ENGR 301 – Engineering

Management Principles and

Economics
François Tardy
Credits: 3
Lecture 3
 Comparison Methods, Part I
CHAPTER 11

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 Outline
11.1 Introduction
11.2 Relations Among Projects
11.3 Minimum Acceptable Rate of Return (MARR)
11.4 Present Worth (PW) and Annual Worth (AW) Comparisons
11.4.1 Present Worth Comparisons for Independent
Projects
11.4.2 Present Worth Comparisons for Mutually Exclusive
Projects
11.4.3 Annual Worth Comparisons
11.4.4 Comparison of Alternatives With Unequal Lives
11.5 Payback Period
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 11.1 Introduction

An investment is an exchange of something valuable

now for the expectation of something of greater value
later.
• The estimation of expected costs/returns from the
investment opportunity (or project) is important.
• Therefore, an appropriate comparison method is
needed.
• If we classify projects correctly then we can select
appropriate comparison methods.

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 11.1 Introduction

The following are several widely used comparison

methods for evaluating opportunities:
➢ Present Worth (PW),
➢ Annual Worth (AW),
➢ Payback Period.

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 11.1 Introduction
Six Assumptions regarding Comparison Methods:
1. Costs/Benefits are always measurable in terms of money.
2. Future cash flows are known with certainty.
• Uncertainty/Risk is dealt with in other Chapters (not part of
this course).
3. Cash flows are unaffected by inflation or deflation.
• Inflation is accommodated in Chapter 15.
4. Sufficient funds are available to implement all projects.

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 11.1 Introduction
Six Assumptions regarding Comparison Methods:
5. Taxes are not applicable.
• Taxes are included in decision-making by Chapter 14.
6. All investments have a cash outflow at the start.
• These outflows are called first costs/initial investment.

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 11.2 Relations Among Projects
We classify groups of Projects as one of the three:
1. Independent: expected costs/benefits of each project
independent of whether other is chosen
2. Mutually Exclusive: By virtue of choosing one all other
alternatives must be excluded.

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 11.2 Relations Among Projects
3) Related but not Mutually Exclusive: For such, expected
costs/benefits of one depends on other(s) being chosen.
• combine them into an exhaustive list of mutually exclusive
sets.
• Special cases of related projects:
o One project is contingent on another.
o Resource or financial constraints (all sets of projects that
meet the budget form a mutually exclusive set of
alternatives).

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 Figure 11.1 Possible Relations Among
Projects and How to Treat Them

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 11.3 Minimum Acceptable Rate of
Return (MARR)
Investing in a project implies foregoing the opportunity to invest
elsewhere.
• Hence, MARR is an opportunity cost
• MARR is sometimes called the “hurdle rate”
Another view: any project investment must earn at least enough to
pay “cost of capital”.
MARR: Interest rate required for any project to be accepted.

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 11.4 Present Worth (PW) and Annual
Worth (AW) Comparisons
For these methods, find a comparable basis to evaluate
projects in monetary units.
Present Worth (PW) method: compare projects by
computing their present worth at MARR.
Annual Worth (AW) method: compare projects by
computing their annual worth at MARR.

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 11.4.1 Present Worth Comparisons
for Independent Projects
• Assume n > 1 independent projects – same benefit.
• We may invest in 0, 1, 2,…n of the projects…or “do nothing” by
investing elsewhere at MARR.

CLOSE-UP 11.1 Present Cost and Annual Cost

Mutually exclusive projects can be compared in terms of Cost –
Present or Annual.
• The best one has minimum PW or AW of cost.
Two conditions are needed 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.
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 11.4.2 Present Worth Comparisons
for Mutually Exclusive Projects
Decision Rule:
• Pick the project with the greatest PW at MARR
• For minimum cost, pick project with lowest present cost

Example 11.4
You must purchase a new lathe for an aircraft. Each of the four choices
has same life (10 years) with $0 scrap value. MARR = 15%.

