Lecture 4

Comparing Alternatives

Associate Professor. Mohamed El Ashhab

‫ﺩﻣﺣﻣﺩ ﺍﻟﺳﻳﺩ ﺍﻷﺷﻬﺏ‬

Introduction
 Projects classification:
 Independent Projects
 Dependent Projects
 Mutually exclusive
 Comparing Alternative Methods
 PW, AW, FW

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 Projects Classification
 Independent
 The choice of project is independent of the choice of any other
project in the group.

 Dependent
 The choice of a project is conditional on the choice of one or more
other projects.

 Mutually exclusive
 At most one project out of the group can be chosen.

Mutually Exclusive Alternatives

 Independent projects can be transformed to

mutually exclusive projects (Alternatives).
 A, B, C three independent projects
 A, B, C, AB, AC, BC, ABC seven mutually
exclusive alternatives of these three
independent projects.

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 Types of Alternatives

 Revenue Alternatives: Each alternative

generate cost (or disbursement) and revenue
(or receipt) cash flow estimates, and possibly
savings.

 Service Alternatives: Each alternative has

only cost cash flow estimate.

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Investment Projects
MARR = 10% Alternative
A B
Capital Investment –$60,000 –$73,000
Annual revenues less expenses 22,000 26,225
Useful life 4 4

PW (10%)A = –$60,000 + $22,000 (P/A,10%, 4) = $9,738

PW (10%)B = –$73,000 + $26,225 (P/A, 10%, 4) = $10,131

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 Cost Projects
MARR = 10% Alternative

End of Year C D
0 -$380,000 -$415,000
1 -38,100 -27,400
2 -39,100 -27,400
3 -40,100 -27,400
3a 0 26,000

PW (10%)C = – $380,000 – $38,100 (P/A, 10%, 3) - 1,000 (P/G, 10%,3)

PW (10%)C = – $477,077
PW (10%)D = – $415,000 – $27,400 (P/A, 10%, 3) + $26,000 (P/F, 10%, 3)
PW (10%)D = – $463,607

PWD > PWC Alternative D is justified

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Rules
 RULE 1 –
 When revenues and other economic benefits are presented
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.

 RULE 2 –
 When revenues and other economic benefits are not
presented or are constant among alternatives, consider only
the costs and select the alternative that minimizes total cost.
That is, select the alternative that has the least negative
equivalent worth at i = MARR and satisfies all project
requirements.

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 The Study (Analysis) Period
 Case 1:
 Useful lives are the same for all alternatives.

 Case 2:
 Useful lives are different among alternatives.

Case 1: Useful Lives Are Equal

 There is no need to make adjustments to

cash flows.

 Equivalent Worth Methods (PW, FW, AW).

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 Equivalent Worth Methods
 The most straightforward technique for comparing
mutually exclusive alternatives when all useful lives are
equal, is to determine the equivalent worth of each
alternative based on the investment at i = MARR.
 Then for investment alternative the one with the greatest
positive equivalent worth is selected.
 And, in the case of cost alternatives, the one with the
least negative equivalent worth is selected.

Equivalent worth = PW or FW or AW

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Example - 1
 Three mutually exclusive investment alternatives for
implementing an office automation plan in an
engineering design firm are being considered.
 Each alternative meets the same service (support)
requirements, but differences in capital investment
amounts and benefits (cost savings) exist among them.
 The useful lives of all three alternatives are 10 years.
 Market values of all alternatives are assumed to be zero
at the end of their useful lives.
 If the firm’s MARR is 10% per year, which alternative
should be selected in view of the following estimates?

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 Example - 1

Alternative
A B C
Capital investment $390,000 $920,000 $660,000

Annual cost savings 69,000 167,000 133,500

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Solution - 1
Alternative
A B C
Capital investment $390,000 $920,000 $660,000
Annual cost savings 69,000 167,000 133,500

PW method:
PW(10%)A = -$390,000 + $69,000 (P/A, 10%, 10) = $33,977
PW(10%)B = -$920,000 + $167,000 (P/A, 10%, 10) = $106,148
PW(10%)C = -$660,000 + $133,500 (P/A, 10%, 10) = $160,304

C>B>A Alternative C is selected

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 Solution - 1
Alternative
A B C
Capital investment $390,000 $920,000 $660,000
Annual cost savings 69,000 167,000 133,500

