Chapter 4

Comparison Methods Part I

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Outline

4.1 Introduction
4.2 Relations Among Projects
4.3 Minimum Acceptable Rate of Return (MARR)
4.4 Present Worth (PW) and Annual Worth (AW) Comparisons
4.4.1 Present Worth Comparisons for Independent Projects
4.4.2 Present Worth Comparisons for Mutually Exclusive Projects
4.4.3 Annual Worth Comparisons
4.4.4 Comparison of Alternatives With Unequal Lives
4.5 Payback Period

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4.3 Minimum Acceptable Rate of Return
(MARR)

• Investing in a project implies foregoing the opportunity to

invest elsewhere.
• Any investment must earn at least enough to pay the “cost
of capital” (e.g. interest on loans)
• In business and engineering, the minimum acceptable
rate of return, often abbreviated MARR, is the minimum
rate of return on a project a manager or company is willing
to accept before starting a project, given its risk and the
opportunity cost of forgoing other projects.
• MARR: Interest rate required for any project to be
accepted.

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4.4 Present Worth (PW) and Annual Worth
(AW) Comparisons

• The Present Worth (PW) and Annual Worth (AW)

comparison methods are based on finding a
comparable basis to evaluate projects in monetary
units.
• With the Present Worth (PW) method, the analyst
compares (say) two projects A and B by computing
their present worth at the MARR.
• With the Annual Worth (AW) method, two projects
are compared by computing their annual worth at the
MARR.

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4.4.1 Present Worth Comparisons for
Independent Projects

• Consider the situation where we have n > 1

independent projects.
• We may invest in none (i.e., do nothing), 1, 2,
… or up to n of the projects.
• To “do nothing” usually means that the money
is invested elsewhere at a rate of return which
is at least the MARR.

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CLOSE-UP 4.1 Present Cost and Annual Cost

• Sometimes mutually exclusive projects are compared

in terms of present cost or annual cost.
• The best project is the one with the minimum present
worth of cost as opposed to the maximum present
worth.
• Two conditions for this to be valid:
– All projects must have the same major benefit
– The estimated value of the major benefit clearly outweighs
the projects’ costs
• The “do nothing” alternative is rejected.

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4.4.1 Present Worth Comparisons for
Independent Projects, cont’d

• Decision Rule:
– Select any project that has a PW  0
• Observe:
– Projects with a positive PW yield a rate of return >
MARR
– Projects with a zero PW yield exactly the MARR
– Projects with a negative PW yield less than the
MARR

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Practice Problem 4-2

• A software genius is selling the rights to a new video

game that he is developing right now. He has a
contract under consideration. It offers £10,000 at the
end of each year for the next 5 years, and then
£20,000 per year for the next 10 years.
• The genius has to pay £50 000 for development and
testing up front. His MARR is 9% per year.
• Should he take the contract? Base your analysis on a
PW analysis.

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Practice Problem 4-2, cont’d

Answer
PW = - 50,000 + 10,000(P/A,9%,5)
+ 20,000(P/A,9%,10)(P/F,9%,5)
= - 50,000 + 10,000(3.8896)
+ 20,000(6.4176)(0.64993)
= 72,316

Since the present worth is non-negative,

(PW = £72,316), he should take the contract

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4.4.2 Present Worth Comparisons for
Mutually Exclusive Projects

• Engineers are frequently asked to select the best of

several mutually exclusive project
• Decision Rule:
– Pick the project which has the greatest PW at the
MARR
• Note: For minimum cost problems, pick the project
which has the smallest present cost at the MARR

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Practice Problem 4-3

• A software genius is selling the rights to a new video game that

he is developing now. He has two contracts under
consideration.
• The first offers £10 000 at each year-end for the next 5 years,
and then £20 000 per year for the next 10 years.
• The second offers 10 payments starting with £10 000 at the end
of year 1, £13 000 at the end year 2, and so forth (G = £3000).
• The genius must invest £50 000 now for development and
testing for either option. If his MARR is 9%, which (if either)
contract should he choose?