Lathe 1: first cost is $100,000 & annual savings is $25,000

Lathe 2: first cost is $150,000 & annual savings is $34,000
Lathe 3: first cost is $200,000 & annual savings is $46,000
Lathe 4: first cost is $255,000 & annual savings is $55,000

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 Example 11.4 (cont)
PW1 = -100,000 + 25,000(P/A,15%,10)
= -100,000 + 25,000(5.0187) = 25,468
PW2 = -150,000 + 34,000(P/A,15%,10)
= -150,000 + 34,000(5.0187) = 20,636
PW3 = -200,000 + 46,000(P/A,15%,10)
= -200,000 + 46,000(5.0187) = 30,860
PW4 = -255,000 + 55,000(P/A,15%,10)
= -255,000 + 55,000(5.0187) = 21,029
Since Lathe 3 has the highest PW, it is preferred alternative.
 11.4.3 Annual Worth Comparisons
• The AW is essentially the same as PW, except all disbursements &
receipts are transformed into uniform series at MARR.
• AW comparisons may be easier to conceptualize than PW (i.e.
present cost or annual cost to operate your car?).
• Comparison of two projects by PW or AW methods having the
same life always indicate same preferred alternative.
• Sometimes justification for using one method over the other is
computational ease or ease of grasping mentally.
o When you communicate such in the “boardroom” which
method will your audience find easiest to grasp?

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 CLOSE-UP 11.2 Future Worth
• It may be desirable to compare projects based on Future Worth
(i.e. money saved for a future expense).
• With investment plans, the Future Worth has more meaning for
the typical investor.
Plan A consists of a $10,000 payment today, and $2000/year for
20 years (10% interest).
Plan B is $3000/year over 20 years (10% interest).
➢ FWA = 10,000(F/P,10%,20) + 2000(F/A,10%,20)
➢ FWA = 10,000(6.7275) + 2000(57.275) = 181,825
➢ FWB = 3000(F/A,10%,20) = 3000(57.275) = 171,825
➢ FWA > FWB and so Plan A is better choice.
You could use PW or AW but FW is most meaningful (why?)
 11.4.4 Comparison of Alternatives
With Unequal Lives
When making PW comparisons, same period must always be used
in to account for full costs/benefits.
If service lives of alternative projects are unequal, we transform
them into equal lives:
• Repeated Lives Approach: Repeat the service life of each
alternative over least common multiple of service lives.
• Study Period Approach: Adopt a specified study period for
comparison, realizing the need of salvage (or market) value
at the end of the study period.

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 Practice Problem
Two machines are considered, A and B. Assume MARR is 10%.
Using PW, which is the preferred one?

Need to have equal analysis periods for PW analysis. So, again

buy Machine A at 5 years (with identical cash flow) giving a 10 year
analysis period.
Machine A Machine B

First cost $15 000 $20 000

Annual revenues 9 000 11 000

Annual costs 6 000 8 000

Scrap value 1 000 2 000

Service life 5 years 10 years

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 Practice Problem
PWB = –20000 + (11000–8000)(P/A,10%,10) + 2000(P/F,10%,10)
PWB = –20000 + 3000*6.1445 + 2000*0.38554 = –795
PWA = –15000 + (9000–6000)(P/A,10%,5) + 1000(P/F,10%,5) +
[–15000+3000(P/A,10%,5) + 1000(P/F,10%,5)](P/F,10%,5)]
PWA = (–15000+ 3000*3.7908 + 1000*0.62092)(1 + 0.62092)
PWA = –3007*1.62092 = –4,874
Since PWB > PWA, Machine B is preferred over Machine A.
However, both have a negative PW (money is lost with both).

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 Least Common Multiple
When comparing two projects with unequal lives, for example 4
years and 6 years respectively, what is the shortest possible
analysis period common to both alternatives?
Evaluate the Least Common Multiple (LCM):
4=2*2
6=2*3
So, we need at least two 2’s and one 3.
LCM = 2 * 2 * 3 = 12 years

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 11.4.4 Comparison of Alternatives
With Unequal Lives
• Use AW comparisons when the “repeated lives” method is not
easy and convenient.
• Observe that the AW of a project over one “life” is same as its
annual worth over any number of lives.
• With AW comparisons, when the assets are needed indefinitely,
you may simply compute the AW over each project’s “service
life.”
• If it cannot be assumed that alternatives will “fit” the Least
Common Multiples approach then use the Study Period
approach.

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 Practice Problem
Two machines are considered, A and B. Assume MARR is 10%.
Using AW, which is the preferred one?

Need not have equal analysis periods for AW analysis.

