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Decisions Under Certainty

This document discusses evaluation methods for mutually exclusive and independent projects. It provides examples of using net present worth to evaluate mutually exclusive alternatives that have different first costs and benefit amounts over different useful lives. It also discusses concepts like inflation, depreciation, replacement studies, and after-tax cash flows that are relevant to project evaluation. Worked examples are provided to illustrate calculations for mutually exclusive and replacement study problems.

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Jom Ancheta Bautista
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2K views23 pages

Decisions Under Certainty

This document discusses evaluation methods for mutually exclusive and independent projects. It provides examples of using net present worth to evaluate mutually exclusive alternatives that have different first costs and benefit amounts over different useful lives. It also discusses concepts like inflation, depreciation, replacement studies, and after-tax cash flows that are relevant to project evaluation. Worked examples are provided to illustrate calculations for mutually exclusive and replacement study problems.

Uploaded by

Jom Ancheta Bautista
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Decisions

Under
Certainty
Evaluation of Mutually Exclusive
Alternatives
When alternatives are mutually exclusive only one can be
selected because only one is needed. Therefore,
the alternatives are compared against each other and the one
having the most favorable PW is identified as “the best”.
Example:
1.Using a 10% interest rate, determine which alternative, if any, should be selected, based on net present
worth. Alternative A B First Cost $5,300 $10,700 Uniform Annual Benefit 1,800 2,100 Useful life 4 years 8
years

Solution

Alternative A:

NPW = 1,800(P/A, 10%, 8) - 5,300 - 5,300(P/F, 10%, 4)

= $683.10

Alternative B: NPW = 2,100(P/A, 10%, 8) - 10,700

= $503.50
2.Three purchase plans are available for a new car.
Plan A: $5,000 cash immediately
Plan B: $1,500 down and 36 monthly payments of $116.25
Plan C: $1,000 down and 48 monthly payments of $120.50
If a customer expects to keep the car five years and her cost of money is 18% compounded
monthly, which payment plan should she choose?

Solution:
i = 18/12 = 1½%

PWA = $5,000 PWB


= 1,500 + 116.25(P/A, 1½%, 36)
= $4,715.59

PWC = 1,000 + 120.50(P/A, 1½%, 48)


= $5,102.18
Therefore Plan B is the best plan.
3.Given the following three mutually exclusive alternatives Alternative A B C Initial Cost $50 $30 $40
Annual Benefits 15 10 12 Useful Life (years) 5 5 5
What alternative is preferable, if any, assuming i = 10%?

Solution :

PWA = -50 + 15(P/A, 10%, 5)


= $6.87

PWB = -30 + 10(P/A, 10%, 5)


= $7.91

PWC = -40 + 12(P/A, 10%, 5)


= $5.49
Choose C
4.Projects A and B have first costs of $6,500 and $17,000, respectively. Project A has net annual
benefits of $2,000 during each year of its 5-year useful life, after which it can be replaced
identically.

Project B has net annual benefits of $3,000 during each year of its 10-year life. Use present worth
analysis, and an interest rate of 10% to determine which project to select.

Solution:
PWA = -6,500[1 + (P/F, 10%, 5)] + 2,000(P/A, 10%, 10)
= $1,754.15

PWB = -17,000 + 3,000(P/A, 10%, 10)


= $ 1,435.00
Select A because of higher present worth
Evaluation of Independent
Projects
An Independent Project Evaluation is the evaluation of an
individual project designed to achieve specific objectives
within specified resources, in an adopted time span and
following an established plan of action, often within the
framework of a broader programme.
Inflation
Inflation is the decline of purchasing power of a given currency over
time. A quantitative estimate of the rate at which the decline in
purchasing power occurs can be reflected in the increase of an
average price level of a basket of selected goods and services in an
economy over some period of time. The rise in the general level of
prices, often expressed a a percentage means that a unit of currency
effectively buys less than it did in prior periods.
Example:
Effects of Inflation
Depreciation
Depreciation is defined as decrease in the value of a physical
property or asset with the passage of time. Depreciation, thus,
represents decrease in the value due to lessening in the ability to
produce these future cash flows, as a result of several causes such as
wear and tear and obsolescence.
after-tax cash flow
CFAT after taxes is a measure of cash flow that takes into account the
impact of taxes on profits. To calculate the after-tax cash flow,
depreciation must be added back to net income. Depreciation is a
non-cash expense that represents the declining economic value of an
asset but is not an actual cash outflow.
Replacement Studies
Replacement Studies Opportunity costs is a conceptual term referring to the
foregone returns of an investment not pursued, or what you will lose by not doing
anything Opportunity costs are most often representing in engineering economics
problems as the cash flows forfeited.

Replacement Studies When examining whether to continue using (economically) an


existing process or product (equipment), the calculation is called a replacement
study Any of the basic methods will work for comparison, but the annual cost
method is most common Existing equipment is sometimes called the defender and
the new is the challenger by not selling (replacing) an asset before its useful life is
up.
Example:
1.One of the four ovens at a bakery is being considered for replacement. Its salvage value and
maintenance costs are given in the table below for several years. A new oven costs $80,000 and this
price includes a complete guarantee of the maintenance costs for the first two years, and it covers a
good proportion of the maintenance costs for years 3 and 4. The salvage value and maintenance costs
are also summarized in the table.
Both the old and new ovens have similar productivities and energy costs. Should the oven be replaced this
year, if the MARR equals 10%?
2.The cash flow diagram below indicates the costs associated with a piece of equipment. The investment cost is $5,000
and there is no salvage. During the first 3 years the equipment is under warranty so there are no maintenance costs.
Then the estimated maintenance costs over 15 years follow the pattern shown in the cash flow diagram. Determine the
equivalent annual cost (EAC) for n = 12 if the minimum attractive rate of return (MARR) = 15%. Use gradient and
uniform series factors in your solution.
3.A manufacturer is contemplating the purchase of an additional forklift truck to improve material handling
in the plant. He is considering two popular models, the Convair T6 and the FMC 340. The relevant financial
data are shown below. The manufacturer’s MARR is 12%.

The FMC is more economical.


b. That either truck can be
1) repeated with identical costs indefinitely
2) the service to be provided (material handling) is required forever.
4.A graduate of an engineering economy course has complied the following set of estimated costs and salvage
values for a proposed machine with a first cost of $15,000; however, he has forgotten how to find the most
economic life. Your task is to show him how to do this by calculating the equivalent annual cost (EAC) for n =
8, if the minimum attractive rate of return (MARR) is 15%.
Remember: Calculate only one EAC (for n = 8). You are not expected to actually find the most economical
life.
5.Ten years ago, the Cool Chemical Company installed a heat exchanger in its plant for $10,000. The
company is considering replacing the heat exchanger because maintenance costs have been increasing.
The estimated maintenance costs for the next 5 years are as follow:

Whenever the heat exchanger is replaced, the cost of removal will be $1,500 more than the heat exchanger
is worth as scrap metal. The replacement the company is considering has an equivalent annual cost (EAC)
= $900 at its most economic life. Should the heat exchanger be replaced now if the company’s minimum
attractive rate of return (MARR) is 20%?
Reflection:

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