1

Engineering Economy and

Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Content
Introduction
Defining Investment Alternatives
Defining the Planning Horizon
Developing Cash Flow Profiles
Specifying the MARR
Comparing the Investment Alternatives
Equivalent Worth Methods
Internal Rate of Return Method
2
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Content (cont.d)
External Rate of Return Method
Savings/Investment Ratio Method
Payback Period Method
Capitalized Worth Method
Performing Supplementary Analyses
Selecting Preferred Alternative
Alternatives With No Positive Cash Flows
Unequal Lives
Replacement Analysis
3
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Introduction
Assume that set of investment alternatives is collectively exhausting and
mutually exclusive.
Collectively exhaustive: not to leave out any alternatives
Mutually exclusive: either or situation; no more than one alternative can
be chosen
A systematic approach that can be used in comparing economic
investment alternatives is summarised as follows:
1. Define a set of feasible, mutually exclusive economic investment
alternatives to be compared.
2. Define the planning horizon to be used in comparison.
3. Develop CF profiles for each alternative.
4. Specify the MARR to be used.
5. Compare alternatives using a specified measure of worth.
6. Perform supplementary analyses
7. Select the preferred alternative.
4
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Defining Investment Alternatives
An individual alternative selected from a set of mutually
exclusive alternatives can be made up of several investment
proposals.
Investment alternatives are decision options whereas investment
proposals are single projects or undertakings that are being
considered as investment possibilities.
If there are m investment proposals, we can form up to 2
m
mutually exclusive alternatives.
Among the alternatives formed, some of them may not be
feasible, not satisfying the constraints (i.e. budget limitation)
Some of the proposals might be mutually exclusive (i.e. if one is
selected, the other can not be)
Some of the proposals might be contingent(i.e. one cannot be
selected unless another one is also selected).
5
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Defining Investment Alternatives
Example 5.1
The Belt Company is considering three investment proposals, A, B, and
C. Proposals A and B are mutually exclusive, and proposal C is contingent
on proposal B. The cash flow data for the investments over a 10-year
planning horizon are given below. The Belt Company has a budget limit
of $1M for the investments of the type being considered currently.
MARR=25%. Clearly specify the alternatives and their CF profiles.
NCF(A) NCF(B) NCF(C)
Initial investment $600,000 $800,000 $470,000
Life 10 years 10 years 10 years
Salvage value $70,000 $130,000 $65,000
Annual receipts $400,000 $600,000 $260,000
Annual disbursements $130,000 $270,000 $70,000
6
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Defining Investment Alternatives
Example 5.1(solution)
Alternatives A B C Comments
0 0 0 0 Do-nothing
1 1 0 0
2 0 1 0
3 0 0 1 (Cont. on B)
4 1 1 0 (A&B M.E.)
5 1 0 1 Budget limit
6 0 1 1 Budget limit
7 1 1 1 Budget limit
7
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Defining Investment Alternatives
Example 5.1(solution cont.d)
Alternatives 0 1 2
Initial Investment 0 $600,000 $800,000
Life 10 years 10 years 10 years
Salvage value 0 $70,000 $130,000
Annual receipts 0 $400,000 $600,000
Annual disbursements 0 $130,000 $270,000
8
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Defining the Planning Horizon
Alternatives must be compared over a common period of
time.
If the investment is an equipment, then the period of time
over which the service is required might be used as the
planning horizon.
Length of P-H, working life of equipment and depreciable
life of equipment should all be distinguished from each
other.
The working life: actual period of time the equipment is
capable of being used.
9
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Defining the Planning Horizon
Depreciable life: allowable period of time for depreciating
the asset.
P-H: simply the time frame to be used in comparing the
alternatives and should realistically represent the period of
time over which reasonably accurate CF estimates can be
provided.
The same time window must be used in viewing each
alternative. Some commonly used methods for determining
the P-H to use in economy studies:
1. Least common multiple of lives for the set of feasible
alternatives, denoted (repeatability assumption).
.
T
10
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Defining the Planning Horizon
2. Study period (cotermination assumption)
a) Shortest life among alternatives, denoted T
s
b) Longest life among alternatives, denoted T
l
c) Some other period of time
Selection of the first method is usually made implicitly
when one calculates and compares the annual worth of
unequal-lived alternatives.
Example 5.2
Consider the two CF diagrams given below. The two
alternatives are mutually exclusive, one-shot investments.
11
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.2 (solution)
Alternative 1 Alternative 2
We are unable to predict what investment alternatives will be
available in the future, but we do anticipate that recovered capital can
be reinvested and earn a 15% return.
A 6-year P-H is suggested, with 0 CFs occuring in years 5 and 6
with alternative 1.
Defining the Planning Horizon
4M
3.5M 3.5M 3.5M
4.5M
0 1 2 3 4
5M
1M
2M
3M
4M
5M
6M
0 1 2 3 4 5 6
12
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.2 (solution cont.d)
At EOY 6, NFW for the two alternatives:
Defining the Planning Horizon
( )
( ) ( )
Alt.2 select
0 $15,546,46
15,6 F/P 5M 15,6 F/A 15,6 A/G 1M 15,6 F/A 1M 15% FW
290 , 183 , 15 $
15,6 F/P 4M 15,6 F/P 15,3 P/A 3.5M 15,2 F/P 4.5M 15% FW
2.3131 8.7537 2.0972 8.7537
2
2.3131 2.3131 2.2832 1.3225
1

