Engineering

Economy
Chapter 6: Comparison and Selection
Among Alternatives
 Chapter 6:
Evaluate correctly capital
investment alternatives
when the time value of
money is a key influence.
 Making decisions means
comparing alternatives.
v In this chapter we examine feasible design alternatives.

v Selecting from among a set of mutually exclusive

alternatives—when selecting one excludes the choice of
any of the others.
Mutually exclusive alternatives
(MEAs)
v We examine these on the basis of economic
considerations alone.

v The alternatives may have different initial

investments and their annual revenues and costs may
vary.

v The alternatives must provide comparable

“usefulness”: performance, quality, etc.

v The basic methods from chapter 5 provide the basis

for economic comparison of the alternatives.
 Apply this rule, based on
Principle 2 from Chapter 1.
The alternative that requires the minimum investment of
capital and produces satisfactory functional results will be
chosen unless the incremental capital associated with an
alternative having a larger investment can be justified with
respect to its incremental benefits. This alternative is the
base alternative.
For alternatives that have a larger
investment than the base…
If the extra benefits obtained by investing additional capital
are better than those that could be obtained from investment
of the same capital elsewhere in the company at the MARR,
the investment should be made.

*Please note that there are some cautions when considering more than two
alternatives, which will be examined later.)
 There are two basic types
of alternatives.
Investment Alternatives
Those with initial (or front-end) capital investment
that produces positive cash flows from increased
revenue, savings through reduced costs, or both.

Cost Alternatives
Those with all negative cash flows, except for a
possible positive cash flow from disposal of
assets at the end of the project’s useful life.
 Select the alternative that
gives you the most money!
v For investment alternatives the PW of all cash flows must
be positive, at the MARR, to be attractive. Select the
alternative with the largest PW.

v For cost alternatives the PW of all cash flows will be

negative. Select the alternative with the largest (smallest
in absolute value) PW.
Investment alternative example
Use a MARR of 10% and useful life of 5 years to select
between the investment alternatives below.
Alternative
A B
Capital investment -$100,000 -$125,000
Annual revenues less expenses $34,000 $41,000

P WA = 100, 000 + 34, 000(P/A, 10%, 5) = 28, 887

P WB = 125, 000 + 41, 000(P/A, 10%, 5) = 30, 423

Both alternatives are attractive, but Alternative B provides

a greater present worth, so is better economically.
 Cost alternative example
Use a MARR of 12% and useful life of 4 years to select
between the cost alternatives below.
Alternative
C D
Capital investment -$80,000 -$60,000
Annual expenses -$25,000 -$30,000

P WC = 80, 000 25, 000(P/A, 12%, 4) = 155, 933

P WD = 60, 000 30, 000(P/A, 12%, 4) = 151, 119

Alternative D costs less than Alternative C, it has a greater

PW, so is better economically.
 Example #1
Your local foundry is adding a new furnace. There are
several different styles and types of furnaces, so the foundry
must select from among a set of mutually exclusive
alternatives. Initial capital investment and annual expenses
for each alternative are given in the table below. None have
any market value at the end of its useful life. Using a
MARR of 15%, which furnace should be chosen?

Furnace
F1 F2 F3
Investment $110,000 $125,000 $138,000
Useful life 10 years 10 years 10 years
Total annual expenses $53,800 $51,625 $45,033
 Solution
Using a MARR of 15%, the PW is shown for each of the
three alternatives in the table below.

Furnace
F1 F2 F3
Investment $110,000 $125,000 $138,000
Useful life 10 years 10 years 10 years
Total annual expenses $53,800 $51,625 $45,033
Present Worth @ 15% -$380,010 -$384,094 -$364,010

The largest value is -$364,010, indicating that Furnace

F3 is the best alternative.
 Determining the study
period.
v A study period (or planning horizon) is the time
period over which MEAs are compared, and it must
be appropriate for the decision situation.

v MEAs can have equal lives (in which case the study
period used is these equal lives), or they can have
unequal lives, and at least one does not match the
study period.

v The equal life case is straightforward, and was used

in the previous two examples.
 Unequal lives are handled
in one of two ways.
v Repeatability assumption
v The study period is either indefinitely long or equal to
a common multiple of the lives of the MEAs.
v The economic consequences expected during the
MEAs’ life spans will also happen in succeeding life
spans (replacements).

v Coterminated assumption: uses a finite and

identical study period for all MEAs. Cash flow
adjustments may be made to satisfy alternative
performance needs over the study period.
Comparing MEAs with equal lives.
• When lives are equal adjustments to cash flows are not required.
• The MEAs can be compared by directly comparing their equivalent
worth (PW, FW, or AW) calculated using the MARR.
• The decision will be the same regardless of the equivalent worth method
you use.

