ComparingAlternatives

Chapter 6

1
Outline

1. Useful lives are equal to study period

1A. Equivalent-Worth Methods
1B. Rate of Return Methods
Inconsistent ranking problem
Incremental analysis

2
Outlineconti

2. Useful lives are different among alternatives

2A. Repeatability assumption
Least Common Multiple of useful years
AW method
IRR method
2B. Coterminated assumption
Useful life < study period
Useful life > study period
3. Infinite length of study period and repeatability
assumption: Capitalized Worth method

3
LearningObjectives
4.1 Given stated alternatives, form mutually exclusive alternatives.
4.2 For alternatives with equal useful life, use equivalent worth
methods to compare them directly.
4.3 Explain the Inconsistent Ranking problem when rate of return
methods are applied directly to compare alternatives.
4.4 Apply incremental analysis to compare alternatives using rate of
return methods or equivalent worth methods.
4.5 When alternatives have different useful lives, identify which
assumption is appropriate between Repeatability assumption
and Coterminated assumption, and being able to adjust cash
flow appropriately under each assumption.

4
LearningObjectives

4.6 Being able to use all five methods (three

equivalent worth methods and two rate of return
methods) to evaluate alternatives with different
useful lives after cash flows are properly adjusted.
4.7 Explain why AW method can be applied directly
under repeatability assumption.
4.8 Use Capitalized Worth method to compare
alternative with infinite length of study period.
4.9 Use Imputed Market Value technique to estimate
the projects market value when terminated
prematurely.

5
Formingalternatives

Mutually exclusive alternatives

6
PlanningHorizon
The selected time period over which mutually
exclusive alternatives are compared -- study period
May be influenced by factors including:
service period required
useful life of the shorter-lived alternative
useful life of the longer-lived alternative
company policy
It is key that the study period be appropriate for the
decision situation under investigation

7
Alternatives
Investment Alternatives:
those alternatives with initial capital investments that
produce positive cash flows from increased revenue,
savings through reduced costs, or both.
both benefit and cost of an alternative is stated.
Cost Alternatives:
those alternatives with negative cash flows except for a
possible positive cash flow element from disposal of assets
at the end of the projects useful life.
only the cost of an alternative is stated.

8
Exampleofinvestmentalternative

An investment of $10,000 can be made in a

project that will produce a uniform annual
revenue of $5,500 for five years and then
have a market value of $2,000. Annual
expenses will be $2,500 each year.

9
Exampleofcostalternative
Engineers at SeaWorld has completed an
innovation on an existing water sports ride to make
it more exciting. The modification costs only $8000
and is expected to last 6 years with a $1300 salvage
value for the solenoid mechanisms. The
maintenance cost is expected to be high at $1700
the first year, increasing by 11% per year thereafter.
Determine the equivalent present worth of the
modification and maintenance cost. The interest rate
is 8% per year.

10
1.Equalusefullives

1A: Equivalent Worth Methods

For investment alternatives, select the alternative
that has greatest positive equivalent worth at
MARR and satisfies project requirement.
For cost alternatives, select the alternative that
minimizes cost (with smallest | equivalent worth| )

11
1A.Equalusefullives:EquivalentWorthMethods

If : PWA (i) < PWB (i)

then
PWA (i) ( A / P,i,N ) < PWB (i) ( A / P,i,N )
and
AWA (i) < AWB (i)
similarly
PWA (i) ( F / P, i, N ) < PWB (i) ( F / P, i, N )
and
FWA (i) < FWB (i)
Select alternative B

12
1B.Equalusefullives:RORmethods

Inconsistent Ranking problem

Example: n=4 years, MARR=10%

Alternative Alternative Difference

A B (B-A)
Capital $60,000 $73,000 $13,000
Annual net 22,000 26,225 4,225
cash flow

13
 PW --i

$25,000.00

$20,000.00

$15,000.00
PW A
PW

$10,000.00
PW B
$5,000.00

$0.00
0.00% 5.00% 10.00% 15.00% 20.00%
($5,000.00)
i

14
1B.InconsistentRankingProblem

Ranking errors can occur when a selection among

mutually exclusive alternatives is based wrongly on
maximization of IRR (or ERR) on the total cash flow,
as opposed to the PW of the total cash flow.
Decision should not be based on Rate of Return
only, but also on the amount of capital that is
earning the ROR.
We need to use incremental analysis!
For both IRR and ERR!!