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13
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Once set of mutually exclusive alternatives (MEA) has been specified
and the P-H decision has been made, CF profiles can be developed
for the alternatives.
CF profiles should be developed by giving careful consideration to
future conditions instead of relying completely on past CFs.
CFs for an investment alternative are obtained by aggregating the
CFs for all investment proposals included in the investment
alternative.
Example 5.3
Four investment proposals, W, X, Y, and Z are being considered by the
Ajax Corporation. Proposals X and Z are mutually exclusive. Proposal
Y is contingent on either X or Z. Proposals W and Y are mutually
Developing CF Profiles
14
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.3 (cont.d)
exclusive. A budget limitation of $4M exists. Either Proposal X or
Proposal Z must be included in the alternatives selected.
CF profiles for the proposals:
a) Determine the set of feasible alternatives
b) Determine the net CF for each alternative
Developing CF Profiles
EOY NCF(W) NCF(X) NCF(Y) NCF(Z)
0 -$2M -$2.5M -$1.8M -2M
1-8 $0.6M $1M $0.5M $0.4M
8 $0.8M $0.2M $2.4M $2M
15
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.3 (solution)
Developing CF Profiles
Proposals Feasible Alt.
W X Y Z
Investment
Required
Comments
0 0 0 0 0 X or Z must exist
1 0 0 0 $2M X or Z must exist
1 0 1 0 0 $2.5M
0 0 1 0 $1.8M X or Z must exist
2 0 0 0 1 $2M
1 1 0 0 $4.5M Exceeds Budget
1 0 1 0 $3.8M X or Z must exist
3 1 0 0 1 $4M
0 1 1 0 $4.3M Exceeds Budget
0 1 0 1 $4.5M Exceeds Budget
4 0 0 1 1 $3.8M
1 1 1 0 $6.3M Exceeds Budget
1 1 0 1 $6.5M Exceeds Budget
1 0 1 1 $5.8M Exceeds Budget
0 1 1 1 $6.3M Exceeds Budget
1 1 1 1 $8.3M Exceeds Budget
16
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.3 (solution cont.d)
Do-nothing alternative serves as base against which other
alternatives are considered. Some cases this alternative is not
feasible (i.e. there should definitely be cooling system, pollution
control, waste treatment, etc.).
Do-nothing does not necessarily have 0 CF associated with it.
Costs & revenues which will remain const. regardless of alt.
selected can be omitted.
Developing CF Profiles
EOY A
1
A
2
A
3
A
4
0 -$2.5M -$2M -$4M -$3.8M
1-8 $1M $0.4M $1M $0.9M
8 $0.2M $2M $2.8M $4.4M
17
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
A specified interest is needed to convert the mix of CFs occurring
throughout the P-H to a meaningful economic measure that can be
used rationally to compare engineering alternatives.
Regardless of the basis used for determining the value of the MARR,
its value should be greater than the cost of securing capital; it should
represent the opportunity cost associated with investing in the
candidate alternative as opposed to other available alternatives.
Cost of Capital
Debt capital: money borrowed for the purpose of investment.
The lender forgoes his opportunities to invest his money himself and allows
the borrower to invest it instead.
The borrower must compensate the lender for the lost opportunity.
Equity capital: money owned by the stock holders
Specifying the MARR
18
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
A stock holder expects periodic dividends and hopes to sell his share of stocks
at a higher price after some time to another investor.
The dividends paid to stock holders comes from the firms earnings in a
particular year.
Rest of the earnings are retained by the firm and reinvested (retained earnings)
The portion of the dividends must be enough to compensate the stock holders
for the lost opportunities to invest their money elsewhere, hence the dividends
are a cost of equity capital.
The retained earnings also have cost of capital because they will be
considered as additional equity capital that has an opportunity to generate a
return if invested elsewhere.
The overall weighted average cost of capital(k) is simply the individual source
costs of capital weighted by the fraction of total funding from that source:
k = E

