CHAPTER TWO

Methods of comparison of alternatives and

Decision Analysis
Present worth method of comparing alternatives
Future worth method of comparing alternatives
Annual payment method of comparing alternatives
Rate of return (ROR) method of comparing alternatives
Incremental rate of return (IROR) on required investment
 Comparison of alternatives
• For most of the engineering projects,
equipments etc., there are more than one
feasible alternative.
• The Project management team of the client
organization selects the best alternative that
involves less cost and results more revenue.
• For this purpose, the economic comparison
of the alternatives is made.
 Comparison of alternatives
 Alternatives are always present for any
economic decision
 Alternatives evaluation variables are:
 Initial cost; interest rate (rate of return)
 Anticipated life of equipment (economic life)
 Annual maintenance/operating cost or benefit
 Resale or salvage value
 Alternative Selection
• To select an alternative among different ones, the
measure-of-worth values are compared
• This is simply the result of engineering economy
analysis

• Once the alternatives are evaluated and compared,

the best alternative is selected and implemented

• Keep in mind that the alternatives represent projects

that are economically and technologically viable
 Project Categories
To help formulate alternatives, projects are
categorizes as one of the following:
• Mutually exclusive. Only one of the viable projects can be
selected by the economic analysis. Each viable project is an
alternative and compete among each other (when an
engineer must select the one best diesel-powered engine
from several competing models)

• Independent. More than one viable project may be selected

by the economic analysis. They do not compete among each
other
1. PRESENT WORTH METHOD OF COMPARING
ALTERNATIVES
 Present Worth Analysis of Equal-Life Alternatives
• In present worth analysis, the P value, now called PW, is
calculated at the MARR for each alternative.
• MARR is the minimum attractive rate of return and is higher
than the rate expected from a bank or some safe investment.
• The expected rate of return must meet or exceed the MARR for
an alternative to be financially viable.
• The present worth method is popular because future cost and
revenue estimates are transformed into equivalent birr now
• Converts all cash flows to a single sum equivalent at time zero
using i = MARR over the planning horizon
• Bring all cash flows back to “time zero” and add them up
 Present Worth Analysis of Equal-Life
Alternatives
• That is, all future cash flows are converted into present birr

• This makes it easy to determine the economic advantage of

one alternative over another

• The PW comparison of alternatives with equal lives is

straightforward

• If alternatives are used for the same time period, they are
termed equal-service alternatives
 Present Worth Analysis of Equal-Life
Alternatives
In mutually exclusive alternatives, the following guidelines
are applied to select one alternative:

• One alternative. Calculate PW at the MARR. If PW ≥ 0, the

requested MARR is met or exceeded and the alternative is
financially viable

• Two or more alternatives. Calculate the PW of each

alternative at the MARR. Select the alternative with the PW
value that is numerically largest (less negative or more
positive), indicating a lower PW of cost cash flows or larger
PW of net cash flows of receipts minus disbursements
 Present Worth Analysis of Equal-Life
Alternatives

• Note that the guideline to select one alternative with the

lowest cost or the highest income uses the criterion of
numerically largest

• This is NOT the absolute value of the PW amount, because the

sign matters

• If the projects are independent, the selection guideline is as

follows:
• For one or more independent projects, select all projects with
PW ≥ 0 at the MARR
 Examples 1
• Perform a present worth analysis of equal-service machines
with the costs shown below, if the MARR is 10% per year.
Revenues for all three alternatives are expected to be the
same

Cost Type Electric- Gas- Solar-

Powered Powered Powered
First cost, ETB -2,500 -3,500 -6,000
Annual operating -900 -700 -50
Cost, ETB
Salvage Value, ETB 200 350 100
Life, years 5 5 5
Solution:
• The salvage values are considered a “revenue” not cost, so a +
sign precedes them
• The PW of each machine is calculated at i = 10% for n = 5years

PWE = – 2,500 – 900(P/A,10%,5) + 200(P/F,10%,5) = – 5,788Br

PWG = – 3500 – 700(P/A,10%,5) + 350(P/F,10%,5) = – 5,936Br
PWS = – 6000 – 50(P/A,10%,5) + 100(P/F,10%,5) = – 6,127Br

• The electric-powered machine is selected since the PW of its

costs is the lowest; it has the numerically largest PW value
 Examples 2
• A firm is considering which of two mechanical devices to
install to reduce costs in a particular situation. Both devices
cost $1000 and have useful lives of 5 years and no salvage
value. Device A can be expected to result in $300 savings
annually. Device B will provide cost savings of $400 the first
year but will decline $50 annually, making the second-year
savings $350, the third-year savings $300, and so forth. With
interest at 7%, which device should the firm purchase?
 Examples 3
• X County will build an aqueduct to bring water in from the
upper part of the state. It can be built at a reduced size now
for $300 million and be enlarged 25 years hence for an
additional $350 million. An alternatives to construct the full-
sized aqueduct now for $400 million. Both alternatives would
provide the needed capacity for the 50-year analysis period.
Maintenance costs are small and may. Be ignored. At 6%
interest, which alternative should be selected?
I. For the two stage construction
PW = 300 million + 350 million(P/F, 6%, 25)
II. For the one stage construction
PW = 400 million
Since the two stage construction have smaller PW, it is preferred
to invest in the form 300 million now and enlarge after 25 year.
 Present Worth Analysis of Different-life
Alternatives

