Chapter Four

Economic Analysis of Alternatives

Techniques for comparing two or more mutually exclusive alternatives by
the present worth method are treated. Two additional applications are covered
here—future worth and capitalized cost. Capitalized costs are used for
projects with very long expected lives or long planning horizons.

4.1 Formulating Alternatives

The nature of the economic proposals is always one of two types:

1. Mutually Exclusive Set
a. Mutually Exclusive set is where more than one alternative exist
b. Objective: Pick one from the set.
c. Once selected, the remaining alternatives are excluded.
2. Independent Project Set

Given a set of alternatives

The objective is to:
1. Select the best possible combination of projects from the set that will optimize a given
criteria. Subject to constraints.
2. More difficult problem than the mutually exclusive approach

The Do Nothing ( DN ) alternative or project means that the current approach is

maintained; nothing new is initiated. No new costs, revenues, or savings are generated.

4.2. Present Worth – A function of the assumed interest rate

a. If the cash flow contains a mixture of positive and negative cash flows,
b. Calculate:
• PW( positive Cash Flows) at i %;
• PW( negative Cash Flows) at i %;
• Add the result.
1. If P( i% ) > 0 then the project is deemed acceptable.
2. If P( i%) < 0 then the project is deemed unacceptable.
3. If the net present worth = 0 then, the project earns i % return.
4.3 Present Worth Analysis of Equal-Life Alternatives

If the alternatives have the same capacities for the same time period (life), the equal-
service requirement is met. Calculate the PW value at the stated MARR for each
alternative.

1. One alternative: If PW ≥ 0, the requested MARR is met or exceeded and the alternative
is economically justified.
2. Two or more alternatives: Select the alternative with the PW that is numerically
largest, that is, less negative or more positive. This indicates a lower PW of cost for cost
alternatives or a larger PW of net cash flows for revenue alternatives.
3. One or more independent projects: Select all projects with PW ≥ 0 at the MARR.

Example 4-1:

Note that the guideline to select one alternative with the lowest cost or highest revenue
uses the criterion of numerically largest. This is not the absolute value of the PW amount
because the sign matters. The selections below correctly apply the guideline for two
alternatives A and B.
 PWA PWB Selected Alternative
L.D −2300 L.D −1500 B
−500 +1000 B
+2500 +2000 A
+4800 −400 A

For independent projects, each PW is considered separately, that is, compared with the
DN project, which always has PW = 0.

Example 4-2:

You have been asked to evaluate two alternatives, X and Y, that may increase plant
capacity for manufacturing high-pressure hydraulic hoses. The parameters associated with
each alternative have been estimated. Which one should be selected on the basis of a
present worth comparison at an interest rate of 12% per year? Why is yours the correct?
Alternative X Y
First cost L.D -45,000 L.D -58,000
Maintenance cost, L.D /year L.D −8,000 L.D -4,000
Salvage value L.D 2000 L.D 12,000
Life, years 5 5
Solution:
12000
2000

8000 4000
45000
Alternative X 58000
Alternative Y

PWX = -45,000 – 8000(P/A,12%,5) + 2000(P/F,12%,5)

= -45,000 – 8000(3.6048) + 2000(0.5674) = L.D -72,704
PWY = -58,000 – 4000(P/A,12%,5) + 12,000(P/F,12%,5)
= -58,000 – 4000(3.6048) + 12,000(0.5674) = L.D -65,615
Select Alternative Y, because it has the larger PW value, that is, the lower PW of
costs.
4.4 Present Worth Analysis of Different-Life Alternatives

• LCM: Compare the PW of alternatives over a period of time equal to the least common
Multiple (LCM) of their estimated lives.

• Study period: Compare the PW of alternatives using a specified study period of n years.
This approach does not necessarily consider the useful life of an alternative. The study
period is also called the planning horizon.

Example 4-3:
National Homebuilders, Inc. plans to purchase new cut-and-finish equipment. Two
manufacturers offered the following estimates:
Vendor A Vendor B
First cost L.D −15,000 L.D −18,000
Annual M&O cost Per −3,500 −3,100
Year
Salvage value 1,000 2,000
Life, years 6 9

a. Determine which vendor should be selected on the basis of a PW comparison, if

the MARR is 15% per year.
b. National Homebuilders has a standard practice of evaluating all options over a 5-
year period. If a study period of 5 years is used and the salvage values are not
expected to change, which vendor should be selected?
Solution:
a)
Since the equipment has different lives, compare them over the LCM of 18 years. For life
cycles after the first, the first cost is repeated each new cycle, which is the last year of the
previous cycle. These are years 6 and 12 for vendor A and year 9 for B. The cash flow diagram is
shown below for vendor A. Calculate PWA at 15% over 18 years.

