UNIT 3

Comparison of Alternatives
Most decisions are based on economic criteria. Investments are unattractive, unless it seems likely they will be recovered with interest. Economic decisions can be divided into two classes: 1. Income-expansionthat is, the objective of capitalism 2. Cost-reductionthe basis of profitability Fire protection engineering economic analysis is primarily concerned with cost-reduction decisions, finding the least expensive way to fulfill certain requirements, or minimizing the sum of expected fire losses plus investment in fire protection. There are four common methods of comparing alternative investments: (1) present worth, (2) annual cost, (3) Rate of return and (4) benefit-cost analysis. Each of these is dependent on a selected interest rate or discount rate to adjust cash flows at different points in time. Discount Rate The term discount rate is often used for the interest rate when comparing alternative projects or strategies. Selection of discount rate: If costs and benefits accrue equally over the life of a project or strategy, the selection of discount rate will have little impact on the estimated benefit-cost ratios. However, most benefits and costs occur at different times over the project life cycle. Thus, costs of constructing a fireresistive building will be incurred early in contrast to benefits, which will accrue over the life of the building. The discount rate then has a significant impact on measures such as benefit-cost ratios, since the higher the discount rate, the lower the present value of future benefits. In view of the uncertainty concerning appropriate discount rate, analysts frequently use a range of discount rates. This procedure indicates the sensitivity of the analysis to variations in the discount rate. In some instances, project rankings based on present values may be affected by the discount rate Inflation and the discount rate: Provision for inflation may be made in two ways: (1) estimate all future costs and benefits in constant prices, and use a discount rate which represents the opportunity cost of capital in the absence of inflation; or (2) estimate all future benefits and costs in current or inflated prices, and use a discount rate which includes an allowance for inflation. The discount rate in the first instance may be considered the real discount rate, while the discount rate in the second instance is the nominal discount rate. The use of current or inflated prices with the real discount rate, or constant prices with the nominal discount rate, will result in serious distortions in economic analysis. Present Worth In a present worth comparison of alternatives, the costs associated with each alternative investment are all converted to a present sum of money, and the least of these values represents the best alternative. Annual costs, future payments, and gradients must be brought to the present. Converting all cash flows to present worth is often referred to as discounting.

The Present worth Method of comparison: The Present Worth method evaluates the desirability of an alternative relative to some base point in time called the present (usually year 0). Basically, it looks at the present equivalent of all the cash flows of an alternative's study period. An alternative is profitable if its PW (MARR)>=0. When choosing from a set of alternatives, the most desirable is the alternative with the most positive present worth. To find PW as a function of i % (per interest period) of a series of cash inflows and outflows, it is necessary to discount future amounts to the present by using the interest rate over the appropriate study period (years, for example) in the following manner:

Where i = effective interest rate, or MARR, per compounding period k= index for each compounding period Fk= future cash flows at the end of period k N = number of compounding periods in the planning horizon (i.e., study period) The Present Worth Method: Example: You have the opportunity to invest in a new project with the following estimated cash flows and information: Investment Cost Annual Receipts Annual Expenses Expected Life If your MARR is 10%, is this project profitable? (Use PW) Solution: To find the PW at the MARR, we need to find the present equivalent of all the cash flows involved: PW(MARR) = -$5,000 + (1,300 - 350)(P/A,MARR,8) PW(10%) = -$5,000 + 950(P/A,10%,8) PW(10%) = -$5,000 + 950(5.3349) PW(10%) = $68.16 Since PW(MARR) > 0, the project is profitable. $5,000 1,300 350 8 years

The Future worth Method of comparison

The Future Worth method evaluates the desirability of an alternative relative to some future point in time, such as the end of the study period. An alternative is profitable if its FW(MARR)>=0. When choosing from a set of alternatives, the most desirable is the alternative with the most positive annual worth.

