IE 353

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)

 For cost alternatives the EW of all cash flows will be

negative. Select the alternative with the largest (smallest in
absolute value) EW. (objective is to minimize cost)
Investment alternative example
Use a MARR of 10% and useful life of 5 years to select
between the investment alternatives below.
Alternative
A B
Capital investment -$100,000 -$125,000
Annual revenues less $34,000 $41,000
expenses

Both alternatives are attractive, but Alternative B provides a greater present

worth, so is better economically.

Assume PWA= -28,887 and PWB = -30,423 we choose do nothing alternative

Cost alternative example
Use a MARR of 12% and useful life of 4 years to select
between the cost alternatives below.
Alternative
C D
Capital investment -$80,000 -$60,000
Annual expenses -$25,000 -$30,000

Alternative D costs less than Alternative C, it has a greater

PW (min cost) , so is better economically.
Pause and solve
Your local foundry is adding a new furnace. There are
several different styles and types of furnaces, so the foundry
must select from among a set of mutually exclusive
alternatives. Initial capital investment and annual expenses
for each alternative are given in the table below. None have
any market value at the end of its useful life. Using a
MARR of 15%, which furnace should be chosen?
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
Solution
Using a MARR of 15%, the PW is shown for each of the
three alternatives in the table below.

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

The largest value is -$364,010, indicating that Furnace

F3 is the best alternative. F3>F1>F2
Determining the study period.
 A study period (or planning horizon) is the time
period over which MEAs are compared, and it
must be appropriate for the decision situation.
 MEAs can have equal lives (in which case the
study period used is these equal lives), or they can
have unequal lives, and at least one does not
match the study period.
 The equal life case is straightforward, and was
used in the previous two examples.
Comparing MEAs with equal lives.
When lives are equal adjustments to cash flows are not required. The MEAs
can be compared by directly comparing their equivalent worth (PW, FW, or
AW) calculated using the MARR. The decision will be the same regardless
of the equivalent worth method you use. For a MARR of 12%, select from
among the MEAs below.

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

Annual worth analysis—the decision is the same.

 Example: Future Worth Analysis

 A firm is considering 2 alternatives for

establishing a plant. Using future worth analysis, an
interest rate of 8% (MARR), and the provided
cost data, determine which alternative should be
selected.

Year New Plant Remodel

0 $85,000 $850,000
1 200,000 250,000
2 1,200,000 250,000
3 200,000 250,000
14
 Future Worth Analysis

0 1 2 3 0 1 2 3

85K 200K 200K 250K 250K 250K

850K
1,200K
FW New Plant FW Remodel

FWNew Plant = 85,000( F P,8%,3) + 200,000 ( F A,8%,3) + 1,000,000 ( F P,8%,1)

= $1,836,000
FW Remodel = 850,000(F P,8%,3) + 250,000 (F A,8%,3)
= $1,882,000
The new plant is projected to have a smaller future
worth of costs and thus it is the preferred alternative
Apply this rule.
The alternative that requires the minimum
investment of capital and produces satisfactory
functional results will be chosen unless the
incremental capital associated with an
alternative having a larger investment can be
justified with respect to its incremental
benefits.

The alternative with minimum investment is

called the base alternative.
For alternatives that have a larger investment than
the base…
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.

(Please note that there are some cautions when considering

more than two alternatives, which will be examined later.)
 MARR = 10%

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 if EW(Δ ) >=0 or

IRR(Δ) >=MARR
Here IRR(Δ)=11.4% > 10%
Never compare IRRs

Only compare IRR Δ with MARR

IRR Δ = 11.4 >10% MARR

Δ is feasible -------B>A

From the figure:

MARR<11.4 B>A>do nothing

MARR=11.4 B<=>A
11.4<MARR<16.3 A>B>do nothing
16.3<MARR<17.3 A>do nothing>B
MARR>17.3 do nothing
 1. EW methods :
1.1. simple comparison (max profit in case of
investment projects, min cost in case of cost
alternatives)
1.2 Incremental EW. EW(Δ)>=0

2. IRR method (only incremental, never

compare IRRs of different projects). Only
compare IRR Δ with MARR.
PWC = -380000 – 38,100(P/A,10%,3)-1000 (P/G,10%,3) = −$477,077

PWD = -415000 – 27,400 (P/A,10%,3) + 26000(P/F,10%,3) = −$463,607

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

If we calculate IRR Δ, it will be more than 10%

Using excel IRR = 26.32% > MARR

Using rates of return is another way to
compare alternatives.
 The return on investment (rate of return) 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 or PW >0), 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, or PW(MARR)>=0) 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 or FW or AW >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
Alt. A Alt. B Alt. B-Alt. A
Initial cost -$25,000 -$35,000 -$10,000
Net annual income $7,500 $10,200 $2,700
IRR on total cash flow 15% 14% 11%

Which is preferred using a 5 year study period and MARR=10%?

Both alternatives A and B are acceptable—each one has a rate of return
that exceeds the MARR. Choosing Alternative A because of its larger
IRR would be an incorrect decision. By examining the incremental cash
flows we see that the extra amount invested in Alternative B earns a
return that exceeds the IRR—so B is preferred to A. Also note…
Pause and solve
Acme Molding is examining 5 alternatives for a piece of
material handling equipment. Each has an expected life of 8
years with no salvage value, and Acme’s MARR is 12%.
Using an incremental analysis, which material handling
alternative should be chosen? The table below includes
initial investment, net annual income, and IRR for each
alternative.
Alternative
A B C D E
Capital investment $12,000 $12,500 $14,400 $16,250 $20,000

Net annual $2,500 $2,520 $3,050 $3,620 $4,400

income
IRR 12.99% 12.04% 13.48% 14.99% 14.61%
Solution
Alternative A is the base alternative, with an IRR > MARR.
The next largest investment is in Alternative B, so first
examine the incremental investment of B over A. In the
table below the IRR of B – A is shown.

