Chapter 4

EVALUATING
ALTERNATIVES

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Analysis tools
 Three commonly used analysis tools are
◦ Present Worth Analysis
◦ Annual Worth Analysis
◦ Rate of Return Analysis
 Other Methods
◦ Cost – benefit analysis

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Present Worth Analysis

 Steps to do present worth analysis for a single

alternative (investment)
◦ Select a desired value of the return on investment
(i)
◦ Using the compound interest formulas bring all
benefits and costs to present worth
◦ Select the alternative if its net present worth
(Present worth of benefits – Present worth of
costs) ≥ 0

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 Present Worth Analysis
 Steps to do present worth analysis for
selecting a single alternative (investment) from
among multiple alternatives
◦ Step 1: Select a desired value of the return on
investment (i)
◦ Step 2: Using the compound interest formulas
bring all benefits and costs to present worth for
each alternative
◦ Step 3: Select the alternative with the largest net
present worth (Present worth of benefits –
Present worth of costs)

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 The PW comparison of alternatives with equal time
duration is straightforward.
 When the present worth method is used to compare
mutually exclusive alternatives that have different
lives, the equal-service requirement must be met.
 The PW of the alternatives must be compared over
the same number of years and must end
at the same time to satisfy the equal-service
requirement.
 Compare the PW of alternatives over a period of
time equal to the least common multiple (LCM)
of their estimated lives.
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Example
 During lab research, three equal-service machines
need to be evaluated economically. Perform the
present worth analysis with the costs shown below.
The MARR is 10% per year.

Electric - Gas-powered Solar

powered powered

First cost 4500 3500 6000

Annual OC 900 700 50
Salvage value 200 350 100
Life, years 8 8 8

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 Solution
PWE = - 4500 - 900( P/A ,10%,8)+ 200(P/F ,10%,8)= - $9208
PW G =-3500 - 700(P/A ,10%,8) + 350(P/F ,10%,8)= - $7071
PW S = -6000 - 50(P/A ,10%,8) + 100(P/F ,10%,8) = - $6220

 The solar-powered machine is selected since the PW of

its costs is the lowest; it has the numerically largest PW
value.

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Example
Determine which alternative should be selected on the basis of a present
worth comparison, if the MARR is 15% per year.

Alternative Alternative
A B
First cost 15000 18000
Annual OC 3500 3100
Salvage value 1000 2000
Life, years 6 9
PW A= -15,000 - 15,000(P/F,15%,6) + 1000(P/F,15%,6) -15,000(P/F,15%,12)
+1000(P/F,15%,12) +1000(P/F,15%,18)-3,500(P/A,15%,18) = -45,036
PW B =- 18,000 - 18,000(P/F,15%,9) + 2000(P/F,15%,9)+ 2000(P/F,15%,18)
-3100(P/A,15%,18) = -41,384

Based on PW analysis method, Alternative B is selected since it costs less.

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9
Annual Worth Analysis
 It is considered to be the most desirable
method because the AW method is easy to
calculate and is easily understood by anyone.
 Some of its assumption is identical with the
present worth method
 The AW value has to be calculated for only one
life cycle. The AW value determined over one
life cycle is the AW for all future life cycles.
 Therefore it is not necessary to use LCM of
lives compared to PW and FW method.

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Assumptions of AW Method
 When alternatives being compared have
different lives, the AW method makes the
assumption that:
1. The services provided are needed for at
least the LCM of the lives of the
alternatives.
2. The selected alternative will be repeated for
succeeding life cycle in exactly the same
manner as for the first life cycle.
3. All cash flow will have the same estimated
values in every life cycle.
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Annual Worth Values
1. Initial Investment (P) – Total first cost of
all assets and services required to
initiate the alternative.
2. Salvage Value (S) – This is the terminal
estimated value of the assets at the end
of their useful life.
3. Annual Amount (A) – This is the
equivalent annual amount, sometimes
referred as annual operating cost.
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Consider the example already seen in evaluating alternative A based
on PW method of analysis

AW = 45,036( A/P ,15%,18) = $7349

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 AW = -15,000( A/P ,15%,6) + 1000( A/F ,15%,6) - 3500 = $7349

**The one-life-cycle AW value and the AW value based on 18 years are equal.
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AW of an Alternative
 It is comprised of two components: Capital
recovery for the initial investment P at a stated
interest rate, usually MARR and the equivalent
annual amount A.
 In equation;
AW = CR + A
 Capital recovery (CR) is the equivalent annual
amount that the asset, process, or system must
earn (new revenue) each year to just recover the
initial investment plus a stated rate of return
over its expected life.
 Any expected salvage value is considered in the
computation of CR.