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Practice Problem 4-3, cont’d

Answer
Contract 1:
PW(C1) = 72,316 (as before)
Contract 2:
PW(C2) = -50,000 +10,000(P/A,9%,10)
+ 3,000(A/G,9%,10)(P/A,9%,10)
= -50,000 + (P/A,9%,10)[10 000
+ 3000(A/G,9%,10)]
= -50,000 + 6.418 [ 10 000 + 3000(3.798) ]
= 87,295
The genius should choose the second contract as it has the greater PW.

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4.4.3 Annual Worth Comparisons

• AW comparisons are essentially the same as

PW comparisons, except that all
disbursements and receipts are transformed
into a uniform series at the MARR.
• AW comparisons may lead to amounts which
are easier to conceptualize than PW
amounts.

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4.4.3 Annual Worth Comparisons, cont’d

• A comparison of two projects that have the

same life by the present worth and annual
worth methods will always indicate the same
preferred alternative.
• Sometimes there is no clear justification for
using one method over the other except
computational ease or easier to grasp
mentally.

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Practice Problem 4-4

• CB Electronix needs to expand its plant. It is

considering two alternative plans. Both will last
indefinitely. The MARR is 15%. Use an AW
comparison to select the preferred alternative.
Plan 1: Expand by 20,000 square feet now
First cost = £2,000,000
Annual Maintenance costs = £10 000 per year
Periodic maintenance costs = £15 000 every 15
years, starting in 15 years

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Practice Problem 4-4, cont’d

• Plan 1: Expand by 20 000 square feet now

First cost = £2 000 000

Annual maintenance costs = £10,000/yr
Periodic maintenance costs = £15,000 every 15
years, starting in 15 years.

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Practice Problem 4-4, cont’d

• Plan 2: Expand by 12,500 square feet now and 7,500

square feet in 10 years.

First cost £1,250,000 £1,000,000

Annual maintenance cost £5,000 years 1-10 £11,000 starting

in year 11
Periodic maintenance costs N/A £15,000 every 15
years starting 15
years after 2nd
addition

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Practice Problem 4-4, cont’d

Answer
Plan 1

Using the capitalized cost formula for long lived assets:

P = A/i  A = Pi
AW = (2,000,000 i) + 10 000 + 15 000(A/F,15%,15)

AW = 2,000,000(0.15) + 10 000 + 15 000(0.02102)

= £310,315

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Practice Problem 4-4, cont’d

Answer
Plan 2

Step AW Equation Answer

1 First cost 1,250,000(0.15) + 1,000,000 (P/F,15%,10) (0.15) £224,578.50

2 Maintenance cost: 5000(P/A,15%,10)(0.15) £3,764.01

years 1 to 10
3 Maintenance cost: [(11,000)/(0.15)](P/F,15%,10) (0.15) £2,720.00
years 11 and on

4 Periodic [15000(A/F,15%,15)/(0.15)](P/F,15%,10)(0.15) £77.90

maintenance costs

Total £231 140

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Practice Problem 4-4, cont’d

Answer

AW of plan 1: £310,315

AW of plan 2: £231,140

Select plan 2, which has the lowest AW

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• Sometimes it may be desirable to compare

projects with the future worth (FW) method,
on the basis of the future worth of each
project.
• This is most likely true for cases where
money is being saved for some future
expense.

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4.4.4 Comparison of Alternatives With
Unequal Lives

• When making PW comparisons, the same

time period must always be used in order to
take into account the full costs and benefits of
each alternative.
– e.g. Compare two pieces of testing equipment for
printed circuit boards.
– One has a small first cost and a service life of 5
years, the other has a larger first cost and a
service life of 7 years.
– The need for the equipment continues indefinitely.

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4.4.4 Comparison of Alternatives With Unequal
Lives, cont’d

• If the service lives of alternative projects are unequal,

we can transform them into equal lives with one of
two methods:
– Repeated Lives Approach: Repeat the service life of each
alternative over the least common multiple of the service
lives (e.g., 35 years for the testing equipment).
– Study Period Approach: Adopt a specified study period for
comparison. Note that we need a salvage value for the
assets at the end of the study period.

