ENS191: Engineering Economy

Comparing Alternatives
Chapter 7 (Sta. Maria)
Comparison and Selection
Among Alternatives
Chapter 6 (Sullivan)

Engr. Adrian Keith R. Caamiño

Engr. Maria Cristina P. Vegafria, PhD
College of Engineering & Technology
MSU-Iligan Institute of Technology
 Making decisions means comparing alternatives.
Feasible Design Alternatives
Alternatives may be mutually exclusive (i.e. choice of one excludes the choice of
any other alternatives) because :
➢ The alternatives being considered may require different amounts of capital
investment, and their annual revenues and cost may vary .
➢ The alternatives may have different useful lives.

Mutually Exclusive Alternatives (MEAs)

➢examined based on economic considerations alone
➢must provide comparable “usefulness”: performance, quality, etc.

Chapter 7 Comparing Alternatives

 Rules for Choosing Among Alternatives
➢ The alternative that requires the minimum investment 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 savings (or benefits).
➢ The alternative requiring the least investment is the base alternative.
➢ Rule ensures that as much capital as possible is invested at a rate of return equal
to or greater than the MARR.
➢ 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

Chapter 7 Comparing Alternatives

 Ensuring Comparable Basis for Selecting
Mutually Exclusive Alternatives
Include any economic impacts of alternative differences in
estimated cash flows
Two Rules
Rule 1. When revenues and other economic benefits are present,
select alternative that has greatest positive equivalent worth
at i = MARR and satisfies project requirements.
Rule 2. When revenues and economic benefits are not present,
select alternative that minimizes cost.

Chapter 7 Comparing Alternatives

 Two Basic Types of Alternatives

1. Investment Alternatives
Those with initial (or front-end) capital investment that produces
positive cash flows from increased revenue, savings through
reduced costs, or both.
2. 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.

Chapter 7 Comparing Alternatives

 Select the alternative that gives you the most money!
For investment alternatives
➢ The present worth of all cash flows must be positive, at the
MARR, to be attractive.
➢ Select the alternative with the largest present worth.

For cost alternatives

➢ The present worth of all cash flows will be negative.
➢ Select the alternative with the largest (smallest in absolute
value) present worth.

Chapter 7 Comparing Alternatives

 Investment Alternative Example
Use a MARR of 10% and useful life of 5 years to select between the investment
alternatives below:
AR(P/A,10%,5)
Alternative AR AR AR AR AR
A B
Capital investment -$100,000 -$125,000 0 1 2 3 4 5
Annual revenues less expenses (AR) $34,000 $41,000
Investment

𝑃𝑊𝐴 = −$100,000 + $34,000(𝑃/𝐴, 10%, 5) 𝑃𝑊𝐵 = −$125,000 + $41,000(𝑃/𝐴, 10%, 5)

−5
1 − 1 + 0.10 −5 1 − 1 + 0.10
= −$100,000 + $34,000 = −$125,000 + $41,000
0.10 0.10
= $𝟐𝟖, 𝟖𝟖𝟕 = $𝟑𝟎, 𝟒𝟐𝟑
Both alternatives are attractive,
but Alternative B provides a greater present worth, so is better economically.
Chapter 7 Comparing Alternatives
 Cost Alternative Example
Use a MARR of 12% and useful life of 4 years to select between the cost
alternatives below:
0 1 2 3 4
Alternative
C D AE AE AE AE
Capital investment -$80,000 -$60,000 AE(P/A,12%,4)
Investment
Annual expenses (AE) -$25,000 -$30,000

𝑃𝑊𝐶 = −$80,000 − $25,000(𝑃/𝐴, 12%, 4) 𝑃𝑊𝐷 = −$60,000 − $30,000(𝑃/𝐴, 12%, 4)

−4
1 − 1 + 0.12 −4 1 − 1 + 0.12
= −$80,000 − $25,000 = −$60,000 − $30,000
0.12 0.12
= −$𝟏𝟓𝟓, 𝟗𝟑𝟑 = −$𝟏𝟓𝟏, 𝟏𝟏𝟗
Alternative D costs less than Alternative C,
it has a greater present worth, so is better economically.
Chapter 7 Comparing Alternatives
 Methods in Comparing Alternatives