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Capital Recovery and AW Values
 Assume the potential purchase of any
productive asset
 One needs to know or estimate
◦ Initial investment, P
◦ Estimated future salvage value, S
◦ Estimated life of the asset, N
◦ Estimated operating cost and timing
◦ Operative interest rate, i%

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Example
An equipment is expected to require an investment of $13 million, with
$8 million committed now and the remaining $5 million expended at the
end of year 1 of the project. Annual operating costs for the system are
expected to start the first year and continue at $0.9 million per year. The
useful life of the tracker is 8 years with a salvage value of $0.5 million.
Calculate the CR and AW values for the system, if the corporate MARR
is 12% per year.

Solution
P = 8 + 5( P/F ,12%,1)=$12.46
CR = -12.46(A/P ,12%,8) + 0.5( A/F ,12%,8) = - $2.47 Million per year

 It means that each and every year for 8 years, the equivalent total net
revenue from the equipment must be at least $2,470,000

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 AW= -2.47 - 0.9 = - $3.37 million per year

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 Evaluating Alternatives by AW
Analysis
 The annual worth method is typically the easiest to apply of
the evaluation techniques when the MARR is specified.
 For mutually exclusive alternatives, whether cost or
revenue-based, the guidelines are as follows:
 One alternative: If AW>= 0, the requested
MARR is met or exceeded and the alternative is
economically justified.
 Two or more alternatives: Select the alternative
with the AW that is numerically largest, that is, less
negative or more positive. This indicates a lower
AW of cost for cost alternatives or a larger AW of
net cash flows for revenue alternatives.

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 Five systems planned to be installed. Each system costs
$4600, has a 5-year useful life, and may be salvaged for
an estimated $300. Total operating cost for all systems is
$1000 for the first year, increasing by $100 per year
thereafter. The MARR is 10%.
a)How much new annual net income is necessary to
recover the investment?
b) increased net income of $6000 per year for all five
systems. Is this project financially viable at the MARR?
c) Determine the net income required to Justify economic
viability for the same operating cost?

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Solution
a) capital recovery amount
CR= - 5[4600( A/P ,10%,5)] + 5[300( A/F ,10%,5)]=$ -5882
 The five systems must generate an equivalent annual new revenue of
$5822 to recover the initial investment plus a 10% per year return.
b) Annual worth
AW = CR + A= - 5822 + (6000-1000) - 100( AG ,10%,5) = $ -1003
 The system is not financially justified at the net income level of $6000
per year
c) find the minimum income to justify the system
AW=0= - 5822 + ( R - 1000) - 100( A/G ,10%,5)
R=$ 7003

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Exercise
A machine shown below are under consideration
for an improvement on the mixing capacity of a
mixer. The cost are shown below. Which
should be selected on the basis of an annual
worth comparison at an interest rate of 10 %
compounded monthly.

Machine A Machine B
First Cost 7,560 12,900
Maintenance Cost 1200 900
Salvage Value 0 2,000
Life in years 2 4

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 Future Worth Analysis
 The future worth (FW) of an alternative may be
determined directly from the cash flows, or by
multiplying the PW value by the FP factor, at the
established MARR.
 Analysis of alternatives using FW values is especially
applicable to large capital investment decisions when
a prime goal is to maximize the future wealth of a
corporation’s stockholders.
 The selection guidelines for FW analysis are the same
as for PW analysis; FW >= 0 means the MARR is met
or exceeded. For two or more mutually exclusive
alternatives, select the one with the numerically
largest FW value.
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Rate of Return Analysis
 Rate of return (ROR) is the rate paid on the unpaid
balance of borrowed money, or the rate earned on
the unrecovered balance of an investment
 The rate of return is expressed as a percent per
period
 Single alternative case
 In this method all revenues and costs of the
alternative are reduced to a single percentage
number
 This percentage number can be compared to other
investment returns and interest rates inside and
outside the organization

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Rate of Return Analysis
 Steps to determine rate of return for a single stand-
alone investment
◦ Step 1: Take the dollar amounts to the same point in
time using the compound interest formulas
◦ Step 2: Equate the sum of the revenues to the sum of
the costs at that point in time and solve for I
 The rate of return is the interest rate that makes the
present worth or annual worth of a cash flow series
exactly equal to 0.
 Solve for i using either of the relations

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 The i value that makes these equations
numerically correct is called i *. It is the root of
the ROR relation. To determine if the investment
project’s cash flow series is viable, compare i *
with the established MARR.
 If i * >= MARR, accept the project as
economically viable.
 If i * < MARR, the project is not economically
viable.

