Module 6: Comparison and Selection

Among Alternatives
 Alternatives for Waste Storage

A large electric utility company is considering two methods for containing and storing
its coal combustion by-products (fly ash). One method is wet slurry storage, and the
second method is dry storage of the fly ash. The company will adopt one of these
methods for all 28 fly ash impoundments at its seven coal-fired power plants. Wet
storage has an initial capital investment of $2 billion, followed by annual maintenance
expenses of $300 million over the 10-year life of the method. Dry storage has a $2.5
billion capital investment and $150 million per year annual upkeep expenditures over
its 7-year life. If the utility’s MARR is 10% per year, which method of fly ash storage
should be selected assuming an indefinitely long study period?
 Chapter Objectives

At the end of this chapter, you will be able to:

• Investigate feasible design alternatives

• Identify mutually exclusive alternatives

• Evaluate capital investment alternatives

Mutually
Exclusive
Projects
Alternative vs.
Project

Do-Nothing
Alternative

3
 Case Study – ECRL

• ECRL project to build and maintain a double tracking

rail system connecting the states on the east-coast
belt was approved in October 2016.
• Total development costs were originally estimated at
RM66 billion and now being cut to less than RM60
billion by shortening the route and reducing stations
to be built.
• The project was initially set to be handled by China
Communication Constructions Company (CCCC),
with financing by Export-Import Bank of China (Exim
Bank of China).

❑At issue:
• How to reduce the final costs
• How to finance the project
• Which alternative is better in short run and long run
 Mutually Exclusive Alternatives
(MEA)
The term mutually exclusive means that when one of several
alternatives that meet the same need is selected, the others will be
rejected.
 We examine these on the basis of economic considerations alone.
 The alternatives may have different initial investments and their annual revenues
and costs may vary.
 The alternatives must provide comparable “usefulness”: performance, quality, etc.
 The basic methods from chapter 5 provide the basis for economic comparison of
the alternatives.
 Comparing Mutually Exclusive
Alternatives
 Alternative that requires the minimum investment of capital and produces
satisfactory functional results will be chosen unless the incremental capital
associated with an alternative having a larger investment can be justified with
respect to its incremental benefits. This alternative is the base alternative.
 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.
 Types of Alternatives

Investment Alternatives (Revenue)

Those with initial (or front-end) capital investment that produces positive cash flows from
increased revenue, savings through reduced costs, or both.

For investment alternatives the PW of all cash flows must be positive, at the MARR, to be
attractive. Select the alternative with the largest PW.

Cost Alternatives (Service)

Those with all negative cash flows, except for a possible positive cash flow from disposal
of assets at the end of the project’s useful life.

For cost alternatives the PW of all cash flows will be negative. Select the alternative with
the largest (smallest in absolute value) PW.
 Example 1 – Investments

Investment alternative example

Use a MARR of 10% and useful life of 5 years to select between the investment
alternatives below.
Alternative
A B
Capital investment -$100,000 -$125,000
Annual revenues less expenses $34,000 $41,000

Both alternatives are attractive, but Alternative B provides a greater present

worth, so is better economically.
 Example 2 – Costs
Cost alternative example

Use a MARR of 12% and useful life of 4 years to select between the cost
alternatives below.
Alternative
C D
Capital investment -$80,000 -$60,000
Annual expenses -$25,000 -$30,000

Alternative D costs less than Alternative C, it has a greater PW, so is better

economically.
 Exercise 1 – Furnace

Your local foundry is adding a new furnace. There are several different
styles and types of furnaces, so the foundry must select from among a set
of mutually exclusive alternatives. Initial capital investment and annual
expenses for each alternative are given in the table below. None have
any market value at the end of its useful life. Using a MARR of 15%,
which furnace should be chosen?
Furnace
F1 F2 F3
Investment $110,000 $125,000 $138,000
Useful life 10 years 10 years 10 years
Total annual expenses $53,800 $51,625 $45,033
 Exercise 1 – Furnace

Using a MARR of 15%, the PW is shown for each of the three

alternatives in the table below.
Furnace
F1 F2 F3
Investment $110,000 $125,000 $138,000
Useful life 10 years 10 years 10 years
Total annual expenses $53,800 $51,625 $45,033
Present Worth @ 15% -$380,010 -$384,094 -$364,010

The largest value is -$364,010, indicating that Furnace F3 is the

best alternative.
 Planning Horizon

Determining the study period.

