Engineering Economy

Lecture 5
Comparing Alternatives Chapter 6

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Making decisions means comparing alternatives

In this lecture we examine feasible design

alternatives.
The decisions considered are those selecting
from among a set of mutually exclusive
alternatives (MEA) —when selecting one
excludes the choice of any of the others.

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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 (PW, AW, FW)
provide the basis for economic comparison of the
alternatives.

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Apply this rule, based on Principle 2 from Chapter 1

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. This
alternative is the base alternative.

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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)

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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.

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Select the alternative that gives you the most money!

For investment alternatives the PW of all cash

flows must be positive, at the MARR, to be
attractive. Select the alternative with the largest
PW.
For cost alternatives the PW of all cash flows
will be negative. Select the alternative with the
largest (smallest in absolute value) PW.

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 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 expenses $34,000 $41,000

Both alternatives are attractive, but Alternative B provides

a greater present worth, so is better economically.
 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, so is better economically.
 Example
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
 Investment alternative example
Use a MARR of 10% and useful life of 4 years to select
between the investment alternatives below.
Alternative
A B Δ(B-A)
Capital investment -$60,000 -$73,000 -$13,000
Annual revenues less $22,000 $26,225 4,225
expenses

Both alternatives are attractive, but Alternative B provides

a greater present worth, so is better economically.
Cash Flows of Previous Example
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.

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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).
Coterminated 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.

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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).

Annual worth analysis—the decision is the same.

Example
A company is planning to install a new automated plastic-molding press. Four
different presses are available. The initial capital investments and annual
expenses for these four mutually exclusive alternatives are as follows:

Assume that each press has the same output capacity (120,000 units per year)
and has no market value at the end of its useful life; the selected analysis period
is five years; and any additional capital invested is expected to earn at least 10%
per year. Which press should be chosen if 120,000 nondefective units per year
are produced by each press and all units can be sold? The selling price is $0.375
per unit.

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Example (cont.)
Equivalent-Worth Values for Press 1

When compared the four alternative’s equivalent-worth values are as follows:

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Example (cont.)
Now suppose that each press is still capable of producing 120,000 total units
per year, but the estimated reject rate is different for each alternative. This
means that the expected revenue will differ among the alternatives since only
nondefective units can be sold. The data for the four presses are summarized
below. The life of each press (and the study period) is five years.

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Example (cont.)

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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), and the additional
investment in other alternatives must itself make a
satisfactory rate of return on that increment.

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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.

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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.

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 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…
 Example
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 $12,000 $12,500 $14,400 $16,250 $20,000
investment
Net annual $2,500 $2,520 $3,050 $3,620 $4,400
income
IRR 12.99% 12.04% 13.48% 14.99% 14.61%
Inconsistent Ranking Problem

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Incremental Analysis Procedure

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Incremental Analysis Example

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Incremental Analysis Example (Cont.)

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Comparing MEAs with unequal lives.

• The repeatability assumption, when applicable,

simplifies 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.
– An alternative is to invest the money from the short
period project inside the company at MARR

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The useful life of an alternative is less than the study period

Cost alternatives
Contracting or leasing for remaining years may be
appropriate
Repeat part of the useful life and use an estimated
market value to truncate
Investment alternatives
Cash flows reinvested at the MARR at the end of the
study period
Replace with another asset, with possibly different cash
flows, after the study period

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The repeatability assumption: Example
The following data have been estimated for two mutually
exclusive investment alternatives, A and B, associated with a
small engineering project for which revenues as well as expenses
are involved. They have useful lives of four and six years,
respectively. If MARR = 10% per year, show which alternative is
more desirable by using equivalent-worth methods. Use the
repeatability assumption.

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The repeatability assumption: Example
The least common multiple of the
useful lives of Alternatives A and B is
12 years. Using the repeatability
assumption and a 12-year study
period, the first like (identical)
replacement of Alternative A would
occur at EOY four, and the second
would be at EOY eight. For Alternative
B, one like replacement would occur at
EOY six.
The PW (or FW) solution must be
based on the total study period (12
years). The PW of the initial useful life
cycle will be different than the PW of
subsequent replacement cycles

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Coterminated assumption: Example
Suppose that the previous example is
modified such that an analysis period of
six years is used (coterminated
assumption) instead of 12 years, which
was based on repeatability and the least
common multiple of the useful lives.
Perhaps the responsible manager did not
agree with the repeatability assumption
and wanted a six-year analysis period
because it is the planning horizon used in
the company for small investment
projects.

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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 market value.
The underlying principle in all such analysis is
to compare the MEAs in a decision situation
over the same study (analysis) period.

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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 cotermination, use any equivalent worth
method using the cash flows available for
the study period.