Example You have the opportunity to invest in a new project with the following estimated cash flows and information: Investment Cost Annual Receipts Annual Expenses Expected Life $5,000 1,300 350 8 years

If your MARR is 10%, is this project profitable? (Use FW at the end of the study period) Solution: To find the FW at the MARR, we need to find the EOY 8 equivalent of all the cash flows involved: FW (MARR) = -$5,000(F/P, MARR, 8) + (1,300 - 350)(F/A, MARR, 8) FW (10%) = -$5,000(F/P, 10%, 8) + 950 (F/A, 10%, 8) FW (10%) = -$5,000(2.1436) + 950(11.4359) FW (10%) = $146.11 Since FW (MARR) > 0, the project is profitable.

The Annual Worth Method of comparison

The Annual Worth method evaluates the desirability of an alternative as an equal annual series of cash flows during the study period. Basically, it looks at the annual equivalent of all the cash flows of an alternative. An alternative is profitable if its AW (MARR)>=0. When choosing from a set of alternatives, the most desirable is the alternative with the most positive annual worth. The AW of a project is annual equivalent revenues or savings (R) minus annual equivalent annual expenses (E), less its annual equivalent Capital Recovery (CR) amount, which is can be calculated by, CR(i%)=I(A/P, i%, N)-S(A/F, i%, N) where, I= initial investment for the project S=salvage(market) value at the end of the study period N=project study period An annual equivalent value pf R, E and CR is computed for the study period, N, which is usually in years. In euation form the AW, which is a function of i%, is N, which is usually in years. The AW can be calculated by the following formula, AW(i%)=R-E-CR(i%) Also, we need to notice that the AW of a project is equivalent to its PW and FW. That is, AW=PW(A/P, i%,N) and AW=FW(A/F,i%,N). Hence, it can be computed for a project from these equivalent values. The AW worth is most useful when comparing alternatives with unequal expected lives.

Example: You have the opportunity to invest in a new project with the following estimated cash flows and information: Investment Cost Annual Receipts Annual Expenses Expected Life If your MARR is 10%, is this project profitable? (Use AW) $5,000 1,300 350 8 years

Solution: To find the AW at the MARR, we need to find the annual equivalent of all the cash flows involved: AW (MARR) = -$5,000(A/P, MARR, 8) + (1,300 - 350) AW(10%) = -$5,000(A/P, 10%, 8) + 950 AW(10%) = -$5,000(0.1874) + 950 AW(10%) = $13.00 Since AW(MARR) > 0, the project is profitable. Example I: Choosing among investment alternatives. ABC Company is evaluating three new product lines. All relevant estimates are supplied in the table below. If the company's MARR is 15%, which alternative should they pursue? PRODUCT A 120,000 45,000 13,500 10,000 6 years PRODUCT B 140,500 53,000 18,000 5,000 6 years PRODUCT C 150,000 52,000 12,000 12,000 6 years

Investment Est. Annual Sales Est. Annual Expenses Salvage Value Expected Life Solution

Although no method was specified, PW is usually the most straightforward to use. Since all 3 products have expected lives of 6 years, PW is a good choice. We'll also assume that the study period is 6 years. Now, we just have to calculate the PW of each alternative. Remember, since these are investment alternatives, Do Nothing is also a possible choice, if none of the alternatives prove profitable with a MARR of 15%. PWA = -$120,000 + (45,000-13,500)(P/A, 15%,6) + 10,000(P/F, 15%, 6) PWA = -$120,000 + 31,500(3.7845) + 10,000(0.4323) PWA = $3,535 PWB = -$140,500 + (53,000-18,000)(P/A, 15%,6) + 5,000(P/F, 15%, 6) PWB = -$140,500 + 35,000(3.7845) + 5,000(0.4323) PWB = -$5,381 PWC = -$150,000 + (52,000-12,000)(P/A, 15%,6) + 12,000(P/F, 15%, 6) PWC = -$150,000 + 40,000(3.7845) + 12,000(0.4323) PWC = $6,567 Since PWB<0, it can immediately be ruled out as an option since at a MARR of 15% it is not profitable. The final choice must be made between products A and B, both have PW>0. Since PWC>PWA, Product C is the final choice, since it is the most profitable - even though it has the highest initial investment. Final Choice - Go with Product C

