xt if the minimum ... . . ..:..

.,.
,,, ;
,
he IRR, determine
sirable. . .. .

!VIM machine for

Comparison among Alternatives
., .
revenue from the v
120,000 per year.
: t per year are
The salvage value
's five-year opera- -=ARNINGOBJECTIVES
I U have been asked
----. -
1is project and ro - rh~sc h a ~ ill learn a b ~
egarding the pro- -
- '
- - . . .. return method for comparlsc
11's MARR is 20% Study p eriod and Ilseful lives ofalternati ves alrematirres
Equivalent meth~ o d For wmpariso,n of ' Benefit* mst ratio (B-C rat] 3 for
alternarives
-- .c- .I-.- natives

Introduction
.!I\, problem, there are a number of solutions. W e need to analyze the available alternatives for a solution
- ~ c c the
t most suitable one. When selecrion of one alternative excludes the c h o i e of any other alternative,
i dternatives are called mutuully exclusive. Typically, the alternatives to he considered require investment of
%rent amounts of capital, and their annual revenues and costs may vary. Sometimes the alternatives have
%rent useful lives. Five of the basic methods discussed in Chapter 10 For analyzing cash flows are used in
.::zing the alternatives. These methods are: present worth (PW), annual worth (AW), future worth (FW),
-:ma1 rate of return (IRR),and external rate of return (ERR). These methods provide a basis for economic
xparison of the alternatives for an engineering project. The alternative having minimum investment of
::a1 and producing satisfactory Functional results will be chosen unless the incremental capital associ-
z with an alternative having a larger investment can be justified with respect ro its incremental benefits.
t x . incremental is meant for differential investment and differential benefits at the same interest rate. The

::mental rate of return should be larger than the MARR (minimum attractive rate of return).

7 Basis for Comparison of Alternatives

rsumed that all mutually exclusive alternatives selected For analysis meet the funcrional requirements
-121ished for an engineering project. However, differences among the alternatives may occur in many
-11s. These forms may be operational performance factors (such as output capacity, speed, thrust, heat
ripation rate, reliability, fuel efficiency, and setup time); qualiry factors; useful life; capital investment
:-ired; revenue changes; and annual expenses or cost savings.
3uring analysis of the alternatives for a project, following two important points must be kept in mind:
I. When revenues and orher economic benefits are present and vary among the alternatives, choose the
alternative having maximum overall profitability.
. When revenues and other economic benefits are not present or are constant among the alternatives,
consider only the costs and select the alternative having minimum total cost.
222 . CHAPTER 1liCO"vlPARtSO~NAMONG ALTERNI- -

Study Period
.- ~ ---~
Tlii stuiiy period is the planninghorizon on timescaleoverwhich mutually exclusivealternatives are comlr_-
The useful lives of the alternatives relative to the selected study period may involve the following simatic:-
1. Useful lives are same for all alternatives and are equal to the study period.
2. The alrernativci have unequal useful lives, and the useful life of at least one alternative does not m y
the study period.
Unequal lives of the alternatives complicate their analys~sand comparison. T o conduct enginer-
economy analyses in such cases, we compare mutually exclusive alternatives over the same period of r-
The repeatability assumption and the co-terminated assumption are used for these comparisons. The r c r
ability assumption involves the following two main conditions:
I . The study ~ e r i o dover which the alternatives are being compared is e~rherindefinitely long or e q E
a common m~~lriple of the lives of the alternatives. .
2. The economic consequences that are projected to h a p p a in an alternative's iliitial useful life span =
also happen in all succeeding life spans.

Useful Lives of Alternatives Are, Equal to the Study Period

.
, . &,' .$. i

As ih!: licading suggests, in this section we are going to consider cases where the lives of the alternativer :
equal to thc study period. Considering the study period as the life of alternatives, we will use the equivzr
wonh method and the rate of return method to analyze alternatives. -, .

Equivalgnt Worth Methods

In Chapter 10, we learned three variaors of equivalent worth methods: PW, AW, and FW. T o cornp:
the jlternarivec, conyert all relevant cash flows into equivalent present, annual, or future amounts. 7-
economic ranking of mutuaily cxdusi\,e alternatives will be the same when using these three metho:
Consider the general case of w o alternari~.esXand Y If PET,;%) X < PWi%)Y, then the FWand .-
anaiyses will result in the same preference for the alternative Y.

Three mutual(^, exclusive alternatives are being evaluated, and their costr and revenues are listedin Tabk 1.
1 (a) If the MrLPR is 18% per year and the analysis period is 12 years, use the PWmethod to d e t e m -

Ii which.alternatives are economically acceptable and which one should be selected.