1. The Rate of Return (RoR) on Additional Investment Method

2. The Annual Cost (AC) Method

3. The Equivalent Uniform Annual Cost (EUAC) Method

4. The Present Worth Cost (PWC) Method

5. The Capitalized Cost (CC) Method

6. The Payback (Payout) Period Method

Chapter 7 Comparing Alternatives

 1. The Rate of Return (RoR) on Additional Investment Method

𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
𝑎𝑑𝑑𝑖𝑡𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

➢ If the rate of return on additional investment is satisfactory, then

the alternative requiring a bigger investment is more economical
and should be chosen.
➢ The alternative that requires the largest investment of capital is
selected as long as the incremental investment is justified by the
benefits that earn at least the MARR.

Chapter 7 Comparing Alternatives

 1. The RoR on Additional Investment Method
1.1510 − 1
Example 1a: A company is considering two types of Solution: 𝐹/𝐴, 15%, 10 =
0.15
equipment for its manufacturing plant. Pertinent data Type A Annual Costs
are as follows: ₱2 0 0 ,000 ₱2 0 0 ,000 ₱9,850
Depreciation = =
𝐹/𝐴,15%,10 20.3037
Type A Type B
Operation 32,000
First cost ₱200,000 ₱300,000
Labor 50,000
Annual operating cost 32,000 24,000
Payroll taxes = (₱50,000)(0.04) 2,000
Annual labor cost 50,000 32,000
Taxes & insurance = (₱200,000)(0.03) 6,000
Insurance & property taxes 3% 3%
Payroll taxes 4% 4% Total Annual Cost ₱99,850

Estimated life 10 10 Type B Annual Costs

If MARR is 15%, which equipment should be used? ₱3 0 0 ,000 ₱3 0 0 ,000 ₱14,776
Depreciation = =
𝐹/𝐴,15%,10 20.3037
𝑎𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 Operation 24,000
𝑅𝑜𝑅 𝑜𝑛 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 =
𝑎𝑑𝑑𝑖𝑡𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Labor 32,000
₱9 9 ,850−₱8 1 ,056 ₱1 8 ,794
= ₱3 0 0 ,000−₱2 0 0 ,000= ₱1 0 0 ,000 = 𝟎. 𝟏𝟖𝟕𝟗 Payroll taxes = (₱32,000)(0.04) 1,280
Taxes & insurance = (₱300,000)(0.03) 9,000
Since 18.79% > 15%, Type B should be selected.
Total Annual Cost ₱81,056
Chapter 7 Comparing Alternatives
 2. The Annual Cost (AC) Method

➢ The annual cost of the alternatives including interest on

investment is determined.
➢ The alternative with the least annual cost is chosen.
➢ Applies only to alternatives which has a uniform cost data for
each year and a single investment of capital at the beginning of
the first year of the project life

Chapter 7 Comparing Alternatives

 2. The Annual Cost (AC) Method
Solution:
Example 1b: A company is considering two types of Type A
equipment for its manufacturing plant. Pertinent data Annual Costs
are as follows: ₱2 0 0 ,000 ₱2 0 0 ,000 ₱9,850
Depreciation = =
𝐹/𝐴,15%,10 20.3037
Type A Type B Operation 32,000
First cost ₱200,000 ₱300,000 Labor 50,000
Annual operating cost 32,000 24,000 Payroll taxes = (₱50,000)(0.04) 2,000
Annual labor cost 50,000 32,000 Taxes & insurance = (₱200,000)(0.03) 6,000
Insurance & property taxes 3% 3% Interest on Capital = (₱200,000)(0.15) 30,000
Payroll taxes 4% 4% Total Annual Cost ₱129,850
Estimated life 10 10 Type B Annual Costs
₱3 0 0 ,000 ₱3 0 0 ,000 ₱14,776
If MARR is 15%, which equipment should be used? Depreciation =
𝐹/𝐴,15%,10
=
20.3037

Operation 24,000
Labor 32,000
Since ACB < ACA, Type B should be selected. Payroll taxes = (₱32,000)(0.04) 1,280
Taxes & insurance = (₱300,000)(0.03) 9,000
Interest on Capital = (₱300,000)(0.15) 45,000
Chapter 7 Comparing Alternatives Total Annual Cost ₱126,056
 3. The Present Worth Cost (PWC) Method

➢ The present worth of the net cash outflows for each alternative
for the same period of time is determined.
➢ The alternative with the least present worth of cost is selected.

