Comparison of Alternatives

Comparing & Selecting
Alternatives
Engineering Economy, 15th Edition

By William G. Sullivan, Elin wicks,and C. Patrick Koelling
The objective of chapter 6
is to evaluate correctly
capital investment
alternatives when the time
value of money is a key
influence.

Making decisions means
comparing alternatives.
• 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.

1.
Mutually exclusive
alternatives (MEAs)

Mutually exclusive alternatives (MEAs)
✘We examine these on the ✘The alternatives must provide

basis of economic comparable “usefulness”:
considerations alone. performance, quality, etc.
✘The basic methods from chapter

✘The alternatives may have
5 provide the basis for economic
different initial investments comparison of the alternatives.
and their annual revenues and
costs may vary.

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.)

2.
Two Basic Types of
Alternatives

There are two basic types of alternatives.
✘ Investment Alternatives ✘ Cost Alternatives

Those with initial (or Those with all negative
front-end) capital investment cash flows, except for a
that produces positive cash possible positive cash flow
flows from increased revenue, from disposal of assets at the
savings through reduced costs, end of the project’s useful life.
or both.

Select the alternative that gives you the most money!
✘For investment alternatives ✘For cost alternatives the

the PW of all cash flows must PW of all cash flows will be
be positive, at the MARR, to be negative. Select the
attractive. Select the alternative with the largest
alternative with the largest (smallest in absolute value)
PW. PW.

3.
Determining Study
Period
Determining the study period.
✘A study period (or ✘MEAs can have ✘The equal life case
planning horizon) is equal lives (in which is straightforward,
the time period over case the study period and was used in the
which MEAs are used is these equal previous two
compared, and it must lives), or they can examples.
be appropriate for have unequal lives,
the decision situation. and at least one does
not match the study
period.

Unequal lives are handled in one of two ways.
✘Repeatability assumption ✘Coterminated assumption: uses a

○The study period is either finite and identical study period
indefinitely long or equal to a for all MEAs. Cash flow
common multiple of the lives of adjustments may be made to
the MEAs. satisfy alternative performance
○The economic consequences needs over the study period.
expected during the MEAs’ life
spans will also happen in
succeeding life spans
(replacements).

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

Selecting the best alternative.
Present worth analysis  select Alternative A (but C is
close).
Annual worth analysis—the decision is the same.

4.
Using Rates Of
Return
Using rates of return is another way to
compare alternatives.
✘The return on ✘Selecting the ✘Remember, the base

investment (rate of alternative with the alternative must be
return) is a popular largest rate of return attractive (rate of
measure of investment can lead to incorrect return greater than
performance. decisions—do not the MARR), and the
compare the IRR of one additional investment in
alternative to the IRR other alternatives must
of another alternative. itself make a
The only legitimate satisfactory rate of
comparison is the IRR to return on that
the MARR. increment.

Use the incremental investment analysis
procedure.
✘Arrange (rank order) ✘Establish a base ✘(Iteratively evaluate

the feasible alternative. differences
alternatives based on ○Cost alternatives—the (incremental cash
increasing capital first alternative is the flows) between
investment. base. alternatives until all
○Investment have been considered.
alternatives—the first
acceptable alternative
IRR>MARR) is the base.

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.

Incremental analysis
• is a decision-making technique used in business to determine the true cost
difference between alternatives.
• Initial cost - are those that are incurred during the design and
construction process.
• Net annual income – income after paying taxes or expenses.
• Internal rate of return (IRR) - is the interest rate at which the net
present value of all the cash flows (both positive and negative) from a
project or investment equal zero.
• Minimum acceptable rate of return (MARR) - the minimum rate of

return on a project a manager or company is willing to accept before
starting a project.