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

Select
Higher
PW
 Types of Alternatives

Revenue Projects Service Projects

o Project revenues depend on the o Project revenues do not depend on

choice of alternatives the choice of alternatives

o Revenue and cost streams vary o Fixed (or constant) revenues for all
with the choice of alternatives alternatives

❑ Principle: Projects must be compared over an equal time span.

❑ Rule of Thumb: If the required service period is given, the

analysis period should be the same as the required service period.
 Planning Horizon

Unequal lives are handled in one of two ways.

 Repeatability assumption:
 The study period is either indefinitely long or equal to a common multiple of
the lives of the MEAs.
 The economic consequences expected during the MEAs’ life spans will also
happen in succeeding life spans (replacements).
 Co-terminated assumption:
uses a finite and identical study period for all MEAs. Cash flow
adjustments may be made to satisfy alternative performance needs over
the study period.
Planning Horizon
 Example 3 – Equal Live

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
 Example 3 – Equal Live

Selecting the best alternative.

Present worth analysis → select Alternative A (but C is close).

Annual worth analysis—the decision is the same.

 Rates of Return

Using rates of return is another way to compare alternatives.

 The return on investment (rate of return) is a popular measure of
investment performance.
 Selecting the alternative with the largest rate of return can lead to
incorrect decisions—do not compare the IRR of one alternative to the
IRR of another alternative. The only legitimate comparison is the IRR
to the MARR.
 Remember, the base alternative must be attractive (rate of return
greater than the MARR), and the additional investment in other
alternatives must itself make a satisfactory rate of return on that
increment.
 Case Study 1 – ROR

Investment decision

Net Cash Flow

Period
n Project Project Project
A B C

0 -1,000 -1,000 1,000

1 -500 3,900 -450
2 800 -5,030 -450
3 1,500 2,145 -450
4 2,000

Project A: a simple investment

Project B: a nonsimple investment
Project C: a simple borrowing
 Incremental Analysis

Use the incremental investment analysis procedure.

 Arrange (rank order) the feasible alternatives based on increasing capital
investment.
 Establish a base alternative.
 Cost alternatives—the first alternative is the base.
 Investment alternatives—the first acceptable alternative (IRR>MARR) is the base.
 Iteratively evaluate differences (incremental cash flows) between alternatives
until all have been considered.
o Step 1: Compute the cash flow series for the difference between the
projects (A, B) by subtracting the cash flow of the lower investment
cost project (A) from that of the higher investment cost project (B).
o Step 2: Compute the IRR on this incremental investment (IRRB-A ).
o Step 3: Accept the investment B if, and only if, IRR B-A > MARR.
 Cash Flow Analysis

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.
 Example 4 – Incremental Analysis

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%?

Both alternatives A and B are acceptable—each one has a rate of return that
exceeds the MARR. Choosing Alternative A because of its larger IRR would be
an incorrect decision. By examining the incremental cash flows we see that the
extra amount invested in Alternative B earns a return that exceeds the IRR—so B
is preferred to A. Also note…
 Example 5 – Incremental Analysis

Which project is a better choice at

MARR = 10%?

Since IRRB2-B1=15% > 10%, and also

IRRB2 > 10%, select B2.
 Exercise 2 – Material Handling

Acme Molding is examining 5 alternatives for a piece of material

handling equipment. Each has an expected life of 8 years with no
salvage value, and Acme’s MARR is 12%. Using an incremental
analysis, which material handling alternative should be chosen? The
table below includes initial investment, net annual income, and IRR for
each alternative.
Alternative
A B C D E
Capital $12,000 $12,500 $14,400 $16,250 $20,00
investment 0
Net annual $2,500 $2,520 $3,050 $3,620 $4,400
income
IRR 12.99% 12.04% 13.48% 14.99% 14.61%
 Exercise 2 – Material Handling

Alternative A is the base alternative, with an IRR > MARR. The next
largest investment is in Alternative B, so first examine the incremental
investment of B over A. In the table below the IRR of B – A is shown.

Alternative
A B B-A
Capital $12,000 $12,500 $500
investment
Net annual $2,500 $2,520 $20
income
IRR 12.99% 12.04% -20.11%

Alternative B is not better than A—A “wins.”

 Exercise 2 – Material Handling

The next largest investment is in Alternative C, so examine the

incremental investment of C over A. In the table below the IRR of C – A
is shown.
Alternative
A C C-A
Capital $12,000 $14,400 $2,400
investment
Net annual $2,500 $3,050 $550
income
IRR 12.99% 13.48% 15.86%

15.86% > MARR, so Alternative C “wins.”

 Exercise 2 – Material Handling

The next largest investment is in Alternative D, so examine the

incremental investment of D over C. In the table below the IRR of D –
C is shown.

Alternative
C D D-C
Capital $14,400 $16,250 $1,850
investment
Net annual $3,050 $3,620 $570
income
IRR 13.48% 14.99% 25.94%

25.94% > MARR, so Alternative D “wins.”

 Exercise 2 – Material Handling

Finally, examine the incremental investment of E over D.

Alternative
D E E-D
Capital $16,250 $20,000 $3,750
investment
Net annual $3,620 $4,400 $780
income
IRR 14.99% 14.61% 12.95%

12.95% > MARR, so Alternative E “wins,” and we would select

Alternative E as the best of these five alternatives.
 Unequal Project Lives

Comparing MEAs with unequal lives.

 The repeatability assumption, when applicable, simplified comparison of
alternatives.
 If repeatability cannot be used, an appropriate study period must be selected (the co-
terminated assumption). This is most often used in engineering practice because
product life cycles are becoming shorter.
 Short Project Lives

The useful life of an alternative is less than the study period.

 Cost alternatives
 Contracting or leasing for remaining years may be appropriate
 Repeat part of the useful life and use an estimated market value to truncate
 Investment alternatives
 Cash flows reinvested at the MARR at the end of the study period
 Replace with another asset, with possibly different cash flows, after the
study period
 Example 6 – Short Project

Come up with replacement

projects that match or exceed
the required service period

Compute the NPW for each project over the

required service period.
o PW(15%)A = −$34,359
o PW(15%)B = −$31,031
 Long Project Lives

The useful life of an alternative is greater than the study

period.
 Truncate the alternative at the end of the study period, using an
estimated market value.
 The underlying principle in all such analysis is to compare the MEAs in
a decision situation over the same study (analysis) period.
 Example 7 – Long Project

Estimate the salvage value at

the end of the required service
period.

Compute the NPW for each project

over the required service period.
o PW(15%)A = −$362,031
o PW(15%)B = −$364,145
 Example 8 – Longest Project

Compute the NPW of each

project over its analysis period,
assuming no cash flows after
the service life for the shorter-
lived project

Compute the NPW for each project

over the longest service period.
❑ PW(15%)Drill = $2,208.40
❑ PW(15%)Lease = $2,180.07
 Equivalent Worth

Equivalent worth methods can be used for MEAs with

unequal lives.
 If repeatability can be assumed, the MEAs are most easily compared by
finding the annual worth (AW) of each alternative over its own useful
life, and recommending the one having the most economical value.
 For co-termination, use any equivalent worth method using the cash
flows available for the study period.
 Rate-of-Return (ROR) method
 Example 6-7 & 6-8 : Useful Lives ≠ Study Period

The following data have been estimated for two mutually exclusive
investment alternatives, A and B, associated with a small engineering project
for which revenues as well as expenses are involved. They have useful lives of
four and six years, respectively. If MARR = 10% per year, show which
alternative is more desirable by using equivalent-worth methods (computed
by hand and by spreadsheet).

