Kathmandu University

Engineering Economy MGTS 301

Chapter-6
Comparison and
Selection among
Alternatives
 Kathmandu
University
Today’s class

Basic Concepts for Comparing Alternatives

The Study (Analysis) Period

Useful lives are Equal to the Study Period

Useful lives are Unequal among the Alternatives

2
 Kathmandu
University

The objective of chapter 6 is to evaluate

correctly capital investment alternatives
when the time value of money is a key
influence.
 Kathmandu
University

• 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.
 Kathmandu
University

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.
 Kathmandu
University

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.
 Kathmandu
University

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.)
 Kathmandu
University

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.
 Kathmandu
University

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.
 Kathmandu
University

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.
 Kathmandu
University

Cost alternative example

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.
 Kathmandu
University

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
 Kathmandu
University

Pause and solve

Best flight, Inc., is considering three mutual exclusive alternatives for
implementing an automated passenger chick-in counter at its hub airport. Each
alternative meets the same service requirements, but differences in capital
investment amounts and benefits exist among them. Market values of all
alternatives are assumed to be zero at the end of their useful lives. If the
MARR is 10% per year, which alternative should be selected?
Alternative
A1 A2 A3
Investment $390,000 $920,000 $660,000
Useful life 10 years 10 years 10 years
Total annual revenues $69,000 $167,000 $133,500
 A= $69,000 per year

Alternative A:
1 2 3 9 10

P0=$390,000 End of Year

A= $167,000 per year

Alternative B: 1 2 3 9 10

P0=$920,000 End of Year

A= $133,000 per year

Alternative C:

1 2 3 9 10

P0=$660,000 End of Year

   A
  𝑃𝑊 𝐴 (10 %)= $ 69,000 ¿
¿  − $ 390 , 000× 0.1627+ $ 69,000
¿  $ 69,000× 6.1446 − $ 390 , 000
¿  −63,453+ $ 69 , 000
¿  $ 423,977.4 − $ 390 , 000
¿  $ 5,547
¿  $ 𝟑𝟑 ,𝟗𝟕𝟕 . 𝟒

 𝑃𝑊 𝐵 (10 % )= $ 167,000 ¿   A

¿  $ 167,000 × 6.1446 − $ 920 , 000 A
 
¿  $ 1,026,148.2 − $ 920 ,000
¿  $ 𝟏𝟎𝟔 ,𝟏𝟒𝟖 . 𝟐
  F

  2.5937
 𝑃𝑊 𝐶 (10 %)=$ 133,500 ¿
¿  $ 1,099,680.6 − $ 1,011,543
¿  $ 133,500 × 6.1446 − $ 660 , 000
¿  $ 𝟖𝟖 ,𝟏𝟑𝟕 . 𝟔
¿  $ 820,304.1− $ 660 , 000
  F
¿  $ 𝟏𝟔𝟎 ,𝟑𝟎𝟒 . 𝟏
  F
 Kathmandu
University

Pause and solve

Four mutually exclusive alternatives are being evaluated, and their cost and revenues
are itemized below:

a) If the MARR=15% per year and the analysis period is 12 years, use PW method to
determine which alternatives are economically acceptable and which should be
selected.
b) If the total capital investment budget is available is $200,000, which alternative
should be selected?
Mutually Exclusive Alternative
A B C D
Capital investment $100,000 $152,000 $184,000 $220,000
Net annual income $15,200 $31,900 $35,900 $41,500
Market value 10,000 0 15,000 20,000
Useful life (years) 12 12 12 12
,  15%, 12)-$100,000
¿  $ 15,200 × 5.4206+$ 10,000 × 0.1869− $ 100 ,000
¿  $ 82,393.12+1,869 − $ 100 , 000
¿  − $ 𝟏𝟓 ,𝟕𝟑𝟕 .𝟖𝟖