Chapter 7 Comparing Alternatives

 3. The Present Worth Cost Method

Solution:
Example 1c: A company is considering two types of
equipment for its manufacturing plant. Pertinent data Type A Annual Costs (excluding depreciation)
are as follows:
Operation 32,000
Type A Type B Labor 50,000
First cost ₱200,000 ₱300,000 Payroll taxes = (₱50,000)(0.04) 2,000
Annual operating cost 32,000 24,000 Taxes & insurance = (₱200,000)(0.03) 6,000
Annual labor cost 50,000 32,000 Total Annual Cost ₱90,000
Insurance & property taxes 3% 3%
Payroll taxes 4% 4% Type B Annual Costs (excluding depreciation)
Estimated life 10 10 Operation 24,000
Labor 32,000
If MARR is 15%, which equipment should be used?
Payroll taxes = (₱32,000)(0.04) 1,280
Taxes & insurance = (₱300,000)(0.03) 9,000
Total Annual Cost ₱66,280

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 3. The Present Worth Cost Method
Solution: Type A
0 1 2 9 10
Type A Annual Costs (excluding depreciation)
Operation 32,000
₱90,000 ₱90,000 ₱90,000 ₱90,000
Labor 50,000 ₱90,000(P/A,15%,10)
Payroll taxes = (₱50,000)(0.04) 2,000 ₱200,000

Taxes & insurance = (₱200,000)(0.03) 6,000 𝑃𝑊𝐶𝐴 = ₱200,000+₱90,000(P/A,15%,10)

−10
Total Annual Cost ₱90,000 1 − 1 + 0.15
= ₱200,000 + ₱90,000 = ₱𝟔𝟓𝟏, 𝟔𝟗𝟐
0.15
Type B Annual Costs (excluding depreciation) Type B 0 1 2 9 10
Operation 24,000
Labor 32,000 ₱66,280 ₱66,280 ₱66,280 ₱66,280
₱66,280(P/A,15%,10)
Payroll taxes = (₱32,000)(0.04) 1,280
₱300,000
Taxes & insurance = (₱300,000)(0.03) 9,000
𝑃𝑊𝐶𝐵 = ₱300,000+₱66,280(P/A,15%,10)
−10
1 − 1 + 0.15
Total Annual Cost ₱66,280 = ₱300,000 + ₱66,280 = ₱𝟔𝟑𝟐, 𝟔𝟒𝟔
0.15
Since PWCB < PWCA for the same period of time, Type B should be selected.
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 4. The Equivalent Uniform Annual Cost (EUAC) Method

➢ All cash flows (irregular or uniform) must be converted to an

equivalent uniform annual cost, i.e. a year-end amount which is
the same each year
➢ The alternative with the least equivalent uniform annual cost is
preferred.
➢ When used, the equivalent uniform annual cost of the alternative
must be calculated for one life cycle only.

Chapter 7 Comparing Alternatives

 4. The EUAC Method

Solution:
Example 1d: A company is considering two types of
equipment for its manufacturing plant. Pertinent data Type A Annual Costs (excluding depreciation)
are as follows:
Operation 32,000
Type A Type B Labor 50,000
First cost ₱200,000 ₱300,000 Payroll taxes = (₱50,000)(0.04) 2,000
Annual operating cost 32,000 24,000 Taxes & insurance = (₱200,000)(0.03) 6,000
Annual labor cost 50,000 32,000 Total Annual Cost ₱90,000
Insurance & property taxes 3% 3%
Payroll taxes 4% 4% Type B Annual Costs (excluding depreciation)
Estimated life 10 10 Operation 24,000
Labor 32,000
If MARR is 15%, which equipment should be used?
Payroll taxes = (₱32,000)(0.04) 1,280
Taxes & insurance = (₱300,000)(0.03) 9,000
Total Annual Cost ₱66,280