For a MARR of 12%, select from among the MEAs below.

Alternatives
A B C D
Capital investment -$150,000 -$85,000 -$75,000 -$120,000
Annual revenues $28,000 $16,000 $15,000 $22,000
Annual expenses -$1,000 -$550 -$500 -$700
Market Value (EOL) $20,000 $10,000 $6,000 $11,000
Life (years) 10 10 10 10
Selecting the best alternative.
Present worth analysis à select Alternative A (but C is close).
P WA = 150, 000 + 27, 000(P/A, 12%, 10) + 20, 000(P/F, 12%, 10) =8,995
P WB = 85, 000 + 15, 450(P/A, 12%, 10) + 10, 000(P/F, 12%, 10) =5,516
P WC = 75, 000 + 14, 500(P/A, 12%, 10) + 6, 000(P/F, 12%, 10) =8,860
P WD = 120, 000 + 21, 300(P/A, 12%, 10) + 11, 000(P/F, 12%, 10) =3,891

Annual worth analysis—the decision is the same.

AWA = $1, 592 AWC = $1, 568

AWB = $976 AWD = $689

 Example #2
Consider the following two mutually exclusive alternatives for
reclaiming a deteriorating inner-city neighborhood (one of them
must be chosen). Notice that the IRR for both alternatives is
27.19%.

6-19
 Example #2 continued
a) What is the simple payback period for each alternative?
b) If MARR is 15% per year, which alternative is better?
c) Which alternative would you recommend?
d) If MARR is 27.5% per year, which alternative is better?

6-19
 Solution

a) The simple payback period for X is 2 years.

The simple payback period for Y is 3 years.

a) PWX (15%) = $21,493

PWY (15%) = $35,291 *recommend Y

c) Alternative Y

d) PWX (27.5%) = -$464 *recommend X

PWY (27.5%) = -$727

6-19
Using rates of return is another
way to compare alternatives.
v The return on investment (rate of return) is a popular
measure of investment performance.

v Selecting the alternative with the largest rate of return can

lead to incorrect decisions—do not compare the IRR of
one alternative to the IRR of another alternative. The
only legitimate comparison is the IRR to the MARR.

v Remember, the base alternative must be attractive (rate of

return greater than the MARR), and the additional
investment in other alternatives must itself make a
satisfactory rate of return on that increment.
Ch 6.4: Useful Lives are Equal to the Study Period

Incremental analysis
Alt. A Alt. B
Initial cost -$25,000 -$35,000
Net annual income $7,500 $10,200
IRR on total cash flow 15% 14%

Which is preferred using a 5 year study period and MARR=10%?

*
Ch 6.4: Useful Lives are Equal to the Study Period

Incremental analysis
Base Alternative
Alt. A Alt. B
Initial cost -$25,000 -$35,000
Net annual income $7,500 $10,200
IRR on total cash flow 15% 14%

Which is preferred using a 5 year study period and MARR=10%?

Ch 6.4: Useful Lives are Equal to the Study Period

Incremental analysis
Base Alternative
Alt. A Alt. B Alt. B-Alt. A
Initial cost -$25,000 -$35,000 -$10,000
Net annual income $7,500 $10,700 $3200
IRR on total cash flow 15% 14% 18%

Which is preferred using a 5 year study period and MARR=10%?

Ch 6.4: Useful Lives are Equal to the Study Period

Incremental analysis
Alt. A Alt. B Alt. B-Alt. A
Initial cost -$25,000 -$35,000 -$10,000
Net annual income $7,500 $10,700 $3200
IRR on total cash flow 15% 14% 18%

Which is preferred using a 5 year study period and MARR=10%?

Both alternatives A and B are acceptable—each one has a rate of return that
exceeds the MARR. Choosing Alternative A because of its larger IRR would be
an incorrect decision. By examining the incremental cash flows we see that the
extra amount invested in Alternative B earns a return that exceeds the IRR—so B
is preferred to A. Also note…
Ch 6.4: Useful Lives are Equal to the Study Period

Incremental analysis
Alt. A Alt. B Alt. B-Alt. A
Initial cost -$25,000 -$35,000 -$10,000
Net annual income $7,500 $10,700 $3,200
IRR on total cash flow 15% 14% 18%

Which is preferred using a 5 year study period and MARR=10%?

