Evaluating Alternatives

EVALUATING ALTERNATIVES
Blank & Tarquin: 5th Edition. Ch. 5 Authored By: Dr. Don
Smith, Texas A&M University.
Evaluating Alternatives
• Part of Engineering Economy is the selection and
execution of the best alternative from among a set of
feasible alternatives
• Alternatives must be generated from within the
organization
 One of the roles of engineers!
• In part, the role of the engineer to properly evaluate
alternatives from a technical and economic view
• Must generate a set of feasible alternatives to solve a
specific problem/concern
Two types of investment categories:
• Mutually Exclusive Set
• Independent Project Set

Mutually Exclusive Alternatives

• Mutually Exclusive set is where a candidate set of
alternatives exist (more than one)
• Objective: Pick one and only one from the set
• Once selected, the remaining alternatives are
excluded
Independent Project Set

• Given a set of alternatives (more than one)
• The objective is to:

• Select the best possible combination of projects
from the set that will optimize a given criteria
• Subjects to constraints
• More difficult problem than the mutually exclusive
approach
Type of Alternatives
• Revenue/Cost – the alternatives consist of cash inflow
and cash outflows (alternatif investasi)
• Select the alternative with the maximum economic
value
• Service – the alternatives consist mainly of cost

elements (alternatif biaya)
• Select the alternative with the minimum economic
value (min. cost alternative)
Methods
• Metode Nilai Ekivalen (PW / AW Method)
• Metode Tingkat Pengembalian (IRR Method)

METODE NILAI EKIVALEN
PRESENT WORTH --- Equal Lives Alternatives
• Compute the Present Worth of each alternative and select

the best
i.e., smallest if cost and largest if profit
Example
Consider: Machine A Machine B

First Cost $2,500 $3,500
Annual Operating Cost 900 700
Salvage Value 200 350
Life 5 years 5 years
i = 10% per year
Which alternative should we select?

Cash Flow Diagram
F5=$200
MA
0 1 2 3 4
5
A = $900
$2,500
F5=$350
MB
0 1 2 3 4
5
$3,500 A = $700
Solving
PA = 2,500 + 900 (P|A, .10, 5) – 200 (P|F, .01, 5)

= 2,500 + 900 (3.7908) - 200 (.6209)
= 2,500 + 3,411.72 - 124.18 = $5,788
PB = 3,500 + 700 (P|A, .10, 5) – 350 (P|F, .10, 5)

= 3,500 + 2,653.56 - 217.31 = $5,936
SELECT MACHINE A : Lower PW cost!

PRESENT WORTH --- Different Lives Alternatives
• Comparison must be made over equal time periods

Compare over the least common multiple, LCM, for their
lives
• Remember – if the lives of the alternatives are not equal,

one must create or force a study period where the life is
the same for all of the alternatives
• If the alternatives have different study periods, you find

the lowest common life for all of the alternatives in
question
Example
Machine A Machine B
First Cost $11,000 $18,000
Annual Operating Cost 3,500 3,100
Salvage Value 1,000 2,000
Life 6 years 9 years
i = 15% per year

Cash Flow Diagram
Machine A F6=$1,000
0 1 2 3 4 5 6
A 1-6 =$3,500
$11,000
F6=$2,000
Machine B
0 1 2 3 4 5 6 7 8
9
A 1-9 =$3,100
i = 15% per year
$18,000
LCM(6,9) = 18 year study period will apply for present worth

Cash Flow Diagram
Machine A
6 years 6 years 6 years
Cycle 1 for A Cycle 2 for A Cycle 3 for A
Machine B
9 years 9 years
Cycle 1 for B Cycle 2 for B
18 years
i = 15% per year
LCM(6,9) = 18 year study period will apply for present worth

Solving
Calculate the present worth of a 6-year cycle for A

PA = 11,000 + 3,500 (P|A, .15, 6) – 1,000 (P|F, .15, 6)
= 11,000 + 3,500 (3.7845) – 1,000 (.4323)
= $23,813, which occurs at time 0, 6 and 12
0 6 12
18
$23,813 $23,813 $23,813
PA= 23,813+23,813 (P|F, .15, 6)+ 23,813 (P|F, .15, 12)

= 23,813 + 10,294 + 4,451 = 38,558
Calculate the Present Worth of a 9-year cycle for B
PB = 18,000+3,100(P|A, .15, 9) – 1,000(P|F, .15, 9)

= 18,000 + 3,100(4.7716) - 1,000(.2843)
= $32,508 which occurs at time 0 and 9
0 9 18
$32,508 $32,508
PB = 32,508 + 32,508 (P|F, .15, 9)

= 32,508 + 32,508(.2843)
PB = $41,750
Choose Machine A
Different Lives Alternatives --- Study Period

