Comparison and 

Selection among 
Alternatives 
Lecture Week (Chapter) 6
Mutually Exclusive
When there are many alternatives to choose, we apply the concept of mutually
exclusive to select the best alternative.
Mutually exclusive investment selection is the acceptance of a project precludes the
acceptance of one or more alternative projects  any one of the alternative will fulfill
the same need, and implied that the others will be excluded.
One of the fundamental principles is that they must be compared over an equal time
span (analysis period)  study period equals to project useful lifespan.
Choose the alternative that requires minimum investment of capital but produces
satisfactory functional results, unless the incremental capital associated with an
alternative having a larger capital outlay can be justified with respect to its
incremental benefits (principle‐3 of engineering economic principles).
Basic Concepts for Comparing Alternatives
If the extra benefits obtained by investing additional capital are better than those that 
could be obtained from investment of the same capital elsewhere in the company at 
the MARR, the investment should be made.
The basic concepts for comparing alternatives include:
1. Investment and cost alternatives,
2. Ensuring a comparable basis.
Investment and Cost Alternatives
The basic policy for comparing mutually exclusive project alternatives can be demonstrated
with two examples;
The first example involves an investment project situation.
Consider alternative A and B are mutually exclusive alternatives with initial capital investment
and annual net benefits with 4 years project life, and MARR = 10% per year are as follows:
Alternative
A B ∆(B‐A)
Capital investment ‐RM60,000 ‐RM73,000 ‐RM13,000
Revenues ‐ Expenses 22,000 26,000 4,226

Use PW method to compare the two alternatives:
PW(10%)A = ‐RM60,000 + RM22,000(P/A, 10%, 4) = RM9,738
PW(10%)B = ‐RM73,000 + RM26,000(P/A, 10%, 4) = RM10,131
Both alternatives produce positive PW at MARR, but alternative B is selected because of higher PW.
The second example involves a cost project situation.
Consider mutually exclusive alternatives C and D with the following cost over three 
years lifespan. Alternative
End of Year (EOY) C D ∆(D – C)
0 ‐RM380,000 ‐RM415,000 ‐RM35,000
1 ‐38,100 ‐27,400 10,700
2 ‐39,100 ‐27,400 11,700
3 ‐40,100 ‐27,400 12,700
3(salvage value) 0 26,000 26,000
In mutually exclusive situation, alternative D is preferred because the cost saving is 
higher than C, although C has lower initial capital investment. If MARR is 10% per 
year, PW(10%)C = ‐RM477,077, and PW(10%)D = ‐RM463,607, and the PW(10%)Diff = 
RM13,470, to show that additional capital invested is justified.
Ensuring a Comparable Basis
When we make a comparison between alternatives, ensure that any economic
impacts of the differences are included into the cash flow estimation.
The example of differences that may occur:
a) Operational performance factors, such as output capacity, speed, thrust, fuel
efficiency, etc.
b) Quality factor, such as number of defect‐free unit per production, percentage of
defective units, etc.
c) Useful life, capital investment outlay, increment in revenue, cost saving, etc.
Two rules to follow for mutually exclusive