Both alternatives A and B are acceptable—each one has a rate of return that
exceeds the MARR. Choosing Alternative A because of its larger IRR would be
an incorrect decision. By examining the incremental cash flows we see that the
extra amount invested in Alternative B earns a return that exceeds the IRR—so B
is preferred to A. Also note…
P WA = 25, 000 + 7, 500(P/A, 10%, 5) = 3, 431
P WB = 35, 000 + 10, 200(P/A, 10%, 5) = 3, 666
 Why wouldn’t we invest in project that gives us
higher return?
Incremental analysis
Alt. A Alt. B Alt. B-Alt. A
Initial cost -$25,000 -$35,000 -$10,000
Net annual income $7,500 $10,700 $3,200
IRR on total cash flow 15% 14% 18%

Which is preferred using a 5 year study period and MARR=10%?

 Why wouldn’t we invest in project that gives us
higher return?
Incremental analysis
Alt. A Alt. B Alt. B-Alt. A
Initial cost -$25,000 -$35,000 -$10,000
Net annual income $7,500 $10,200 $3,200
IRR on total cash flow 15% 14% 18%

Which is preferred using a 5 year study period and MARR=10%?

We assume available capital ($10,000) will be invested in a project

where it will earn annual return = MARR (10%)
Use the incremental investment
analysis procedure.
v Arrange (rank order) the feasible alternatives
based on increasing capital investment.
v Establish a base alternative.
v Cost alternatives—the first alternative is the base.
v Investment alternatives—the first acceptable
alternative (IRR>MARR) is the base.

v Iteratively evaluate differences (incremental cash

flows) between alternatives until all have been
considered.
Evaluating incremental cash flows
v Work up the order of ranked alternatives smallest to largest.

v Subtract cash flows of the lower ranked alternative from the

higher ranked.

v Determine if the incremental initial investment in the higher

ranked alternative is attractive (e.g., IRR>MARR, PW, FW, AW
all >0). If it is attractive, it is the “winner.” If not, the lower
ranked alternative is the “winner.” The “loser” from this
comparison is removed from consideration. Continue until all
alternatives have been considered.

v This works for both cost and investment alternatives.

 Incremental analysis
Alt. A Alt. B Alt. B-Alt. A
Initial cost -$25,000 -$35,000 -$10,000
Net annual income $7,500 $10,200 $3,200
IRR on total cash flow 15% 14% 11%

Which is preferred using a 5 year study period and MARR=10%?

Both alternatives A and B are acceptable—each one has a rate of return
that exceeds the MARR. Choosing Alternative A because of its larger
IRR would be an incorrect decision. By examining the incremental cash
flows we see that the extra amount invested in Alternative B earns a
return that exceeds the IRR—so B is preferred to A. Also note…

P WA = 25, 000 + 7, 500(P/A, 10%, 5) = 3, 431

P WB = 35, 000 + 10, 200(P/A, 10%, 5) = 3, 666
 Example #3
Acme Molding is examining 5 alternatives for a piece of
material handling equipment. Each has an expected life of 8
years with no salvage value, and Acme’s MARR is 12%.
Using an incremental analysis, which material handling
alternative should be chosen? The table below includes
initial investment, net annual income, and IRR for each
alternative.
Alternative
A B C D E
Capital $12,000 $12,500 $14,400 $16,250 $20,000
investment
Net annual $2,500 $2,520 $3,050 $3,620 $4,400
income
IRR 12.99% 12.04% 13.48% 14.99% 14.61%
 Solution
Alternative A is the base alternative, with an IRR > MARR.
The next largest investment is in Alternative B, so first
examine the incremental investment of B over A. In the
table below the IRR of B – A is shown.

Alternative
A B B-A
Capital $12,000 $12,500 $500
investment
Net annual $2,500 $2,520 $20
income
IRR 12.99% 12.04% -20.11%

Alternative B is not better than A — A “wins.”

 Solution
The next largest investment is in Alternative C, so examine
the incremental investment of C over A. In the table below
the IRR of C – A is shown.

Alternative
A C C-A
Capital $12,000 $14,400 $2,400
investment
Net annual $2,500 $3,050 $550
income
IRR 12.99% 13.48% 15.86%

15.86% > MARR, so Alternative C “wins.”

 Solution
The next largest investment is in Alternative D, so examine
the incremental investment of D over C. In the table below
the IRR of D – C is shown.

