Scribd Logo
Upload

Welcome to Scribd!

  • Best Alternatives

    Uploaded by

    Palash Dongre
    12 views13 pages

    Copyright

    © © All Rights Reserved

    Available Formats

    PDF or read online from Scribd

    Did you find this document useful?

    Is this content inappropriate?

    Report this Document

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    Download as pdf
    12 views13 pages

    Best Alternatives

    Uploaded by

    Palash Dongre

    Copyright:

    © All Rights Reserved
    Download as PDF or read online from Scribd
    Flag for inappropriate content
    Download as pdf
    of 13
    INCREMENTAL ANALYSIS CHOOSING THE BEST ALTERNATIVE Inprevious editions this chapter was titled, Incremental Analysis, and it extended the incre mental analysis presented in Chapter 7 to multiple altemnatives—solely for the rate of return IRR) measure. The approach relied on a series of numerical comparisons of challengers and defenders. Th this edition we use the more powerful and easier-to-understand approach of eraph- ical present worth (PW), equivalent uniform annual cost (EUAC), or equivalent uniform ‘annual worth (EUAW) comparisons. This also supports calculation of incremental rates of return. “This graphical approach has the added benefit of focusing on the difference between alternatives. Often the difference is much smaller than the uncertainty in our estimated data, For ease of grading and instruction, we may assume in this text and in your exams that answers are exact, but in the real world the uncertainty in the data must always be considered. Engineering design continually selects one of a set of alternatives to be pat Pine design. In engineering economy the words mutually exclusive alternatives ae offen used | toemphasize that only one alternative may be implemented. Thus our problem is selecting the best of these mutually exclusive alternatives. Tn earlier chapters we did this by maximizing PW, minimizing EUAC, or maximizing EUAW. We will do the same here. In Chapter 7 we compared two alternatives incrementally to decide whether the IRR on the increment was acceptable. Thus any two altematives can bbe compared by recognizing that: [Higher-cost alternative] = {Lower-cost alternative] + [Increment between them] When there are two alternatives, only a single incremental analysis is required. With more alternatives, a series of “challenger-defender” comparisons is required. Also, only by doing the analysis step by step can we determine which pairs must be compared. For example if there are 4 alternatives, then 3 of 6 possible comparisons must be made. For 5 alternatives then 4 of 10 possible comparisons must be made. For N alternatives, N— 1 ‘comparisons must be made from N(V— 1)/2 possibilities. ‘The graphical approach is best implemented with spreadsheets, but it provides information, and it is easier to understand and to present to others. GRAPHICAL SOLUTIONS. Examples 8-1 and 8-2 illustrate why incremental or graphical analyses for the IRR criterion are required. They show that graphing makes it easy to choose the best altemative. Chapter 4 presented xy plots done with spreadsheets, and in Chapter 7 spreadsheets were used 10 raph the present worth versus the rate of return. In this chapter the present worth of eact Etemative is one y variable for graphs with multiple alternatives (or variables). In Chapter 9, ‘one of the spreadsheet sections will present some of the ways that graphs can be customized fora better appearance. HU 501 /B.Tech /3 year/ Economics for Engineers / Prof. Aditi Ghosh Graphical Solutions 1G ae aie The student engineering society is building a snack cart to raise money. The members must decide what capacity the cart should be able to serve. To serve 100 customers per hour will cost €10,310, and to serve 150 customers per hour will cost €13,400. The 50% increase in capacity is less than 50% of €10,310 because of economies of scale, but the increase in net revenue will be less than 50%, since the cart will not always be serving 150 customers per hour. The estimated net annual income for the lower capacity is €3300, and for the higher capacity it is €4000, After 5 years the cart is expected to have no salvage value. The engineer- ing society is unsure of what interest rate touse to decide on the capacity. Make a recommendation. ‘Since we do not know the interest rate, the easiest way to analyze the problem is to graph the PW @ of each alternative versus the interest rate, as in Figure 8-1. The Excel function! cost + PV(interest rate, life, —annual benefit) is used to graph these two equations: PWiow = ~€10,310 + €3300(P/A, i, 5) PWhigh = —€13,400 + €4000(P/A,i, 5) CHAPTER 8: CHOOSING THE BEST ALTERNATIVE rate is below 4.3%, the high-capacity cart has ry cart has a higher PW. Above 18%, the third cart. This can be From Figure 8-1, we see that if the interest a higher PW. From 4.3 to 18% the lower-capacit alternative of doing nothing is a better choice than building a low-capacity summarized in a choice table: Interest Rate Best Choice 0% 23% do nothing > MARR > 10% choose X >MARR > 3.5% choose Z = MARR = A 0% choose ¥ table reads = 10% choose X If 10% =MARR= 35% chooseZ “if 35% >MARR> eas exclusive alternatives that have 20-year useful lives, The decision maker may choose any one of the options or reject them all. Prepare a choice table. 