PWA = −15,000 − 15,000(P∕F,15%,6) + 1000(P∕F,15%,6) −15,000(P∕F,15%,12) +

1000(P∕F,15%,12) + 1000(P∕F,15%,18) −3,500(P∕A,15%,18) = L.D −45,036

PW(A) = ?
1000 1000
1000

3500 3500 3500

1500 1500 1500

Cash flow diagram for vendor B becomes:

PW(B) = ?
2000 2000

3100 3100 3100

18000

18000

PWB = −18,000 − 18,000(P∕F,15%,9) + 2000(P∕F,15%,9) + 2000(P∕F,15%,18) –

3100(P∕A,15%,18) = L.D −41,384
Vendor B is selected, since it costs less in PW terms; that is, the PW B value is numerically
larger than PWA.

b)
For a 5-year study period, no cycle repeats are necessary. The PW analysis is
PWA = −15,000 − 3500(P∕A,15%,5) + 1000(P∕F,15%,5) = L.D −26,236
PWB = −18,000 − 3100(P∕A,15%,5) + 2000(P∕F,15%,5) = L.D −27,397
Vendor A is now selected based on its smaller PW value. This means that the shortened
study period of 5 years has caused a switch in the economic decision. In situations such
as this, the standard practice of using a fixed study period should be carefully examined
to ensure that the appropriate approach, that is, LCM or fixed study period, is used to
satisfy the equal-service requirement
4.5 Future Worth Analysis

The selection guidelines for FW analysis are the same as for PW analysis; FW ≥ 0
means the MARR is met or exceeded. For two or more mutually exclusive alternatives,
select the one with the numerically largest FW value.
Example 4-4:

A Bosh company distribution conglomerate purchased a Philips spare parts store chain for
L.D 750 million 3 years ago. There was a net loss of L.D 100 million at the end of year
1 of ownership. Net cash flow is increasing with an arithmetic gradient of L.D +50
million per year starting the second year, and this pattern is expected to continue for the
foreseeable future. Because of the heavy debt financing used to purchase the Philips
chain, the international board of directors expects a MARR of 25% per year from any
sale.
a. The Bosh conglomerate has just been offered L.D 1595 million by a French company
wishing to get a foothold in Canada. Use FW analysis to determine if the MARR will
be realized at this selling price.
b. If the Bosh conglomerate continues to own the chain, what selling price must be
obtained at the end of 5 years of ownership to just make the MARR?
Solution:
a)
Set up the FW relation in year 3 (FW3) at i = 25% per year and an offer price of L.D 1595
Million as shown in next cash flow diagram.
1595

0 1 2
3

50

100

750

FW3 = −750(F∕P,25%,3) − 100(F∕P,25%,2) − 50(F∕P,25%,1) + 1595

= -750 ( 1.9530) – 100 (1.560) – 50(1.2500 ) + 1595
= −1683.6 + 1595 = L.D −88.6 million

No, the MARR of 25% will not be realized if the L.D 1595 million offer is accepted.
(b)
Determine the future worth 5 years from now at 25% per year, as shown in the next cash
flow diagram.
100

50
0 1 2
3

4 5
50

100

750

The A∕G and F∕A factors are applied to the arithmetic gradient.

FW5 = −750(F∕P,25%,5) + [ -100 + 50 ( A∕G,25%,5) ] (F∕A,25%,5)

= -750(3.0520) + [ -100 + 50(1.5631)](8.2070) = L.D -2468.3

The offer must be for at least L.D 2468.3 million to make the MARR. This is approximately
3.3 times the purchase price only 5 years earlier, in large part based on the required MARR
of 25%.
Example 4-5:
An electric switch manufacturing company is trying to decide between three different
assembly methods. Method A has an estimated first cost of L.D 40,000, an annual operating
cost (AOC) of L.D 9000, and a service life of 2 years. Method B will cost L.D 80,000 to buy
and will have an AOC of L.D 6000 over its 4-year service life. Method C costs $130,000
initially with an AOC of $4000 over its 8-year life. Methods A and B will have no salvage
value, but Method C will have equipment worth 10% of its first cost. Perform both (a) future
worth, and (b) present worth analyses to select the method at i = 10% per year.

Solution:
a)
Cash flow diagram for method A

0 2 4 6 8

9000 9000 9000

40,000 40,000 40,000 40,000

FWA = -40,000[(F/P,10%,8) + (F/P,10%,6) + (F/P,10%,4) + (F/P,10%,2)]
– 9000 (F/A,10%,8) = -40,000[(2.1436) + (1.7716) + (1.4641) +
(1.2100)] – 9000(11.4359) = L.D -366,495

Cash flow diagram for method B

0 2 4 6 8

6000 6000 6000 6000

80,000 80,000

FWB = -80,000[(F/P,10%,8) + (F/P,10%,4)] - 6000(F/A,10%,8)

= -80,000[(2.1436) + (1.4641)] - 6000(11.4359) = L.D -357,231
 Cash flow diagram for method C
13,000

0 2 4 6 8

4000
130,000

FWC = -130,000(F/P,10%,8) - 4000(F/A,10%,8) + 13,000

= -130,000(2.1436) - 4000(11.4359) + 13,000 = L.D -311,412
Select method C

(b)
Find the PW values from the FW values with n = 8 years.
PWA = FWA(P/F,10%,8) = -366,495(0.4665) = L.D -170,970
PWB = FWB(P/F,10%,8) = -357231(0.4665 ) = L.D -166,648
PWC = FWC(P/F,10%,8) = -311412 (0.4665) = L.D -145,274
Select method C
4.6 Capitalized Cost Analysis [ CC ]

Many public sector projects such as bridges, dams, highways and toll roads, railroads,
and hydroelectric and other power generation facilities have very long expected useful
lives. A perpetual or infinite life is the effective planning horizon.