Ex. II: Choosing among cost alternatives. ABC Company must install a water purification system to comply with local clean water laws. All relevant estimates for systems on the market are supplied in the table below. If the company's MARR is 12%, which alternative should they pursue? A 80,000 8,000 22,000 15 years B 88,000 6,200 26,000 15 years C 94,000 5,800 31,000 15 years

Investment Estimated Annual Expenses Salvage Value Expected Life Solution:

Although no method was specified, PW is usually the most straightforward to use. Since all 3 products have expected lives of 15 years, PW is a good choice. We'll also assume that the study period is 15 years. Now, we just have to calculate the PW of each alternative. Remember, since these are cost alternatives, Do Nothing is not a possible choice, none of the alternatives will be profitable with a MARR of 12% (since they involve mostly negative cash flows) but the company must choose one. PWA = -$80,000 - 8,000(P/A, 12%,15) + 22,000(P/F, 12%, 15) PWA = -$80,000 - 8,000(6.8109) + 22,000(0.1827) PWA = -$130,468 PWB = -$88,000 - 6,200(P/A, 12%, 15) + 26,000(P/F, 12%, 15) PWB = -$88,500 - 6,200(6.8109) + 26,000(0.1827) PWB = -$125,477 PWC = -$94,000 - 5,800(P/A, 12%, 15) + 31,000(P/F, 12%, 15) PWC = -$94,000 - 5,800(6.8109) + 31,000(0.1827) PWC = -$127,840 Since we have cost alternatives, we want to choose the one that has the least negative present worth, that is the one that costs the least over the study period. System B is the final choice, since it is the least costly- even though it is not the least expensive to install or operate. Final Choice - Go with System B We can verify our answer using the AW method: AWA = -$80,000(A/P, 12%, 15) - 8,000 + 22,000(A/F, 12%, 15) AWA = -$80,000(0.1468) - 8,000 + 22,000(0.0315) AWA = -$19,051

AWB = -$88,000(A/P, 12%, 15) - 6,200 + 26,000(A/F, 12%, 15) AWB = -$88,500(0.1468) - 6,200 + 26,000(0.0315) AWB = -$18,299 AWC = -$94,000(A/P, 12%, 15) - 5,800 + 31,000(A/F, 12%, 15) AWC = -$94,000(0.1468) - 5,800 + 31,000(0.0315) AWC = -$18,623 Confirming our PW calculations, AW also indicates System B to be the least expensive. Ex. III: Alternatives with different useful lives. Two possible investment alternatives are under consideration for a study period of 10 years. Given the data in the table and a MARR of 10%, which alternative would you choose? State all assumptions Do Nothing Initial Investment (I) Annual revenues (R) Annual expenses (E) Salvage Value (SV) Useful life, in years Solution In this case the useful life of Investment B is shorter than the study period of 10 years, so we can assume repeatability, we will invest in B in years 0 and 5 - repeating it twice. Since we are assuming repeatability, it is easiest to use the Annual Worth method to compare the alternatives. That way, we only need to compute the AW for each during its useful life. AWA = -$40k(A/P, 10%, 10) + ($8k - 2k) + 10k(A/F, 10%, 10) AWA = -$40k(0.1627) + $6k + 10k(0.0627) AWA = $0.119k = $119 AWB = -$60k(A/P, 10%, 5) + ($12k - 1.5k) + 25k(A/F, 10%, 5) AWB = -$60k(0.2638) + $10.5k + 25k(0.1638) AWB = -$1.233k = -$1,223 Since we are looking at investment alternatives, we want to choose the most profitable project. B is not profitable while A is just profitable at the chosen MARR, so the final selection would be alternative A. Why not use PW? In cases where repeatability is assumed, comparing the AW over the useful lives of alternatives is preferable. It is computationally less work than using the PW. If PW was used however, one would need to compare the PW over the study period. In this case: PWA = -$40k + ($8k - 2k)(P/A, 10%, 10) + 10k(P/F, 10%, 10) 0 0 0 0 N/A Invest in A $40k 8k 2k 10k (EOY 10) 10 Invest in B $60k 12k 1.5k 25k (EOY 5) 5

