Chapter6 PDF
Chapter6 PDF
Engineering Economy
Chapter 6: Comparison and Selection
Among Alternatives
1
Learning Objectives
Apply
present worth,
annual worth,
future worth,
rate of return techniques, and
Incremental Analysis
2
Making decisions means comparing alternatives:
Mutually Exclusive Alternatives (MEA)
Most engineering projects can be accomplished by
more than one feasible design alternative.
When the selection of one of these alternatives
excludes the choice of any of the others, the
alternatives are called mutually exclusive
alternatives.
Typically, the alternatives being considered require
different capital investments, and their annual
revenues and costs may vary. Sometimes, they may
have different useful lives.
We need to analyze and compare alternatives to
determine the preferred one.
3
Basic concepts for comparing alternatives
1. Fundamental purpose of capital investment: to obtain at least the
MARR for each dollar invested.
2. Focus on differences:→ Incremental analysis “the alternative that
requires the minimum investment of capital (base alternative) and
produces satisfactory functional results will be chosen unless the
incremental capital Δ 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”
3. Ensure a comparable basis: differences among alternatives must be
identified and their economic impact must be included in the cash
flow estimates.
4. Compare alternatives over the same period of time (aka, study or
analysis period, or planning horizon).
5. Do nothing may be a feasible alternative ( in case of investment
projects , not cost projects)
6. Rules for comparison (economic criteria) 4
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.
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. (Salvage value)
Select the alternative that gives you the
most money!
For investment alternatives the EW of all cash flows must
be positive, at the MARR, to be attractive. Select the
alternative with the largest EW. (objective is to maximize
profit)
In investment alternatives the do nothing alternative is
always an option (EW=zero at do nothing)
Furnace
F1 F2 F3
Investment $110,000 $125,000 $138,000
Useful life 10 years 10 years 10 years
Total annual expenses $53,800 $51,625 $45,033
Present Worth @ 15% -$380,010 -$384,094 -$364,010
Alternatives
A B C D
Capital investment -$150,000 -$85,000 -$75,000 -$120,000
Annual revenues $28,000 $16,000 $15,000 $22,000
Annual expenses -$1,000 -$550 -$500 -$700
Market Value (EOL) $20,000 $10,000 $6,000 $11,000
Life (years) 10 10 10 10
Selecting the best alternative.
Present worth analysis → select Alternative A (but C is close).
A >C>B>D> do nothing
0 1 2 3 0 1 2 3
B>A>do nothing
Δ = B-A
B= A + Δ
If Δ is feasible------ B >A
If Δ is infeasible ------------A>B
Δ is feasible -------B>A
Min cost D>C--------- here do nothing is not an option since they are cost alternatives
PW Δ = -35,000 + 10700(P/A,10%,3)
+1000 (P/G,10%,3) + 26000 (P/F,10%,3)
= $13,470 >0
Δ is feasible
D>C
Alternative
A B B -A
Capital $12,000 $12,500 $500
investment
Net annual $2,500 $2,520 $20
income
IRR 12.99% 12.04% -ve%
Alternative
A C C -A
Capital $12,000 $14,400 $2,400
investment
Net annual $2,500 $3,050 $550
income
IRR 12.99% 13.48% 15.86%
Alternative
C D D-C
Capital $14,400 $16,250 $1,850
investment
Net annual $3,050 $3,620 $570
income
IRR 13.48% 14.99% 25.94%
Alternative
D E E-D
Capital $16,250 $20,000 $3,750
investment
Net annual $3,620 $4,400 $780
income
IRR 14.99% 14.61% 12.95%
◦ Replace with another asset, with possibly different cash flows, after the
study period ( will not be included in our course)
Cost alternatives
◦ Contracting or leasing for remaining years may be appropriate (leasing
expenses may be given in the question. If not given assume it to be the
same as the previous annual cost)
◦ Repeat part of the useful life and use an estimated market value to
truncate. (example 6-9 later in this presentation)
In case of co-termination assumption if the useful
life of an alternative is greater than the study period.
0 n
S
0 T n CR
=I(A/P,i%,n)-S(A/F,i%,n)
I
S
CR
0 T
n
IMVT
=CR(P/A, i%, n-T)+S(P/F,i%,n-T)
39
Implied (Imputed) Market Value
Estimating market value at time T< useful life:
◦ Obtaining a current estimate from the marketplace for a piece
of equipment is the preferred procedure; however, it may not be
feasible in some cases.