Alternative
C D D-C
Capital $14,400 $16,250 $1,850
investment
Net annual $3,050 $3,620 $570
income
IRR 13.48% 14.99% 25.94%

25.94% > MARR, so Alternative D “wins.”

 Solution
Finally, examine the incremental investment of E over D.

Alternative
D E E-D
Capital $16,250 $20,000 $3,750
investment
Net annual $3,620 $4,400 $780
income
IRR 14.99% 14.61% 12.95%

12.95% > MARR, so Alternative E “wins,” and we would

select Alternative E as the best of these five alternatives.
 Comparing MEAs with unequal lives.
v The repeatability assumption, when applicable, simplified
comparison of alternatives.

v If repeatability cannot be used, an appropriate study

period must be selected (the coterminated assumption).
This is most often used in engineering practice because
product life cycles are becoming shorter.
 The useful life of an alternative is less
than the study period.
v Cost alternatives
v Contracting or leasing for remaining years may be
appropriate
v Repeat part of the useful life and use an estimated market
value to truncate

v Investment alternatives
v Cash flows reinvested at the MARR at the end of the study
period
v Replace with another asset, with possibly different cash
flows, after the study period
The useful life of an alternative
is greater than the study period.
v Truncate the alternative at the end of the study period,
using an estimated market value.

v The underlying principle in all such analysis is to compare

the MEAs in a decision situation over the same study
(analysis) period.
 Equivalent worth methods can be
used for MEAs with unequal lives.
v If repeatability can be assumed, the MEAs are most easily
compared by finding the annual worth (AW) of each
alternative over its own useful life, and recommending the
one having the most economical value.

v For co-termination, use any equivalent worth method

using the cash flows available for the study period.
 Equivalent Worth Methods
Equate the MEAs annual worths (AW) over
equivalent lives.

A B
Capital Investment $3,500 $5,000
Annual Cash Flow $1,255 $1,480
Useful Live (years) 4 6
 Repeatability &
Coterminated Assumptions
We can use incremental rate of return
analysis on MEAs with unequal lives.
Equate the MEAs annual worths (AW) over their
respective lives. MARR = 10%
A B
Capital Investment $3,500 $5,000
Annual Cash Flow $1,255 $1,480
Useful Live (years) 4 6

Solving, we find i*=26%, so Alt B is preferred.

 Example #4

Consider the following EOY cash flows for two mutually

exclusive alternatives (one must be chosen).
MARR=5%

Lead Acid Lithium Ion

Capital Investment $6,000 $14,000
Annual Expenses $2,500 $2,400
Useful Life 12 years 18 years
Market Value at end of life $0 $2,800
A. Assuming repeatability, which alternative should be selected?
Solution
 Example #5

Consider the following EOY cash flows for two mutually

exclusive alternatives (one must be chosen).

Lead Acid Lithium Ion

Capital Investment $6,000 $14,000
Annual Expenses $2,500 $2,400
Useful Life 12 years 18 years
Market Value at end of life $0 $2,800

B. Which alternative should be selected if analysis period is 18 years, the

repeatability assumption does not apply, and a battery system can be leased
for $8,000 per year after the useful life of either battery is over
Solution
 Imputed Market Value
For the given study period: Find the PW of the
Capital Recovery and the PW of Market Value

E1 E2

Capital Invest $15,000 $65,000

Ann Exp $15,000 $8,000

Useful Life 5 20

MV $8,500 $14,000

MARR 12%
 PW of CR
1. Find AW of Capital at its own life
$65,000(A/P,12%,20 = $8,702.12

2. Find A of MV at its own life

$14,000(A/F,12%,20) = $194.30

3. Find the Capital Recovery at own life:

$8702.12 – $194.30 = 8507.82

4. Bring into Present Worth AT STUDY PERIOD

$8507.82(P/A,12%,15 = $57,945.61
PW of CR Find PW of
1. Find AW of
Capital at its own
MV
life 5. Find PW of Market Value at the End
$65,000(A/P,12%,20 of study period.
= $8,702.12 $14,000(P/F,12%,15) = $2,557.75
2. Find A of MV at its
own life 6. MARKET VALUE OF EOY5 =
$14,000(A/F,12%,20) PW of capital recovery + PW of market
= $194.30
value
3. Find the Capital $57,945.61 + $2,557.75 = $60,503.36
Recovery at own life:
$8702.12 – $194.30 =
8507.82 Bring into A
60,503.36(A/P,12%,5) = $16,507.81
4. Bring into Present
Worth AT STUDY
PERIOD
$8507.82(P/A,12%,15
= $57,945.61