(b) If the t o d capital investment budget is R r 450,000, which alternarive should be selected?
1 Table 1 Details of three alternatives

! Capital investment Rs. 250,000 Rs. 450,000 Rs. 550,000

p Annual revenues RS. 200,000 Rs. 125,000 Rs. 150,000
1 Annual expenses Rs. 50,000 Rs. 50,000 Rs. 75,000
!
i Market value Rs. 50,000 Rs. 50,000 Rs. 100,000
Useful life (Years) 12 12 12
I
 3 N G ALTERNATI? I: 11.4 USEFUL LIVES OF ALTERNATIVES ARE EQUAL TO THE STUDY PERIOD - 223

:marives are compare:

II Solution
(a) GivenMARR= 18%, N = 12 years. Then
following situations:
PW for4 = -P + ( R- E)(PIA,i%, N ) + SV(PIF, i%, N )
=-250,000+150,000 (PIA,18%,12)+50,000 (PIF,18%,12)
-native does not mar:-
= -250,000 + 150,000 x 4.7932 + 50,000 X 0.1372
o n d u n engineen-: = Rs. 475,840
e same period of t i r . PW f o r e = -P + ( R - E)(PIA,i%, N ) +SV(PIF,i%, N )
rnparisons. The reps;-
= -450,000+75,000 (PIA,18%, 12)+ 50,000 (PIF,18%, 12)
= -450,000+ 75,000 x4.7932 + 50,000 x 0.1372
inirely long or equal '
= -(Rs.) 83,650
rial useful life span a. PW for P, = -P + ( R - E)(PIA,i%, N ) + SV(PIF, i%, N )
= -550,000+ 75,000 (PIA,18%, 12)+ 100,000 (PIF,18%, 12)

Iv Period
3 of the alternatives -
e will use the equivalr
*,
j Since P y > PW, > PW,, so alternative 1 should be selected.
! (b) The capital available is only Rs. 450,000; therefore we have only two alternatives 1 and 2.Among
I these two alternatives, alternative 1 should be selected as PW, > PVI',.
, and FW. T o Corny>-
-
,r future amounts. -.
1% these three metho:
: then the FW and --
A universig? R&D Deparment has to analyze three projectpropo~ak.All the projecu are mutually exclusiuc,
and the budget limit is Rr. 8,000,000. Each project: capital inwe~nnentand annual operating q e n s e j are
PIare lilted in Tabk I . rhown in Table 2.
W method to deterr; -. U1in.f IIIP dPllrcd.44Alll(Rof 15% p e ~J M Z andfir rhe some fz~z,zll~prrind,
determinr u,/~ichpmje.lrl~oald
cted. ~dopredon rbe baij ofrhr prrrrnr u~orth(PIY3 mohod Confirnz lour rcltr~ionujinf the annual worrh (Aw7
d be selected?
Table 2 Details of three project proposals

Capital investment Rs. 700,000 Rs. 600,000 Rs. 400,000

Project life 8 years 8 years 8 years
Annual revenue Rs. 400,000 Rs. 350,000 Rs. 225,000
Annual expenses Rs. 250,000 Rs. 200,000 Rs. 175,000
Market value Rs. 100,000 Rs. 80,000 Rs. 60,000
224 CHAPTER 11ICOMPARISON AMONG ALTERNATIVES

Present W m t h Method
Limit= 8,000,000, MARR= 15%, N = 8 years.
PWfor? = -P + ( R - E)(PIA,i%,N) + SV(PIF,i%,N)
= -700,000 + 150,000 (PIA,15%, 8) + 100,000 (PIF,15%, 8)
= -700,000 + 150,000 X 4.4873 + 100,000 X 0.3269
= Rs. 5,785

PW for P, = -P + ( R - E)(PIA,i%,N)+ SV(PIF,i%,N)

= -400,000 + 50,000 (PIA,15%, 8) + 60,000 (PIF,15%, 8)
= -400,000 + 50,000 X 4.4873 + 60,000 X 0.3269
= -(Rs.) 156,021

Since PW, > PW; > PW,, project 2 is preferred.

Annul Worth Menhod
AW f o r e = - P(AIP,i%,N) + ( R - E ) + S V ( A I F , i % , N )
= -700,0OO(AIP,15%,8) + 150,000 + 100,0OO(AIF,15%,8)
= -700,000 X 0.2229 + 150,000 + 100,000 X 0.0729
= Rs. 1,260

A W f o r P , = -P(A/P,i%,N) + ( R - E ) + SV(AIF,i%,N)
+
= -600,000 (AIP,15%,8) 150,000 + 80,000 (AIF,15%,8)
= -600,000 X 0.2229 + 150,000 + 80,000 X 0.0729
= Rs. 22,092

A W f o r P , = -P(AIP,i%,N) + ( R - E ) + SV(AIF,i%,N)
= -400,000 (AIP,15%,8)+ 50,000 + 60,000 (AIF,15%,8)
= -400,000 x 0.2229 + 50,000 + 60,000 x 0.0729
= - (Rs.) 34,786

Since AW, >AT > AW,, project 2 is preferred.

ALTERNATIVES 1 USEFUL LIVES OF ALTERNATIVESA R E EQUAL TO THE STUDY PERIOD 225

Futum WorthMethod

F W f o r P, = - P(FIP,i%,N)+ ( R - E)(FIA,i%,N) + SV
= -600,000 (FIP,15%,8) + 150,000 (FIA,i%,N) + 80,000
= -600,000 X 3.0590 + 150,000 X 13.7268 + 80,000
= Rs. 303,620

iince M, > FW, > FW,, project 2 is preferred

:manuj%cturingjirm is evaluating three drilling machines. The estimated production rarp and con datafor

~.:ihmachine aregiven in Table 3. The MARR is 18% peryear. Annual rmenues are based on the number of
.:!its soidand the sellingprice. Ann& expenses are based onfived and variabk costs. Dermine rr,hichsekctinn
~refemblebased on annual worth (AW).

Table 3 Details of three drilling machines

DriffingMachine A Drilling .WahineB W i n gM a c k C

Investment cosr Rs. 45,000 &. -0.000 Rs. 65,000

Production rate (per year) 25,000 units 40,000 units 35,000 units
Selling price (Rs./unit) Rs. 5 Rs. 6 Rs. 5.5
Variable costs (&./unit) Rs. 3 Rs. 4 Rs. 2.5
.Annual expenses Rs. 18,000 Rs. 32,000 Rs. 30,000
Market value Rs. 20,000 Rs. 30,000 Rs. 20,000
Useful life hears) 10 10 10
226 CHAPTER 111COMPARISON AMONG ALTERNATI: <: , ...
. --.
... .

1I Solution
AWforA = -45,000 (A/P,18%,10)+ 25,000 (5 - 3) - 18,000 + 20,000 (AIF,18%,10)
= -45,000 X 0.2225 + 25,000 (5 - 3 ) - 18,000 + 20,000 X 0.0425

j = Rs. 22,837.5

I AWforB = -70,000 (A/P,18%,10) + 40,000 (6 - 4 ) - 32,000 + 30,000 (AIF,18%,10)

+ 40,000 ( 6 - 4 ) - 32,000 + 30,000 X 0.0425
I = -70,000 x 0.2225

ii = Rs. 33,700

1 AWforC =-65,000(AIP,18%,10)+35,000(5-3)-30,000+20,000(AF,18%,10)
1 = -65,000 x 0.2225 + 35,000 (5.5 - 2.5) - 30,000 + 20,000~0.0425
= Rs.61,387.5

Since AW, > AW, > AW,, machine C is preferred.

Conditions for Present Worth Comparison

Present worth comparison can be used under the following conditions:
1. Cash flows are known.
2. Cash flows are in constant value rupees.
3. The interest rate is known.
4. Comparisons are made before tax cash flows.
5. Comparisons do not include intangible considerations.
6. Comparisons do not include consideration of the availability of funds to implement alternatives.

Rate of Return Methods

In Chapter 10, we have learned two rate of return methods: IRR and ERR. T o compare the alternatk
convert aII relevant cash flows into equivalent PW, and find the rate of interest for which PW equivaler:
of cash inflows become equal to cash oudlows; this interest rate is known as IRR. Similarly, conven r
relevant cash flows into equivalent FW and find the rare of interest for which FW equivalence of G
inflows become equal to cash outflows; this interest rate is known as ERR. Consider the general case of F
alternatives Xand Y. If MARR <I&? (X)< I&? (Yi, then alternative Ywill be desirable for investment. ? - -
incremental IRR, if MGPR <IRRforA N-X), then Ywill be desirable for investment. Similar, concepts i-
used for ERR, that is, MARR < ERR (X) < ERR 0, andMARR< ERRforA (YX?,to invest in alternative

7iuo mutualiy excluiiue generators are consideTpdforpurchare by a purchase committee. Information rekrz-
fir comparing thegenerators is summarized in Table 4. Use the IRR method to determine the bettergeneraw- -
bepurcbaed. The MARR is 10% peryear.
O N G ALTERNATI. F 1 aSEFUL LIVES O F ALTERNATIVES ARE EQUAL T O T H E STUDY PERIOD 227

Table 4 Details of two generators

Generata

Capital investment Rs. 120,000 Rs. 90,000

Marker value at the end of Rs. 40,000 Rs. 25,000
service life
Annual fuel and maintenance Rs. 4,000 Rs. 6,000
expenses
Service life 10 years 10 years

- r tirsr find the value of IRR for both the generators by equating the present worth of cash outflows and
~ 2 inflows
5 (i.e., PW= 0). Select the generator for which IRR is greater than M A R R and larger between
r: alternatives.
Generator A:
PW = 0 = -120,000 - 4,00O(PIA,i%lO) + 40,000 (PIF,i%,lO)
A t i = 10%,PW = -120,000 - 4,000 x 6.1446 + 40,000 x 0.3855 = -(Rs.) 129,158.4
Ati = 15%,PW = - 120,000 - 4,000 x 5.0188 + 40,000 x 0.2472 = - (Rs.) 130,187.2
Using interpolation:
IRR = - 617.71%< 0,Not justifiedas cash outflows aremore than thecash inflows.
Generator B:

ment alternatives.

Ati = 15%,PW = -90,000 - 6,000 x 5.0188 + 25,000 x 0.2472 = -(Rs.) 113,932.8

mpare the alternaurc Using intqolation :
which PW equivaler: IRR = 184.76% >,Justified as cash outflows are less than the cash inflows.
.. Similarly, convert i Generator B should he purchased.
W equivalence of cr-
the general case of r.,
ble for investment. F:
t . Similar, concepts ;- - ;!rr mutual4 exclwive machines are being consideredfir a company. The life of the machines is expected to
invest in alternative -:.50years, and the company? MARR is 15%peryear. Annual incomefrom the machines has been estimated
n a committee and is shown in Table 5. Use the IRR method linrrementallyl to select the best machine.
Table 5 Investment on and income from four machines
.
A Machi;;% c
~achine
,....,...
Mrlchim? bi ,
ee. Information releva-
ne the bettergenerator .-
Initial investment Rs. 3,200 Rs. 2,600 Rs. 7,200 Rs. 2,700
Annual income Rs. 500 Rs. 450 Rs. 1,000 Rs. 475
228 . CHAPTER l l / C O M P A R I 5 0 N AMONG ALTEr"'-

1 Solution
Incremental analysis
For incremental analysis, find the differential present worth ofcash inflows and outflows of two alter:-
to each other, we will get the value of AIRR. The procedure is demonstrate? -

A t i = 15%
APWforA(B - A) = 600 - 50(PIA,15%,50) = 600 - 50 x 6.6605 = Rs. 266.97
I
Using interpolation,
Ii
PWAforA(B - A) = 0

1 At i = 6.79% = IRR < 15% (MARR). Thus, B is eliminated.

i Now,
I PWAforA(C - A) = -(7,200 - 3,200) + (1,000 - 500)(PIA,i,50)
I
/ Ati=lO%,
j PWAforA(C - A) = -4,000 + 500(PIA,10%,50) = -4,000 + 500 x 9.9148 = Rs. 957.4
At i = 15%,
PWAforA(C - A) = - 4,000 + 500(PIA,15%,50) = -4,000 + 500 x 6.6605 = Rs. 669.75
Using interpolation, we get
PWAforA(C - A) = 0

Ari = 26.63% = IRR > 15% WARR). Thus A is eliminated. ~:

::
Again,
PWAfbr A(D - C) = -(2,700 - 7,200) + (475 - 1,00O)(PIA,i,50)
LC.
~~~
At i = lo%,
PWAforA(D - C ) = 4,500 - 525(PIA,10%,50) = 4,500 - 525 x 9.9148 = -(Rs.) 705.27
..
At i = 15%, 1 m-2: z

PWAforA(D - C) = 4,500 - 525(PIA,15%,50) = 4,500 - 525 x 6.6605 = Rs. 1003.23

I
 MONG ALTERNA- JSEFUL LIVES O F ALTERNATIVES A R E EQUAL TO THE STUDY PERIOD 229

. ~ .
i ~ n ginterpolation, we get
P W A f o r A ( D - C )= 0
rflows of two alter-?
is demonstrated - Ati = 7.93% = IRR < 15%
-7ur D should be eliminated, and machine C should be selected.

= Rs. 104.26

:5 m has ide1ztr3ed three mutually exclwive investment alternatiues. The expected annual income from the
= Rs. 266.97 ;.>ematiues is shown in Table 6 The life of all the three alternatiues is estimated to be eight years with zero
rrsrket value. The MARR is 12%.Find the alternative that should be selected by using theibllowing:
IRR on incremental investment.
5)Present worth on incremental investment.
Table 6 Income from three ~nvestrnentalternat~ves
-
Alter C
Altnnahnnahve
-
Investment Rs. 12,000 Rs. 15,000 Rs. 18,000
Annual net income Rs.2,800 Rs. 4,000 Rs. 4,500

Solution
(a) IRR on incremental investment:
P W o f A ( B - A) = -(15,000 - 12,000) + (4,000 - 2,80O)(PIA,i%,8)
0 = -3,000 + 1,200 (PIA,i%,8)
At i= lo%,
P W A = -3,000 + 1,200 x 5.3349 = 3,401
At i = 15%,
P W A = -3,000 + 1,200 X 4.4873 = 2,384.73
Using interpolation, at i = 26.72%,PWA = 0,
!
! IRR = 26.72% > 2O%(MlRR)
which is justified and A should be eliminated.

I5 = Rs. 1003.23 P W o f A(C - B ) = -(1,8000 - 1,5000) + (4,500 - 4,00O)(PlA,i%,8)

0 = -3,000 + 500 (PIA,i%,8)
 ::
1 ...
230 CHAPTER IIICOMPARISON AMONG ALTERNATIVES

I A t i = lo%,
1 PWA = -3,000 + 500 X 5.3349 = -332.55
At i=15%
PWA = - 3,000 + 500 x 4.4873 = - 2,775.63
I
Using interpolation, at i = 9.31%,PWA = 0,

IRR = 9.31% < 20%(MARR)

which is not justified. Hence B should be selected.
(h) PWA at MARR (12%) for incremental investment:
PWof A(B- A) = -(l,5000 - 1,2000) + (4,000 - 2,80O)(PIA,12%,8)
= - 3,000 + 1,200 x 4.9676
= Rs. 2,961.12>0
B is superior than A. Also
+
PWof A(C - B) = -(1,8000 - 1,5000) (4,500 - 4,00O)(P/A,12%,8)
= -3000 + 500 X 4.9676
= -(Rs.) 516.20 < 0
Thus B is superior than C and so B should be selected,

1 Thefollowing cashfiw estimatesfor two mutually exclusive investment dternatiues arr shown in Table 7.
!
Table 7 Cash flow estimates for two investment alternatives

Rs. 10,000 Rs. 12,000

Rs. 6,000 Rs. 5,000
Rs. 2,000 Rs. 2,000
Rs. 2,000 Rs. 2,000
Rs. 2,000 Rs. 2,000
5 Rs. 4,000 Rs. 5,000

(a) Find the internal rate of return (IRR) on the incremental cash flow (A, - A,).
(b) Calculate the PWon incremental investment for each alternative for MARR of 18% and select the best
alternative.
 ALTERNATIVES
"
4 U S E F U L LIVES OF ALTERNATIVES A R E EQUAL T O THE S T U D Y PERIOD 231

Solution
ia) Internal rate of remrn (IRR) on the incremental cash flow:

PW A ( 4 - A,) = (12,000- 10,000)+ (5,000- 6,00O)(PIF,i%,l)+ (5,000 - 4,00O)(P/F,i%,5)

At i= lo%,

P W A = 2,000 -1,000 X 0.8264 + 1,OOOX 0.6209 = Rs. 1,794.50

At i=12%,
P W A = 2,000 - 1,000 x 0.7972 + 1,000 x 0.5674 = Rs. 1,770.20
I Using interpolation P W A = 0, ati = 156.69%,

IRR = 156.69% > 25%(MARR),

Alternative A, should he selected.

(b) We have
PW A(& -A,) = 2,000 - 1,000 (PIF,18%,1) + 1,00O(PIF,I8%,5)
= 2,000 - 1,000 x 0.6400 + 1,000 x 0.3277
I = Rs. 1687.7 >0

I Hence alternative A, should be selected.

A manufacturing company is consi&ngjue a l t m t i v e s for the purchase of a new ekctro-discharge machine

to increase the productivity of its existingprodum'on process. All the alternatives have a life of 10 years, and
they have no salvage value at the end of lif The capital investment and annual revenues of the alternatives