would be compared to, PWB = -$60k + ($12k - 1.5k)(P/A,10%,10) + 25k(P/F, 10%, 5) -60k(P/F,10%,5) +25k(P/F, 10%,10) Ex. IV: Cost Alternatives with different useful lives. Your plant must add another boiler to its steam generating system. Bids have been obtained from two boiler manufacturers as follows: Boiler A $50,000 20 years 10,000 9,000 Boiler B $120,000 40 years 20,000 3,000 increasing 300 per year after the first year

Capital Investment Useful Life (N) Salvage Value at EOY N Annual Operating Costs

If the MARR is 10% per year, which boiler would you recommend? State all assumptions. Solution: First, the choice involves cost alternatives, so Do Nothing is not an option - the plant must add another boiler. From the data we can assume that the study period is 40 years, and since the useful life of Boiler A is 20 years, we must assume repeatability. Once again we will use the Annual Worth method to compare the alternatives. That way, we only need to compute the AW for each during its useful life. AWA = -$50,000(A/P, 10%, 20) + 10,000(A/F, 10%, 20) - 9,000 AWA = -$50,000(0.1175) + 10,000(0.0175) - 9,000 AWA = -$14,704 For Boiler B, operating costs increase by $300 each year after year 1 so a gradient will be needed to solve the problem. AWB = -$120,000(A/P, 10%, 40) + 20,000(A/F, 10%, 40) -3000 -300(A/G,10%,40) AWB = -$120,000(0.1023) + 20,000(0.0023) -3000 -300(9.0962) AWB = -$17,962 Since we are considering cost alternatives, we want to choose the least costly project. Because boiler B is about $3,200 more expensive per year to own and operate than Boiler A, we recommend that Boiler A should be purchased. Ex. V: Alternatives involving electrical efficiency. Two electric motors X and Y are being considered to drive a centrifugal pump. One of the motors must be selected. Each motor is capable of delivering 50 horsepower (output) to the pumping operation. It is expected that the motors will be in use 1000 hours per year.

If electricity costs $0.07 per kilowatt-hour, which motor should be selected if MARR=8% per year? Refer to the data below. Pump X $1,200 0.82 $60 5 years 0 Pump Y $1,000 0.77 $100 5 years 0

Initial cost Electrical efficiency Annual Maintenance cost Useful Life Salvage value at end of useful life

Solution: First, the choice involves cost alternatives, so Do Nothing is not an option - a pump must be purchased. Any of the equivalent worth methods can be used to make the recommendation, we'll use AW and then check the answer using PW. Motor X Each pump has three costs associated with it: the initial purchase cost, the annual maintenance cost, and the annual operating cost (consumption of electricity - Cx). The first two are given to us and we have enough data to calculate the third as follows: Cx = Electrical Input x (conversion factor from hp to kW) x (hours of operation) x (cost of electricity) [HINT: Check your units to make sure the final number is in the correct units] Electrical input refers to the electrical efficiency of the pump. Both motors output 50hp but require different amounts of input since neither is 100% efficient. Since efficiency=ouput/input, we can find the electrical input of pump X as follows: Input = Output/Efficiency = 50 hp/0.82 We know electricity costs $0.07 per kW-hr and we need 1000 hours per year. Finally, we find that 1hp = 0.746kw. We are ready to find Cx: Cx = (50 hp/ 0.82) x (0.746 kW/hp) x (1000 hrs / year) x ($0.07/kw-hr) Cx = $3,184.15 per year [Checking units shows that all but $ in the numerator and years in the denominator cancel out - giving us $ per year] To find the AW of X we use: AWX = -$1,200(A/P, 8%, 5) -$60 -$3,184.15 AWX = -$1,200(0.2505) -$60 -$3,184.15 AWX = -$3,544.75 Motor Y