15
16
1B.RORmethods:Incrementalanalysis

1. Order the feasible alternatives based on initial capital

requirements starting with the alternative with minimum
investment.
2. Establish a base alternative
a. Cost alternatives -- The first alternative is the base
b. Investment alternatives - If the first alternative is acceptable,
select as base. If the first alternative is not acceptable, choose
the next alternative.
3. Use iteration to evaluate differences (incremental cash flows)
between alternatives until no more alternatives exist
a. If incremental cash flow between next alternative and current
base is acceptable, update the next alternative as the base
b. Repeat, and select as the preferred alternative the last one
for which the incremental cash flow was acceptable

17
1B.RORmethods:Incrementalanalysis

ROR decision rule:

The best alternative produces satisfactory
functional results and requires the minimum
investment of capital, unless a larger investment
can be justified with respect to the incremental
costs and benefits it produces

18
1B:Incrementalanalysisexample

Example 6-4: useful life=10 years MARR=10%, use

IRR and ERR
A B C D E F

Capital $900 $1,500 2,500 4,000 5,000 7,000

investment

Annual net 150 276 400 925 1125 1425

cash flow

19
1B:Incrementalanalysisexamplecost
alternatives
year design A design B design C
Three preliminary design
alternatives for a heavy- 0 -85600 -63200 -71800

duty industrial compressor. 1 -7400 -12100 -10050

MARR=12%per year. 2 -7400 -12100 -10050

Study period is 7 years.
3 -7400 -12100 -10050

4 -7400 -12100 -10050

5 -7400 -12100 -10050

6 -7400 -12100 -10050

7 -7400 -12100 -10050

20
1B:Incrementalanalysis

Study period=15 years MARR=10%

Mutually Exclusive Alternatives

P B1 B2 B3
Improve One-story Two-story Three-story
parking lot building building building
Capital $200,000 $4,000,000 $5,550,000 $7,500,000
investment
Net annual 22,000 600,000 720,000 960,000
income
Residual 100,000 2,000,000 2,775,000 3,750,000
value
IRR 9.3% 13.8% 11.6% 11.4%
21
1B.Incrementalanalysis

Equivalent worth methods may also be

applied using the incremental analysis
procedure to compare mutually exclusive
alternatives
Alternative ranking will be consistent with
equivalent worth values based on total
investment of each alternative
Ranking will be consistent with ROR methods
when using incremental analysis

22
2.UnequalUsefulLives

EXAMPLE
Machine A Machine B
First Cost $11,000 $18,000
Annual Operating Cost 3,500 3,100
Salvage Value 1,000 2,000
Life 6 years 9 years

i=15%peryear
Note:Wherecostsdominateaproblemitiscustomarytoassigna
positivevaluetocostandnegativetoinflows

23
2.ExampleUnequalUsefulLives

Acommonmistakeisto
computethepresent
worthofthe6yearproject
andcompareittothe
presentworthofthe9
yearproject.
NO!NO!NO!

24
2.UnequalUsefulLives

MachineA F6=$1,000

0123456

A16=$3,500
$11,000 F9=$2,000

0123456789
A19=$3,100
MachineB

i=15%peryear
$18,000

25
2.UnequalUsefulLives

2A. Repeatability assumption

Least Common Multiple of useful years
AW method
IRR method
2B. Coterminated assumption
Useful life < study period
Useful life > study period

26
2A.RepeatabilityAssumption
The study period over which the alternatives are
being considered is either indefinitely long or equal
to a common multiple of the lives of the alternatives.
The economic consequences that are estimated to
happen in an alternatives initial useful life span will
also happen in all succeeding life spans
(replacements)
Actual situations in engineering practice seldom meet both
conditions

27
2A:UnequalLives:2Alternatives

MachineA
6years 6years 6years

Cycle1forA Cycle2forA Cycle3forA

MachineB
9years 9years

Cycle1forB Cycle2forB

18years

i=15%peryear
LCM(6,9)=18yearstudyperiodwillapplyforprojectworth

28
2A:Example:UnequalLivesSolving

LCM = 18 years

Calculate the present worth of a 6-year cycle for A

PA=11,000+3,500(P|A,0.15,6)
1,000(P|F,0.15,6)
=11,000+3,500(3.7845)1,000(0.4323)
=$23,813,whichoccursattime0,6and12

