Chapter 6.

COMPARING
ALTERNATIVES

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1
 Introduction
In the real world, the majority of engineering economic
analysis problems are alternative comparisons or the
selection of best option from alternatives. We all know that
a certain engineering problems may come up into more
feasible solutions. In these case, two or more mutually
exclusive investments compete for limited funds. A variety
of methods exists for selecting the superior alternative
from a group of proposals. These methods includes rate of
return, annual worth, present worth, future worth and
payback period and cost-benefit analysis.
This topic is very helpful in analyzing and choosing the
best alternative considering economic factors.
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 Learning Objectives

Determine the basic principles of

comparing alternatives

Apply methods in comparing

alternatives
Compare alternatives based
on economic decisions.

Choose best alternative based on

methods being applied
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 Basic Concepts for Comparing Alternatives
Principle 1. Emphasized that a choice or decision is among
alternatives. Such choices must incorporate the fundamental
purpose of capital investment. In practice, there are usually a limited
number of feasible alternatives to consider for an engineering
project. The problem of deciding which mutually exclusive
alternative should be selected is made easier if we adopt different
methods.
Principle 2 (focus on the differences). 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.
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 Methods of Comparing Alternatives
We consider different methods on alternative comparison.
This methods includes;

1. Present Worth Method

2. Future Worth Method
3. Annual Cost Analysis
4. Rate of Return

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 Methods of Comparing Alternatives
1. Present Worth Analysis.
When two or more alternatives are capable of performing the same
functions, the economically superior alternative would be the largest
present worth. The present worth method is restricted to evaluating
alternatives that are mutually exclusive and that have the same lives.
This method is suitable for ranking the desirability of alternatives.

In this method, we consider the possible inflows (cash-in) and

outflows (cash-out) in an engineering projects. All inflows and
outflows were turned into the present value of money. In this case,
we choose best alternative based on the largest present value. On the
other hand, some cases considers only the cost of the project. From
that point since we are pertaining to cost, the alternative with least
present worth cost is the best option.
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 Methods of Comparing Alternatives
Example 1. Consider the following information in determining the
best alternative using present worth analysis.

Parameters Alternatives
A B
Capital Investment $60,000 $73,000
Annual revenue less expenses $22,000 $26,225

The useful life of each alternatives is 4 years and with minimum

required rate of return of 10%. Which is the best alternative?

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 Present Worth Analysis
Solution: The present worth of alternative A and B would
be cash inflow less the outflow. From the given problem,
annual revenue would be the inflow and capital invested as
outflow.

Since we are considering present value or amount of

money today, capital investment is already at present time,
while annual revenue could be turned into present value by
simple using ordinary annuity since it occurs annually for
4 years.

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 Present Worth Analysis
Solution: Solving for the present value of A and B

PWA = Inflow – Outflow

𝑃𝑊𝐴 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
1−(1+0.10)−4
𝑃𝑊𝐴 = $22,000 − $60,000 = $9,738
0.10

PWB = Inflow – Outflow

𝑃𝑊𝐵 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
1−(1+0.10)−4
𝑃𝑊𝐴 = $26,225 − $73,000 = $10,131
0.10

Therefore choose alternative B since it has greater present worth

value
9
than A.
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 Present Worth Analysis
Example 2. A company is considering two types of equipment for
its manufacturing plant. Pertinent data are as follows:

Parameters A B
First Cost P200,000 P300,000
Annual Operating Cost 32,000 24,000
Annual Labor Cost 50,000 32,000
Insurance and Property Taxes 3% 3%
Payroll Taxes 4% 4%
Estimated useful life 10 10

If the minimum required rate of return is 15%, which equipment

should be selected using present worth cost method?
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 Present Worth Analysis
Solution. In this case, all the given data are cost. We need to just
bring the money into present value and sum up. Alternative with
least cost is desirable.

Parameters A B
First Cost P200,000 P300,000
Annual Operating Cost 32,000 24,000
Annual Labor Cost 50,000 32,000
Insurance and Property Taxes 6,000 (3% of first cost) 9,000 (3% of first cost)
Payroll Taxes 2,000 (4% of labor cost) 1,280 (4% of labor cost)
Total Annual Cost 90,000 66,280

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 Present Worth Analysis
Solution. Compute for the present worth cost of both
alternatives.

