Chapter 2

Evaluation and Comparison of Engineering

Projects

2.1 Methods of Project Evaluation

An engineering project must be evaluated to determine if the project is
economically acceptable. The economical comparison is used as a tool to make
the decision of selecting the best alternative for engineering projects.
Alternatives may be different projects or different options of the same project.
Several discounting techniques or measures of worth may be used:

i) Present Worth (PW): This method selects the alternative with the largest
PW of the discounted algebraic sum of benefits B and costs C over its life.

∑( )( ) ( )

ii) Future Worth (FW): This method is comparable to the PW method except
that all cash flows are converted to a reference time in the future.

iii) Annual Worth (AW): This method converts all benefits and costs into
equivalent uniform annual figures.

iv) Internal rate of Return (IRR): This method finds the discount rate that
equates the PW inflows to the outflows. This means that at IRR, the net
PW = 0 and the benefit-cost ratio is close to one (B/C ≈ 1).

This rate represents the average interest rate at which a project pays back
the investment over its life time. It is, therefore, a criterion for comparing
alternative investment opportunities. This technique is also called rate-of-
return (ROR) method.

When mutually exclusive alternatives are evaluated, ROR method will

not lead to the same decisions as the PW method unless an incremental
analysis is used:
( )

The procedure of calculating IRR is as follows:-

12
 1) Rank the alternatives in order of increasing initial cost. The one with the
larger initial investment is the column (A) in the table.
2) Develop the incremental cash flow series.
3) Determine IRRA–B:
 Select a discount rate which gives a + net PW close to zero.
 Select another discount rate which gives a –net PW close to zero.
 Process interpolation to find IRR.

+PW1

i1 IRR
i2

| |
( ) -PW2

X (i2−i1) −X
( )
| |

( )
( )
| |

4) Select the economically better alternative as follows:

 IRRA–B< MARR: select alternative B.
 IRRA–B>MARR: the extra investment of A is justified; select A.
 IRRA–B ≈ MARR: the alternatives are equally attractive. Noneconomic
considerations help in the selection of the better alternative.

5) Continue the analysis by considering the alternative on the less costly

side of each increment being the most costly project chosen thus far.

When independent projects are evaluated, there is no incremental analysis.

Each project is evaluated separately, and more than one can be selected. The
only comparison is with the do-nothing alternative for each project. All
projects with IRR ≥ MARR are accepted. For example, assume MARR = 10%
and three independent projects are available with ROR values as:
IRRA= 12% IRRB= 9% IRRC= 23%
Projects A and C are selected, but B is not because IRRB< MARR.

13
2.2 Minimum Attractive Rate of Return (MARR)
For any investment to be profitable, the investor expects to receive more money
than that invested. In other words, a fair return rate must be realizable.
Engineering alternatives are evaluated upon the prognosis that a reasonable
ROR can be expected. Therefore, some reasonable rate must be established for
the selection criteria of the engineering economy study.
The Minimum Attractive Rate of Return (MARR) is a reasonable rate of return
established for the evaluation and selection of alternatives. MARR is also
referred to as the minimum acceptable rate of return, cut-off rate, benchmark
rate, and hurdle rate.
A project is not economically viable unless it is expected to return at least the
MARR. The MARR is not a rate that is calculated, as a ROR, it is established by
(financial) managers.

2.3 Capitalized Equivalent Method (CE)

It is a special case of the PW method that is useful when the usefullife of a
proposed project or the planning horizon is extremely long (say, 50 years or
more). Many public projects, such as bridges, waterway structures, irrigation
systems, and hydroelectric dams, are expected to generate benefits over an
extended period.
In this method, the PW for an (almost infinite) uniform series of cash inflows is
determined. The process of computing the PW cost for this infinite series is
referred to as the capitalization of the project cost.
The cost, known as the capitalized cost, represents the amount of money
that must be invested today to yield a certain return A at the end of each and
every period forever.

( ) ( )
( ) [ ] [ ] ( )
( )

() ( ) () ( )

Another way of looking at this problem is to ask what uniform income infinite
stream could be generated by PW(i) today. Clearly, the answer is ( ).

14
Note: When comparing proposals for a permanent project using AW method,
use i PW(i) for permanent proposals. For other proposals, compute AW for one
cycle of cash flow.

15
 Chapter 2

Evaluation and Comparison of

Engineering Projects

Tutorial

16
Example (1):

An investment of $10,000 can be made in a municipal project that will produce

uniform annual revenue of $5,310 for 5 years, and then has a salvage value of
$2000. The annual disbursement (cost) for operation and maintenance is $3,000.
The company is willing to accept any project that earns 10% or more in all
invested capital. Show whether this is a desirable investment using:
(1) PW method (2) IRR method

Example (2):

New equipment has been proposed to increase the productivity of a project by

$8,000 per year. The purchase value of the equipment is $25,000 and the salvage
value is $5,000 at the end of its economic life of 5 years. Using FW and AW
methods determine whether the equipment is recommended or not. i = 20%.

Example (3):

As groundwater wells age, they sometimes begin to pump sand (and become
known as sanders). This can cause damage to downstream desalting equipment.
The situation can be dealt with by drilling a new well at a cost of $1,000,000 or
by installing a tank and self-cleaning screen ahead of the desalting equipment.
The tank and screen will cost $230,000 to install and $61,000 per year to operate
and maintain. A new well will have a pump that is more efficient than the old
one, and it will require almost no maintenance, so its operating cost will
be$18,000 per year. If the salvage values are estimated at 10% of the first cost,
calculate the incremental rate of return and determine which alternative is better
at a MARR of 6% per year over a 20-year study period.

17
Example (4):

Two alternative energy supply projects are described in the table below. Project
A has a large initial investment to meet the energy demands for 40 years. Project
B uses investment in two stages to meet the same demand. Decide which project
should be selected using: (1) PW method (2) IRR method

Example (5):
Two equivalent machines are being considered for purchase. Machine 2 is
expected to be technologically advanced enough to provide net income longer
than machine 1.

Which machine should be recommended?

18
Example (6):
A small hydroelectric plant was built for $800,000 during a decade (without
considering the time value of money). A company will purchase any electricity
the plant can supply, which is estimated as 6 million kilowatt-hours per year.
Suppose that the net annual income will be $120,000. With normal maintenance,
the plant is expected to provide service for at least 50 years.

Was the $800,000 investment a wise one? Examine the situation by computing
the project NPW at return rates of 8% and 12%.

Example (7):
Resolve the previous example using infinite service life of the project. Examine
the use of the CE(i) criterion for engineering projects with long lives.

Example (8):
A dam has just installed new software system for management and monitoring
of water storage in the reservoir. The system is to be used for the indefinite
future. The director wants to know the total equivalent cost of the system: (a)
now (CE cost), and (b) for each year hereafter (AW value). The system has an
initial cost of $150,000 and an additional cost of $50,000 after 10 years. The
annual software maintenance contract cost is $5,000 for the first 4 years, and
$8,000 thereafter. In addition, there is expected to be a periodic major upgrade
cost of $15,000 every 13 years. Assume that i= 5% per year.

19