Example
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%
Which is preferred using a 5 year study period and MARR=10%?
Alternative B is preferred to A.
Comparing MEAs with unequal lives.w
✘The repeatability assumption, ✘If repeatability cannot be used,

when applicable, simplified an appropriate study period must
comparison of alternatives. be selected (the coterminated
assumption). This is most often
used in engineering practice
because product life cycles are
becoming shorter.

The useful life of an alternative is less than
the study period.
✘Cost alternatives ✘Investment alternatives
○Contracting or leasing for ○Cash flows reinvested at the

remaining years may be MARR at the end of the study
appropriate period
○Repeat part of the useful life ○Replace with another asset, with
and use an estimated market possibly different cash flows,
value to truncate after the study period

The useful life of an alternative is greater
than the study period.
✘Truncate the alternative at the ✘The underlying principle in all

end of the study period, using an such analysis is to compare the
estimated market value. MEAs in a decision situation over
the same study (analysis) period.

Equivalent worth methods can be used for
MEAs with unequal lives.
✘For cotermination, use any ✘If repeatability can be assumed,

equivalent worth method using the the MEAs are most easily
cash flows available for the compared by finding the annual
study period. worth (AW) of each alternative
over its own useful life, and
recommending the one having the
most economical value.

We can use incremental rate of return
analysis on MEAs with unequal lives.
Equate the MEAs annual worths (AW) over their respective lives.
A B
Capital Investment $3,500 $5,000
Annual Cash Flow $1,255 $1,480
Useful Live (years) 4 6
Solving, we find i*=26%, so Alt B is preferred.

Group 1
Alegre, Elliezar
Ampo, Susano
Bohol, Jlex
Constantino, Charelle
Gimutao, Desiree Fae
Glor, Blessie Jane
Guevarra, Precious Abby
Salamea, Vens
Perez, Angelo

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Comparing & Selecting

Engineering Economy, 15th Edition

Engineering Economy, 15th Edition

• The decisions considered are those selecting from among a

Engineering Economy, 15th Edition

Engineering Economy, 15th Edition

✘We examine these on the ✘The alternatives must provide

✘The basic methods from chapter

Engineering Economy, 15th Edition

If the extra benefits obtained by investing additional capital

(Please note that there are some cautions when considering

Engineering Economy, 15th Edition

Engineering Economy, 15th Edition

✘ Investment Alternatives ✘ Cost Alternatives

Engineering Economy, 15th Edition

✘For investment alternatives ✘For cost alternatives the

Engineering Economy, 15th Edition

Engineering Economy, 15th Edition

✘Repeatability assumption ✘Coterminated assumption: uses a

Engineering Economy, 15th Edition

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

Engineering Economy, 15th Edition

Annual worth analysis—the decision is the same.

✘The return on ✘Selecting the ✘Remember, the base

Engineering Economy, 15th Edition

✘Arrange (rank order) ✘Establish a base ✘(Iteratively evaluate

Engineering Economy, 15th Edition

• Work up the order of ranked alternatives smallest to largest.

• Determine if the incremental initial investment in the higher ranked

• This works for both cost and investment alternatives.

Engineering Economy, 15th Edition

• Net annual income – income after paying taxes or expenses.

• Minimum acceptable rate of return (MARR) - the minimum rate of

Engineering Economy, 15th Edition

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%

Which is preferred using a 5 year study period and MARR=10%?

✘The repeatability assumption, ✘If repeatability cannot be used,

Engineering Economy, 15th Edition

✘Cost alternatives ✘Investment alternatives

○Contracting or leasing for ○Cash flows reinvested at the

Engineering Economy, 15th Edition

✘Truncate the alternative at the ✘The underlying principle in all

Engineering Economy, 15th Edition

✘For cotermination, use any ✘If repeatability can be assumed,

Engineering Economy, 15th Edition

Capital Investment $3,500 $5,000

Annual Cash Flow $1,255 $1,480

Useful Live (years) 4 6

Solving, we find i*=26%, so Alt B is preferred.

Engineering Economy, 15th Edition

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