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 The purpose of engineering economy
calculations is equivalence in PW or AW
terms for a stated i >= 0%.
 In rate of return calculations, the objective
is to find the interest rate i* at which the
cash flows are equivalent.
 The calculations are the reverse of those
made in previous chapters,where the
interest rate was known.
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Example
If you deposit $1000 now and are promised
payments of $500 three years from now and
$1500 five years from now, determine the
rate of return.
Solution
1000 = 500( P/F , i *,3)+1500( P/F , i *,5)
0 = -1000+500( P/F , i *,3)+1500( P/F , i *,5)
i * =16.9 % by trial and error

** Spread sheet used in order to compute i * easily.

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Cost- Benefit Analysis

 It is a systematic process for calculating and

comparing benefits and cost of a project,
decision or policy.
 Present and future benefits (income) and costs
need to be estimated to determine the
attractiveness (worthiness) of a new product
investment alternative
 It has two purposes:
◦ To determine if it is a sound investment/decision
◦ To provide basis for comparing projects

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 Costs:-estimated expenditures to the government
entity for construction, operation, and
maintenance of the project, less any expected
salvage value.
 Benefits :-advantages to be experienced by the
owners, the public.
 Disbenefits :- expected undesirable or negative
consequences to the owners if the alternative is
implemented. Disbenefits may be indirect
economic disadvantages of the alternative.

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Benefit/Cost Ratio
 The B/C analysis can use equivalency
computations based on PW, AW, or FW values
 Initially used in the economic analysis of public
sector evaluation by reducing the effect of
politics and special interest
Characteristic Public sector Private sector
Size of investment Large medium to small
Life estimates Longer (30-50 + yrs) Shorter (2-25 yrs)
Annual cash flow No profit t; costs, benefits, and Revenues contribute to
estimates Dis-benefits are estimated profi ts; costs are estimated

Interest rate Lower Higher, based on cost of

capital

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Public Sector Projects
 These projects are owned, used and
financed by the citizenry of any
government level.
 Areas of public sector that require
engineering economic analysis:
◦ Health
◦ Safety
◦ Economic welfare
◦ Utilities

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Benefit Cost Analysis of a Single
Project
 The B/C ratio is calculated using one of
these relations:
B/C=PW of benefits/PW of costs
B/C=AW of benefits/AW of costs
B/C=FW of benefits/FW of benefits
If B/C≥ 1.0, accept the project as economically
acceptable for the estimates and discount
rate applied.
If B/C <1.0, the project is not economically
acceptable.

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Conventional B/C Ratio
 It is the most widely use B/C ratio in
public and private sector.
benefits  disbenefit s
B/C 
cos ts

 The disbenefits are subtracted from the

benefits and not added to the cost

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Modified B/C ratio
 In this method the maintenance and
operation (M&O)is in the numerator and
treated as disbenefits
benefits  disbenefit s  M & O cos t
ModefiedB / C 
initial investment

 Salvage value is included in the

denominator as a negative cost

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Benefit and Cost Difference

 It is a measure of worth which does not

involve ratio, and is based on the
difference between the PW, AW or FW of
benefits and cost.
 If B – C is ≥0; the project is acceptable

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Example
Award amount : $20 million (end of) first year, decreasing
by $5 million per year for 3 additional years; local
government will fund during the first year only.
Annual costs: $2 million per year for 10 years, as
proposed
Benefits : Reduction of $8 million per year in health-
related expenses for citizens.
Dis-benefits: $0.1 to $0.6 million per year for removal of
arable land and commercial districts
Use the conventional and modified B/C methods to
determine if this grant proposal is economically justified
over a 10-year study period
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 Solution
Determine the AW for each parameter over 10 years.
Award: 20 − 5(A/G,6%,4)= $12.864 M per year
Annual costs: $2 M per year
Benefits: $8 M per year
Disbenefits: 0.1 to $0.6 M

conventional B/C and modified B/C analysis

8.0−0.6 8.0−0.1
B/C= =0.50 , B/C= =0.53
12.864+2.0 12.864+2.0

8.0−0.6−2.0 8.0−0.1−2.0
modified B/C = =0.42 , modified B/C = =0.46
12.864 12.864

The proposal is not justified economically using both analysis since

B/C is less than 1.0
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 Example
The construction cost of the bypass is $20 million, and
$500,000 would be required each year for annual
maintenance. The annual benefits to the public have been
estimated to be $2 million. If the study period is 50 years
and the state’s interest rate is 8% per year, should the bypass
be constructed? What impact does a social interest rate of
4% per year have on the B–C ratio of the project?
Solution
At an interest rate of 8% per year, the conventional B–C ratio of
the proposed bypass is
2
B/C = = 0.94
20 (𝐴 𝑃 ,8%,50)+0.5
 The bypass is not economically acceptable at 8% interest.
 If a social interest rate of 4% per year was used, the B–C ratio
would be 1.40 and the bypass would be acceptable.
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