ENGR 3360U Winter 2014

Unit 8
Picking the Best Choice
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-01

Unit 8 Picking the Best Choice

Change Record
2014-I-01 Initial Creation
Text Reference Chapter 8

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Course Outline
1.
2.

3.
4.
5.
6.
7.
8.
9.
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Engineering Economics
General Economics
1.
Microeconomics
2.
Macroeconomics
3.
Money and the Bank of
Canada
Engineering Estimation
Interest and Equivalence
Present Worth Analysis
Annual Cash Flow
Rate of Return Analysis
Picking the Best Choice
Other Choosing Techniques
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10. Uncertainty and Risk

11. Income and Depreciation
12. After-tax Cash Flows
13. Replacement Analysis
14. Inflation
15. MARR Selection
16. Public Sector Issues
17. What Engineering should know
about Accounting
18. Personal Economics for the
Engineer

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Unit 8 Road Map

8.1 Graphical techniques to visualize
problems
8.2 Incremental Analysis for multiple
alternatives

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

8.1 Graphical Approach

When there are multiple alternatives, a convenient
way to understand what is happening is by
graphing:

Present Worth versus interest rate OR

Uniform Annual Worth versus interest rate

By graphing each alternative on the same graph,

the information becomes more understandable by
being visible and indicates what is happening to
the alternatives as the interest rate is adjusted.
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Example 8-1
The eng soc is building a snack cart to raise
money. To serve 100 customers per hour
would cost $10,310 and to serve 150,
$13,300. The net annual income for the
lower capacity is $3,300 and the higher,
$4,000. after 5 years the cart has no salvage
value. What interest rate should be used to
decide?

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Example 8-1
The following equations hold:
PWlow = -$10,310 + $3,300(P/A, i, 5)
PWhigh = -$13,400 + $4000(P/A, i, 5)

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Example 8-1 Graph

The graph of those equations (previous
slide) versus interest rate:

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Example 8-1 Graph Explained

To maximize the PW, the choice between
the alternatives is defined by where the
curves intersect (4.3%).

This is the incremental rate of return!

Its also clear to see that:

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Above 4.3%, the low capacity alternative has a

higher PW.
Below 4.3%, the high capacity alternative has
a higher PW .

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Choice Table
Interest Rate
0 i 4.3%
4.3% i 18%
18% i

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Best Choice
High-capacity cart
Low-capacity cart
Do nothing

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Alternatives
The graph approach further enhances
understanding when dealing with more
than two alternatives.
It becomes immediately apparent where
each alternative provides value over the
others.
EUAC or EUAW can also be used for the
graphs instead of PW.

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Example 8.4
A pressure vessel can be made out of brass,
stainless steel or titanium. The first cost and
expected life for each are:
brass
SS
Titanium

Cost
100K 175K 300K
Life
4
10
25
AC = firstcost (A/P, i , life)
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Example 8-4
The graphed results of example 8-4:

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Graph Example 8-4 Explained

The graph shows the IRR for each pair of
alternatives from highest to lowest initial cost.
The graph shows the range(s) where each
alternative should be selected
Interest Rate
0% i 6.3%
6.3% i 15.3%
15.3% i
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Best Choice
Titanium
Stainless Steel
Brass

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Example 8.6
Here are 5 mutually exclusive alternatives, all
with 20 year lives. Prepare a choice table.
A B
C
D
E
COST
4K 2K 6K 1K 9K
AB 639 410 761 117 785
IRR(C-A): 6K-4K= (761-639)(P/A, i, 20)
i = 2%
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Graphing, contd.
Example 8-6 graph showing many alternatives

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Unit 8 Picking the Best Choice

Example 8-6 Explained

The graph clearly shows in this case that
alternatives D and E are never part of the
solution.
The do-nothing alternative is a possibility
due to the present worth of all alternatives
going below 0 if MARR is above 20%.

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Choice table
If
MARR 20% do nothing
If 20% MARR 9.6% select B
If 9.6% MARR 2% select A
If 2% MARR select C

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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

8.2 Elements of Incremental Rate of Return

1. Be sure all the alternatives are identified.
2. Construct an NPW or EUAW graph
showing all alternatives plotted on the same
axes.
3. Examine the line of maximum values and
determine which alternatives create it, and
over what range.
4. Determine the changeover points.
5. Create a choice table.
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Summary
Analysis Methods:

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Unless MARR is known, neither Present

Worth nor Annual Worth analysis is possible.
Present and Annual Worth analysis often
require far less computation.
Rate of return is easier to explain to people
unfamiliar with economic analysis.
Businesses tend to adopt one type of analysis
and rate of return is popular.
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 8 Picking the Best Choice

Summary, contd.
Rate of Return analysis between alternatives requires
incremental rate of return.
It becomes more complex when more than two
alternatives are available.
Constructing graphs helps visualize and immediately
recognize the constraints of the alternatives.
Graphing allows one to see the range of values
where each alternative provides the greatest value
and choices are values.
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Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco