram to demonstrate the present

4.3 COST-DOMINATED CASH FLOW DIAGRAM

A generalized cost-dominated cash flow diagram to demonstrate the present

In Fig. 4.2, P represents an initial investment, Cj the net cost of operation

In this section, the concept of present worth method of comparison applied to

EXAMPLE 4.1 Alpha Industry is planning to expand its production operation.

Initial outlay Annual revenue Life

Initial outlay, P = Rs. 12,00,000

4,00,000 4,00,000 4,00,000 . . 4,00,000

The present worth expression for this technology is

The present worth expression for this technology is

EXAMPLE 4.2 An engineer has two bids for an elevator to be installed in a

Bid Engineer’s estimates

27,000 27,000 27,000 27,000 27,000

Bid 2: Beta Elevator Inc.

The cash flow diagram of bid 2 is shown in Fig. 4.7.

28,500 28,500 28,500 28,500 28,500

Proposal End of years

Compare the present worth of A with that of B at i = 18%. Which proposal

3,000 3,000 7,000 6,000

The present worth of the above cash flow diagram is computed as

PWA(18%) = –10,000 + 3,000(P/F, 18%, 1) + 3,000(P/F, 18%, 2)

Present worth of B at i = 18%. The cash flow diagram of the proposal

6,000 6,000 3,000 3,000

The present worth of the above cash flow diagram is calculated as

PWB(18%) = –10,000 + 6,000(P/F, 18%, 1) + 6,000(P/F, 18%, 2)

At i = 18%, the present worth of proposal B is higher than that of proposal A.

EXAMPLE 4.4 A granite company is planning to buy a fully automated

Solution There are two alternatives available for the company:

2,00,000 2,00,000 2,00,000 2,00,000

The present worth of the above cash flow diagram is computed as

EXAMPLE 4.5 A finance company advertises two investment plans. In plan 1,

The present worth of the above cash flow diagram is calculated as

The present worth of the above cash flow diagram is computed as

10,000 10,000 10,000 10,000

Fig. 4.13 Cash flow diagram for Novel Investment Ltd.

The present worth of the above cash flow diagram is computed as

10,000 10,000 10,000 10,000

The present worth of the above cash flow diagram is calculated as

The equation for the present worth is

End Maintenance and Revenue

End of year Cash flow (Rs.)

Initial Annual Salvage

Alternative 1: Renting a vehicle at a cost of Rs. 10,00,000 per year.