Engineering Economy

TOPIC: SELECTION OF INVESTMENT ALTERNATIVES

This topic is about determining which among the alternatives or options is the most economical to
buy or to invest in. This concern comes in when a person or company is thinking about buying a certain
equipment or machine like a pump or a generating set. Obviously in the market, for a given machine,
there are several brands to choose from and we need to know which among them is the most
economical. We will be dealing with the three (3) most common methods: 1) Present Value Method,
2) Annual Equivalent Method, and 3) Annual Cost Method.

A. Methods for Investment Analysis

1. Present Worth Method –

CL CL
Machine A Machine B
0 1 2 3 4 5 -VS- 0 1 2 3 4 5

Ao Ao Ao Ao Ao Ao Ao Ao Ao Ao

Co Co

Where:
Co = includes purchase price plus cost of delivery and installation and
corresponding fees and taxes.
Ao = Annual Operating Cost which includes annual labor cost, annual fuel cost,
and annual repair cost
CL = It can be either Salvage value or Scrap Value. Salvage Value – aka second-
hand value, or the amount for which the equipment or machine can be
sold as second hand. It implies that the machine can still be used. On
the other hand, Scrap or Junk Value is the amount the equipment can
be sold for when disposed off as junk.

The options, which are Machines A and Machines, are represented by two (2)
cashflow diagrams. Each diagram has arrows. The downward arrows (Co & Ao)
 indicate the costs that a person will incur the moment he buys it, while the
upward arrow (CL) is a recovery of investment.

To find the Present Value (PV) for each option, all we have to do is move all the
arrows to the present in which we can get the following:

(𝟏+𝒊)𝒏 −𝟏
PV (for Machine A) = Co + Ao [ ] - CL (1+i)-n
𝒊(𝟏+𝒊)𝒏

Do the same thing for Machine B. Then, substitute the values given to each
equation, we would be able to find their Present Values. Then, make the
proper recommendation, say, “Therefore, since the PV for Machine A is less
than that of Machine B, choose Machine A.” Please note, in the exam, if you
have correct values but without recommendation, your answer will be
considered as incomplete; hence, you will not get the full credit.

Please note also that the options carry the same periods of five (5) years or useful lives.
If they don’t, the approach will be different.

When the useful lives are different, you have to follow the following steps:

1. Find first the Least Common Multiple (or LCM) or the least number of year
where the useful lives can be the same, say, one machine has a useful life of
3 years, while the other is 4 years, thus, their LCM is 12.
2. Then, extend the “timeline” of their corresponding cashflow diagram. So
both the timeline of the 3-year cashflow diagram and the 4-year cashflow
diagram will be extended to 12 years.
3. Then, all the arrows (or cashflows) that you have on the original cashflow
will repeated (or copied) on the extended timeline; hence, for the 3-year
cashflow diagram, they will be repeated 3 times, while for 4-year, 2 times.
4. Then, develop or establish the PV equation based on the modified cashflow
diagram. Once developed, substitute the given values to find the PV and
then make the necessary recommendation.

2. Annual Equivalent Cost (AEC) Method – Using the same cashflow diagram that
we have used for the PV Method, for AEC Method, all we have to do is to sum
up the annualized value of the Co, Ao, and CL. Please note that CL is already in its
annualized form as it is already distributed equally per year. So the only
quantities that need to be annualized are the Co and CL and to do so is to multiply
 to them their corresponding annuity factor (af), thus giving us the following
equation:
𝑖(1+𝑖)𝑛 𝑖
AEC (for Machine A) = Ao + Co [ ] - CL [ ]
(1+𝑖)𝑛 −1 (1+𝑖)𝑛 −1

Do the same thing for Machine B. Then, substitute the values given to each
equation, we would be able to find their AEC Values. Then, make the proper
recommendation, say, “Therefore, since the AEC for Machine A is less than
that of Machine B, choose Machine A.” Again, if you have correct values but
without recommendation, you will not get the full credit.

Please note also that AEC is not affected by the difference in the useful lives of the
options. This means that you just have to follow the same approach if you are dealing
with options having different lives.

3. Annual Cost (AC) Method – This is similar to that of the AEC with some variation.
The answers that you will get for the AEC method will be the same as those for
the AC Method. The equation for the AC Method will be as follows:

AC (for Machine A) = Ao + Annual Depreciation (or d) using the Sinking Fund

Method + MARR (or Minimum Acceptable Rate of Interest or
simply the i or the interest given in the problem.)

𝑪𝒐−𝑪𝐿
= Ao + (𝟏+𝒊)𝑳 −𝟏
+ Co(i) ; L stands for useful life of the machine
𝒊

Do the same thing for Machine B. Then, substitute the values given to
each equation, we would be able to find their AC Values. Then, make the
proper recommendation, say, “Therefore, since the AC for Machine A is
less than that of Machine B, choose Machine A.” Again, if you have
correct values but without recommendation, you will not get the full
credit.