Chapter 6 Basic Concepts for Comparing Alternatives

Principles of Engineering Economy (Chapter 1 Review)

1) Develop the Alternatives
2) Focus on the Differences
3) Use a Consistent Viewpoint
4) Use a common unit of measure
5) Consider all relevant Criteria
6) Make Uncertainty Explicit
7) Revisit your Decisions (Follow-up)

1
Updated Principles
#2(p 248)
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 incremental
benefits.
(This second part is the assumption of “unlimited capital” for
multiple investments or this for a single investment)

Rules for facilitating the correct analysis and comparison of

mutually exclusive alternatives including the time value of money.

1) When revenues and other economic benefits are present and

vary among alternatives, choose the alternative that maximizes
overall profitability. That is select the alternative that has the
greatest positive equivalent worth at i=MARR and satisfies all
project requirements.

2) When revenues and other economic benefits are NOT present or

are constant among all alternatives, consider only the costs and
select the alternatives that minimize total cost. That is, select the
alternative with the least negative equivalent worth at i=MARR
and satisfies all project requirements.

2
Study Period Analysis Cases
A) Useful lives are the same for all alternatives and equal to the
study period. (Common multiples or repeatability assumption
included if equal to the study period)

B) Useful lives are different among the alternatives and at least

one does not match the study period.

Case A
Equivalent Worth Methods
If PW(i%)A < PW(i%)B

Then FW(i%)A < FW(i%)B

And AW(i%)A < AW(i%)B

Thus for investment alternatives, the one with the greatest positive
equivalent worth is selected.
For cost alternatives, the one with the least negative equivalent
worth is selected.

B If the useful lives are different among the alternatives then the
annual worth method is the correct method.

3
Rate of Return with equal study periods and unlimited capital
investment.

(1) Select the alternative that requires the largest investment of

capital AS LONG AS the incremental investment is justified by
benefits that earn at least the MARR. This maximizes equivalent
worth on total investment at i=MARR.

(Do NOT compare the IRR’s of mutually exclusive alternatives(or

IRRs of the differences between mutually exclusive alternatives)
against those of other alternatives. Compare an IRR only against
the MARR (IRR>=MARR) in determining the acceptability of an
alternative.) This done for unlimited capital investment situations.

4
Inconsistent Ranking Problem
A. Present Worth Analysis

MARR = 10% Alternative Difference(+)

A B (B-A)
Investment 60,000 73,000 13,000
Net Cash Flows 22,000 26,225 4,225

PW(A-10%) = -60,000 + 22,000(P/A,i=10,n=4)

= - 60,000 + 69,737 = 9,737
PW(B-10%) = -73,000 + 26,225(P/A,i=10,n=4)
= - 73,000 + 83,130 = 10,130

PW(B-A) = -13,000 + 4,225(P/A,i=10,n=4)

= -13,000 + 13,393 = 393

Select Alternative B

PW(B-A) gives the solution in one calculation instead of doing

both PW(A) and PW(B). However, if one must need to compare
with the “Do Nothing “ alternative, either PW(A) or PW(B) must
be calculated.

Note if i=12%
PW(B-A) = -13,000 + 4,225(P/A,i=12,n=4)
= -13,000 + 4,225 * 3.0373 = - 167

5
B. IRR Analysis
Find IRR
PW(A,IRR) = 0 = -60,000 + 22,000(P/A,i=?,n=4)
(P/A,i=?,n=4) = 60,000/22,000 = 2.727272

From Tables
(P/A, i=10, n=4) = 3.1699
(P/A, i=12, n=4) = 3.0373
(P/A, i=15, n=4) = 2.8550
(P/A, i=18, n=4) = 2.6901

For alternative A
From the values, IRR is between 15 and 18, & interpolation
IRR = 15 + 3 (2.8550 – 2.7272)/(2.8550 – 2.6901)
= 15 + 2.3 = 17.3

Similarly for Alternative B

(P/A,i=?,n=4) = 73,000/26,225 = 2.7836
IRR = 15 + 3 (2.8550 – 2.7826)/(2.8550 – 2.6901)
= 15 + 1.3 = 16.3

Note: Highest IRR is for Alternative A and would tend to be

selected, but
Similarly For the difference B-A
PW(B-A, IRR) = 0 = -13,000 + 4,225(P/A,i=?, n=4)
(P/A,i=?,n=4) = 13,000/4,225 = 3.0769
IRR = 10 + 2 (3.1699 – 3.0769)/(3.1699 – 3.0373)
= 10 + 1.4 = 11.4 > 10, so select alternative B
Although A has the higher IRR, alternative B is selected since the
incremental IRR is greater than the MARR.

6
Select B because (B-A) is > 10 which is the desired level. This
assumes that one is investing the “extra money” and getting an
acceptable return. But if the alternatives are getting 16 or
17percent, would one first look for other investments at this level
rather than accept 11%?

7
Coterminated Assumption – all cash flows will be reinvested by
the firm at the MARR until the end of the study period which
implies the study period is longer than the useful life. (This is
basically what occurs with the AW method as the costs are taken
to be the same through the useful life). The method calculates the
costs during the useful life and extends them to the end of the
study period.

FW(i,n=sp) =[- I(F/P,i,n=ul) + AC(F/A,i,n=ul)] x[F/P,i,n=sp-ul }

= (future worth at ul) x (future worth sp-ul)
= future worth over study period

FW(i,n=sp) = [-I(A/P,i, n=ul) + AC] x [F/A,i,n=sp]

=(annual cost over useful life) x FW(over study period)
= future worth over study period)

8
Imputed Market Value(Salvage Value)

This occurs when an item is replaced before the end of its life.
This is a calculated value and tends to be higher than determined
by other methods such as depreciation

MV(T) = PW[at the end of year T of capital invested] +

PW[of original salvage vale at end of useful life T]

I = 47,600
S = 5,000
n=9
i = 20%
Find value at end of year 5 (T = 5)
= average annual cost over remaining life of investmen
MV(5) = [47,600 (A/P,i,n=9) – 5,000(A/F,i,n=9)] x [P/A,i,n=9-5]

= [ 47,600 x .2481 - 5,000 x 0.0481] x 2.5887

= [ 11,809 - 240 ] x 2.5887
= 11,569 x 2.5887
= 29,949

MV(1) = 11,569 x 3.8372 = 44,268 (loss of only 3.,322)

Depreciation (Straight Line)

(47,600 – 5,000) /9 = 4,733

MV = 47,600 – 5(4,773) = 23,933