• When the present worth method is used to compare mutually

exclusive alternatives that have different lives, then the PW of
the alternatives must be compared over the same number of
years and end at the same time

• A fair comparison can be made only when the PW values

represent costs (and receipts) associated with equal periods

• The equal-period requirement can be satisfied by comparing

the alternatives over a period of time equal to the least
common multiple (LCM) of their lives.
 Present Worth Analysis of Different-life
Alternatives – The LCM Approach
• The LCM approach automatically makes the cash flows for all
alternatives extend to the same time period
• For example, alternatives with expected lives of 2 and 3 years
are compared over a 6-year time period
• Such a procedure requires that some assumptions be made
about subsequent life cycles of the alternatives
• The assumptions of a PW analysis of different-life alternatives
for the LCM method are as follows:
 The service provided by the alternatives will be needed for at
least the LCM of years
 The selected alternative will be repeated over each life cycle of
the LCM in exactly the same manner
 The cash flow estimates will be the same in every life cycle
 Examples

1. A project engineer is assigned to start up a new office in a

city where a 6-year contract has been finalized
Two lease options are available, each with a first cost, annual
lease cost, and deposit-return estimates shown below
Location A Location B
First cost, ETB -15,000 -18,000
Annual lease cost, ETB -3,500 -3,100
Deposit return, ETB 1,000 2,000
Lease term, years 6 9

• Determine which lease option should be selected on the basis

of a present worth comparison, if the MARR is 15% per year
Solution
Solution:
• Since the leases have different lives, compare them over the
LCM of 18 years
• Repeat the first cost in year 0 of each new cycle
• Calculate PW at 15% over 18 years
• PWA = – 15,000 – 15,000(P/F,15%,6)+1,000(P/F,15%,6)
– 15,000 (P/F,15%,12)+1,000(P/F,15%,12)
+ 1,000(P/F,15%,18) –3,500(P/A,15%,18) = –45,036 ETB
• PWB = – 18,000 – 18,000(P/F,15%,9) + 2,000(P/F,15%,9) +
2,000(P/F,15%,18) – 3,100(P/A,15%,18) = –41,384 ETB

 Location B is selected, since it costs less in PW terms;

that is, the PWB value is numerically larger than PWA
 Examples

• Two processes can be used for producing a polymer that

reduces friction loss in engines. Process K will have a first cost
of $160,000, an operating cost of $7000 per quarter, and a
salvage value of $40,000 after its 2-year life. Process L will
have a first cost of $210,000, an operating cost of $5000 per
quarter, and a $26,000 salvage value after its 4-year life.
Which process should be selected on the basis of a present
worth analysis at an interest rate of 8% per year, compounded
quarterly?
 Capitalized worth (Cost) method of Analysis
•  
Cont…

Or CW= AW/i
 Cont…
• Capitalized cost (CC) called also capitalized worth(CW)
• A perpetuity is an investment that has an infinite life
• And capitalized worth is the present worth of a perpetuity
• The capitalized worth indicates the amount of money needed
“up front” such that the interest earned will cover the cash
flow requirements forever for the investment
• Used mostly by government
 Examples
1. A new computer system will be used for the
indefinite future, find the equivalent value now if
the system has an installed cost of 150,000 ETBand
an additional cost of 50,000 ETB after 10 years. The
annual maintenance cost is 5,000 ETB for the first 4
years and 8,000 ETB thereafter. In addition, it is
expected to be a recurring major upgrade cost of
15,000 ETB every 13 years. Assume that i = 5% per
year.
Solution:
• Draw a cash flow diagram for
Solution
 Examples:
1. Two sites are currently under consideration for a bridge over a small
river. The north site requires a suspension bridge. The south site has
a much shorter span, allowing for a truss bridge, but it would
require new road construction. The suspension bridge will cost $500
million with annual inspection and maintenance costs of $350,000.
In addition, the concrete deck would have to be resurfaced every 10
years at a cost of $1,000,000. The truss bridge and approach roads
are expected to cost $250 million and have annual maintenance
costs of $200,000. This bridge would have to be painted every 3
years at a cost of $400,000. In addition, the bridge would have to be
sandblasted every 10 years at a cost of $1,900,000. The cost of
purchasing right-of-way is expected to be $20 million for the
suspension bridge and $150 million for the truss bridge. Compare
the alternatives on the basis of their capitalized cost if the interest
rate is 6% per year.