p
i
k
i
p
i
= fraction of funding from source i
k
i
= cost of capital from source i
Specifying the MARR
19
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.4
k = 1/4(10%) + 2/4(8%) + 1/4 (9%) = 8.75%
Specifying the MARR
Source Funding Fraction Cost
Loans $100,000 1/4 10%
Stocks $200,000 2/4 8%
Retained earnings $100,000 1/4 9%
TOTAL $400,000
20
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
The MARR
Some approaches used to establish the MARR:
1. Add a fixed percentage to the firms cost of capital
2. Average rate of return over the past 5 years
3. Use different MARR for different P-H
4. Use different MARR for different magnitudes of initial investments
5. Use different MARR for new ventures than cost improvement
projects
6. Use as a management tool to stimulate or discourage capital
investments, depending on the overall economic condition of the
firm
7. Use the average stockholders return on investment for all
companies in the same industry group.
Specifying the MARR
21
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Instead of increasing the value of MARR with respect to increases in risks
associated with the project, it is better to perform an explicit risk analysis.
MARR should be selected using the opportunity cost concept.
Comparing the Investment Alternatives
Example 5.5
Cash flow profiles for four investment alternatives are given below:
MARR=10%
Specifying the MARR
EOY, t A
0t
A
1t
A
2t
A
3t
0 $0 -$50M -$20M -$50M
1 0 -5M -4M 0
2 0 10M 2M 8M
3 0 25M 8M 16M
4 0 40M 14M 24M
5 0 10M 25M 45M
22
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Simply compute the EW (PW, AW, or FW) of each investment
alternative and recommend the one with highest EW.
Alternatively, EW of each increment of investment can be computed
and increments can be selected or rejected, depending upon whether
or not they have positive or negative EW.
Example 5.5 (cont.d)
For the data given in above table:
Equivalent Worth Methods
( )
( )
d. recommende be to is Alt3
M $14.207900 P/F10,5 M 13 10,5 P/G 8M 50M (10%) PW
112 . 9 $ 10,5 P/F 5M 5 10, P/G 6M 10,5 P/A 4M 20M 10% PW
$6.032500M 5 , 10 P/F M 45 10,5 P/G 15M ,10,5 P/A 5M 50M (10%) PW
0 10% PW
0.6209 6.8618
1
0.6209 6.8618 3.7908
2
6209 . 0 6.8618 3.7908
1
0