Approach
• Alternative: 1 with a 5-year life Alt-1: N = 5 yrs
• Alternative: 2 with a 7-year life Alt-2: N= 7 yrs
• LCM = 35 years ?
• Could assumed study period of, 5 years
• Assume a 5-yr. study period

• Estimate a salvage value for the 7-year project at the
end of t = 5
• Truncate the 7-yr project to 5 years  IMV method
Alt-1: N = 5 yrs
Alt-2: N= 7 yrs
• Now, evaluate both over 5 years using the PW

method!
IMV (Imputed Market Value)
• MVT = market value at T, T<U

• U = useful life
• present value (evaluated at time T) of the total loss of the asset value
during the period [T, U] and the present value (evaluated at time T) of
the salvage value of the asset at time U.
CAPITALIZED COST
• CAPITALIZED COST--- the present worth of a project that

lasts forever
• Exp: Government Projects, Roads, Dams, Bridges, etc.
• Infinite analysis period
 (1  i ) N  1 
P  A N 
, let N  
 i (1  i ) 
 (1  i ) N  1  1 1  A
lim N   N 
 P  A  
 i (1  i )  i i  i
CAPITALIZED COST
Assume you are called on to maintain a cemetery site

forever, if the interest rate = 4% and $50/year is
required to maintain the site, Find the PW of an infinite
annuity flow!
…………………..
1 2 3 4 5 .. N=inf.
A=$50/yr
P=?
CAPITALIZED COST
• P0 = $50[1/0.04]
• P0 = $50[25] = $1,250.00
• Invest $1,250 into an account that earns 4% per year will
yield $50 of interest forever if the fund is not touched and
the i-rate stays constant.
Blank & Tarquin: 5th Edition. Ch. 6 Authored by: Dr. Don Smith,
Texas A&M University.
Annual Worth Method
Advantages and Uses of Annual Worth

• Popular Analysis Technique
• Easily understood – results are reported in $/time
period
• Eliminates the LCM problem associated with the
present worth method
 Only have to evaluate one life cycle of a project
• If two or more alternatives possess unequal lives, then
one need only evaluate the AW for any given cycle
• The annual worth of one cycle is the same as the
annual worth of the other cycles (by assumption)
Example: 6-year & 9-year Problem
• Need an 18-year study period for both
6-year Project 6-year Project 6-year Project
9-year Project 9-year Project
• Present Worth would mandate a 18-year study period

• 3 Cycles of the 6-year project
• 2 cycles of the 9-year project
• Means a lot of calculation time!

• If one assumes the cash flow patterns remain the

same for the 6- and 9-year projects,
then all one has to do is:
6-year Project Find the AW of any 6 – year cycle
Find the annual worth of

9-year Project
any 9-year cycle
And then compare the AW6 yr to AW9 yr.

Capital Recovery (CR)
Capital Recovery (CR) is the annualized equivalent of the

initial investment P0 and the annualized amount of the
future salvage value Fn
CR = the equivalent annual worth of the asset
CR is a function of {P, S, i%, and “n” }

S
•Given: FN
……….
0 1 2 3 N-1 N
P0
•Convert to: FN
……….
0 1 2 3 N-1 N
P0
$A per year (CR)
COMPUTING CR FOR INVESTMENTS WITH SALVAGE VALUES:
• Method I - Compute EAC of the original cost and subtract the EAC of
the salvage value
EAC = P(A|P, i, n) - S(A|F, i, n)
• Method II – Subtract the salvage value from the original cost and
compute the annual cost of the difference. Add to that the interest that
the salvage value would return each year, S(i).
CR(i%)= (P - S) (A|P, i, n) + S(i)
EXAMPLE
Two alternatives are considered for covering a football field.

The first is to plant natural grass and the second is to install AstroTurf
(artificial carpet). Interest rate is 10%/year.
Assume the field is to last a “long time”.
Natural Grass -- Replanting will be required each 10 years at a cost
of $10,000. Annual cost for maintenance is $5,000. Equipment
must be purchased for $50,000, which will be replaced after 5 years
with a salvage value of $5,000
Artificial Carpet – PW for perpetual life project is $150,000, and
annual maintenance is $5,000/year
Natural Grass F5 = $5,000

F5 = $5,000
0 1 2 3 4 5 6 7 8 9 10
A = $5,000
F5=$50,000
P = $50,000+ $10,000
CR = (+) $60,000 (A/P,10%,10) (+) $5,000 (already an annual cost)

(+) $50,000 (P/F,10%,5)(A/P,10%,10) (-) $5,000
(P/F,10%,5)(A/P,10%,10)
(-) $5,000 (A/F,10%,10) = $ 19,046/year
Artificial Carpet
• A = P(i) for a perpetual life project
Annual Cost of Installation = $150,000 (.10) = $15,000/ year
• Annual Maintenance = $5,000/year
• Total: $15,000 + $5,000 = $20,000/Yr
Choose A, cost less per year!

