Comparison of alternative investments

Example 8 Comparison of alternative investments using capitalized costs. A... 

A major source of new capital is from internal capital, including, primarily, undistributed profits and depreciation funds. Since this definitely is owned capital, it is not necessary to consider interest as a cost. However, some concerns prefer to assign a cost to this type of capital, particularly if comparisons of alternative investments are to be made. The reasoning here is that the owned capital could be loaned out or put into other ventures to give a definite return. 

A general rule for making comparisons of alternative investments can be stated as follows The minimum investment which will give the necessary functional results and the required rate of return should always be accepted unless there is a specific reason for accepting an alternative investment requiring more initial capital When alternatives are available, therefore, the base plan would be that requiring the minimum acceptable investment. The alternatives should be compared with the base plan, and additional capital would not be invested unless an acceptable incremental return or some other distinct advantage could be shown. 

Comparison of alternative investments when one investment must be made for a given service and there are a limited number of choices. 

This simplified example has been used to illustrate the basic concepts involved in making comparisons of alternative investments. The approach was based on using the simple return on initial investment in which time value of money is neglected. Although this method may be satisfactory for preliminary and rough estimations, for final evaluations a more sophisticated approach is needed in which the time value of money is considered along with other practical factors to assure the best possible chance for future success. Typical more advanced approaches of this type are presented in the following sections. 

Example 5 Comparison of alternative investments by different profitability methods. A company has three alternative investments which are being considered. Because all three investments are for the same type of unit and yield the same service, only one of the investments can be accepted. The risk factors are the same for all three cases. Company policies, based on the current economic situation, dictate that a minimum annual return on the original investment of 15 percent after taxes must be predicted for any unnecessary investment with interest on investment not included as a cost. (This may be assumed to mean that other equally sound investments yielding a 15 percent return after taxes are available.) Company policies also dictate that, where applicable, straight-line depreciation is used and, for time-value of money interpretations, end-of-year cost and profit analysis is used. Land value and prestartup costs can be ignored. 

When the reason for a replacement falls in the first general type, the only alternatives are to make the necessary changes or else go out of business. Under these conditions, the final economic analysis is usually reduced to a comparison of alternative investments. 

Sp ecial cases of capital investment decisions include lease or buy decisions, when-to-replace decisions, which design to choose, and comparison of alternatives with unequal service lives. These special cases are covered in Park (1997) and in Ruegg and Marshall (1990), as are the other methods for capital investment decisions. 

Because of the different methods used for treating interest as a cost, a definite statement should be made concerning the particular method employed in any given economic analysis. Interest costs become especially important when making comparisons among alternative investments. These comparisons, as well as the overall cost picture, are simplified if the role of interest in the economic analysis is clearly defined. 

The point of maximum net savings, as indicated by 0 in Fig. 10-5, represents a classical optimum condition. However, the last incremental investment before this maximum point is attained is at essentially a zero percent return. On the basis of alternative investment comparisons, therefore, some investment less than that for maximum net savings should be recommended. 

The design of a chemical processing unit to meet a specific consumer demand and the comparison of alternative process costs (by retum-on-investment and discounted-cash-flow analysis) are well covered in texts on process economics and are not treated in this book. 

A Comparison of Capital Investment Requirements for Alternative Domestic Energy Supplies, American Gas Association Report, Planning Analysis Group, May 1978. 

The rar e of national development objectives, both economic and social, also varies widely between countries and over time. This requires a standard analytical -formaUn-ordeiLto-make. comparisons between alternative investment projects. Although many national objectives often cannot be measured in monetary terms and for this reason are not directly comparable, economic evaluation attempts to identify as much as possible the... 

The key to performing any economic analysis is the ability to evaluate and conpare equivalent investments. In order to understand that the equations presented in Table 9.1 provide a comparison of alternatives, it is suggested to replace the equal sign with the words is equivalent to. As an example, consider the equation given for the value of an annuity. A, needed to provide a specific future worth, F. From Table 9.1. Equation (9JT) can be expressed as... 

The subject of the study can be either a single energy-using device, such as a pump, or an entire ventilation system with all its components. A study focuses on the life cycle of the system or device, and normally is a comparison of two or more alternatives. The goal is to find the most economical solution on the basis of the total costs (investment and operation). 

Capital investments can also be selected on the basis of other measures of performance such as return on investment, internal rate of return, and benefit-cost ratio (or savings-to-investment ratio). Flowever, care must be taken in the application of these methods, as an incremental analysis is required to ensure consistent comparison of mutually exclusive alternatives. Also, rather than requiring a separate value to be calculated for each alternative, as in the case of the life-cycle cost method, these other methods incorporate the difference between two mutually exclusive alternatives within a single measure. For example, the net benefits measure directly pressures the degree to which one alternative is more economically desirable than another. 

In general, one or more of three methods are used to justify major expenditures. The first, payback, is a measure of the time it will take for cumulative benefits to equal cumulative costs (time to break even). This, by itself, may not be sufficient to compare alternative investments and projects competing for the same limited resources so one of two other methods may be used. These methods, Net Present Value and Internal Rate of Return, consider the earning power of money in making comparisons. Because investments earn compound interest, a dollar to be gained in the future has less present value than one gained today. The NPV is computed by estimating the yearly... 

Methods for including the cost of capital in economic analyses have been discussed in Chap. 7. Although the management and stockholders of each company must establish the company s characteristic cost of capital, the simplest approach is to assume that investment of capital is made at a hypothetical cost or rate of return equivalent to the total profit or rate of return over the full expected life of the particular project. This method has the advantage of putting the profitability analysis of all alternative investments on an equal basis, thereby permitting a clear comparison of risk factors. This method is particularly useful for preliminary estimates, but it may need to be refined further to take care of income-tax effects for final evaluation. 

The basic aim of a profitability analysis is to give a measure of the attractiveness of the project for comparison to other possible courses of action. It is, therefore, veiy important to consider the exact purpose of a profitability analysis before f c standard reference or base case is chosen. If the purpose is merely to present the total profitability of a given project, a simple statement of total profit per year or annual rate of return may be satisfactoiy. On the other hand, if the purpose is to permit comparison of several different projects in which capital might be invested, the method of analysis should be such that all cases are on the same basis so that direct comparison can be made among the appropriate alternatives. 

The rate of return on the 1,200,000 unit is 20 percent, and that for the alternative addition is 15 percent. Both of these returns exceed the minimum required value, and it might appear that the 2 million investment should be recommended because it yields the greater amount of profit per year. However, a comparison of the incremental investment between the two proposals shows that the extra investment of 800,000 gives a profit of only 60,000, or an incremental return of 7.5 percent. Therefore, if the company has 2 million to invest, it would be more profitable to accept the 1,200,000 proposal and put the other 800,000 in another investment at the indicated 14 percent return. 

The base plan for an alternative comparison of the type discussed in the preceding paragraph would be the minimum investment which gives the necessary functional results. The alternatives should then be compared with the base plan, and an additional investment would be recommended only if it would give a definite advantage. 

When investment comparisons are made, alternatives requiring more initial capital are compared only with lower investments which have been found to be acceptable. Consider an example in which an investment of 50,000 will give a desired result, while alternative investments of 60,000 and 70,000 will give the same result with less annual expense. Suppose that comparison between the 60,000 and the 50,000 cases shows that 60,000 investment to be unacceptable. Certainly, there would be no reason to give further consideration to the 60,000 investment, and the next comparison should be between the 70,000 and the 50,000 cases. This type of reasoning, in which alternatives are compared in pairs on a mutually exclusive basis, is illustrated in the following simplified example. 

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