are given in Table 8. Use the IRR method incremental^) to make your recommendation. The jinnj
ir 10%per year.
I

1 Table 8 Capital investment and operating costs of five alternatives

II 1
AIternutive Capitd Znvesmaent

Rs. 100,000
Annual Revenue

Rs.-20,000

I 2 Rs. 110,000 Rs. 18,500

3 Rs. 125,000 Rs. 17,000
4 Rs. 130,000 Rs. 15,500
5 Rs. 150,000 Rs. 10,000
md select the best
232 . CHAPTER IIICOMPARISON AMONG ALTERNATIVES

Similar to the previous example, first find the IRR of each alternative. Eliminate the alternatives having
IRR less rhan the MARR. To find the IRR of each alternative, equate the value of PWto zero and find the
corresponding rate of interest that will be IRR of that investment.

I
!
PW,= 0 = -100,000 + 20,00O(P/A, i%, 10); Using interpolation, we get IRR, (i%) = 15.08%
PW,= 0 = -1 10,000 + 18,50O(PIA, i%, 10); Using interpolation, we get IRR, (i%) = 10.88%
PW,= 0 = -125,000 + 17,00O(P/A, i%, 10); Using interpolation, we get IRR, (i%) = 04.63%
PW,= 0 = -130,000 + 15,50O(P/A, i%, 10); Using interpolation, we get I& (i%) = 0.04%
PW,= 0 = -150,000 + 10,00O(P/A, i%, 10); Using interpolation, we get IRR, (i%) =-29.32%
IRR of alternatives 3, 4, and 5 can be eliminated, as they are less than MARR (10%). O n the basis oi
increment analysis,
P W o f A(2 -1) = -(1,10,000 - 1,00,000) + (18,500 - 20,00O)(P/A,i%,10)
At i = 5%,
A(2-1) = -10,000 - 1,500 x 7.722 = -(Rs.) 21,583
Ati=8%
A(2-1) = -10,000 - 1,500 x 6.710 = -(Rs.) 20,065

1 Now,

oA 2 -1 = 0, a t i = 47.65% > IO%(Z4RR).Alternative 1 is eliminated and alternative 2 is

In the case of unequal useful lives of mutually exclusive alternatives, the repeatability assumption may be
used in their comparison. According to this assumption, the economic estimates for an alternative's inid2
useful life cycle will be repeated in all subsequent replacement cycles. If the repeatability assumption is nor
applicable to a decision situation, then an appropriate study period needs to be selected (co-terminat&
assumption). This is the approach most frequently used in engineering practice because product life cycle:
are becoming shorter. In this case, all the alternatives are compared over the same study period. The follow in^
guidelines apply to compare the alternatives having unequal useful lives:
A. Useful Life < Study Period
1. Cost alternatives: Because each cost alternative has to provide the same level of service over the stud:-
period, contracting for the service or leasing the needed equipment for the remaining years may be
 j ALTERNATIVES i . j E F U L LIVES O F ALTERNATIVES ARE UNEQUAL . 233

ippropriate. Another course of action is to repeat part of the usefill life of rhe original alternative and
:hen use an estimated market value to truncate it at the end of the study period.
dternatives havin: . !qvrsment alternatives: The first assumption is that all cash flows will be reinvested in other oppor-
zero and find the runities available to the firm at the MARR till the end of the study period. Asecond assumption
involves replacing the initial investment with another asset having possibly different cash flows over
;he remaining life.

'.sefd Life > Soldy Period

-
h: most common technique is to truncate the alternative at the end of the study period, using an
-- ~ a t e dmarket value. This assumes that the disposable assets will be sold at the end of the study period
:at value.

:=uivalent Worth Methods

- m the lives of alternatives are unequal, the repeatability assumption is used if the study period is very
6). On the basis of - z in length or is a common multiple of the lives. Under this assumption, the cash flows for an alternative's
- :A life cycle will be repeated (i.e., they are identical) in all subsequent replacement cycles.

.
- rzuo mmurzmlly exclusive alternatives, A and B, associatzd costs are given in Table 9. Thg, have usefir1 lives
.-3 and 4 years, respective(y. lfMARR = 12%per yeas show which alternative is more desirable by wing
,7sivalent worth methods. Use the repeatability assumption.

Table 9 Details of two alternatives

AIrernatiz*e A Altpntmiwe B

Cap~talinvestment Rs 30,000 Rs t j 000

ative 2 is
Annual cash lnflow Rs. 12,500 Rs. 15,000
Useful life 3 Years 4 years
Market value ar the end of usell life 0 0

Solution
:assumption may be Iornmon multiple of alternative lives is 12 years. Thus study period is 12 years.