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 4. The EUAC Method
Solution:
Type A
0 1 2 9 10 0 1 2 9 10

₱90,000 ₱90,000 ₱90,000 ₱90,000 EUACA EUACA EUACA EUACA

𝐸𝑈𝐴𝐶𝐴 = ₱200,000 (A/P,15%,10) +₱90,000

₱200,000
0.15
= ₱200,000 + ₱90,000 = ₱𝟏𝟐𝟗, 𝟖𝟔𝟎
1 − (1 + 0.15 −10
Type B
0 1 2 9 10 0 1 2 9 10

₱66,280 ₱66,280 ₱66,280 ₱66,280

EUACB EUACB EUACB EUACB

₱300,000 𝐸𝑈𝐴𝐶𝐵 = ₱300,000 (A/P,15%,10) +₱66,280

0.15
= ₱300,000 + ₱66,280 = ₱𝟏𝟐𝟔, 𝟎𝟕𝟎
1 − (1 + 0.15 −10

Since EUACB < EUACA, Type B is more economical.

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 5. The Capitalized Cost Method

➢ A variation of the present worth cost pattern

➢ Used for alternatives having long lives
➢ The capitalized cost of all alternatives is determined
➢ The alternative with the least capitalized cost is chosen.

Chapter 7 Comparing Alternatives

 5. The Capitalized Cost Method
Example 2: A plant to provide the company’s present needs can be constructed for ₱2,800,000 with annual operating
disbursements of ₱600,000. It is expected that at the end of 5 years, the production requirements could be doubled, which
will necessitate the addition of an extension costing ₱2,400,000. The disbursements after 5 years will likewise double. A
plant to provide the entire expected capacity can be constructed for P4,000,000 and its operating disbursements will be
₱640,000 when operating on half capacity (for the first 5 years) and ₱900,000 on full capacity. The plants are predicted to
have indeterminately long life. The required rate of return is 20%. What would you recommend?
Solution:
Deferred Expansion Full-Size Plant
0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7

₱600k ₱600k ₱600k ₱600k ₱600k ₱640k ₱640k ₱640k ₱640k ₱640k
₱600,000(P/A,20%,5) ₱640,000(P/A,20%,5) ₱900k ₱900k
₱1.2M ₱1.2M
₱2.4M(P/F,20%,5)
₱900,000
₱2.4M 0.20
(P/F,20%,5)
₱1,200,000 ₱4M
(P/F,20%,5)
₱2.8M 0.20

Capitalized Cost Capitalized Cost

₱1,200,000 ₱900,000
= ₱2,800,000 + ₱600,000 𝑃/𝐴, 20%, 5 + ₱2,400,000 𝑃/𝐹, 20%, 5 + (𝑃/𝐹, 20%, 5) = ₱4,000,000 + ₱640,000 𝑃/𝐴, 20%, 5 + (𝑃/𝐹, 20%, 5)
0.20 0.20
1 − 1.20−5 ₱1,200,000 1 − 1.20−5 ₱900,000
= ₱2,800,000 + ₱600,000 + ₱2,400,000(1.20)−5 + (1.20)−5 = ₱4,000,000 + ₱640,000 + (1.20)−5
0.20 0.20 0.20 0.20
= ₱𝟕, 𝟗𝟕𝟎, 𝟑𝟐𝟎 = ₱𝟕, 𝟕𝟐𝟐, 𝟓𝟑𝟒
Since CC full-size plant < CC deferred expansion, the full-size plant should be constructed.
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 6. The Payback (Payout) Period Method

𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

𝑃𝑎𝑦𝑜𝑢𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 (𝑦𝑒𝑎𝑟𝑠) =
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤

➢ The payback period of each alternative is computed

➢ The alternative with the shortest payback period is adopted.
➢ Seldom used

Chapter 7 Comparing Alternatives