• The two approaches may lead to different

conclusions.

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Practice Problem 4-5

• Sam is buying a refrigerator. He has two choices:

1. A used one, at £475, should last about 3 years.
2. A new one will cost £1250 and has an expected service life
of 8 years.

• Both will have a salvage value of £0 at the end of

their service life and will have similar operating costs.
Interest is at 8% per year.
• Which should Sam choose? Use a PW comparison
and the repeated lives approach.

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Practice Problem 4-5, cont’d

Answer
The least common multiple of the service lives is 24
years.
PW (used) = 475(A/P,8%,3)(P/A,8%,24) = 475(0.388 03)
(10.529) = £1940.65

PW (new) = 1250 + 1250(P/F,8%,8) + 1250(P/F,8%,16)

= 1250(1 + 0.54027 + 0.29189) = £2290.20

The used refrigerator has the lowest PW of costs over

the 24 years (£1940.65 vs. £2290.20).

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Practice Problem 4-6

• Sam is buying a refrigerator. He has two choices. A

used one, at £475, should last about 3 years and no
salvage value at that time. A new one will cost £1250
and has an expected service life of 8 years. Sam will
need a refrigerator for only 3 more years. At that time,
he expects that the new refrigerator will have a resale
value of £1000. Interest is at 8% per year.
• Which should Sam choose? Use a PW comparison
and the study period approach.

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Practice Problem 4-6, cont’d

Answer
PW (used) = £475.00

PW (new) = 1250 - 1000(P/F,8%,3) = 1250 - 1000(0.793

83) = £456.17

The new refrigerator has the smallest PW of costs

(£456.17 vs. £475.00), and is thus preferable.

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4.4.4 Comparison of Alternatives With Unequal
Lives, cont’d

• AW comparisons when the “repeated lives”

method is easy and convenient.
• Observe that the annual worth of a project
over one “life” is the same as its annual worth
over any number of lives.

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Practice Problem 4-7 (4-5 revisited)

• Which refrigerator should Sam choose? Use

the AW approach.

Answer
AWused = 475(A/P, 8%, 3) = £184.31
AWnew = 1250(A/P, 8%, 8) = £217.52

The used refrigerator has the lowest AW of costs

(£184.31 vs. £217.52).

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4.5 Payback Period

• Payback period: The number of years it

takes for an investment to be recovered when
the interest rate is assumed to be zero.
• It is the simplest method for judging the
economic viability of projects.

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4.5 Payback Period, cont’d

• If annual savings are constant, the payback

period is usually calculated as follows:

First cost
Payback period =
Annual savings

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4.5 Payback Period, cont’d

• If annual savings are not constant, the

payback period is computed by deducting
each year of savings from the first cost until
the first cost is recovered.
• According to the payback period method of
comparison, the project with the shorter
payback period is the preferred investment.

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4.5 Payback Period, cont’d

• As a common rule, a payback period of two

years is often considered acceptable.
• More than four years is unacceptable.
• The payback period need not, and perhaps
should not, be used as a the sole criterion for
evaluating projects.

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Practice Problem 4-8

• Two independent investment opportunities are

shown below. What is the payback period for each? If
you require a 3 year payback period, should none,
either or both be purchased?

Machine A Machine B

First cost £15 000 £20 000

Annual revenues 9000 11000

Annual costs 6000 8000

Scrap value 1000 2000

Service life 5 years 10 years
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Practice Problem 4-8, cont’d

Answer
Machine A:
First cost = £15 000
Annual net benefits = 9 000 - 6 000 = £3 000
Payback period = (15 000)/(3 000) = 5 years

Machine B:
First cost = £20 000
Annual net benefits = £11 000 - 8 000 = £3 000
Payback period = (20 000)/(3 000) = 6.7 years

(or, 7 years if you assume cash flows occur at year-end).

Machine A and machine B are rejected.

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