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M
23
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.5 (cont.d)
Incremental approach
PW
2-0
(10%) = $9.1121 M>0 Alt2 preferred to Alt0
PW
3-2
(10%) = $5.0958 M>0 Alt3 preferred to Alt2
PW
1-3
(10%) = -$8.1754 M>0 Alt3 preferred to Alt1
Internal Rate of Return Method
a) Aggregate CF Approach
b) Incremental CF Approach - easier to implement
Example 5.5 (cont.d)
Using incremental CF approach:
Equivalent Worth Methods
( ) ( ) ( )( ) 0 M 5 i,5 F/P i,5 P/G 6M i,5 F/A 4M i,5 F/P 20M (i) FW
0 - 2
= + + =
24
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.5 (cont.d)
at i =18%
at i = 20%
Internal Rate of Return Method
M 434836 . 2 $
5M 2.2878 6Mx5.2312x 4Mx7.1542 20Mx2.2878 (18%) FW
0 - 2
=
+ + =
( )
Alt0. to preferable Alt2
10% 19.31% x2%
1,285,308 2,434,836
2,434,836
18% i
$1.285308M
5M 2.4883 6Mx4.9061x 4Mx7.4416 20Mx2.4883 20% FW
0 2

> =
+
+ =
=
+ + =

( ) ( ) ( )( ) 0 M 8 i,5 F/P i,5 P/G 2M i,5 F/A 4M i,5 F/P 30M (i) FW
2 - 3
= + + + =
25
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.5 (cont.d)
at i =12%
at i = 15%
Internal Rate of Return Method
M 089066 . 3 $
8M 1.7623 2Mx6.3970x 4Mx6.3528 30Mx1.7623 (12%) FW
2 - 3
=
+ + + =
( )
Alt2. to preferable Alt3
10% 13.77% x3%
2.140328M 3,089,066
3,089,066
12% i
$2.140328M
8M 2.0114 2Mx5.7751x 4Mx6.7424 Mx2.0114 0 3 15% FW
2 - 3

> =
+
+ =
=
+ + + =
( ) ( )( )
Alt1 to pref. Alt3 i, all for 0 (i) FW since undefined i
0 M 5 i,5 F/P i,5 P/G 7M i,5 F/P 5M (i) FW
3 - 1 3 1
3 - 1
< =
= + =

26
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.5 (cont.d)
Using incremental CF approach:
External Rate of Return Method
( ) ( )
( ) ( ) 0 53.5112M ,4 i F/A 4M ,5 i F/P 20M ) i ( FW
0 5M 10,4 F/P 10,4 P/G 6M
) 10,4 F/A 2M( ,4 i F/A 4M ,5 i F/P 20M ) i ( FW
0 - 2
1.4641 4.3781
4.6410
0 - 2
= +
'

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Alt0 to pref. Alt2 % 10 % 6 . 17 %) 15 % 18 (
200 , 769 000 , 418 , 5
000 , 418 , 5
% 5 1 i
ion, interpolat by
000 , 418 , 5 52,742,000 ) 4Mx1.7490 4 (20Mx2.011
% 5 1 i at
200 , 769 52,742,000 ) 4Mx1.9388 8 (20Mx2.287
18% i at
'
0 - 2
47,224,000
'
0 - 2
53,511,200
'
0 - 2
> ~
+
+ =
= + +
=
= + +
=
27
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.5 (cont.d)
External Rate of Return Method
( )
( )
( ) Alt2 to pref. Alt3 % 10 % 69 . 12 i 1.8174 i 1
0 54.522258M ,5 i F/P 30M ) i ( FW
0 8M 10,5 F/P 10,5 P/G 2M 10,5 F/A 4M ,5 i F/P 30M ) i ( FW
'
2 - 3
5
2 - 3
1.6105 6.8618 6.1051
2 - 3
> = =
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( )
( )
( )
Alt1 to preferred Alt3
values, ve for defined not is i 1 0.77
5M
M 3.84816653
,5 i F/P
0 M 3.84816653 ,5 i F/P 5M ) i ( FW
0 58M 10,4 F/P 10,4 P/G 7M 10,4 F/A 2M ,4 i F/P 5M ) i ( FW
'
3 - 1
3 - 1
1.4641 4.3781 4.6410
3 - 1