an alternative's initial PWof A = - 30,000 [1+ (PIF,12%,3) + (PIF,12%,6) + (PIF,12%,9)] + 12,500 (PIA,12%,12)
ity assumption is not = -30,000 [I + 0.7118 + 0.5066 + 0.36061 + 12,500 X 6.194
lected (co-terminated
= Rs. 55
Ise life cycles
The following PWof B = - 45,000 [1+ (PIF,12%,4) + (PIF,12%,8)] + 15,000 (PIA,12%,12)
= -45,000 [I + 0.6355 + 0.40391 + 15,000 x 6.194
= Rs. 1137
service over the study
naining years may be ?Wof B is greater than PWofA. Therefore, alternative B is preferred.
234 CHAPTER IIICOMPARISON AMONG ALTERNATIii.

; A companyipr+-t ofice hasproposed two generators A and B, muhrally exclusiue, to supply electricity w ;-,
i oA;ces uf'the universiiq Their cost data aregiuen in Table 10. The MARR is 5%per year.
1I(a) Determine which generator should be sekcted ifthe repeatability assumption applies.
I (b) Determine which generator should be selected if
the analysis period is 7 years, the rppeatabi.'-
i assumption does not apply, and the machine can be learedfir Rs.12,000peryear a f t r the us+l [{i.
1 either machine.

Table 10 Details o f two generators

f

Capiral investment Rs. 90,000 Rs. 80,000

Annual expenses Rs. 50,000 Rs. 60,000
Useful life 4 yean 6 years
: Marker value at the Rs. 10,000 Rs. 9,000
J
end of useful life

I (a) We have study period (common multiple) of 12 years.

i

1 PWof generatorA = -90,000 [I + (PIF,5%,4) + (PIF,5%,8)] - 50,000 (PIA,5%,12)

1 +lO,OOO [(P/F,5%,4) + (P/F,5%,8) + (P/F,5%,12)1

I = -90,000 [1 + 0.8227 + 0.67681 - 50,000 X 8.863

+lO,OOO [0.8277 + 0.6768 + 0.55681
i = -(Rs.) 647,942
I
?
PWof generatorB = -80,000 [1+ (PlF,5%,6)] - 60,000 (PIA,5%,12)
I
!
I
+ 9,000 [(PIF,5%,6) + (PIF,5%,12)1
= -80,000 [l +0.7462] - 60,000 x 8.863 + 9,000 10.7462 + 0.55681
f = - (Rs.)659,749
i
I1 Since PWof generator A > PWof generator B, generaror A should be preferred
1
I (b) We have
P W of generator A = -90,000 - 50,000 (PIA,5%,4)
+ 10,000 (PIF,5%,4) - 12,000 (PIA,5%,3)(PIF, 5%,4)
= -90,000 - 50,000 x 3.546 + 10,000 x 0.8227 - 12,000 X 2.732 X 0.821-
= -(%.I 285,957.51
:ALTERNATI-. :' I USEFUL LIVES OF ALTERNATIVES A R E UNEQUAL 235

PWof generatorB = -80,000 - 60,000 (PIA,5%,6) + 9,000 (PIF,5%,6)

iy electriffiy to .-.- - 12,000 (PIA,5%,l)(PIF,5%,6)
= -80,000 - 60,000 X 5.076 + 9,000 X 0.7462 - 12,000 X 0.952 X 0.7462
= -.(Rs.) 386,368.78
the repeatabr.--
.r the w&l lifi
Since PWof p e r a t o r A > PWof generator B, generator A should be preferred.

.i manuficturing concern requires a lathe machine. It is considering two mutually exclusive lathe
machines. Doing nothing is not an option. Re@r to the data in Table 11 and state your kty assumptions
in working out this problem. Use the P W method to determine which lathe rho& be selected when the
MARR is 8% per year.
Table 11 Details of two lathe machines

Capital investment Rs.200,000 Rs. 280,000

Annual rwenues Rs. 5,000 Rs.6,000
Annual expenses Rs. 1,500 Rs. 2.000
Market value at the Rr. 4,000 0
end of useful life
Useful life 5van 10 rears
I Solution
In this case, rhe useful lives of lathes 1 and 2 are of common muldple of 10 years, therefore the repeatability
assumption is used.
PWof lathe1 = -200,000 [I + (PIF,8%,5)] + (5,000 - l,jOO)(PIA,8%,10)
+4,00O[(PIF,8%,5) + (PIF,S%,lO)j
= -(Rs.) 3,08,059.8
PWoflathe2= -280,000 + (6,000 - 2,0OO)(PlA,8%,10)= -(Rs.) 253,160
I Since PWof lathe2 > PWof lathe 1, therefore lathe 2 is preferred.

A,tirm is considering thepurchase of one of two new machines. The data on these machines isgiven in Z b k IZ.
Ifperpetual service from the machine is e m e d which machine would you recommend? The MARR is
15%peryear.
236 . CHAPTER 111COMPARISON AMONG ALTERNA- I

Table12 Data on two machines

Initial cost Rs. 3,500 Rs. 7,500

Senrice life 30 years 60 years
Market value Rs. 200 Rs. 500
Annual expenses Rs. 2,000 Rs. 1,800

Solution
The capitalized cost equation for perpetual service is

Machine A
There are end-of-period disbursements A,. Here we have renewals of the machine every 30 years. T -
compute the capitalized cost, it is necessary to first compute an end-of-period disbursement A, thar
equivalent to Rs. (3,500 - 200) = Rs. 3,300 every 30 years.

Now
Total annual worth, A = A, + Annual expenses A, = 20.06 + 2,000 = Rs. 2,020.06
1 The capitalized cost is
A 2,020.06
P = 3,300 + 7= 3,300 + = Rs. 23,500.06
1 0.10