-$152,000
 
¿  $ 31,900 × 5.4206− $ 152, 000
¿  $ 172,917.14 − $ 152 ,000
¿  $ 𝟐𝟎 , 𝟗𝟏𝟕 .𝟏𝟒

,  15%, 12)-$220,000
¿  $ 41,500 ×5.4206+ $ 20,000 ×0.1869 − $ 220 , 000
¿  $ 224,954.9+3,738− $ 220 ,000
¿  $ 𝟖 ,𝟔𝟗𝟐 . 𝟗
,  15%, 12)-$184,000
¿  $ 35,900 × 5.4206+$ 15,000 × 0.1869− $ 184 , 000
¿  $ 194,599.54 +2,803.5 − $ 184 , 000
¿  $ 𝟏𝟑 , 𝟒𝟎𝟑 .𝟎𝟒
 Kathmandu
University

Pause and solve

At the Motorola plant in Mesa, Arizona, it is desired to determine
whether one-inch-thick insulation or two inch-thick insulation
should be used to reduce heat loss from a long section of steam
pipe. The heat loss from this pipe without any insulation would cost
$2.00 per linear foot per year. The one-inch insulation will
eliminate 88% of the heat loss and will cost $0.60 per foot. Two
inch insulation will eliminate 92% of the heat loss and will cost
$1.10 per foot. The steam pipe is 1,000 feet in length and will last
for 10 years. MARR=6% per year. Which insulation thickness
should be recommended?
1-Inch of Insulation:
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
  𝐶𝑜𝑠𝑡 = ( 1000 𝑓𝑒𝑒𝑡 × $ 0.60 𝑝𝑒𝑟 𝑓𝑒𝑒𝑡 ) =$ 600

  𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐻𝑒𝑎𝑡 𝐿𝑜𝑠𝑠 =¿

 𝐴𝑊 ( 6 % )=− $ 600 ( 𝐴 / 𝑃 ,6 % , 10 ) − $ 240

 𝐴𝑊 ( 6 % )=− $ 600 × 0.1359− $ 240
= -$321.54
2-Inch of Insulation:
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
  𝐶𝑜𝑠𝑡 = ( 1000 𝑓𝑒𝑒𝑡 × $ 1.10 𝑝𝑒𝑟 𝑓𝑒𝑒𝑡 ) =$ 1,100

  𝐴𝑛𝑛𝑢𝑎𝑙 𝐶𝑜𝑠𝑡 𝑜𝑓 𝐻𝑒𝑎𝑡 𝐿𝑜𝑠𝑠 =¿

 𝐴𝑊 ( 6 % )=− $ 1100 ( 𝐴 / 𝑃 , 6 % , 10 ) − $ 160

 𝐴𝑊 ( 6 % )=− $ 1100 × 0.1359 −$ 160
= -$309.49

2-inches of Insulation should be recommended

 Pause and solve
The 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.

A B C
Investment cost $30,000 $60,000 $40,000
Estimated units to be sold/year 15,000 20,000 18,000
Unit selling price, $/unit $3.10 $4.40 $3.70
Variable cost, $/unit $1.00 $1.40 $0.90
Annual exp. (F/C) $15,000 $30,000 $25,000
Market value $10,000 $10,000 $10,000
Useful life 10 years 10 years 10 years

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 preferrable based on AW.
State your assumptions.
  A
¿  − $ 30 , 000× 0.2385 − $ 15 ,000+ $ 31500+ $ 10,000 ×0.0385
¿  $ 9,730

  A
¿  − $ 60 , 000 ×0.2385 − $ 30 , 000+$ 60,000+ $ 10,000 ×0.0385
¿  $ 16,075

  A
¿  − $ 40 , 000 ×0.2385 − $ 25 , 000+ $ 50,400+$ 10,000× 0.0385
¿  $ 16,245

Note: Calculation of sales revenue=sold unit/year × (unit selling price, $/unit – variable cost,
$/unit)
 Kathmandu
University

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).