METODE
TINGKAT PENGEMBALIAN
Metode Tingkat Pengembalian
• Dengan rumusan PW, tingkat pengembalian internal (i%) didapat jika
N N
 R P / F , i'%, k    E P / F , i'%, k 
k 0
k
k 0
k
dimana
Rk = pendapatan atau penghematan bersih untuk tahun ke-k
Ek = pembelanjaan bersih termasuk semua biaya investasi untuk tahun ke-k
N = periode studi
• Atau:
N N
 R P / F , i'%, k    E P / F , i'%, k   0
k 0
k
k 0
k
Aturan yang Berlaku
• Setiap tambahan modal harus dievaluasi kelayakannya dengan
menghasilkan tingkat pengembalian yang memuaskan pada
tambahan tersebut.
• Bandingkan alternatif dengan investasi lebih besar terhadap yang

lebih kecil hanya jika alternatif lebih kecil dapat diterima.
• Pilih alternatif dengan investasi modal lebih besar selama investasi

tambahan menguntungkan dengan tingkat pengembalian minimal
sama dengan MARR.
Masalah Peringkat yang Tidak Konsisten
• Evaluasi kelayakan terhadap modal tambahan harus dilakukan.
• Menjadi pertimbangan dalam pemilihan alternatif dengan metode

tingkat pengembalian.
• Jika tingkat pengembalian hanya dilakukan terhadap modal total dari

masing-masing alternatif, dapat menghasilkan peringkat yang tidak
konsisten.
Contoh
Alternatif
A B
Investasi modal -$60,000 -$73,000
Pendapatan dikurangi biaya tahunan 22,000 26,225
Umur manfaat dan periode studi 4 tahun, MARR 10%.
Hasil perhitungan PW (10%) dan IRR untuk kedua

alternatif:
Alternatif IRR PW(10%)
A 17.3% $ 9,738
B 16.3% 10,131
Jika evaluasi hanya dilakukan atas IRR dari total investasi dari masing-
masing alternatif, terlihat peringkat hasil yang berbeda dengan yang
ditunjukkan oleh metode PW.
Hasil PWB > PWA pada MARR 10%, walaupun IRRA > IRRB
Perlu dilakukan evaluasi terhadap IRR tambahan, IRR, untuk

menghindari kesalahan tersebut.
Alternatif Selisih
A B  (B-A)
Investasi modal -$60,000 -$73,000 -$13,000
Pendapatan dikurangi biaya tahunan 22,000 26,225 4,225
Alternatif IRR PW(10%)

A 17.3% $ 9,738
B 16.3% 10,131
 (B-A) 11.4% 393
Analisis Selisih Investasi
• Peranan utama aliran kas netto dari selisih modal, untuk 2 alternatif A
dan B (investasi B > A), (B-A), dalam perbandingan kedua alternatif
tersebut berdasarkan atas hubungan:
aliran kas B = aliran kas A + aliran kas selisih B dan A
• Aliran kas B tersusun dari dua bagian, yaitu aliran kas alternatif A dan
aliran kas tambahan (selisih) antara A dan B.
• Sehingga jika nilai ekivalen dari aliran kas tambahan lebih besar dari
nol pada MARR, alternatif B yang dipilih.
• Jika tidak, alternatif A yang dipilih dengan ketentuan bahwa alternatif

A layak.
Prosedur Analisis Selisih Investasi
1. Urutkan alternatif yang layak berdasarkan kenaikan investasi
modal.
2. Tentukan alternatif dasar
3. Lakukan iterasi antar alternatif untuk mengevaluasi selisih aliran
kas sampai seluruh alternatif terevaluasi.
4. Jika selisih aliran kas antara alternatif lanjutan (dengan investasi
lebih besar) dan alternatif terpilih dapat diterima, pilih alternatif
lanjutan. Jika tidak, alternatif terpilih yang terakhir tetap sebagai
alternatif terbaik.
5. Ulangi, alternatif terpilih adalah alternatif terbaik yang didapat dari
evaluasi terakhir.
Kesalahan yang sering terjadi, memilih alternatif
terbaik berdasarkan:
• IRR atas investasi total tertinggi.
• IRR atas selisih investasi modal tertinggi.
• Investasi modal terbesar yang mempunyai IRR lebih besar atau sama
dengan MARR.
Informasi Tambahan:
• Metode nilai ekivalen dapat juga diterapkan menggunakan prosedur
analisis selisih modal.
• Peringkat alternatif akan konsisten dengan nilai ekivalen atas
investasi total untuk masing-masing alternatif dan analisis selisih
modal dengan metode IRR.
• Oleh karena itu cara ini disebut „metode saringan‟ untuk metode IRR.
Contoh
• Diketahui 6 alternatif yang mutually exclusive dengan umur manfaat
masing-masing 10 tahun, dan MARR 10% per tahun. Dengan periode
analisis 10 tahun dan nilai sisa 0, alternatif mana yang harus dipilih
dengan menggunakan metode IRR?
Alternatif
A B C D E F
Investasi modal -$900 -$1,500 -$2,500 -$4,000 -$5,000 -$7,000
Pendapatan dikurang
150 276 400 925 1,125 1,425
pengeluaran tahunan
Penyelesaian
• Langkah pertama: tentukan tingkat pengembalian (IRR) atas investasi
total untuk semua alternatif, menggunakan nilai ekivalen (PW atau
AW).
• Misalnya, untuk alternatif A dengan AW:

0 = -$900(A/P,i‟%,10) + $150 i% = ?
dengan trial and error  i% = 10.6%
Penyelesaian
• Hasil perhitungan IRR
A B C D E F
IRR atas invest.
10.6 13.0 9.6  19.1 18.3 15.6
total (%)
Alternatif C tidak dapat diterima (IRR < MARR)  tidak

disertakan dalam analisis selisih
Penyelesaian
• Alternatif dasar: A
Selisih yang dianalisis A (B-A) (D-B) (E-D) (F-E)

 investasi modal -$900 -$600 -$2,500 -$1,000 -$2,000
 pendapatan
$150 $126 $649 $200 $300
dikurang pengeluaran
IRR (%) 10.6 16.4 22.6 15.1 8.1
ekonomis ? Ya Ya Ya Ya Tidak
E  alternatif terbaik

Evaluating Alternatives

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Evaluating Alternatives

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EVALUATING ALTERNATIVES

Two types of investment categories:

• Mutually Exclusive Set

• Independent Project Set

Mutually Exclusive Alternatives

Independent Project Set

• The objective is to:

• Service – the alternatives consist mainly of cost

• Metode Nilai Ekivalen (PW / AW Method)

• Metode Tingkat Pengembalian (IRR Method)

PRESENT WORTH --- Equal Lives Alternatives

• Compute the Present Worth of each alternative and select

Consider: Machine A Machine B

i = 10% per year

Which alternative should we select?

Cash Flow Diagram

PA = 2,500 + 900 (P|A, .10, 5) – 200 (P|F, .01, 5)

PB = 3,500 + 700 (P|A, .10, 5) – 350 (P|F, .10, 5)

SELECT MACHINE A : Lower PW cost!

PRESENT WORTH --- Different Lives Alternatives

• Comparison must be made over equal time periods

• Remember – if the lives of the alternatives are not equal,

• If the alternatives have different study periods, you find

i = 15% per year

Cash Flow Diagram

i = 15% per year

LCM(6,9) = 18 year study period will apply for present worth

Cash Flow Diagram

Cycle 1 for A Cycle 2 for A Cycle 3 for A

Cycle 1 for B Cycle 2 for B

i = 15% per year

LCM(6,9) = 18 year study period will apply for present worth

Calculate the present worth of a 6-year cycle for A

$23,813 $23,813 $23,813

PA= 23,813+23,813 (P|F, .15, 6)+ 23,813 (P|F, .15, 12)

Calculate the Present Worth of a 9-year cycle for B

PB = 18,000+3,100(P|A, .15, 9) – 1,000(P|F, .15, 9)

PB = 32,508 + 32,508 (P|F, .15, 9)

Different Lives Alternatives --- Study Period

• Alternative: 1 with a 5-year life Alt-1: N = 5 yrs

• Alternative: 2 with a 7-year life Alt-2: N= 7 yrs

• Assume a 5-yr. study period

• Now, evaluate both over 5 years using the PW

• MVT = market value at T, T<U

• CAPITALIZED COST--- the present worth of a project that

Assume you are called on to maintain a cemetery site

Annual Worth Method

Advantages and Uses of Annual Worth

Example: 6-year & 9-year Problem

• Need an 18-year study period for both

6-year Project 6-year Project 6-year Project

9-year Project 9-year Project

• Present Worth would mandate a 18-year study period

• Means a lot of calculation time!

• If one assumes the cash flow patterns remain the

6-year Project Find the AW of any 6 – year cycle

Find the annual worth of

And then compare the AW6 yr to AW9 yr.

Capital Recovery (CR)

Capital Recovery (CR) is the annualized equivalent of the

Capital Recovery (CR)

Capital Recovery (CR)

COMPUTING CR FOR INVESTMENTS WITH SALVAGE VALUES:

Two alternatives are considered for covering a football field.