+ < = =
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28
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Most often used in public sector projects. Also known as benefit/cost
ratio method.
Example 5.5 (cont.d)
Savings/Investment Ratio Method
( )
Alt2 to pref. Alt3 1 29 . 1
30M
33.854M
30M
10,5 P/F 8M 10,5 P/G 2M 5 10, P/A 4M
%) 10 ( SIR
Alt0 pref. Alt2 1 4 . 1
6364 . 23
748796 . 32
10,1 P/F 4M 20M
10,5 P/F 5M 10,1 P/F 10,4 P/G 6M 10,1 P/F 10,4 P/A 2M
10% SIR
0.6309 6.8618 3.7908
2 - 3
0.9091
0.6209 0.9091 4.3781 0.9091 3.1699
0 2
> = =
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29
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.5 (cont.d)
Payback Period
Example 5.5 (cont.d)
Alt1
Savings/Investment Ratio Method
( )
Alt1 pref. Alt3 1 7361 . 0
10,5 P/F 35M 10,1 P/F 5M
10,5 P/F M 3 2 10,1 P/F 10,4 P/G 7M 10,1 P/F 10,4 P/A 2M
10% SIR
6209 . 0 0.9091
0.629 0.9091 4.3781 0.9091 3.1694
3 1
< =
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years) 4 (or 3.5years PBP 75M $ 40 25 10 R

55M $ C
4
2 t
1t
1
0 t
1t
~ = + +
=

=
=
30
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.5 (cont.d)
Alt2
Alt3
Alt1 is the best
Payback Period
4years PBP M 4 2 $ 4 1 8 2 R
M 4 2 $ C
4
1 t
2t
1
0 t
2t
~ = + + =
=

=
=
5years) (or 4.05years PBP M 93 $ 45 24 6 1 8 R
$50M C
5
1 t
2t
30
~ = + + + =
=

=
31
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Example 5.5 (cont.d)
Alt0
CW
0
(10%) = 0
Alt1
Alt2
Alt3
Alt3 is the best
Capitalized Worth Method
( ) 735 , 913 , 15 $
0.1
10,5 A/P 6.0325M
10% CW
0.2638
1
=
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( ) 719 , 037 , 24 $
0.1
10,5 A/P 9.1121M
10% CW
0.2638
2
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( ) 440 , 480 , 37 $
0.1
10,5 A/P 14.2079M
10% CW
0.2638
3
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32
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Performing Supplementary Analyses
Sensitivity analysis: behaviour of measure of investment worth to
changes in values of parameters for an investment alternative, such as
P-H, discount rate, any or all of CFs
Break-even analysis
Risk analysis, etc.
Selecting Preferred Alternative
Alternatives with No Positive CFs
Example 5.6
Consider a case in which two different pumps are under consideration
to increase the pumping efficiency in an irrigation system. CF profiles
for the three mutually exclusive alternatives including the present case
33
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Alternatives with No Positive CFs
t
Present
A
0t
Pump 1
A
1t
Pump 2
A
2t
0 0 -$8M -$14M
1 -$3M -1.6M -1.1M
2 -4M -1.6M -1.1M
3 -5M -1.6M -1.1M
4 -6M -1.6M -1.1M
5 -7M -1.6M -1.1M+6M
(do-nothing) are given in the following table:
Determine which alternative should be selected using a MARR=15%.
34
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
AW Method-Ranking Approach
AW Method-Inc. CF Approach
( ) ( )
( )
( )
best. the is Alt1
/year $4,386,400 15,5 A/F 6 1.1M 15,5 A/P 14M 15% AW
/year $3,986,400 1.6M 15,5 A/P 8M 15% AW
/year $4,722,800 15,5 A/G 1M 3M 15% AW
0.1483 0.2983
2
0.2983
1
1.7228
0