• Co terminated 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.
 Kathmandu
University

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.
 Kathmandu
University

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
 Kathmandu
University

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.
 Kathmandu
University

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.
 Kathmandu
University

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.
 Kathmandu
University

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%

Both alternatives A and B are acceptable—each one has a rate of return that exceeds the
MARR=10%. 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…
 Kathmandu
University

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%

 Kathmandu
University

Pause and solve

Acme Molding is examining 6 mutually exclusive alternatives for a piece of
material handling equipment. Each has an expected life of 10 years with no
salvage value, and Acme’s MARR is 10% per year. 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 F
Capital investment $900 $1,500 $2,500 $4,000 $5,000 $7,000

Net annual income $150 $276 $400 $925 $1,125 $1,425

IRR 10.60% 13.00% 9.60% 19.10% 18.30% 15.60%

Above, only Alternative C is unacceptable and can be eliminated from the comparision because its IRR is less
than MARR of 10% per year. Also A is the base alternative from which to begin the increamental investment
analysis procedure, because it is the mutually exclusive alternative with the lowest capital investment whose IRR
is 10.6% is equal to or greater than MARR i.e. 10%.

Increment considered A ∆(B-A) ∆(D-B) ∆(E-D) ∆(F-E)

∆ Capital Investment $900 $600 $2,500 $1,000 $2,000
∆ Annual revenues less expenses $150 $126 $649 $200 $300
IRR∆ 10.5% 16.4% 22.6% 15.1% 8.1%
Is Incremental justified? Yes Yes Yes Yes No
 Kathmandu
University

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.
 Kathmandu
University

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.
 Kathmandu
University

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 co termination, use any equivalent worth method using

the cash flows available for the study period.
 Kathmandu
University

Bhairahawa Metal Company needs a car. The following

information are given below:
A B
Capital Investment Rs 50,000 Rs 50,000
Annual Cash Flow Rs 9,500 Rs 8,140
Useful Live (years) 10 15
MARR 10% 10%

These two types of car are mutually exclusive.

 A= $9,500 per year

1 2 3 9 10 11 12 13 19 20 21 22 23 29 30

P0=$50,000 P10=$50,000 P20=$50,000

End of Year

A= $8,140 per year

1 2 3 4 5 13 14 15 16 17 18 19 20 29 30

P0=$50,000 P15=$50,000

End of Year
,  10%, 10) $50,000(P/F , 10%, 20)
¿  $ 9 ,5 00 × 9.4269 − $ 50,000− $ 50,000 × 0.3855− $ 50,000× 0.1486
¿  $ 𝟏𝟐 , 𝟖𝟓𝟎 . 𝟓𝟓

,  10%, 15)
¿  $ 8 ,14 0× 9.4269 − $ 50,000 − $ 50,000× 0.2394
¿  $ 𝟏𝟒 ,𝟕𝟔𝟒 . 𝟗𝟕
 Kathmandu
University

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.
 Kathmandu
University

Pause and solve

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 method. Use repeatability assumption.
A B
Capital Investment $3,500 $ 5,000
Annual Cash Flow $ 1,255 $ 1,480
Useful Live (years) 4 6
Market value at the end of useful life 0 0
,  10%, 4) $3,500(P/F , 10%, 8)
¿  $ 1,255 × 6.8137 − $ 3,500 −$ 3,500× 0.6830 − $ 3,500× 0. 4665
¿  $ 𝟏𝟎𝟐𝟕 .𝟗

,  10%, 6)
¿  $ 1,48 0 × 6.8137 − $ 50,00− $ 50,00 × 0.5645
¿  $ 𝟐 ,𝟐𝟔𝟏 . 𝟕𝟖
 Kathmandu
University

Pause and solve

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 method. Use coterminated assumption.
A B
Capital Investment $3,500 $ 5,000
Annual Cash Flow $ 1,255 $ 1,480
Useful Live (years) 4 6
Market value at the end of useful life 0 0
 A= $1,255 per year
F4=$700.11=P4 F6=?

1 4 6
2 3 5
End of Year
PA=$3,500

A= $1,480 per year

1 6
2 3 4 5
End of Year
PB=$5,000
   F%,2)
.4641×
  (1.2100)
¿  $ 𝟖𝟒𝟕 .𝟏𝟑

  F
.7716
 
¿  $ 𝟐𝟓𝟔𝟏. 𝟎𝟖𝟖