Rule‐1:  When there are revenues and other economic benefits  choose higher 
profitability, or greatest positive equivalent worth at i = MARR.
Rule‐2:  When revenues and other economic benefits are not present or constant 
among alternatives  select that minimizes total cost, or least negative equivalent 
worth at i = MARR.
Study Period equals Project Life
When we compare project alternatives, ensure that useful lives for all alternatives are 
the same with equal study period  Adjustment to the cash flow is not required if 
useful lives equals to the study period. 
If the useful lives are not equal, this will complicate the analysis, and to conduct such 
engineering economic analyses, we adopt the rule of comparing mutually exclusive 
alternatives over the same period of time.
We can the compare the mutually exclusive alternatives by using
1. Equivalent‐worth Methods, and
2. Rate‐of‐Return Methods.
The Equivalent‐Worth (EW) Method
We have learned previously that the equivalent‐worth methods convert all relevant
cash flows into equivalent present, annual, or future amounts.
When these methods are used, consistency of alternative selection results from this
equivalency relationship.
Also, the economic ranking of mutually exclusive alternatives will be the same when
using the three methods.
Determine the EW of each alternative based on total investment at i = MARR. Then,
for investment alternatives, the one with the greatest positive equivalent worth is
selected.
Example 6-1: Analyzing Investment Alternatives by Using Equivalent Worth
Asia Asia Berhad., is considering three mutually exclusive alternatives for implementing an
automated passenger check-in counter at its hub airport. Each alternative meets the same
service requirements, but differences in capital investment amounts and benefits (cost savings)
exist among them as shown in the Table 6-1 below. The study period is 10 years, and the useful
lives of all three alternatives are also 10 years. Market values of all alternatives are assumed to
be zero at the end of their useful lives. If the airline’s MARR is 10% per year, which alternative
should be selected.
Alternative Capital Investment Annual Saving
A RM390,000 RM69,000
B RM920,000 RM167,000
C RM660,000 RM133,000
Solution by the PW Method
Alternative A: PW(10%)A = -RM390,000 + RM69,000(P/A, 10%, 10)
= -RM390,000 + RM69,000(6.1446) = +RM33,977
Alternative B: PW(10%)B = -RM920,000 + RM167,000(6.1446) = +RM106,148
Alternative C: PW(10%)C = -RM660,000 + RM133,000(6.1446) = +RM157,231
Based on Rule-1, alternative C should be selected because it has the highest PW value
(RM157,231). Preference among alternatives: ≻ ≻
Example 6‐2: Analyzing Cost‐Only Alternatives, Using Equivalent Worth
A company is planning to install a new automated plastic‐molding press. Four different presses
are available. The initial capital investments and annual expenses for these four mutually
exclusive alternatives are as follows:
Press
P1 P2 P3 P4
Capital investment  24,000 30,400 49,600 52,000
Useful life (years)  5 5 5 5
Annual expenses
Power  2,720 2,720 4,800 5,040
Labor 26,400 24,000 16,800 14,800
Maintenance 1,600 1,800 2,600 2,000
Property taxes and insurance  480 608 992 1,040
Total annual expenses  31,200 29,128 25,192 22,880

