Engineering Economy

Assist. Prof. Krishna P. Gwachha

 Chapter 5, we learned how to evaluate the economic profitability (acceptability) of
a single alternative using various measures (PW, AW, FW, IRR, ERR).
 In Chapter 6, we will learn how to use these profitability measures to evaluate and
compare multiple alternatives. If we have mutually exclusive alternatives, then we
need to compare the alternatives against each other, and we can select at most one
alternative. (Do-nothing may be an implicit alternative.)
 If we have independent alternatives, then we need to compare each alternative
separately against the do-nothing alternative and decide whether it is acceptable or
not. We can select more than one alternative.
 We will focus on mutually exclusive alternatives

KP Gwachha (M.Phil) 2
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.
 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.
 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.
We will use two different methods: Equivalent-Worth (EW)methods
(PW, AW, FW) and Rate-of-Return methods (IRR).
Equivalent-Worth methods:
Procedure to find the best alternative using the equivalent-worth
methods:
1. Find the equivalent worth (EW) of each alternative at i%=MARR.
2. Investment alternatives: select the alternative with the greatest
positive equivalent worth.
3. Cost alternatives: select the alternative with the least negative
equivalent worth
KP Gwachha (M.Phil) 8
 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
 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
 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.
 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
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 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.
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.
 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.

 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.
 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
Alt. A Alt. B Alt. B-Alt. A
Initial cost -$25,000 -$35,000 -$10,000
Net annual income $7,500 $10,200 $3,200
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 income $2,500 $2,520 $3,050 $3,620 $4,400
IRR 12.99% 12.04% 13.48% 14.99% 14.61%
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 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 co-terminated assumption). This is most often used in engineering
practice because product life cycles are becoming shorter.
 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
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.
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 contamination, use any equivalent worth method using the cash flows
available for the study period.
KP Gwachha (M.Phil) 33
 Pause and Solve
• A project engineer with environment care is assigned to start up a new
office in a city. Two lease options are available, each with a first cost,
annual lease cost, and deposit-return estimates shown below. Determine
which lease option should be selected on the basis of a present worth,
future worth and annual worth comparison, if the MARR is 15% per year.
Location A Location B
First Cost (Rs.) (15000) (18000)
ALC (Rs) (3500) (3100)
Deposit Return 1000 2000
Life (Years) 6 9
 MEAs with unequal lives.....
The three mutually exclusive alternatives costs are associated with three tomato-
peeling machine being consider for use. If the canning company uses an interest
rate of 15%, which is the best alternatives?
Machine A B C
Initial Investment $2,000 $4,200 $ 7,000
Annual Maintenance & operating expenses $2,100 $4,000 $5,100
Annual revenue $3,200 $6,000 $8,000
Market value (EOL) $100 $420 $600
Useful life, years 5 10 10

KP Gwachha (M.Phil) 37
 Co-terminated Assumption

• Two cases are involved in the co-terminated assumption

Case 1: Useful life greater than the study period
Case 2: Useful life shorter than the study period
 Useful life less than the study period

• Two assumptions are considered:

1. Cash flow accumulated at the end of the useful life will be reinvested for
the extended periods.
2. Replacement/reinvestment is necessary for remaining period (Study
period – Useful life) and economic consequences that are estimated to
happen in an alternative’s initial life span will also happen in all succeeding
life spans)
 Pause and solve
Consider the following mutually exclusive projects. MARR = 10%
A B
Investment Rs. 350,000 Rs. 500,000
Annual revenue Rs. 190,000 Rs. 250,000
Annual cost 64,500 138,300
Useful life 4 years 8 years
Salvage value 0 0

Which alternative is more desirable based on the co-terminated

assumption.
 Considering assumption 1

FW = 205594.2958 FW =
{-350000(F/P,10%,4)+125500(F/A,10%,4)}(F/P,10%,4)
102502.37
 Considering assumption 2

FW = 205594.2958 FW =
-350000(F/P,10%,8) -350000(F/P,10%,8)+125500(F/A,10%,8)
172510
 Useful life greater than the study period

• The most common technique is to truncate the alternative at the end of

the study period using an estimated market value (Imputed market
value).
• This assumes that the disposable assets will be sold at the end of the
study period at the value derived from calculation.
 Pause and solve
• Use the imputed market value at the end of year five if the useful life of
the alternative is nine years, capital investment is Rs. 47600, market value
at the end of useful life is Rs. 5000, and MARR = 20%.
 Solution
PWCR = [47600(A/P,20%,9)-5000(A/F,20%,9)](P/A,20%4)
= 29949
Compute the PW at the end of year five, based on the original MV at the end
of useful life (9 years)
PW = 5000(P/F,20%,4)=2412
IMV = 29949+2412=32361
 Pause and solve
Using co-terminated assumption recommend the best project taking study
period at 5 years (TU, IOE, 2073)
Project A B
Initial investment 350000 500000
Annual Revenue 130000 175000
Annual cost 15000 25000
Salvage value 35000 50000
Useful life 5 years 8 years
MARR 10%
Solution

Using FW formulation
FWA (10%) = -350000(F/P,10%,5)+(130000-15000)(F/A,10%,5)+35000
= 563678.5+702086.5+35000
FWA (10%) = 173408
Contd….
Applying imputed market value calculation
PWCR (10%) = [500000(A/P,10%,8)-50000(A/F,10%,8)](P/A,10%,3)
= 222200
PW at year 5 of MV for remaining 3 years
PWMV (10%) = 50000(P/F,10%,3)
= 37565
Imputed Market value at the study period i.e. year 5
MV5 = PWCR (10%) + PWMV (10%)
= 222200 + 37565
= 259765 Contd….
Using FW formulation
FWB (10%) = -500000(F/P,10%,5)+(175000-25000)(F/A,10%,5)+259765
= -805255+915765+259765
FWB (10%) = 370275
FWB (10%) > FWA (10%), Recommend Project B
 IRR method for the unequal lives
• The IRR method can also be used to compare projects with unequal lives,
as long as we establish a common analysis period.
• This can be performed by using the Repeatability as well as co-terminated
assumptions.
 We can use incremental rate of return analysis on MEAs
with unequal lives.
Equate the MEAs annual worth's (AW) over their respective lives.
A B
Capital Investment $3,500 $5,000 If the company uses a
Annual Cash Flow $1,255 $1,480 MARR of 15%, which
is the best alternatives?
Useful Live (years) 4 6

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