A similar approach is used to calculate the AW of Motor Y: AWX = -$1,000(A/P, 8%, 5) - $100 - (50hp/0.77) x(0.746kw/hp) x(1000hrs/yr) x($0.07/kw-hr) AWX = -$1,000(0.2505) - $100 - 3,390.91 AWX = -$3,741.41 To minimize the expense of operating the pump, choose pump X. Confirm with PW PWX = -$1,200 + (-$60 -$3,184.15)(P/A,8%,5) PWX = -$1,200 + (-$60 -$3,184.15)(3.9927) PWX = -$14,152.92 PWY = -$1,000 + (-$100 -$3,390.91)(P/A,8%,5) PWY = -$1,000 + (-$100 -$3,390.91)(3.9927) PWY = -$14,938.16 As we should expect, PW confirms that Pump X is the better alternative. We can also use PW to double check our AW calculations: AWX = PWX (A/P,8%,5) AWX = -$14,152.92(0.2505) = $3,545 AWY = PWY (A/P,8%,5) AWX = -$14,938.16(0.2505) = $3,742

Internal Rate of Return Method The term internal rate of return method has been used by different analysts to mean somewhat different procedures for economic evaluation. The method is often misunderstood and misused, and its popularity among analysts in the private sector is undeserved even when the method is defined and interpreted in the most favorable light. The method is usually applied by comparing the MARR to the internal rate of return value(s) for a project or a set of projects. A major difficulty in applying the internal rate of return method to economic evaluation is the possible existence of multiple values of IRR when there are two or more changes of sign in the cash flow profile At,x (for t=0,1,2,...,n). When that happens, the method is generally not applicable either in determining the acceptance of independent projects or for selection of the best among a group of mutually exclusive proposals unless a set of well defined decision rules are introduced for incremental analysis. In any case, no advantage is gained by using this method since the procedure is cumbersome even if the method is correctly applied. This method is not recommended for use either in accepting independent projects or in selecting the best among mutually exclusive proposals.

Example: Evaluation of Four Independent Projects

The cash flow profiles of four independent projects are shown in Table 6-1. Using a MARR of 20%, determine the acceptability of each of the projects on the basis of the net present value criterion for accepting independent projects. TABLE 6-1 Cash Flow Profiles of Four Independent Projects (in $ million) t 0 1 2 3 4 5 At,1 -77.0 0 0 0 0 235.0 At,2 -75.3 28.0 28.0 28.0 28.0 28.0 At,3 -39.9 28.0 28.0 28.0 28.0 -80.0 At,4 18.0 10.0 -40.0 -60.0 30.0 50.0

Using i = 20%, we can compute NPV for x = 1, 2, 3, and 4 from Eq. (6.5). Then, the acceptability of each project can be determined from Eq. (6.6). Thus,
[NPV1]20% = -77 + (235)(P|F, 20%, 5) = -77 + 94.4 = 17.4 [NPV2]20% = -75.3 + (28)(P|U, 20%, 5) = -75.3 + 83.7 = 8.4 [NPV3]20% = -39.9 + (28)(P|U, 20%, 4) - (80)(P|F, 20%, 5) = -39.9 + 72.5 - 32.2 = 0.4 [NPV4]20% = 18 + (10)(P|F, 20%, 1) - (40)(P|F, 20%, 2) - (60)(P|F, 20%, 3) + (30)(P|F, 20%, 4) + (50)(P|F, 20%, 5) = 18 + 8.3 - 27.8 - 34.7 + 14.5 + 20.1 = -1.6

Hence, the first three independent projects are acceptable, but the last project should be rejected. It is interesting to note that if the four projects are mutually exclusive, the net present value method can still be used to evaluate the projects and, according to Eq. (6.7), the project (x = 1) which has the highest positive NPV should be selected. The use of the net equivalent uniform annual value or the net future value method will lead to the same conclusion. However, the project with the highest benefit-cost ratio is not necessarily the best choice among a group of mutually exclusive alternatives. Furthermore, the conventional internal rate of return method cannot be used to make a meaningful evaluation of these projects as the IRR for both x=1 and x=2 are found to be 25% while multiple values of IRR exist for both the x=3 and x=4 alternatives.