=
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=
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=
= =
( )
( )
best. the is 1 Alt
ear $400,000/y 15,5 A/F 6M 0.5 15,5 A/P 6M 15% AW
2 Alt to 1 Alt prefer
ear $736,400/y 15,5 A/G 1M 1.4 15,5 A/P 8M 15% AW
0.1483 0.2983
1 2
1.7228 0.2983
0 1

=
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+ +
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=

=
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=

35
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
IRR Method-Inc. CF Approach
( ) ( ) ( ) ( )( )
( ) ( ) ( )
Alt2 over pref. Alt1 15% 7.95% x1%
24700 459,750
459,750
7% i
-$24,700 6M 6 0.5Mx5.866 6Mx1.4693 -
8% i at
459,750 $ 6M 5 0.5Mx5.750 6Mx1.4026 -
7% i at
0 6M i,5 F/A 0.5M i,5 F/P 6M i FW
Alt0 over pref. Alt1 15% 24.83% x5%
96,36 2,704,510
2,704,510
20% i
-$96,636 3.0518 1Mx4.2035x 0 1.4Mx8.207 8Mx3.0518 -
25% i at
$2,704,510 2.4883 1Mx4.9061x 6 1.4Mx7.441 8Mx2.4883
20% i at
0 i,5 F/P i,5 P/G 1M i,5 F/A 1.4 i,5 F/P 8M i FW
1 2
0 1
< =
+
+ =
= + +
=
= + +
=
= + + =
> =
+
+ =
= + +
=
= + +
=
= + + =