𝑃𝑊𝐶𝐴 =
𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 + 𝐴𝑛𝑛𝑢𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
1−(1+0.15)−10
𝑃𝑊𝐶𝐴 = 𝑃200,000 + 𝑃90,000 = $651,689.18
0.15

𝑃𝑊𝐶𝐵 = 𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 + 𝐴𝑛𝑛𝑢𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

1−(1+0.15)−10
𝑃𝑊𝐶𝐴 = 𝑃300,000 + 𝑃66,280 = $632,643.99
0.15

Therefore, choose alternative B since it has less present worth

cost than A.

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 Future Worth Analysis
2. Future Worth Analysis.
The future worth method for economy studies is
exactly comparable to the present worth method
except that all cash inflows and outflows are
compounded forward to a reference point in time
called the future.

Same with present value, all inflows and outflows

should be forwarded to future. The alternative with
highest future value is desirable. On the other hand, if
it pertains to cost, alternative with least value is
desirable.
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 Future Worth Analysis
Example 3. Considering the given example for
present worth method;
Parameters Alternatives
A B
Capital Investment $60,000 $73,000
Annual revenue less expenses $22,000 $26,225

The useful life of each alternatives is 4 years and with

minimum required rate of return of 10%. Which is the
best alternative?

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 Future Worth Analysis
Solution. Take note the investment is present value, we need to bring it
now at future reference point. For annual revenue, we can get the future
value using the formula in getting F in ordinary annuity.

Solve for future value of alternative A and B

FWA = Inflow – Outflow
F𝑊𝐴 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(1+0.10)4 −1
F𝑊𝐴 = $22,000 − $60,000 (1 + 0.10)4 = $14,256.00
0.10

FWB = Inflow – Outflow

F𝑊𝐵 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
(1+0.10)4 −1
F𝑊𝐵 = $26,225 − $73,000 (1 + 0.10)4 = $14,830.93
0.10
Therefore choose alternative B since it has higher value compared to A
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 Future Worth Analysis
Example 4. Considering now costs as the given data.

Parameters A B
First Cost P200,000 P300,000
Annual Operating Cost 32,000 24,000
Annual Labor Cost 50,000 32,000
Insurance and Property Taxes 3% 3%
Payroll Taxes 4% 4%
Estimated useful life 10 10

If the minimum required rate of return is 15%, which equipment

should be selected using future worth cost method?

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 Future Worth Analysis
Solution. This time forwarded the value into future time. Alternative with
lower future worth cost is advisable to choose.

Parameters A B
First Cost P200,000 P300,000
Annual Operating Cost 32,000 24,000
Annual Labor Cost 50,000 32,000
Insurance and Property Taxes 6,000 (3% of first cost) 9,000 (3% of first cost)
Payroll Taxes 2,000 (4% of labor cost) 1,280 (4% of labor cost)
Total Annual Cost 90,000 66,280

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 Future Worth Analysis
Solution. This time forwarded the value into future time. Alternative with
lower future worth cost is advisable to choose.

Compute for the present worth cost of both alternatives.

F𝑊𝐶𝐴 =
𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 + 𝐴𝑛𝑛𝑢𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠
(1+0.15)10 −1
F𝑊𝐶𝐴 = 200,000(1 + 0.15)10 + 𝑃90,000 = $2,636,446.19
0.15

F𝑊𝐶𝐵 = 𝐹𝑖𝑟𝑠𝑡 𝐶𝑜𝑠𝑡 + 𝐴𝑛𝑛𝑢𝑎𝑙 𝐸𝑥𝑝𝑒𝑛𝑠𝑒𝑠

(1+0.15)10 −1
F𝑊𝐶𝐵 = 300,000(1 + 0.15)10 + 𝑃66,280 = $2,559,397.77
0.15

Therefore, choose alternative B since it has less future worth cost than A.

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 Annual Cost Analysis
3. Annual Cost Analysis.
Alternatives that accomplish the same purpose but that have
unequal lives must be compared by the annual cost method.
The annual cost method assumes that each alternative will be
replaced by an identical twin at the end of its useful life (i.e.,
infinite renewal).
At this case, we need to get the depreciation cost of an
investment using sinking fund method of depreciation. The
alternative with least cost is advisable or desirable.
The calculated annual cost is known as the equivalent uniform
annual cost (EUAC) or equivalent annual cost (EAC). Cost is
a positive number when expenses exceed income.
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 Annual Cost Analysis
Example 5.
Choose from two machines which is more economical using annual
cost analysis. Money is worth at 16% as the rate.