Assume that each press has the same output capacity (120,000 units per year) and has no
market value at the end of its useful life; the selected analysis period is five years; and any
additional capital invested is expected to earn at least 10% per year. Which press should be
chosen if 120,000 non‐defective units per year are produced by each press and all units can be
sold? The selling price is RM0.375 per unit. Solve by hand and by spreadsheet.
Solution by Hand
Since the same number of non‐defective units per year will be produced and sold using each press,
revenue can be disregarded (Principle 2, Chapter 1). The end‐of‐year cash‐flow diagrams of the four
presses are:

The preferred alternative will minimize the equivalent worth of total costs over the five‐year
analysis period (Rule 2, page 245). That is, the four alternatives can be compared as cost
alternatives. The PW, AW, and FW calculations for Alternative P1 are
PW(10%)P1 = −RM24,000 − RM31,200(P/A, 10%, 5) = −RM142,273,
AW(10%)P1 = −RM24,000(A/P, 10%, 5) − RM31,200 = −RM37,531,
FW(10%)P1 = −RM24,000(F/P, 10%, 5) − RM31,200(F/A, 10%, 5)= −RM229,131.
Spreadsheet Solution

=‐B6

=‐SUM(B7:B10)

=‐B$14

=NPV($B$1, B14:B18) + B13

=PMT($B$1, $B$2, ‐B20

= B20*(1 + $B$1)^$B$2
The PW, AW, and FW values for Alternatives P2, P3, and P4 are determined with similar calculations and
shown for all four presses in Table below. Alternative P4 minimizes all three equivalent‐worth values of total
costs and is the preferred alternative. The preference ranking (P4 ≻ P2 ≻ P1 ≻ P3) resulting from the analysis
is the same for all three methods.
Comparison of Four Molding Presses, Using the PW, AW, and FW Methods to Minimize Total Costs
Press (Equivalent‐Worth Values)
Method P1 P2 P3 P4
Present worth  −RM142,273  −RM140,818  −RM145,098  −RM138,734
Annual worth  −37,531  −37,148  −38,276  −36,598
Future worth  −229,131  −226,788  −233,689  −223,431
Rate‐of‐Return Methods
The best alternative produces satisfactory functional results and requires the minimum investment of
capital.
This is true unless a larger investment can be justified in terms of its incremental benefits and costs.
Three guideline for rate‐of‐return method.
1. Each increment of capital must justify itself by producing a sufficient rate of return (greater than 
or equal to MARR) on that increment.
2. Compare a higher investment alternative against a lower investment alternative only when the 
latter is acceptable. The difference between the two alternatives is usually an investment 
alternative and permits the better one to be determined.
3. Select the alternative that requires the largest investment of capital, as long as the incremental 
investment is justified by benefits that earn at least the MARR.
Compare an IRR only against MARR (IRR ≥ MARR) in determining the acceptability of an alternative
Inconsistent Ranking Problem
Inconsistent ranking problem that can occur with incorrect use of rate‐of‐return methods in
the comparison of alternatives. Consider our previous alternatives A and B.

Alternative
A B ∆(B‐A)
Capital investment ‐RM60,000 ‐RM73,000 ‐RM13,000
Revenues ‐ Expenses 22,000 26,000 4,226

The useful life (and the study period) is 4 years, MARR at 10% per year.
In rate‐of‐return method, first we check if the sum of positive cash flows exceeds the sum of negative cash 
flows. So the IRR and PW(10%) for each alternative is calculated as follows:

Alternative IRR PW(10%)

• The choice is made based on maximizing IRR of the total cash flows  alternative A is selected.
• But, based on PW method where MARR = I, then alternative B is preferred because B has higher PW
value.
• Therefore, there is inconsistency for ranking of the two mutually exclusive investment alternatives.

To overcome this inconsistency, we look at the incremental net cash flow between alternatives (∆(B‐A)).
The IRR of the increment, IRR∆ = 11.4%, which is greater than MARR of 10%, hence RM13,000 of incremental 
investment is justified.
This outcome is confirmed by the PW of the increment, PW(10%)∆ is RM393.
Therefore, when the IRR of the increment cash flow is used, the rankings of A and B are consistent with that 
based on the PW on total investment.
 Incremental Investment Analysis Procedure
STOP: This MEA is  Yes
Last MEA?
preferred
This MEA is a New  No Yes
Current Base?
Establish a Current 
Base (Alternative): Develop 
Arrange (rank‐ Is ∆ Cash Flow 
• Cost Alt‐Select First  Incremental Cash 
order) MEAs  Acceptable?
Alt. in rank‐Order (LCI). Select the  Flow = (Next MEA 
by Increasing  IRR  MARR
• Inv Alt‐Select MEA  Next MEA Cash Flow) –
Capital  PW, FW, or AW 
with acceptable LCI. (Current Base Cash 
Investment (at MARR)  0
IRR  IRR, or PW, FW,  Flow
or AW (at MARR)  0
No No
Last MEA?

Yes
MEA = mutually exclusive alternative
LCI = least capital investment STOP: The Current 
Base is preferred
Example 6‐4: Incremental Analysis: Investment Alternatives
Suppose that we are analyzing the following six mutually exclusive alternatives for a small investment
project, using the IRR method. The useful life of each alternative is 10 years, and the MARR is 10% per
year. Also, net annual revenues less expenses vary among all alternatives, and Rule 1 applies. If the study
period is 10 years, and the market (salvage) values are zero, which alternative should be chosen? Notice
that the alternatives have been rank‐ordered from low capital investment to high capital investment.
A B C D E F
Capital Investment RM900 RM1,500 RM2,500 RM4,000 RM5,000 RM7,000
Annual Revenues ‐ Expenses 150 276 400 925 1,125 1,425
Solution
For each of the feasible alternatives, the IRR on the total cash flow can be computed by determining the
interest rate at which the PW, FW, or AW equals zero (use of AW is illustrated for Alternative A):
0 = −$900(A/P, i′A %, 10) + $150; i′% = ?
By trial and error, we determine that i′A% = 10.6%. In the same manner, the IRRs of all the alternatives are
computed and summarized:

At this point, only Alternative C is unacceptable and can be eliminated from the comparison because
its IRR is less than MARR of 10% per year. Also, A is the base alternative from which to begin the
incremental investment analysis procedure, because it is the mutually exclusive alternative with the
lowest capital investment whose IRR (10.6%) is equal to or greater than MARR (10%).
A ∆(B‐A) ∆(D‐B) ∆(E‐D) ∆(F‐E)
∆ Capital Investment RM900 RM600 RM2,500 RM1,000 RM2,000
∆ Annual Rev ‐ Expenses 150 126 649 200 300
IRR∆ 10.6% 16.4% 22.6% 15.1% 8.1%
Is Increment Justified? Yes Yes Yes Yes No
Personal Finance
 Sound financial planning is all about making wise choices for your particular
circumstances (e.g., your amount of personal savings, your job security, your attitude
toward risk).
 Two of the largest investments you’ll ever make involve houses and automobiles.
Example 6‐5:  Buying your First Car
You have decided to purchase a new automobile with a hybrid‐fueled engine and a six‐speed transmission. After
paying the deposit, the purchase price of the new automobile is RM30,000. This balance can be financed by an
auto dealer at 2.9% annual percentage rate (APR) with payments over 48 months. Alternatively, you can get a
RM2,000 discount on the purchase price if you finance the loan balance at an APR of 8.9% over 48 months.
Should you accept the 2.9% financing plan or accept the dealer’s offer of a RM2,000 rebate with 8.9% financing?
Both APRs are compounded monthly.

Solution
In this example, we assume that your objective is to minimize your monthly car payment.
2.9% financing monthly payment: RM30,000 (A/P, 2.9%/12, 48 months) = RM30,000(0.0221)
= RM663.00 per month
8.9% financing monthly payment: RM28,000 (A/P, 8.9%/12, 48 months) = RM28,000(0.0248)
= RM694.90 per month
Therefore, to minimize your monthly payment, you should select the 2.9% financing option.
Example 6‐6: Mortgage Financing Option

A general rule of thumb is that your monthly mortgage payment should not exceed 28% of your
household’s gross monthly income. Consider the situation of Jerry and Tracy, who just committed to a
$300,000 mortgage on their dream home. They have reduced their financing choices to a 30‐year
conventional mortgage at 6% APR, or a 30‐year interest‐only mortgage at 6% APR.
(a) Which mortgage, if either, do they qualify for if their combined gross annual income is RM70,000?
(b) What is the disadvantage in an interest‐only mortgage compared to the conventional mortgage?

Solution
(a) Using the general rule of thumb, Jerry and Tracy can afford a monthly mortgage payment of
(0.28)(RM70,000/12) = RM1,633. The monthly payment for the conventional mortgage is RM300,000
(A/P, 0.5%, 360) = RM1,800.
For the interest‐only mortgage, the monthly payment is (0.005)($300,000) = RM1,500.
Thus, the conventional mortgage payment is larger than what the guideline suggests is affordable. This
type of loan is marginal because it stretches their budget too much. They easily qualify for the interest‐
only mortgage because the RM1,500 payment is less than RM1,633.
(b) If home prices fall in the next several years, Jerry and Tracy may have “negative equity” in their home 
because no principal has been repaid in their monthly interest‐only payments. They will not have any buffer 
to fall back on should they have to sell their house for less than they purchased it for.
It is important to note that interest‐only loans don’t remain interest‐only for the entire loan period. The 
length of time that interest‐only payments may be made is defined in the mortgage contract and can be as 
short as 5 years or as long as 15 years. After the interest‐only period is over, the monthly payment adjusts to 
include principal and interest. It is calculated to repay the entire loan by the end of the loan period. Suppose 
Jerry and Tracy’s interest‐only period was five years. After this time, the monthly payment
would become RM300,000(A/P, 0.5%, 300) = RM1,932.90.
Before Jerry and Tracy accept this type of loan, they should be confident that they will be able to afford the 
RM1,932.90 monthly payment in five years.
Example 6‐7: Comparison of Two Savings Plans