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 B is not better than A—A “wins.”

Solution
The next largest investment is in Alternative C, so examine
the incremental investment of C over A. In the table below
the IRR of C – A is shown.

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%

15.86% > MARR, so Alternative C “wins.”

Solution
The next largest investment is in Alternative D, so examine
the incremental investment of D over C. In the table below
the IRR of D – C is shown.

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%

25.94% > MARR, so Alternative D “wins.”

Solution
Finally, examine the incremental investment of E over D.

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%

12.95% > MARR, so Alternative E “wins,” and we would

select Alternative E as the best of these five alternatives.
 EW methods :
1. simple comparison (max profit in case of
investment projects, min cost in case of cost
alternatives)
2. Incremental EW.

IRR method (only incremental, never compare

IRRS of different projects)
Comparing MEAs with unequal lives.
 The repeatability assumption, when applicable,
simplified comparison of alternatives.

 If repeatability cannot be used, an appropriate

study period must be selected (the
coterminated assumption). This is most often
used in engineering practice because product
life cycles are becoming shorter.
 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 or capitalized worth (CW) and
recommending the one having the most
economical value.

 For cotermination, use any equivalent worth

method using the cash flows available for the
study period.
 In case of co-termination assumption if the useful
life of an alternative is less than the study period.
 Investment alternatives
◦ Cash flows reinvested at the MARR at the end of the study period (see
the example from the other presentation, no modification on the
original cash flow).

◦ 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.

 Truncate the alternative at the end of the

study period, using an estimated (imputed)
market value. (IMV >S original)
 The underlying principle in all such
analysis is to compare the MEAs in a
decision situation over the same study
(analysis) period.
 Implied (Imputed) Market Value

 Estimating market value at time T< useful life:

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

A manufacturer is considering two alternative production

machines. He is using a MARR of 10% per year and
wants to use the PW method to compare these
alternatives assuming a very long study period

Alternatives Alt. 1 Alt. 2

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

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

3500 3500 3500

1480

Alt.2 0 1 2 3 4 5 6 7 8 9 10 11 12

5000 5000

P𝑊Alt1 = −3,500 −3,500(PΤF , 10%,4)−3,500(PΤF , 10%,8) + 1255(PΤA , 10%,12) = $1,028

P𝑊Alt2 = −5,000 −5,000(PΤF , 10%,6) + 1,480(PΤA , 10%,12) = $2,262

To maximize PW, select Alt. 2

42
Annual Cash Flow Analysis
Analysis Period a Common Multiple of
Alternatives’ Lives

Two pumps are being considered for purchase. If

interest rate is 7% and assuming the need for the pump
will exist for some continuing period, which pump
should be bought?

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)

To minimize EUAC, select pump A

44
Annual Cash Flow Analysis
Infinite Analysis Period:
Example 6-8
 Two alternatives exist to expand the water
supply of a city: either a tunnel through a
mountain, or a pipeline around the mountain. If
there is a permanent need for the water supply,
at an interest rate of 6%, should a tunnel or
pipeline be selected?

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

EUACTunnel = P(i) = 5.5 million(6%) = $330,000

EUACPipeline = 5 million(A/P, 6%, 50) = $317,000
To minimize EUAC, select the pipeline
46
Annual Cash Flow Analysis
Infinite Analysis Period:
Example 6-8 or calculate CC
Tunnel Pipeline
0 50
0 

P=5M
5.5M

CC tunnel = P = 5.5 million

C𝐶Pipeline = 5 A/P, 6%, 50 ./%6 = $5.28 million

To minimize CC, select the pipeline

47
 Annual Cash Flow Analysis
Some Other Analysis Period: Example 6-9
 Suppose we have 2 alternatives, the replacement costs at
the end of an alternative’s useful life is same as original
cost. retirement before end of useful life will result in a
terminal value that exceeds the end-of-life salvage value.
If situation indicates that 10 years is the proper analysis
period, which alternative should be selected to minimize
costs at an interest rate of 8%?

Alternatives Alt. 1 Alt. 2

Initial cost $50,000 $75,000
Estimated salvage value at end of useful life $10,000 $12,000
Useful life 7 years 13 years
Estimated market value, end of 10 years $20,000 $15,000

48
 Example 6-9

10000 20000
Alt.1 0 1 2 3 4 5 6 7 8 9 10

50000 50000 15000

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

select Alt. 1, min cost when comparing PW or AW or FW

based on the study period of 10 years
49
 Example 6-11
Future Worth Analysis
 Given the data for three mutually exclusive
alternatives, find the best alternative using
future worth analysis assuming repeatability, if
the MARR is 12%.
AW OF A PROJECT OVER THE STUDY PERIOD (20 YEARS) IS THE SAME AS
THE AW OVER ITS OWN LIFE BECAUSE WE USE REPEATABILITY
ASSUMPTION

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

 FWA (at n=study period 6) = FWA (n= useful life 4) x (F/P,MARR,2)

 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

Choose Alt. B to maximize NFW. 53

We can use incremental rate of return analysis on
MEAs with unequal lives.

Equate the MEAs annual worth (AW) over their

respective lives. Assuming repeatability
A B
Capital Investment $3,500 $5,000
Annual Cash Flow $1,255 $1,480
Useful Live (years) 4 6

Solving, we find IRR of delta (i*=26%) >

MARR=10%, so Alt B is preferred.