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We can use incremental rate of return
analysis on MEAs with unequal lives.
Equate the MEAs annual worths (AW) over their
respective lives.
A B
Capital Investment $3,500 $5,000
Annual Cash Flow $1,255 $1,480
Useful Live (years) 4 6

Solving, we find i*=26%, so Alt B is preferred.

Examples
Three mutually exclusive design alternatives are being considered. The
estimated sales and cost data for each alternative are given below. The
MARR is 20% per year. Annual revenues are based on the number of
units sold and the selling price. Annual expenses are based on fixed
and variable costs. Determine which selection is preferable based on
AW. State your assumptions.

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Examples
An airport needs a modern material handling system for
facilitating access to and from a busy maintenance hangar. A
second-hand system will cost $75,000. A new system with
improved technology can decrease labor hours by 20% compared
to the used system. The new system will cost $150,000 to
purchase and install. Both systems have a useful life of five years.
The market value of the used system is expected to be $20,000 in
five years, and the market value of the new system is anticipated
to be $50,000 in five years. Current maintenance activity will
require the used system to be operated 8 hours per day for 20
days per month. If labor costs $40 per hour and the MARR is 1%
per month, which system should be recommended?

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Examples
Three mutually exclusive design alternatives are being considered.
The estimated cash flows for each alternative are given next. The
MARR is 20% per year. At the conclusion of the useful life, the
investment will be sold. A decision-maker can select one of these
alternatives or decide to select none of them. Make a
recommendation using the PW method.

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Examples
On her thirty-first birthday, Jean invests $1,000 into her
employer’s retirement plan, and she continues to make annual
$1,000 payments for 10 years. So her total contribution (principal)
is $10,000. Jean then stops making payments into her plan and
keeps her money in the savings plan untouched for 25 more years.
Doug starts putting money aside on his forty-first birthday when
he deposits $1,000, and he continues these payments until he
gets to be 65 years old. Doug’s contributed principal amounts to
$25,000 over this period of time. If Jean’s and Doug’s retirement
plans earn interest of 6% per year, how much will they have
accumulated (principal plus interest) when they reach 65 years
old? What is the moral of this situation?

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Examples
Acme Semiconductor is expanding its facility and needs to add equipment.
There are three process tools under consideration. You have been asked to
perform an economic analysis to select the most appropriate tool to
acquire. You have gathered the following information for evaluation. Each of
these tools has a useful life of seven years. Acme’s accounting staff has
established a company-wide MARR of 8% per year. Which one of the
process tools should be selected?

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Examples
Consider the following two mutually exclusive
alternatives for reclaiming a deteriorating inner-city
neighborhood (one of them must be chosen). Notice
that the IRR for both alternatives is 27.19%.
a. If MARR is 15% per year,
which alternative is better?
b. What is the IRR on the
incremental cash flow
c. If the MARR is 27.5% per
year, which alternative is better?
d. What is the simple payback
period for each alternative?
e. Which alternative would you
recommend?

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Examples
The purchase of a new medium-sized, truck-mounted crane is being
evaluated. The economic estimates for the two best alternatives are shown
in the following table. You have selected the longest useful life (nine years)
for the study period and would lease a crane for the final three years under
Alternative A. On the basis of previous experience, the estimated annual
leasing cost at that time will be $66,000 per year (plus the annual expenses
of $28,800 per year). The MARR is 15% per year. Show that the same
selection is made with
a. the PW method.
b. the IRR method.
c. the ERR method.

d. Would leasing Crane A for nine years, assuming the same costs per year as
for three years, be preferred over your present selection? (∈ = MARR = 15%).

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Examples
Potable water is in short supply in many countries. To address
this need, two mutually exclusive water purification systems
are being considered for implementation in China. Doing
nothing is not an option. Refer to the data below and state your
key assumptions in working this problem.
Use the PW method to determine which system should be
selected when MARR = 8% per year.
Which system should be selected when MARR = 15% per year?

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Examples
Two mutually exclusive alternatives for office building
refrigeration and air conditioning are being investigated. Their
relevant costs and lives are summarized as follows. If the hurdle
rate (MARR) is 15% per year and the study period is 18 years,
which chilling system should be recommended?

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Examples
Compare the probable part cost from Machine A and Machine
B, assuming that each will make the part to the same
specification. Which machine yields the lowest part cost?
Assume that the MARR = 10% per year.
If the cost of labor can be cut in half by using part-time
employees, which machine should be recommended?

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Examples
Three mutually exclusive earth-moving pieces of equipment
are being considered for several large building projects in India
over the next five years. The estimated cash flows for each
alternative are given below. The construction company’s MARR
is 15% per year. Which of the three alternatives, if any, should
be adopted? State your main assumptions.

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