Machine A Machine B

First cost $15 000 $20 000

Annual revenues 9 000 11 000

Annual costs 6 000 8 000

Scrap value 1 000 2 000

Service life 5 years 10 years

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 Practice Problem (cont’d)
AWB = –20000(A/P,10%,10) + (11000–8000) + 2000(A/F,10%,10)

AWB = –20000*0.16275 + 3000 + 2000*0.06275 = –129

AWA = –15000(A/P,10%,5) + (9000–6000) + 1000(A/F,10%,5)

AWA = –15000*0.26380 + 3000 + 1000*0.16380 = –793

Since AWB > AWA, Machine B is preferred over Machine A.

However, both have a negative AW (money is lost with both).

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 11.5 Payback Period
Payback period: number of years it takes for an investment to be
recouped (interest assumed 0).
simplest method for judging economic viability of projects (but note
its approximation of i = 0).
If annual savings are constant, the payback period is usually
calculated as follows:

First cost
Payback period =
Annual savings

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 11.5 Payback Period
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.
➢ The project with the shorter payback period wins.
➢ A payback period of two years is often acceptable.
➢ More than four years is usually unacceptable.
➢ The payback period should not be used as the sole criterion
for evaluating projects.
➢ It’s a “quick and dirty” approach - simple to grasp!

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 Figure 11.4 Flows Ignored by the Payback Period

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 Practice Problem 11.5
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 11.5 (cont’d)
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).

Since Machine A has the shorter payback period it is preferred over

Machine B. However, since we require a payback period of 3 years,
both Machines are rejected.
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 Summary
✓ Relations Among Projects
✓ MARR
✓ PW and AW Comparisons
• Comparisons for Independent Projects
• Comparisons for Mutually Exclusive Projects
• Comparisons of projects with unequal service lives
✓ Payback period comparisons

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 App 11A – MARR and Cost of Capital
How is the cost of capital determined?
• MARR required to get investors to invest in a business is that
business’s Cost of Capital.
• Cost of Capital also its MARR for projects
A project’s return on investment should be at least equal to the
company’s cost of obtaining capital.
There are two ways of raising capital: through debt or equity.

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 App 11A – MARR and Cost of Capital

Debt: from lenders

• Pre-determined interest rates and repayment
conditions.
• Assets are pledged as security against defaulting.
Equity: from owners
• Dividends are paid on shares sold.
• Dividends are paid after all loan obligations are met.
The MARR represents the cost of interest and the
opportunity cost of owners’ investment in the company.

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 11A.1 Risk and Cost of Capital

Investing in equity is more risky than debt.

But reliance on debt is limited for two reasons:
1. Company: increasing share of capital from debt
increases chance of not being able to meet
obligations to the lender.
2. Lenders: aware of dangers of high reliance on
debt and will, therefore, limit the amount they
lend to the company.

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 11A.2 Company Size and the Sources
of Capital
• Large companies can secure capital both by
borrowing and by selling ownership shares.
• The cost of capital for companies is the weighted
average of costs of borrowing selling shares, i.e., the
weighted average cost of capital (WACC) which is
also the MARR.
• The weights are the fractions of the total capital that
come from different sources.
• For smaller companies, the cost of capital is the
opportunity cost for the investors.

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 Practice Problem 11A.2
Consider a company that has raised money through both equity and
debt:
• issued 100 000 shares of stock trading at $3.27/share (capital
from equity = $327k).
• also have loans which total $100 000 (i.e. capital from debt =
$100 000) @ 10% interest.
If we simplify the after-tax dividends to be:
• $18,000 (weak performance).
• $54,000 (average performance).
• $90,000 (strong performance).
Statistically, who earns more – lenders or owners? (assume equal
chance for each possibility)
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 Table 11A.1 Cost of Capital Example

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 Practice Problem 11A.2
Answer :
Lenders get a return of 10% (10 000/100 000)
Owners get one of three possible returns, with the same odds:
• 5.5% (18 000/327 273)
• 16.5% (54 000/327 273)
• 27.5% (90 000/327 273)
Average = 16.5% (owners better off on average with risk).
100 000 327 273
𝑾𝑨𝑪𝑪 = 0.1 + 0.165 = 0.150 = 𝟏𝟓%
427 273 427 273

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