0% | choose ¥ Alternatives: B c D E €4,000 €2,000 €6,000 €1,000 €9,000 639 410 Jol UT 785 _ Figure 8-6 is an NPW graph of the alternatives ‘constructed by means of a spreadsheet. Elements in Comparing Mutually Exclusive Alternatives ‘The graph clearly shows that Altematives D and E are never pat ofthe solution, They are dominated by the other three. The erossover points can either be read from the graph if you have Plotied it ata large enough scale) or found by calculating the AIRR of the intersecting graphs Calculating the incremental interest rates: AIRR(C ~ A). ie 2 £6000 — €4000 = (€761 ~ €639)(P/A,i,20) i= 2% LEMENTS IN COMPARING MUTUALLY. EXCLUSIVE ALTERNATIVES 1, Be sure all the alternatives are identified. In textbook problems the alternatives will be well defined, but real-life problems may be less clear. Before Proceeding, one must $s but they are beyond the scope ofthis book and, in any case, are redundant in this era of spread shees Interested readers can consult Economic Analysis for Engineers and Managers by Sprague and Whittaker (Prentice-Hall 1987), HU 501 /B.Tech /3" year/ Economics for Engineers / Prof. Aditi Ghosh CHAPTER 8: CHOOSING THE BEST ALTERNATIVE have all the mutually exclusive alternatives tabulated, including the “do-nothing” or “ki doing the same thing” alternative, if appropriate. 2, Construct an NPW or EUAW graph showing all alternatives plotted on the same axes, This would be a difficult task were it not for spreadsheets. '3, Examine the line of maximum values and determine which alternatives create it, and over what range. 4, Determine the changeover points where the line of maximum NPW changes from cone alternative to another. These can either be read directly off the graph or calculated, since they are the intersection points of the two curves and, what is more important and meaningful for engineering economy, they are the AIRR of the incremental investment between the two alternatives. 'S, Create a choice table to present the information in compact and easily understand- able form. DOING A SET OF INCREMENTAL CHALLENGER-DEFENDER COMPARISONS & ‘This chapter has focused on doing a graphical comparison of the PW of each alternative over range of interest rates. We've calculated incremental interest rates, but we've looked at the ‘curves to see which pair of intersecting PW curves we were analyzing. Before spreadsheets, this type of problem was solved by a series of challenger-defender comparisons, where defender = best alternative identified at this stage of the analysis, and challenger = next alternative being evaluated. Example 8-7 illustrates this approach. ‘The numerically based pairwise incremental comparisons is done at a single interest rate, and it does not show that “near” their intersection, two PW curves have “essentially” the same value. It also does not produce a choice table, since it is ata single interest rate. ‘A choice table can be constructed, but it requires even more incremental comparisons. EX. Forthealtemativesin Example 8-6,conduct a pairwise incremental comparison. Which alternative is the best at an interest rate of 10%? Each of the five alternatives has no salvage value at the end of a 20-year useful life. PLE 8: HU 501 /B.Tech /3™ year/ Economics for Engineers / Prof. Aditi Ghosh Doing a Set of Incremental Challenger-Defender Comparisons Alternati D B A c E Cost €1000 €2000 ©4000 €6000 €9000 Annual benefit 117 410639761785 2, Calculate the IRR of the least expensive alternative to see if itis better than doing nothing at a MARR of 10%. PWp = ‘€1000 + €117(P/A, IRRp, 20) Solving this without a spreadsheet may take several tres and interpolation, but using the Excel function =RATE(ife, annual benefit, fist cost) makes it easy and the answer exact: IRRp = 9.94% Because investment D eams less than 10%, doing nothing is prefered to doing D. 3. Doing nothing is still our defender, and the next Alternative, B, becomes the challenger. Calculate the IRR of Altemative B to see if tis better than doing nothing at a MARR of 10%. PW = 0 = —€2000+ €410(P/A, IRRg, 20) Using the Excel function = RATE(ife, annual benefit, first cost), we find TRRy = 19.96% Because investment B ears more than 10%, Alternative B is preferred to doing nothing, 4, Alternative B is now our defender, and the next. Alternative, A, becomes the challenger. ‘This comparison must be made incrementally, PWa-» =0 = —(€4000 ~ €2000) + (€639 — €410)(P/A,IRRx_»,20) ‘Using the Excel function

    You might also like