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Chris Hendrickson
Carnegie Mellon University
Sue McNeil
Carnegie Mellon University
Practical engineering and management requires choices among competing alternatives. Which
boiler should be used in a plant? Which computer should be purchased for a design office? Which
financing scheme would be most desirable for a new facility? These are practical questions that
arise in the ordinary course of engineering design, organizational management, and even personal
finances. This chapter is intended to present methods for choosing the best among distinct
alternatives.
5. Establish the criterion for accepting or rejecting an alternative and for selecting the best
among a group of mutually exclusive alternatives. The most widely used and simplest
criterion is the net present value criterion. Projects with a positive net present value are
acceptable. Only one from a group of mutually exclusive alternatives can be chosen. For
example, the alternatives might be alternative boilers for a building or alternative airport
configurations. From a set of mutually exclusive alternatives, the alternative with the highest
net present value is best. The next section details the calculation steps for the net present
value and also some other criterion for selection.
6. Perform sensitivity and uncertainty analysis. Calculation of net present values assumes that
cash flow profiles and the value of MARR are reasonably accurate. In many cases
assumptions are made in developing cash flow profile forecasts. Sensitivity analysis can be
performed by testing a variety of such assumptions, such as different values of MARR, to see
how alternative selection might change. Formally treating cash flow profiles and MARR
values as stochastic variables can be done with probabilistic and statistical
methods.
where A(t; x) may be positive or negative in any period. Then, the net present value of the
alternative, NPV(x), is calculated as the sum over the entire planning horizon of the discounted
Other Methods
Several other criteria may be used to select projects. Other discounted flow methods include net
future value [denoted NFV(x)] and equivalent uniform annual value [denoted EUAV(x)]. It can
be shown [Au, 1992] that these criteria are equivalent where
The net future value is the equivalent value of the project at the end of the planning horizon. The
equivalent uniform annual value is the equivalent series in each year of the planning horizon.
Alternatively, benefit-to-cost ratio (the ratio of the discounted benefits to discounted costs) and
the internal rate of return [the equivalent MARR at which NPV(x) = 0] are merit measures, each of
which may be used to formulate a decision. For accept-reject decisions, the benefit-to-cost ratio
must be greater than one and the internal rate of return greater than the MARR. However, these
measures must be used in connection with incremental analyses of alternatives to provide
consistent results for selecting among mutually exclusive alternatives [see, for instance, Au
(1992)].
Similarly, the payback period provides an indication of the time it takes to recoup an investment
but does not indicate the best project in terms of expected net revenues.
183.4 Applications
To illustrate the application of these techniques and the calculations involved, two examples are
presented.
Example 183.1 Alternative Bridge Designs. A state highway agency is planning to build a
new bridge and is considering two distinct configurations. The initial costs and annual costs and
benefits for each bridge are shown in the following table. The bridges are each expected to last 30
years.
Alternative 1 Alternative 2
Initial cost $15 000 000 $25 000 000
Annual maintenance and operating costs $15 000 $10 000
Annual benefits $1 200 000 $1 900 000
Annual benefits less costs $1 185 000 $1 890 000
NPV(1) = (¡15 000 000) + (1 185 000)=(1 + 0:05) + (1 185 000)=(1 + 0:05)2
+ (1 185 000)=(1 + 0:05)3 + ¢ ¢ ¢ + (1 185 000)=(1 + 0:05)30
= $3 216 354
NPV(2) = (¡15 000 000) + (1 890 000)=(1 + 0:05) + (1 890 000)=(1 + 0:05)2
+ (1 890 000)=(1 + 0:05)3 + ¢ ¢ ¢ + (1 890 000)=(1 + 0:05)30
= $4 053 932
Therefore, the department of transportation should select the second alternative, which has the
largest net present value. Both alternatives are acceptable since their net present values are
positive, but the second alternative has a higher net benefit.
Example 183.2 Equipment Purchase. Consider two alternative methods for sealing pavement
cracks [McNeil, 1992]. The first method is a manual method; the second is an automated method
using a specialized equipment system. Which method should be used? We shall solve this problem
by analyzing whether the new automated method has revenues and benefits in excess of the
existing manual method.
Solution. Following the steps outlined earlier, the problem is solved as follows:
1. The alternatives for consideration are (1) the existing manual method, and (2) the automated
method. The alternatives are mutually exclusive because cracks can only be sealed using
either the existing method or the new method.
2. The planning horizon is assumed to be 6 years to coincide with the expected life of the
automated equipment.
3. The cash flow profile for alternative 2 is given in the following table:
The values are estimated using engineering judgment and historical cost experience. We assume
that the productivity and revenues for both alternatives are the same and treat labor savings as
additional benefits for alternative 2. Therefore, only the net present value for alternative 2, which
represents the result of introducing the automated method, need be computed.
4. The MARR is assumed to be 5%. The net present value is computed as follows:
This example illustrates the use of the net present value criteria for an incremental analysis,
which assumes that the benefits are constant for both alternatives and examines incremental costs
for one project over another.
183.5 Conclusion
This chapter has presented the basic steps for assessing economic feasibility and selecting the best
project from a set of mutually exclusive projects, with net present value as a criterion for making
the selection.
Defining Terms
Alternatives: A distinct option for a purchase or project decision.
Base year: The year used as the baseline of price measurement of an investment project.
Cash flow profile: Revenues and costs for each period in the planning horizon.
Equivalent uniform annual value: Series of cash flows with a discounted value equivalent to the
net present value.
Minimum attractive rate of return (MARR): Percentage change representing the time value of
money.
References
Au, T. and Au, T. P. 1992. Engineering Economics for Capital Investment Analysis, 2nd ed.
Prentice Hall, Englewood Cliffs, NJ.
Hendrickson, C. and Au, T. 1989. Project Management for Construction. Prentice Hall,
Englewood Cliffs, NJ.
McNeil, S. 1992. An analysis of the costs and impacts of the automation of pavement crack
sealing. Proc. World Conf. on Transp. Res. Lyon, France, July.
Park, C. S. 1993. Contemporary Engineering Economics. Addison Wesley, Reading, MA.
Further Information
A thorough treatment of project selection is found in Engineering Economics for Capital
Investment Analysis. Many examples are presented in Contemporary Engineering Economics.