Machine B
There are end-of-period disbursements A,. Here we have renewals of the machine every 60 years. T-
compute the capitalized cost, it is necessary to first compute an end-of-period disbursement A, that
equivalent to Rs.(7,500 - 500) = Rs. 7,000 every 60 years.

Now

I1 Total annual worth, A = A, + Annualexpenses4 = 2.31 + 1,800 = Rs. 1,802.31

1 The ca~italizedcost is
A 1,802.31
P = 3,300 + = 7,000 + --------- = Rs. 25,023.1
I 0.10
The capitalized cost of machine B is less than machine A. Therefore machine A should be preferred.
-
 ' 1 5 USEFUL LIVES OF ALTERNATIVES A R E UNEQUAL . 237
Two mutually exclusive equipments a n being conridmdf.r economic analyJs. One of these equipmpna is ro 5.
selected The estimated raAhflowsfor each altonatiue aregiven in ZblP 13.
(a) Which equipment should be selected?The firm's MARR is 20% per year. Assume the equipment will
be needed indefinitely.
(b) Assume the study period shortened to five years. The market value of equipment after 5 years is
estimated to be Rs. 40,000. Which alternative would you recommend?

Table 13 Data on two equipments

Equipment A Eqtripmmt B
--.-...-. -. .. - . . . ..- .. . .. --. ..-.
. .-. --. . - .. . - . .. - -- --
Capird investment Rs. 50,000 Rs. 75,000
.4nnual expenses Rs. 10,000 Rs. 6,000
Market value at the end of useful life Rs. 4,000 Rs. 12,000
every 30 years. : Usehl life 5 years 10 years
ursement A, tht:
Solution
(a) We have

A W of equipment A = -50,000 (AIP,20%,5)- 10,000 + 4,000 (AIF,20%,5)

= -50,000 x 0.3344 - 10,000 + 4,000 x 0.1344
= -(Rs.) 26,182.4

every 60 years. TI
irsement A, that :: Since AWof equipment B > AW of equipment A , equipment B is preferred.
(b) We have

AWof equipmentA = -50,000 (AIP,20%,5) - 10,000 + 4,000 (A/F,20%,5)

= -50,000 x 0.3344 - 10,000 + 4,000 x 0.1344
= -(Rs.) 26,182.4

AWof equipmentB = -75,000 (AIP,20%,5) - 6,000 + 40,000 (AIF,20%,5)

= -75,000 x 0.3344 - 6,000 + 40,000 x 0.1344
= -(Rs.)25,704
be preferred.
Since AWof equipment B > AWof equipment A , equipment B is preferred.
238 . CHAPTER 11ICOMPARISON AMONG ALTERNATI! 5:

Rate-of-Return Analysis

' A j r m ir considering three mutually exc~w'veprojeck.The carhjow details of thereprojectsgivenin Tabk I +

11 At EOY6, Project3 would be rertarted with another same project. hte.
any, should be cboren? llre the inrremental IRRprocedure.
MARR is 8+pcryear whichprojert, f

!
Table 14 Data on three projects

Initial investment RS. 200,000 Rs.260,000 %. 280,000

Net annual revenue Rs. 76,000 Rs. 80,000 Rs. 100,000
Market value 0 0 0
Useful life 12 years 12 years 6 years
Calculated IRR 25+ 22.8+ 23.62+

I Solution
All the IRRvalues are greater than MARR as shown in the Table 14, therefore no project is eliminated at
the initial stage. Using the incremental IRR method, we get blotion
-
:;hare
P W o f A(2 - 1 ) = - 60,000 + 4,000 (PIA,i%,l2)
At i = lo+, .TT I
PW o f A(2 - I ) = - 60,000 + 4,000 x 6.814 = - (Rs.) 32,744 ?r i = 10%.
At i = 12+,
m--
ici2
P W o f A(2 -1) = -60,000 + 4,000 x 6.194 = -(Rs.) 84,776
Using interpolation we get
84776 - 32744 32744
=- 3 i = 8.74%
2 10-i

Now P W of A(2 - 1 ) = 0, at AIRR = 8.74% > 0, so Project 1 is eliminated. Again

P W o f A(3 - 2 ) = - 20,000 - 2,80,000 (PIF,i%,6)+ 20,000 (PIA,i%,12)

At i = lo+,
P W o f A ( 3 - 2 ) = -20,000 - 2,80,000 x 0.5645 + 20,000 x 6.814 = -(Rs.) 41,780
At i= 12+,
rre mur:.: -
ow. Ear,. I-.
.-here three pry-
G ALTERNATIVES : B-C RATIO METHOD FOR COMPARISON O F ALTERNATIVES . 22'

r given in Table 1;
ear which project, :-. i.-. PWof A(3 - 2 ) = 0, at A IRR = 31.92% > 0, which implies that Project 2 is eliminated and Pro;-
' :s preferred.

: the ERR incrementalmethod to decide whether Machine A or Machine B should be r r c o m m ~ d Data on

- -ne machiner is give12 in Tabkl5. These are two mutually exclusive cost alternatives, and one of them must 6e
Gcted. The MARR is 5%peryea,: Asrume repeatabiliy is appropriatefor this compariron.
Table 15 Data on two machines

MmhiMA Machine B

Capital investment Rs. 15,000 Rs. 25,000

Annual operating expenses Rs. 8,000 Rs. 6,500
Useful life 20 years 10 years
Market value 0 0
zct is eliminated zr
Solution
-.
:e have

.
-sing interpolation for
~

F W for A(B - A ) = 0
66,032 - 46,217.5 -
- 46,217.5 i = 5.33% > 0 . Hence machine B is preferred.
2 10 - i

B-C Ratio Method for comparison of Alternatives

