Engineering Economy

LEARNING OUTCOMES
1. Formulate Alternatives
2. PW of equal-life alternatives
3. PW of different-life alternatives
4. Future Worth analysis
5. Capitalized Cost analysis

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 Formulating Alternatives

Two types of economic proposals

Mutually Exclusive (ME) Alternatives: Only one can be selected;

Compete against each other

Independent Projects: More than one can be selected;

Compete only against DN

Do Nothing (DN) – An ME alternative or independent project to

maintain the current approach; no new costs, revenues or savings
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Formulating Alternatives

Two types of alternatives (cash flow estimates)

Revenue: Alternatives include estimates of costs

(cash outflows) and revenues (cash inflows)

Cost: Alternatives include only costs; revenues and savings

assumed equal for all alternatives;
also called service alternatives

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 PW Analysis of Alternatives
Convert all cash flows to PW using MARR
Precede costs by minus sign; receipts by
plus sign

EVALUATION
For one project, if PW > 0, it is economically justified
For mutually exclusive alternatives, select
one with numerically largest PW
For independent projects, select all with PW > 0
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Selection of Alternatives by PW
For the alternatives shown below, which should be selected
ifselected selected
they are (a) mutually exclusive; (b) independent?

Project ID Present Worth

A $30,000
B $12,500
C $-4,000
D $ 2,000
Solution: (a) Select numerically largest PW; alternative A
(b) Select all with PW > 0; projects A, B & D
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Selection of Alternatives by PW
For the alternatives shown below, which should be selected
ifselected selected
they are mutually exclusive

PW Evaluation of ME Alts.

Equal service requirement must

be applied, i.e., each alternative
must have equal life.

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 Alternatives usually have the following
cash flow estimates
Initial investment, P – First cost of an asset
Salvage value, S – Estimated value of asset at end of
useful life
Annual amount, A – Cash flows associated with asset, such
as annual operating cost (AOC), M&O
Costs, etc.

Example: PW Evaluation of Equal-Life ME Alts.

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PW of Different-Life Alternatives
Must compare alternatives for equal service
(i.e., alternatives must end at the same time)

Two ways to compare equal service:

Least common multiple (LCM) of lives
Use total time equal to least common multiple of alternative lives.

Specified study period

Specify a time period of n years. Also called planning horizon.

(The LCM procedure is used unless otherwise specified)

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Assumptions of LCM approach

 Service provided is needed over the LCM or
more years

 Selected alternative can be repeated over

each life cycle of LCM in exactly the same
manner

 Cash flow estimates are the same for each life

cycle (i.e., change in exact accord with the
inflation or deflation rate)
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Example: Different-Life Alternatives
Compare the machines below using present worth analysis at i = 10% per year

Machine A Machine B
First cost, $ 20,000 30,000
Annual cost, $/year 9000 7000
Salvage value, $ 4000 6000
Life, years 3 6

Solution: LCM = 6 years; repurchase A after 3 years

PWA = -20,000 – 9000(P/A,10%,6) – 16,000(P/F,10%,3) + 4000(P/F,10%,6)

= $-68,961
20,000 – 4,000 in
PWB = -30,000 – 7000(P/A,10%,6) + 6000(P/F,10%,6) year 3
= $-57,100

Select alternative B
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Example: Different-Life Alternatives

LCM=20
years

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 PW Evaluation Using a Study Period
 Once a study period is specified, all cash flows after
this time are ignored

 Salvage value is the estimated market value at the end

of study period

Short study periods are often defined by management

when business goals are short-term

Study periods are commonly used in equipment

replacement analysis
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Example: Study Period PW Evaluation

Compare the alternatives below using present worth analysis at i = 10% per year
and a 3-year study period
Machine A Machine B
First cost, $ -20,000 -30,000
Annual cost, $/year -9,000 -7,000
Salvage/market value, $ 4,000 6,000 (after 6 years)
10,000 (after 3 years)
Life, years 3 6
Solution: Study period = 3 years; disregard all estimates after 3 years

PWA = -20,000 – 9000(P/A,10%,3) + 4000(P/F,10%,3) = $-39,376

PWB = -30,000 – 7000(P/A,10%,3) + 10,000(P/F,10%,3) = $-39,895
Marginally, select A; different selection than for LCM = 6 years
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 Future Worth Analysis
FW exactly like PW analysis, except calculate FW

Must compare alternatives for equal service

(i.e. alternatives must end at the same time)

Two ways to compare equal service:

Least common multiple (LCM) of lives

Specified study period

(The LCM procedure is used unless otherwise specified)
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 FW of Different-Life Alternatives
Compare the machines below using future worth analysis at i = 10% per year

Machine A Machine B
First cost, $ -20,000 -30,000
Annual cost, $/year -9000 -7000
Salvage value, $ 4000 6000
Life, years 3 6

Solution: LCM = 6 years; repurchase A after 3 years

FWA = -20,000(F/P,10%,6) – 9000(F/A,10%,6) – 16,000(F/P,10%,3) + 4000
= $-122,168
FWB = -30,000(F/P,10%.6) – 7000(F/A,10%,6) + 6000
= $-101,157
Select B (Note: PW and FW methods will always result in same selection)
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Capitalized Cost (CC) Analysis

CC refers to the present worth of a project with a
very long life, that is, PW as n becomes infinite

(1  i ) n  1
(P / A , i , n ) 
i (1  i ) n

Basic equation is: CC = P = A

i

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 Capitalized Cost (CC) Analysis

Basic equation is: CC = P = A

i
“A” essentially represents the interest on a perpetual investment

For example, in order to be able to withdraw $5000 per year

forever at i = 10% per year, the amount of capital required is
5,000/0.10 = $50,000

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For finite life alternatives, convert all cash flows into

an A value over one life cycle and then divide by i to
obtain CC

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 Example: Capitalized Cost
Compare the machines shown below on the basis of their
capitalized cost. Use i = 10% per year
Machine 1 Machine 2
First cost,$ 20,000 100,000
Annual cost,$/year 9000 7000
Salvage value, $ 4000 --------
Life, years 3 ∞

Solution: Convert machine 1 cash flows into A and then divide by i

A1 = -20,000(A/P,10%,3) – 9000 + 4000(A/F,10%,3) = $-15,834
CC1 = -15,834 / 0.10 = $-158,340

CC2 = -100,000 – 7000/ 0.10 = $-170,000

Select machine 1
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Summary of Important Points

PW method converts all cash flows to present value at MARR

Alternatives can be mutually exclusive or independent

Cash flow estimates can be for revenue or cost alternatives

PW comparison must always be made for equal service

Equal service is achieved by using LCM or study period

Capitalized cost is PW of project with infinite life; CC = P = A/i

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