Parameters Machine A Machine B

First Cost P8,000 P14,000
Salvage Value 0 2,000
Annual Operation 3,000 2,400
Annual Maintenance 1,200 1,000
Taxes and insurance 3% 3%
Useful life in years 10 15

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 Annual Cost Analysis
Solution.
Calculate annual costs including the depreciation and interest on
capital.

Compute for the depreciation cost of both alternatives using sinking

fund method with 16% as interest rate use the formula;
𝑖
𝑑 = (𝐹𝐶 − 𝑆𝑉)
(1 + 𝑖)𝐿 −1
For machine A
0.16
𝑑𝐴 = 8,000 − 0 10 = 375.21
1+0.16 −1

For machine B
0.16
𝑑𝐵 = 14,000 − 2000 = 232.29
1+0.16 15 −1
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 Annual Cost Analysis
Solution.
Create a table for annual expenses
Parameters Machine A Machine B
Depreciation P375.21 P232.29
Annual Operation 3,000 2,400
Annual Maintenance 1,200 1,000
Taxes and insurance 240 420
Interest on capital 1,280 (16% of first 2,240 (16% of
cost) original cost)
Total annual expenses P6,095.21 P6,292.91

Therefore, choose machine A since it has less annual expenses

compared to B.
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 Rate of Return
4. Rate of Return
An intuitive definition of the rate of return (ROR) is the effective
annual interest rate at which an investment accrues income. That is,
the rate of return of an investment is the interest rate that would yield
identical profits if all money was invested at that rate. Although this
definition is correct, it does not provide a method of determining the
rate of return.

In this case, choose the alternative that satisfy the minimum rate of
return. For the computation of the rate of return, use the formula;
𝑁𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑃𝑟𝑜𝑓𝑖𝑡 Note: In RoR, interest on capital is not
𝑅𝑜𝑅 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 included. If it all pertains to cost then
replace net annual profit to annual
expenses.
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 Rate of Return
Example 6. Consider the given example in annual worth analysis.

Money is worth at 16% as the rate. Which machine is more

economical using RoR?

Parameters Machine A Machine B

First Cost P8,000 P14,000
Salvage Value 0 2,000
Annual Operation 3,000 2,400
Annual Maintenance 1,200 1,000
Taxes and insurance 3% 3%
Useful life in years 10 15
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 Rate of Return
Solution. Since we already computed the depreciation from the
previous method, we will just exclude the interest on capital from the
table.

Parameters Machine A Machine B

Depreciation P375.21 P232.29
Annual Operation 3,000 2,400
Annual Maintenance 1,200 1,000
Taxes and insurance 240 420
Total annual expenses P4,815.21 P4,052.29

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 Rate of Return
Solution. Here how to compute the RoR for comparing
alternatives. Use the formula;
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝐴 − 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 (𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝐵)
𝑅𝑜𝑅 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝐴 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 (𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝐵)

To avoid negative answer, use absolute value for the obtained

answer.

For the decision, if RoR is less that minimum required rate of return,
choose the alternative with less investment or first cost, otherwise if
the RoR satisfied the minimum required rate of return, choose
alternative with higher investment.

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 Rate of Return
Solution.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝐴 − 𝐴𝑛𝑛𝑢𝑎𝑙 𝑐𝑜𝑠𝑡 (𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝐵)
𝑅𝑜𝑅 =
𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝐴 − 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 (𝑚𝑎𝑐ℎ𝑖𝑛𝑒 𝐵)

𝑃4,815.21 − 𝑃4,052.29
𝑅𝑜𝑅 =
𝑃8,000 − 𝑃14,000

RoR = 12.71%

Since the computed RoR did not satisfies the minimum required rate
of return, choose machine A since it has a lower investment
compared to machine B.

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 Chapter Test
Direction. Solve the given problem.
Problem 1. A company is going to buy a new machine for manufacturing its
product. Three different machines are available. Cost, operating and other expenses
are as follows:
Money is worth 17% before taxes to the company. Which machine 1 be chosen?
(Using ROR, Annual Cost method, present worth method and future worth
method)

Parameters A B C
First Cost P24,000 P30,000 P49,600
Power per year 1,300 1,360 2,400
Labor per year 11,600 9,320 4,200
Maintenance per year 2,800 1,900 1,300
Taxes and insurance 3% 3% 3%
Useful life 5 5 5

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