:,ri.c mntzrully excIusiveprojcctsare to be compared. Their respective mrts and benejis aregiven in the table
-.low. Each of the projects /,as us.f.1 life of Goyears, and the nominal rate of interfit is 10%peryea,: Which of
-.,ere three projects should be sekcted?
240 CHAPTER 111COMPARISON AMONG ALTERNA- i

Capital investmenrs Rs. 800,000 Rs. 1,200,000 Rs. 1,400,000

Annual 0 & M costs Rs.75,000 Rs. 78,000 Rs. 68,000
Salvage value Rs. 100,000 Rs. 125.000 Rs. 150,000
Annual benefit Rs. 200,000 Rs.225,000 Rs. 230,000

Solution
200,000 (PlA,10%,60)
B-C ratio of X =
800,000 + 75,000 (PIA,lO%,60)- 100,000 (PIF,lO%,GO)
i

1 B-C ratio of Y= 35.06

I B-C ratio o f Z = 33.71
X>Y>Z
t
68,508,360 - 60,896,320
ABIAC of A(Y - X ) = = 17.7 > 0 ; ProjectX is rejected.
1,977,029.1 - 1,547,210
1I
1 Similarly, ABIAC of A(Z-Y) = 0.015 < 1; Project Z is rejected
1I Hence, Y is the best project.

Summary

In this chapter, we have discussed the methods have been given to address the issue on uric.
to compare the alternatives to know which one service lives. Under equivalent worth mer-
alternative is desirable to invest. Two methods, present worth, future worth, and annual n ~ r -
such as equivalent worth method and rate of return have been used.Furthermore, under rate of r r . -
method, have been used to compare the alternarives. method, internal rate of return and incrc- -
The alternatives may have either equal or unequal tal rate of return have been used to compart
service lives. Moreover, various courses of actions alternatives.

Points to Remember

1. The srudy period is the planning horizon on time alternatives and equate them to each other: =-.
scale over which mutually exclusive alrernanves we will get the value of A IRR.
are compared. 3. Costaltemtiuex Becauseeach cost alternatk . -
2. For incremental analysis, find the differential to provide the same level of service over rhe r
present worth of cash inflows and outflows of two period, contracting for the service or leasir+ -
I N G ALTERNAT . i~ "3LTIPLE-CHOICE QUESTIONS 241

needed equipment for the remaining years may till the end of the study period. A second
he appropriate. Another course of action is to assumption involves replacing the initial invest-
repeat part of the useful life of the original alter- ment with another asset having possibly different
native and then use an estimated market value to cash flows over the remaining life.
truncate it at the end of the study period. 5. When the lives of alternatives are unequal, the
4. Investment altmatiuer. The first assumption repeatability assumption is used if the study
is that all msh flows will be reinvested in other period is very long in length or is a common
opportunities available to the firm at the MARR multiple of the lives.

Multiole-Choice Questions
1. T o calculate IRR of alternatives, which of the (a) APW
following is equated to zero? (b) AAW
(a) P W (c)
(b) A W (d) none of the above
(c) F W 4. To calculate the incremental external rate of
(d) none of these return, which of the following should be equated
2. T o calculate, ERR of alternatives, which of the to zero?
is rejected. following is equated to zero? (a) APW
(a) P W (b) M W
(b) A W (4 A m
(c) FW (d) nonr of the ahore
(d) none of these 5 . Complere the following mal>sk of investment
3. T o calculate the incremental internal rate of alternativcc ad selm the preferred alternative.
return, which of the following should be The rmd: period is i years and ~he.l.fMR=18%
equated to zero? per year.

the issue on unc; - Alternative I Alternative 2 A Z t e m ~ i w3

alent worth me<--,
rh, and annual u-:- Capital investment Rs. 250,000 Rs.450,000 Rs. 550,000
c, under rate of .er:
Annual revenues Rs. 200,000 Rs. 125,000 Rs. 150,000
return and increrrr..
I used to compare : Annual expenses Rs. 50,000 Rs. 50,000 Ks. 75,000
Market value Rs. 50,000 Rs.50,000 Rs. 100,000
Useful life (Years) 12 12 12
PW(18%) - -Rs. 33,650 -Rs. 76,790

hem to each other; i' r

1 IRR. (a) D o nothing 6. Complete the following analysis of cost alterna-
c each cost alternauve - : (b) Alternative A tives and select the preferred alternative. T h e
1 of service over the sr- : (c) Alternative B study period is 10 years and the MARR= 12%
the service or leasing -- (d) Alternative C per year. "Do Nothingn is not an option.