◦ The implied market value, at end of year T <useful life, can be
used based on the assumption about the value of the remaining
useful life for an asset:
MVT=[PW at EOY T of remaining capital recovery amounts]
+ [PW at EOY T of original salvage value at end of useful
life]; where PW is computed at i=MARR.
S
CR
S
0 T n 0 n 0 T
n
CR
I =I(A/P,i%,n)-S(A/F,i%,n) MVT
=CR(P/A, i%, n-T)+S(P/F,i%,n-T) 40
Example 6-4 Applying Present Worth when
Useful Lives are Different
41
Example 6-4 Applying Present Worth using
repeatability: The least common multiple of useful
lives is 12 years:
1255
Alt.1 0 1 2 3 4 5 6 7 8 9 10 11 12
Alt.2 0 1 2 3 4 5 6 7 8 9 10 11 12
5000 5000
Pump A Pump B
Initial cost $7,000 $5,000
End-of-useful-life salvage value $1,500 $1,000
Useful life, in years 12 6
43
Annual Cash Flow Analysis
Analysis Period a Common Multiple of Alternatives’
Lives: Example 6-7
Pump A S=1500 Pump B S=1000
0 12 0 6
P=7000 P=5000
𝐸𝑈𝐴𝐶A = CR + E = P(A/P,i%,n)−S(A/F,i%,n)
= $7,000(A/P,7%,12)−$1,500(A/F,7%,12) = $797.20
𝐸𝑈𝐴𝐶B = $5,000(A/P,7%,6)−$1,000(A/F,i%,6) = $909
NOTE: If EUACB was calculated over 12-year period (Pump B is repeated twice)
Tunnel Pipeline
Initial cost $5.5 million $5 million
Maintenance 0 0
Useful life Permanent 50 years
Salvage value 0 0
45
Annual Cash Flow Analysis
Infinite Analysis Period:
Example 6-8
Tunnel Pipeline
0 50
0
P=5M
5.5M
P=5M
5.5M
48
Example 6-9
10000 20000
Alt.1 0 1 2 3 4 5 6 7 8 9 10
Alt.2
0 1 2 3 4 5 6 7 8 9 10
75000
𝑷
NPW𝟏 = −50,000 − 𝟒𝟎, 𝟎𝟎𝟎( , 𝟖%, 𝟕) + 20,000(𝐏Τ𝐅 , 8%,10) = −$64,076
𝑭
NPW𝟐 = −75,000 + 15,000(𝑷Τ𝑭 , 8%,10) = −$68,052
A EUAB
0 n 0 n
EUAC
I
Note: Analysis Period chosen to be LCM
Alt. A
AW= 525 - 6,000 (A/P, 12%, 20) = 525 - 6,000 (0.1339) = -$278.40
FW = - 278.40 (F/A, 12%, 20) = -278.40 (72.052) = - $20,059.28
Alt. B
AW = 300 - 1,000 (A/P, 12%, 5) = 300 - 1,000 (0.2774) = $22.60 = AW over 20
years
FW =22.60 (F/A, 12%, 20) = 22.60 (72.052) = $1,628.38
Alt. C
AW = 450 - 1,500 (A/P, 12%, 10) = 450 - 1,500 (0.1770) = $184.50 = Aw over 20
years
FW = $184.50 (F/A, 12%, 20) = $184.50 (72.052) = $13,293.59
Choose Alt. C to maximize FW.
Applying Future Worth Analysis
Example 6-12
A firm is considering 2 alternatives associated with a small
engineering project. Using future worth analysis, a MARR of
10% per year, and the provided data, determine which
alternative should be selected, if the responsible manager
wanted a six-year analysis period because it is the planning
horizon used in the firm for small investment projects,
assuming that, for an alternative with useful life less than the
study period, all cash flows will be reinvested by the firm at
the MARR until the end of the study period.
A B
Capital Investment $3,500 $5,000
Annual cash flows 1,255 1,480
Useful life (years) 4 6
Market value at end of useful life 0 0
52
Applying Future Worth Analysis
Example 6-12
A B
Capital Investment $3,500 $5,000
Annual cash flows 1,255 1,480
Useful life (years) 4 6
Market value at end of useful life 0 0
FW(10%)A= [-$3500(F/P,10%,4)+1255(F/A,10%,4)]
(F/P,10%,2)=$847
FW(10%)B= [-$5000(F/P,10%,6)+1480(F/A,10%,6)]=$2561