(a) Use the repeatability assumption

(b) Use six years analysis period (co-terminated Assumption)
(c) Use Rate-of-Return (ROR) analysis

A B
Capital Investment $3,500 $5,000
Annual Cash Flow $1,255 $1,480
Useful Live (years) 4 6
 Example 6-7 & 6-8 : Useful Lives ≠ Study Period
(a)

𝑃𝑊𝐴 = −3,500 − 3,500 𝑃Τ𝐹 , 10%, 4 − 3,500 𝑃Τ𝐹 , 10%, 8 + 1,255 𝑃Τ𝐴 , 10%, 12
= 1,028

𝑃𝑊𝐵 = −5,000 − 5,000 𝑃Τ𝐹 , 10%, 6 + 1,480 𝑃Τ𝐴 , 10%, 12 = 2,262

Choose B
 Example 6-7 & 6-8 : Useful Lives ≠ Study Period
(b)

𝐹𝑊𝐴 = −3,500 𝐹 Τ𝑃 , 10%, 6 + 1,255 𝐹 Τ𝐴 , 10%, 4 (𝐹 Τ𝑃 , 10%, 2) = 846

𝐹𝑊𝐵 = −5,000 𝐹 Τ𝑃 , 10%, 6 + 1,480 𝐹 Τ𝐴 , 10%, 6 = 2,560

Choose B
Example 6-7 & 6-8 : Useful Lives ≠ Study Period
(c)

A B
Capital Investment $3,500 $5,000
Annual Cash Flow $1,255 $1,480
Useful Live (years) 4 6

𝐴𝑊𝐴 𝑖 ∗ % = 𝐴𝑊𝐵 (𝑖 ∗ %)

−3,500 𝐴Τ𝑃 , 𝑖 ∗ %, 4 + 1,255 = −5,000 𝐴Τ𝑃 , 𝑖 ∗ %, 6 + 1,480

𝑖 ∗ = 26%

IRR>MARR : Choose B
 Alternatives for Waste Storage

A large electric utility company is considering two methods for containing and storing
its coal combustion by-products (fly ash). One method is wet slurry storage, and the
second method is dry storage of the fly ash. The company will adopt one of these
methods for all 28 fly ash impoundments at its seven coal-fired power plants. Wet
storage has an initial capital investment of $2 billion, followed by annual maintenance
expenses of $300 million over the 10-year life of the method. Dry storage has a $2.5
billion capital investment and $150 million per year annual upkeep expenditures over
its 7-year life. If the utility’s MARR is 10% per year, which method of fly ash storage
should be selected assuming an indefinitely long study period?
 Alternatives for Waste Storage

𝐴𝑊𝑤𝑒𝑡 = −2,000,000,000 𝐴Τ𝑃 , 10%, 10 − 300,000,000 = −625,400,000

𝐴𝑊𝑤𝑒𝑡 −625,400,000
𝐶𝑊𝑤𝑒𝑡 = = = −6,254,000,000
𝑖 0.1

𝐴𝑊𝑑𝑟𝑦 = −2,500,000,000 𝐴Τ𝑃 , 10%, 7 − 150,000,000 = −663,500,000

𝐴𝑊𝑑𝑟𝑦 −663,500,000
𝐶𝑊𝑑𝑟𝑦 = = = −6,635,000,000
𝑖 0.1
Choose
Wet
 Summary
42

 The term mutually exclusive means that when one of several alternatives that
meet the same need is selected, the others will be rejected.
 Revenue projects are those for which the income generated depends on the
choice of project.
 Service projects are those for which income remains the same, regardless of
which project is selected.
 The analysis period (study period) is the time span over which the economic
effects of an investment will be evaluated.
 The required service period is the time span over which the service of
equipment (or investment) will be needed.
 The analysis period should be chosen to cover the required service period.
 When not specified by management or company policy, the analysis period to
use in a comparison of mutually exclusive projects may be chosen by the
individual analyst.