29
2A:Example:UnequalLives

MachineA

061218

$23,813 $23,813 $23,813

PA= 23,813+23,813 (P|F, 0.15, 6)+

23,813 (P|F, 0.15, 12)
= 23,813 + 10,294 + 4,451 = 38,558

30
2A:UnequalLivesExample:MachineB

Calculate the Present Worth of a 9-year cycle

for B

F9=$2,000

0123456789
A19=$3,100

$18,000

31
2A:9YearCycleforB

Calculate the Present Worth of a 9-year cycle for B

PB = 18,000+3,100(P|A, 0.15, 9)
2,000(P|F, 0.15, 9)
= 18,000 + 3,100(4.7716) - 2,000(0.2843)
= $32,223 which occurs at time 0 and 9

32
2A:AlternativeB2Cycles
MachineA:PW=$38,558

0918

$32,223 $32,223

PB = 32,223 + 32,223 (P|F, 0.15, 9)

= 32,223 + 32,223(0.2843)
PB = $41,384
Choose Machine A
33
2A:AWandRepeatabilityAssumption

If two or more alternatives possess unequal

lives, then one need only evaluate the AW for
any given cycle
The annual worth of one cycle is the same as
the annual worth of the other cycles (by
assumption)

34
2A:AWmethodexample
Calculate the AW of Machine As 6-year cycle
AW(15%)A=11,000(A/P,15%,6)+3,500-
1,000(A/F,15%,6) =11000*0.2642+3500-
1000*0.1142 =6,292
Calculate the AW of Machine As 18-year cycle
AW(15%)=PW(15%)(A/P,15%,18)=38,558*0.1632=6,292.6
Calculate the AW of Machine Bs 9-year cycle
AW(15%)B=18000*(A/P,15%,9)+3100-
2000*(A/F,15%,9)=18000*0.2096+3100-2000*0.0596=6753.6
Calculate the AW of Machine Bs 18-year cycle
AW(15%)=PW(15%)*(A/P,15%,18)=41384*0.1632=6753.8

Choose Machine A because this is an annualized cost!

35
2A.IRRmethodunderRepeatability
assumption
IRRB-A: Form incremental cash flow of B-A for 18
years by repeating A three times and B two times
and then solve for AWB-A(i%)=0
Equivalent to solve for AW 6(i%)=AW 9(i%)
A B
Use linear interpolation:

AW (5%)=11000(A/P,5%,6)+3500-1000(A/F,5%,6)
A
=11000*0.1970+3500-1000*0.1470 =5520
AW (5%)=18000(A/P,5%,9)+3100-2000*(A/F,5%,9)
B

=18000*0.1407+3100-2000*0.0907=5451.2
Use AWA(15%)=6292, AWB(15%)=6754 and linear
interpolation, we find i%=6.37%.
36
2B.CoterminatedAssumption
A finite and identical study period is used for all
alternatives
This planning horizon, combined with appropriate
adjustments to the estimated cash flows, puts the
alternatives on a common and comparable basis
Used when repeatability assumption is not
applicable
Approach most frequently used in engineering
practice

37
2B.CoterminatedAssumption

1. Useful life < study period

a. Cost alternatives -- each cost alternative must
provide same level of service in the study
period : 1) contract for service or lease
equipment for remaining time; 2) repeat part of
useful life of original alternative until study
period ends
b. investment alternatives -- assume all cash
flows reinvested in other opportunities at MARR
to end of study period

38
2B.CoterminatedAssumptioncostalternatives
Suppose the study period is 9 years

MachineA F6=$1,000

0123456

A16=$3,500
$11,000 F6=$2,000

0123456789
A19=$3,100
MachineB

i=15%peryear
$18,000

39
2B.Exampleinvestmentalternatives

Coterminated A B
assumption with an six-
year study period Capital $3,500 $5,000
(alternative A would not investment
be repeated). Annual 1,255 1,480
MARR=10% cash flow

Useful life 4 6
(years

Salvage 1,000 1,000

value

40
2B.CoterminatedAssumption

2. Useful life > study period

Truncate the alternative at the end of the
study period using an estimated market
value. This method assumes disposable
assets will be sold at the end of the study
period at that value

41
2B.Example
Coterminated A B
assumption with an
four-year study period Capital $3,500 $5,000
MARR=10% investment

Annual 1,255 1,480

cash flow

Useful life 4 6
(years

Salvage 1,000 1,000

value

42
2B.Coterminatedassumption:theImputed
MarketValuetechnique
If the equipment can be sold, use the price as its
market value (salvage value) when the project is
terminated.
If its impossible to obtain an estimate for its market
price, you may use the imputed market value
technique.
MVT=[PW at the end of year T of remaining capital
recovery amounts] + [PW at the end of year T of
original market value at the end of useful life]

