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    SUREINTHARAAN A/L NATHAN / UPM
    Using the repeatability assumption, the AW of Alternative A is $1,255 and the AW of Alternative B is $1,480. Alternative B is preferred. Using the co- terminated assumption and a 6 year study period, the PW of Alternative A is $4,520 and the PW of Alternative B is $7,440. Again, Alternative B is preferred.

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    Topic 8

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    SUREINTHARAAN A/L NATHAN / UPM
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    Using the repeatability assumption, the AW of Alternative A is $1,255 and the AW of Alternative B is $1,480. Alternative B is preferred. Using the co- terminated assumption and a 6 year study period, the PW of Alternative A is $4,520 and the PW of Alternative B is $7,440. Again, Alternative B is preferred.

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    Using the repeatability assumption, the AW of Alternative A is $1,255 and the AW of Alternative B is $1,480. Alternative B is preferred. Using the co- terminated assumption and a 6 year study period, the PW of Alternative A is $4,520 and the PW of Alternative B is $7,440. Again, Alternative B is preferred.

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    Download as pptx, pdf, or txt
    33 views16 pages

    Topic 8

    Uploaded by

    SUREINTHARAAN A/L NATHAN / UPM
    Using the repeatability assumption, the AW of Alternative A is $1,255 and the AW of Alternative B is $1,480. Alternative B is preferred. Using the co- terminated assumption and a 6 year study period, the PW of Alternative A is $4,520 and the PW of Alternative B is $7,440. Again, Alternative B is preferred.

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    You are on page 1of 16

    Engineering Economy

    Seventeenth Edition, Global Edition

    Chapter 06
    Comparison and Selection Among
    Alternatives

    Copyright © 2020 Pearson Education Ltd. All Rights Reserved


    Objective
    The objective of chapter 6 is to evaluate correctly capital
    investment alternatives when the time value of money is a key
    influence.
    Making Decisions Means Comparing
    Alternatives
    • In this chapter we examine feasible design alternatives.
    • The decisions considered are those selecting from among a set of
    mutually exclusive alternatives—when selecting one excludes
    the choice of any of the others.
    Mutually Exclusive Alternatives (MEAs)
    • We examine these on the basis of economic considerations
    alone.
    • The alternatives may have different initial investments and their
    annual revenues and costs may vary.
    • The alternatives must provide comparable “usefulness”:
    performance, quality, etc.
    • The basic methods from chapter 5 provide the basis for
    economic comparison of the alternatives.
    General Principle

    • The alternative that requires the minimum investment of capital


    and produces satisfactory functional results (base alternative)
    will be chosen unless the incremental capital associated with an
    alternative having a larger investment can be justified with
    respect to its incremental benefits.

    • 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.
    There are Two Basic Types of
    Alternatives
    Investment Alternatives
    Those with initial (or front-end) capital investment that produces
    positive cash flows from increased revenue, savings through
    reduced costs, or both. (Do-nothing is an option)

    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.
    Equivalent Worth Method
    Select the Alternative that Gives you the Most
    Money!

    • The most straightforward technique for comparing mutually


    exclusive alternatives when all useful lives are equal to the study
    period is to determine the equivalent worth of each alternative
    based on total investment at i (usually taken as the MARR).
    • Then, for investment alternatives, 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.
    Investment Alternative Example

    Use an interest rate of 10% (MARR) per year and useful life of 4 years to select
    between the investment alternatives below.

    Alternative
    A B
    Capital investment -$60,000 -$73,000
    Annual revenues less expenses $22,000 $26,225

    Alternative A is the base alternative as it has the lowest capital investment. Both
    alternatives are attractive, but Alternative B provides a greater present worth, so
    is better economically.
    Cost Alternative Example
    Use an interest rate of 10% and useful life of 3 years to select between the cost
    alternatives below.
    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
    Market value 0 $26,000

    𝑃𝑊𝐶 = −380,000 − 38,100(𝑃/F,10%, 1) − 39,100(𝑃/𝐹,10%,2)


    − 40,100(P/F,10%,3) = −$477,077
    𝑃𝑊𝐷 = −415,000 − 27,400(𝑃/𝐴, 10%, 3) +26,000= −463,407

    Alternative C, which has a lesser capital investment, is the base alternative. As


    compared to Alternative C, Alternative D costs has a greater PW, so is better
    economically.
    Rates of Return Method

    • The return on investment is a popular measure of investment


    performance.
    • Selecting the alternative with the largest rate of return can lead
    to incorrect decisions—do not compare the IRR of one
    alternative to the IRR of another alternative. The only legitimate
    comparison is the IRR to the MARR.
    • Remember, the base alternative must be attractive (rate of return
    greater than the MARR), and the additional investment in other
    alternatives must itself make a satisfactory rate of return on that
    increment.
    Use the Incremental Investment
    Analysis Procedure
    • Arrange (rank order) the feasible alternatives based on
    increasing capital investment.
    • Establish a base alternative.
    – Cost alternatives—the first alternative is the base.
    – Investment alternatives—the first acceptable alternative
    (IRR>MARR) is the base.
    • Iteratively evaluate differences (incremental cash flows) between
    alternatives until all have been considered.
    Evaluating Incremental Cash Flows
    • Work up the order of ranked alternatives smallest to largest.
    • Subtract cash flows of the lower ranked alternative from the
    higher ranked.
    • Determine if the incremental initial investment in the higher
    ranked alternative is attractive (e.g., IRR>MARR, PW, FW, AW
    all >0). If it is attractive, it is the “winner.” If not, the lower
    ranked alternative is the “winner.” The “loser” from this
    comparison is removed from consideration. Continue until all
    alternatives have been considered.
    • This works for both cost and investment alternatives.
    Incremental Analysis
    Alternative Difference
     Both alternatives A and B are
    A B (B-A)
    acceptable (IRR exceeds the
    Capital -$60,000 -$73,000 $13,000 MARR).
    investment
     Choosing Alternative A
    Annual revenues $22,000 $26,225 $4,225 because of its larger IRR
    less expenses
    would be an incorrect
    decision.
     By using Incremental
    Alternative IRR (%) PW ($) Analysis, the extra amount
    invested in Alternative B
    A 17.3 9,378 earns a return that exceeds
    B 16.3 10,131 the MARR.
    Difference  so B is preferred to A.

    (B-A) 11.4 393


    Unequal lives are handled in one of two
    ways
    • Repeatability assumption
    – The study period is either indefinitely long or equal to a
    common multiple of the lives of the MEAs.
    – The economic consequences expected during the MEAs’ life
    spans will also happen in succeeding life spans
    (replacements).
    • Co-terminated assumption: uses a finite and identical study
    period for all MEAs. Cash flow adjustments may be made to
    satisfy alternative performance needs over the study period.
    Equivalent Worth Methods can be Used
    for MEAs with Unequal Lives
    • If repeatability can be assumed, the MEAs are most easily
    compared by finding the annual worth (AW) of each alternative
    over its own useful life, and recommending the one having the
    most economical value.
    • For co-termination, use any equivalent worth method using the
    cash flows available for the study period.
    Example 6-2@MEAs with Unequal Lives
    Compare two alternatives using equivalent-worth methods.
    i =MARR = 10% per year. Use both the repeatability assumption and the co-
    terminated assumption. A B
    Capital Investment $3,500 $5,000
    Annual Cash Flow $1,255 $1,480
    Useful Live (years) 4 6

    Repeatability assumption Co-terminated assumption

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