Factors n = ∞, i = known n = Known , i = 0

( F/P i , n ) ∞ 1
( P/F i , n ) 0 1
( F/A i , n ) ∞ 1n
n
( A/F i , n ) 0
( P/A i , n ) 1/i n1
n
( A/P i , n
) i

 (1  i ) N  1 
P  A 
 i (1  i ) N


Split the fraction into components

  1 
 (1  i ) n


1  1 1  i ) n
 
 

 n 
 i (1  i ) i (1  i )   i
n
i 
 
Then
 1 
 1  
(1  i ) n
P  A  ( 4-1 )
 i 
 

1
As n approaches ∞, the bracketed term becomes i . We replace the symbols P and PW
with CC as a reminder that this is a capitalized cost equivalence. Since the A value can also
be termed AW for annual worth, the capitalized cost formula is simply

1 A (4–2)
P  A  
i  i

 A AW (4–3)
CC    or CC 
i i
Solving for A or AW, the amount of new money that is generated each year by a
capitalization of an amount CC is:
AW = CC (i) (4–4)

Example 4-6:
Compare three alternatives on the basis of their capitalized costs at i = 10% per year.

Alternative E F G
First cost −50,000 −300,000 −900,000
AOC, L.D per year −30,000 −10,000 −3,000
Salvage value 5,000 70,000 200,000
Life, years 2 4 ∞

Solution:
For alternatives E and F, find AW, then divide by i using CC = AW/i
AWE = -50,000(A/P,10%,2) – 30,000 + 5000(A/F,10%,2)
= -50,000(0.57619) – 30,000 + 5000(0.47619) = L.D -56,428.60

AW E 56428.6
CCE    564286
i 0.1
 AWF = -300,000(A/P,10%,4) – 10,000 + 70,000(A/F,10%,4)
= -300,000(0.31547) – 10,000 + 70,000(0.21547) = -89,558.10

AW F 89558.1
CCF    895581
i 0.1
AWG = -900,000( A/P 10%,∞) -3000 +200,000(A/F, i, ∞)
= -900,000 ( 0.1 ) – 3000 + 200,000 ( 0 ) = -93,000

AWG  93000
CCG    930000 Select alternative E
i 0.1

Example 4-7
The Haverty County Transportation Authority (HCTA) has just installed a new software
to charge and track toll fees. The director wants to know the total equivalent cost of all
future costs incurred to purchase the software system. If the new system will be used for
the indefinite future, find the equivalent cost (a) now, a CC value, and (b) for each year
hereafter, an AW value.
The system has an installed cost of L.D 150,000 and an additional cost of L.D 50,000 after
10 years. The annual software maintenance contract cost is L.D 5000 for the first 4 years
and L.D 8000 thereafter. In addition, there is expected to be a recurring major upgrade cost
of L.D 15,000 every 13 years. Assume that i = 5% per year for county funds.

Solution:
 Find the present worth of the nonrecurring costs of 150,000 now and 50,000 in year 10 at
i = 5%. Label this CC1.
CC1 = -15,0000 – 50,000 ( P/F 5,10 ) = -150,000 – 50,000 ( 0.6139 ) = -180,695
Convert the recurring cost of 15,000 every 13 years into an annual worth A 1 for the first 13
years.
A1 = -15,000 (A/F, 5%, 13) = -15000 ( 0.0704 ) = -847

The same value, A1 = -847, applies to the other 13 year periods as well.
The capitalized cost for the two annual maintenance cost series may be determined in
either of two ways:

1. consider a series of 5000 from now to infinity and find the present worth of [ - 8000 - (-
5000) ] = - 3000 from year 5 on; or :
2. find the CC of 5000 for 4 years and the present worth of 8000 from year 5 to infinity.

Using the first method, the annual cost (A2) is 5000 forever. The capitalized cost CC2 of -
3000 from year 5 to infinity is found using Equation [2] times the P/F factor:
CC2 = [ -3000/0.05 ] ( P/F 5,4 ) = [ -3000/0.05] ( 0.8227 ) = - 49362
The two annual cost series are converted into a capitalized cost CC3.

A1  A2  847  ( 5000)
CC3    116940
i 0.05
The total capitalized cost CCT is obtained by adding the three CC values.
CCT = -180695 – 49362 – 116940 = -346997 L.D

b) Equation [4] determines the A value forever.

AW = CCT * i = -346997 ( 0.05 ) = - 17350 L.D

Correctly interpreted, this (HCTA) officials have committed the equivalent of 17,350
forever to operate and maintain the property appraisal software.

The CC2 value is calculated using n = 4 in the P/F factor because the present worth of the
annual 3000 cost is located in year 4, since P is always one period ahead of the first A.