Suppose you start a savings plan in which you save RM500 each year for 15 years. You make your first
payment at age 22 and then leave the accumulated sum in the savings plan (and make no more annual
payments) until you reach age 65, at which time you withdraw the total accumulated amount. The
average annual interest rate you’ll earn on this savings plan is 10%. A friend of yours (exactly your age)
from Universiti Malaysia Perlis waits 10 years to start her savings plan. (That is, she is 32 years old.) She
decides to save RM2,000 each year in an account earning interest at the rate of 10% per year. She will
make these annual payments until she is 65 years old, at which time she will withdraw the total
accumulated amount.
How old will you be when your friend’s accumulated savings amount (including interest) exceeds yours? 
State any assumptions you think are necessary.
Solution
Creating cash‐flow diagrams for Example 6‐7 is an important first step in solving for the unknown number
of years, N, until the future equivalent values of both savings plans are equal. The two diagrams are shown
below. The future equivalent (F) of your plan is RM500(F/A, 10%, 15)(F/P, 10%,N − 36) and that of your
friend is F′ = RM2,000(F/A, 10%,N − 31). It is clear that N, the age at which F = F′, is greater than 32.
Assuming that the interest rate remains constant at 10% per year, the value of N can be determined by
trial and error:
 N Your Plan’s F Friend’s F
36 RM15,886 RM12,210
38 RM19,222 RM18,974
39 RM21,145 RM22,872
40 RM23,259 RM27,159

By the time you reach age 39, your friend’s accumulated savings will exceed yours. (If you had
deposited $1,000 instead of $500, you would be over 76 years when your friend’s plan surpassed
yours. Moral: Start saving early!)
Example 6‐8: Credit Card Offers

Randy just cancelled his credit card with a large bank. A week later, a representative of the bank called
Randy with an offer of a “better” credit card that will advance Randy RM2,000 when he accepts it.
Randy could not refuse the offer and several days later receives a check for RM2,000 from the bank.
With this money, Randy decides to buy a new computer. At the next billing cycle (a month later), the
RM2,000 advance appears as a charge against Randy’s account, and the APR is stated to be 21%
(compounded monthly). At this point in time, Randy elects to pay the minimum monthly payment of
RM40 and cuts up the credit card so that he cannot make any additional purchases.
(a) Over what period of time does this payment extend in order to repay the RM2,000 principal?
(b) If Randy decides to repay all remaining principal after having made 15 monthly payments, how
much will he repay?
Solution
(a) You may be surprised to know that the majority of credit card companies determine the minimum
monthly payment based on a repayment period of 10 years. The monthly interest rate being charged
for Randy’s card is 21%/12 = 1.75%. We can solve the following equivalence relationship to determine
the number of $40 monthly payments required to pay off a loan principal of RM2,000. RM2,000 =
RM40(P/A, 1.75%, N)
This is easily solved using the NPER (rate, payment, principal) function in Excel. NPER(1.75%, −40, 
2000) = 119.86 Sure enough, it will take Randy 120 months to pay off this debt.
(b) After having made 15 payments, Randy has 105 payments remaining. To find the single sum
payoff for this loan, we simply have to determine the present worth of the remaining payments.
Payoff = RM40(P/A, 1.75%, 105) = RM1,915.96

This payoff amount assumes no penalty for early repayment of the loan (which is typically the case
when it comes to credit cards). Notice how very little principal (RM84.06) was repaid in the early
part of the loan.
Assignment 4
Do problems in Chapter 6 of your textbook; 
Problems 6‐5, 6‐7, 6‐10, 6‐11, and 6‐18.