36
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Unequal Lives
P-H should be clearly specified, common to all alternatives.
CFs over P-H must be explicitly given.
Mistakes will arise if alternatives are compared on the basis of
individual life cycles.
Example 5.7
Two CF profiles as below:
15M
8M/year
0 1 2 3 4 5 6
1M
30M
4.5M/year
0 1 2 3 4 5 6 7
7.5M
1
2
MARR=20%
37
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Unequal Lives
Example 5.7 (cont.d)
Annual Worths:
In this comparison of alternatives, it has been implicitly assumed that
there exists a 42 year (least common multiple of lives) P-H over which
the first alternative is repeated 7 times and the second, 6 times.
An alternative assumption:
6 year P-H with salvage value for Alt2, such that same AW= -$12.24M
will still be obtained.
( )
( ) $12.24M 20,7 A/F M 5 . 7 M 5 . 4 20,7 A/P M 0 3 20% AW
$12.41M 20,6 A/F 1M 8M 20,6 A/P 15M 20% AW
0.0774 0.2774
2
0.1007 0.3007
1
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38
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Unequal Lives
Example 5.7 (cont.d)
These two implicit assumptions may or may not be correct.
Replacement Analysis
One of the alternatives to maintain status quo (defender)
Remaining alternatives provide replacement options available
(challengers).
30M
4.5M/year
0 1 2 3 4 5 6
S
( ) ( )
$12.72M
0.1007
12.24 - 4.5 30Mx0.3007
S
$12.24M 20,6 A/F S 4.5 20,6 A/P 30M
=
+
=
= +
39
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Defender may have a number of deficiencies:
high set-up cost
excessive maintenance
declining production efficiency
heavy energy consumption
physical impairment, etc.
Challengers may have a no. of advantages:
new technology
easy set-up
low maintenance cost
high in output
energy efficient
increased capabilities
reduced cost
40
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Environmental effects:
consumer demand preferences change
present equipment insufficient to deal with design changes
demand levels high to cope with
lease options to perform some tasks cheaper and better
Sunk costs must be eliminated
Two approaches:
CF approach (insider-owners point of view)
Outsider view point approach
CF Approach
No additional capital is required, if present asset is kept.
If a replacement is purchased, there is often a trade-in allowance given
for the present asset.
41
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Unrecoverable sunk cost should not be included in the analysis.
P-H, shortest life among the alternatives is often chosen since the
remaining life of the present asset is usually shorter.
Example 5.8
Metallic Peripherals, Inc. has received a production contract for a new
product. The contract lasts for 5 years. To do the necessary machining
operations, the firm can use one of its own lathes, which was purchased
3 years ago at a cost of $32,000. Today the lathe can be sold for
$16,000. In five years the lathe will have a 0 salvage value. Annual
operating and maintenance costs for the lathe are $ 8,000 /year. If the
firm uses its own lathe, it must also purchase an additional lathe at a
42
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Example 5.8 (cont.d)
cost of $24,000, its value in 5 years will be $6,000. The new lathe
willhave annual operating and maintenance costs $7,000/year.
As an alternative, the presently owned lathe can be traded-in for
$20,000 and a new lathe of larger capacity purchased for a cost of
$48,000; its value in 5 years is estimated to be $16,000, and its annual
operating and maintenance costs will be $12,000/year.
An additional alternative is to sell the presently owned lathe and
subcontract the work to another firm. Company X has agreed to do the
work for the 5-year period at an annual cost of $24,000/EOY. Using a
15% interest rate, determine the least-cost alternative for performing the
required production operations. Use the CF approach.
43
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Solution
CF diagrams: Challenger-buy new lathe:
Defender:
$15,000/year
$24,000
$6,000
0 1 2 3 4 5
0 1 2 3 4 5
$12,000/year
$48,000
$16,000
$20,000
$24,000/year
0 1 2 3 4 5
$16,000
Challenger-lease:
44
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Solution(cont.d):
buying a new lathe and trading in the old lathe with the new one is
the best course of action.
( )
( )
( ) 227 , 19 $ 000 , 24 15,5 A/P 000 , 16 % 15 AW
980 , 17 $ 15,5 A/F 6,000 1 000 , 12 15,5 A/P 000 , 28 % 15 AW
269 , 21 $ 15,5 A/F 6,000 000 , 15 15,5 A/P 000 , 24 % 15 AW
0.2983
2
0.1483 0.2983
1
0.1483 0.2983
0
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45
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Outsider (Opportunity Cost) Viewpoint Approach
Forces the decision maker to view both the existing asset and its
challengers from an objective point of view as would an outsider.
Outsider is free to choose either a used asset (defender) available for
the price of its market value, or any of the potential replacement assets
(challengers).
Salvage value of the existing asset is considered to be its investment
cost if it is retained in the service.
Example 5.9
Solve the previous problem using the outsider viewpoint approach.
Note
Trade-in values must be carefully treated when the outsider viewpoint
46
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Example 5.9(cont.d)
approach is adopted. These values re usually inflated and do not reflect
the true value of the existing asset. If they are greater than the actual
salvage value of the existing asset, in finding the true value of each
asset the difference should be subtracted from the inflated value of
each alternative. However, if the trade-in value is less than the salvage
value (market value) no adjustment is necessary since the defender can
be disposed separately at the market value price.
Solution:
CF diagram for the defender:
$15,000/year
$16,000+$24,000
$6,000
0 1 2 3 4 5
47
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Solution(cont.d):
CF diagram for the challenger
-buy new lathe of larger capacity:
0 1 2 3 4 5
$12,000/year
$48,000-($20,000-$16,000)
$16,000
$20,000
CF diagram for the challenger
-lease:
$24,000/year
0 1 2 3 4 5
48
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Solution(cont.d):
Optimum Replacement Interval
Despite that replacement studies may yield significant reductions in
cost, many firms still postpone replacing assets beyond optimum time
for replacement.
Some reasons for delaying replacement beyond economic replacement
time:
( )
( )
( ) 000 , 24 $ 000 , 24 % 15 AW
752 , 22 $ 15,5 A/F 6,000 1 000 , 12 15,5 A/P 000 , 44 % 15 AW
042 , 26 $ 15,5 A/F 6,000 000 , 15 15,5 A/P 000 , 40 % 15 AW
2
0.1483 0.2983
1
0.1483 0.2983
0
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49
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
a) Firm still making profit with present equipment
b) Present equipment is still operational, producing acceptable quality
products.
c) There exists risk and uncertainty in expenses of new machine while
those of the old are certain.
d) A decision to replace is stronger commitment for a period of time
into future than keeping the existing equipment.
e) Management is conservative in decision regarding replacement of
costly equipment.
f) There exists limitations on funds to purchase new equipment while
no limitations on funds maintaining existing equipment.
g) Considerable uncertainty concerning future demands for the services
of equipment in question.
50
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
h) Sunk costs psychologically affect decision to replace equipment
i) Due to rapid technological innovations, any adopted equipment may
become obsolete shortly; wait and see attitude hence prevails.
j) Reluctance to be pioneer in adopting new technology.
Life, years
C
o
s
t
s
EUAC
Annual operating
and maintenance cost
CR cost
51
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Example 5.10
A small compressor is to be purchased for $10,000; the salvage value
for the compressor is assumed to be negligible, regardless of the
replacement interval. Annual operating and maintenance costs are
expected to increase by $750/year with 1st years cost anticipated to be
$1,500. Using a MARR=20%, find the economic life of the
compressor.
Solution
EUAC(n=1) = 10,000(A/P 20,1)+1,500+750(A/G 20,1) = $13,500/yr
EUAC(n=2) = 10,000(A/P 20,2)+1,500+750(A/G 20,2) = $8,390/yr
EUAC(n=3) = $6,910/yr
EUAC(n=4) = $6,320/yr
EUAC(n=5) = $6,070/yr
52
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Solution(cont.d)
EUAC(n=6) = $5,991.10/yr
EUAC(n=7) = $5,991.17/yr
EUAC(n=8) = $6,040/yr
EUAC(n=9) = $6,110/yr
EUAC(n=10) = $6,190/yr
EUAC(n=11) = $6,280/yr
min (EUAC) occurs when n=6years, hence the optimum repl. interval is 6 years.
Some assumptions inherent in this analysis:
a) Implicit assumption of P-H being an integer multiple of the replacement interval
selected
b) Each time the compressor is replaced, it will be replaced with a compressor having
identical CF profile.
If neither of the above is valid, the above approach is not valid.
53
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Example 5.11
Suppose in the previous example 11-year P-H is appropriate. We also
assume that replacements will have identical CF profiles.
Solution
If the original compressor is kept 11 years, PW equivalent will be:
If the compressor is to be replaced some other point during P-H, say
after k years, and the replacement is to be kept until the end of P-H, the
following PW calculations result for k=6 and k=7:
174 , 27 $ 20,11 P/A -6280 11) PW(n
4.3271
=
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= =
164 , 26 $ 7 20, P/F 20,4 P/A 320 , 6 20,7 P/A -5,991.70 7) PW(k
003 , 26 $ 6 20, P/F 20,5 P/A 070 , 6 20,6 P/A -5,991.10 6) PW(k
0.2791 5887 . 2 3.6046
0.3349 9906 . 2 3.3255
=
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54
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
Solution(cont.d)
Thus, the compressor should be replaced after 6 years and the
replacement should be kept until the end of P-H.
If k=5:
0 1 2 3 4 5 6 7 8 9 10 11
$6,070/yr
$5,991.10/yr
If k=6:
0 1 2 3 4 5 6 7 8 9 10 11
$6,070/yr
$5,991.10/yr
k=6 is better
55
Engineering Economy and
Production Management
METU, Mech. Eng. Dept.
ME 443 5.
2009 Fall
Chapter 5: Comparison of
Alternatives
Replacement Analysis
The resulting measure of effectiveness is relatively
insensitive to deviations from the optimum strategy.
The firm might establish an operating policy of reviewing
the actual operating and maintenance costs for the
equipment at the anticipated optimum time of replacement.
Then perform a replacement study at that time, using 6-step
procedure comparing investment alternatives.