FW method:
FW(10%)A = -$390,000 (F/P, 10%, 10) + $69,000 (F/A, 10%, 10) = $88,138
FW(10%)B = -$920,000 (F/P, 10%, 10) + $167,000 (F/A, 10%, 10) = $275,342
FW(10%)C = -$660,000 (F/P, 10%, 10) + $133,500 (F/A, 10%, 10) = $415,801

C>B>A Alternative C is selected

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Solution - 1
Alternative
A B C
Capital investment $390,000 $920,000 $660,000
Annual cost savings 69,000 167,000 133,500

AW method:
AW(10%)A = -$390,000 (A/P, 10%, 10) + $69,000 = $5,547
AW(10%)B = -$920,000 (A/P, 10%, 10) + $167,000 = $17,316
AW(10%)C = -$660,000 (A/P, 10%, 10) + $133,500 = $26,118

C>B>A Alternative C is selected

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 Example - 2

 A company is planning to install a new

automated plastic-molding press.
 Four different presses are available.
 The initial capital investments and annual
expenses for these four mutually exclusive
alternatives are as follows:

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Example - 2

Press
P1 P2 P3 P4
Capital investment $24,000 $30,400 $49,600 $52,000
Useful life (years) 5 5 5 5
Annual Expenses $31,200 $29,128 $25,192 $22,880

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 Solution - 2
Calculations for P1:
PW(10%)P1 = -$24,000 - $31,200 (P/A, 10%, 5) = -$142,273
AW(10%)P1 = -$24,000 (A/P, 10%, 5) - $31,200 = -$37,531
FW(10%)P1 = -$24,000 (F/P, 10%, 5) - $31,200 (F/A, 10%, 5) = - $229,131

Press (equivalent worth values)

Method P1 P2 P3 P4
Present Worth PW -$142,273 -$140,818 -$145,098 -$138,734
Annual Worth AW -37,531 -37,148 -38,276 -36,598
Future Worth FW -229,131 -226,788 -233,689 -223,431

P4 > P2 > P1 > P3

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Case 2: Useful Lives Are Different Among

the Alternatives

 Repeatability assumption

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 Repeatability assumption

1. The study period over which the alternatives

are being compared is equal to a common
multiple of the lives of the alternatives.

2. The economic consequences that are

estimated to happen in an alternative’s initial
useful life span will also happen in all
succeeding life spans (replacements).

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Repeatability assumption
Common multiple

B A

N=4 N=3

A
3 6 9 N = 12

B
4 8 N = 12

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 Example - 3
 The following data have been estimated for two
mutually exclusive investment alternatives, A and
B.

 If the MARR = 10% per year, show which

alternative is more desirable by using equivalent
worth methods.

 Use repeatability assumption.

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Example - 3

A B
Capital investment –$3,500 –$5,000
Annual revenue 1,900 2,500
Annual expenses –645 –1,020
Useful life (years) 4 6
Market value at end of useful life 0 0

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 Solution - 3
A B
$1,255 $1,480

N=4 N=6

$3,500 $5,000

Using PW method:
Using repeatability assumption,
Least common multiple = 12 years

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Solution - 3
A
$1,255

4 8
N = 12
$3,500 $3,500 $3,500

PW(10%)A = –$3,500 – $3,500 (P/F, 10%, 4) – $3,500 (P/F, 10%, 8)

+ $1,255 (P/A, 10%, 12)
PW(10%)A = $1,028

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 Solution - 3
B
$1,480

6 N = 12

$5,000 $5,000

PW(10%)B = – $5,000 – $5,000 (P/F, 10%, 6) + $1,480 (P/A, 10%, 12)

PW(10%)B = $2,262

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Solution - 3
A B
$1,255 $1,480

N=4 N=6

$3,500 $5,000

PW(10%)A = $1,028 PW(10%)A < PW(10%)B

PW(10%)B = $2,262 Alternative B is desirable

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 Solution - 3
A B
$1,255 $1,480

N=4 N=6

$3,500 $5,000
Using AW method:
Using repeatability assumption (useful life)

AW(10%)A = $1,028 (A/P, 10%, 12) = $151

AW(10%)B = $2,262 (A/P, 10%, 12) = $332
AW(10%)A < AW(10%)B  Alternative B is desirable

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Solution - 3
A B
$1,255 $1,480

N=4 N=6

$3,500 $5,000
Using AW method:
without repeatability assumption,

AW(10%)A = – $3,500 (A/P, 10%, 4) + $1,255 = $151

AW(10%)B = – $5,000 (A/P, 10%, 6) + $1,480 = $332
AW(10%)A < AW(10%)B  Alternative B is desirable

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