43
2B.Imputedmarketvaluetechnique

Imputed market value of B at the A B

end of year 4=
PW at end of year 4 of remaining
capital recovery Capital $3,500 $5,000
investment
+
PW at end of year 4 of the Annual cash 1,255 1,480
salvage value at end of year 6. flow

CR(10%)=5000(A/P,10%,6)- Useful life 4 6

1000(A/F,10%,6)=1018.4 (years
MV4=1018.4(P/A,10%,2)+1000(P/
Salvage 1,000 1,000
F,10%,2)=2593.8 value

44
3.CapitalizedWorthMethod
Capitalized Worth (CW) method -- Determining the
present worth of all revenues and / or expenses
over an infinite length of time
Capitalized cost -- Determining the present worth of
expenses only over an infinite length of time
Capitalized worth or capitalized cost is a convenient
basis for comparing mutually exclusive alternatives
when a period of needed services is indefinitely long
and the repeatability assumption is applicable

45
3.CapitalizedWorthMethod

CAPITALIZED Worth- the present worth of a

project that lasts forever.
Government Projects
Roads, Dams, Bridges (projects that possess
perpetual life)
Infinite analysis period

46
3.DerivationforCapitalizedWorth

Start with the closed form for the P/A factor

(1 + i ) 1 N
P = A N
i (1 + i )

Next, let N approach infinity and divide the numerator and

denominator by (1+i)N

47
3.DerivationContinued

Dividing by (1+i)N yields

1
1 (1 + i ) N
P = A
i

Now, let n approach infinity and the right
hand side reduces to.

48
3.DerivationContinued

1 A
P = A =
i i
Or,
CW(i%)=A/i

49
3.Example:CapitalizedCost

Assumeyouarecalledontomaintaina
cemeterysiteforeveriftheinterestrate=4%
and$50/yearisrequiredtomaintainthesite.

12345.. N=inf.

..
A=$50/yr

P=?
FindthePWofaninfiniteannuityflow

50
3.Example:CapitalizedCost

P0 = $50[1/0.04]
P0 = $50[25] = $1,250.00
Invest $1,250 into an account that earns 4%
per year will yield $50 of interest forever if the
fund is not touched and the i-rate stays
constant.

51
3.CapitalizedCost:Endowments

Assume a wealthy donor wants to endow a chair in

an engineering department.
The fund should supply the department with
$200,000 per year for a deserving faculty member.
How much will the donor have to come up with to
fund this chair if the interest rate = 8%/yr.

52
3.CapitalizedCost:EndowedChair

The department needs $200,000 per year.

P=$200,000/0.08=$2,500,000
If$2,500,000isinvestedat8%thentheinterestper
year=$200,000

The$200,000istransferredtothedepartment,but
theprincipalsumstaysintheinvestmentto
continuetogeneratetherequired$200,000

53
3.CapitalizedCostmoreexample

Calculate the Capitalized Cost of a project that has

an initial cost of $150,000. The annual operating
cost is $8,000 for the first 4 years and $4000
thereafter. There is an recurring $15,000
maintenance cost each 15 years.
Interest is 15% per year.

54
3. Cash Flow Diagram
i=15%/YR

012345671530

$4,000
$8,000
$15,000 $15,000 $15,000 $15,000
$150,000
N=

Howmuch$$att=0isrequiredtofundthisproject?

Thecapitalizedcostisthetotalamountof$att=0,
wheninvestedattheinterestrate,willprovideannual
interestthatcoversthefutureneedsoftheproject.

55
3.CapitalizedCostExampleContinued

1. Consider $4,000 of the $8,000 cost for the first

four years to be a one-time cost, leaving a $4,000
annual operating cost forever.
P0= 150,000 + 4,000 (P|A, 0.15, 4) =
$161,420 2.855

56
3.CAPITALIZEDCOST:OneCycle

Take any 15-year period and find the equivalent annuity for that
period using the A/F factor

.
015304560..

$15,000

Afora15yearperiod

57
3.CAPITALIZEDCOST

Recurring annual cost is $4,000 plus the equivalent

annual of the 15,000 end-of-cycle cost.
A= 4,000 + 15,000 (A|F, 0.15, 15)
= 4,000 + 15000 (.0210) = $4,315
Recurring costs = $4,315/i = 4,315/0.15 =$28,767

58
3.CAPITALIZEDCOST

Capitalized Cost = 161,420 + 4315/0.15

= $190,187
Thus, if one invests $190,187 at time t = 0, then the
interest at 15% will supply the end-of-year cash flow
to fund the project so long as the principal sum is
not reduced nor the interest rate changes (drops).

59