CHAPTER (4)

Part ”1”

FORMULATING ALTERNATIVES

Application of Present Worth Analysis

Prepared by Dr. Osama Mohammad Irfan

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 INTRODUCTION

Engineering alternatives are evaluated upon the prognosis

that a Reasonable Rate of Return (ROR) can be realized.

A reasonable rate must be established so that the

accept/reject decision can be made.

 The reasonable rate, called the Minimum Attractive Rate of

Return (MARR), must be higher than the cost of money used to
finance the alternative, as well as higher than the rate that would
be expected from a bank or safe (minimal risk) investment.

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 For a corporation, the MARR is always set above its cost of capital, that
is, the interest rate a company must pay for capital funds needed to
finance projects.
For Example: if a corporation can borrow capital funds at an average
of 5% per year and expects to clear at least 6% per year on a project,
the minimum MARR will be 11% per year.
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 MARR is established by financial managers and
is used as a criterion for accept/reject decisions.

 The following inequality must be correct for any

accepted project:

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Some projects are economically and technologically
viable, and others are not. Once the viable projects are
defined, it is possible to formulate the alternatives.

Mutually Exclusive
Alternatives (ME)
are one of
two types
Independent

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A mutually exclusive alternative selection is the most
common type in engineering practice.
 It takes place, for example, when an engineer must select the one
best diesel-powered engine from several competing models.
 Mutually exclusive alternatives are, therefore, the same as the
viable projects; each one is evaluated, and the one best
alternative is chosen.
 Mutually exclusive alternatives compete with one another in the
evaluation.
 All the analysis techniques compare mutually exclusive
alternatives.
Present worth is discussed regarding this issue.
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 The do-nothing (DN) option is usually understood to be an
alternative when the evaluation is performed.

 If it is absolutely required that one of the defined alternatives be

selected, do nothing is not considered an option. (This may occur
when a mandated function must be installed for safety, legal, or
other purposes).

 Selection of the (DN) alternative means that the current approach

is maintained; no new costs, revenues, or savings are generated.

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Independent projects are usually designed to accomplish
different purposes, thus the possibility of selecting any number
of the projects. These alternatives do not compete with one
another; each project is evaluated separately, and the
comparison is with the MARR. Independent project selection
is treated later.

Finally, it is important to classify an alternative’s cash flows

as revenue-based or cost-based. All alternatives evaluated in
one study must be of the same type.

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Revenue. Each alternative generates cost and revenue
cash flow estimates, and possibly savings, which are
treated like revenues. Revenues may be different for each
alternative. These alternatives usually involve new systems,
products, and services that require capital investment to
generate revenues and/or savings. Purchasing new
equipment to increase productivity and sales is a revenue
alternative.

Cost. Each alternative has only cost cash flow

estimates. Revenues are assumed to be equal for all
alternatives. These may be public sector (government)
initiatives, or legally mandated or safety improvements.

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 APPLICATION OF PRESENT WORTH
1- Present Worth Analysis of
Equal-life Alternatives

PW, is calculated at the MARR for each alternative.

This converts all future cash flows into present dollar

equivalents. This makes it easy to determine the
economic advantage of one alternative over another.

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 For mutually exclusive
alternatives the guide
lines according to the
following

More than
One
one
alternative
alternative

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 The second guideline uses the criterion of numerically largest to
indicate a lower PW of costs only or larger PW of net cash flows.
Numerically largest is not the absolute value because the sign
matters here. The selections below correctly apply this guideline.

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 2- PRESENT WORTH ANALYSIS OF
DIFFERENT-LIFE ALTERNATIVES

If equal service is not present, shorter-lived alternatives will

be favored based on lower PW of total costs.
Two ways to use PW analysis to compare alternatives with
unequal life estimates

PW analysis with unequal life estimates

evaluate over a specific use the Least

study period Common Multiple (LCM) of lives for
(planning horizon) each pair of alternatives

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 Planning Horizon (Study Period) Method
Once a study period is selected, only cash flows during this
time frame are considered.
 If an expected life is longer than this period, the estimated
market value of the alternative is used as a “salvage value” in
the last year of the study period.
 If the expected life is shorter than the study period, cash flow
estimates to continue equivalent service must be made for the
time period between the end of the alternative’s life and the
end of the study period.

Assume a construction company wins a highway maintenance contract for 5 years,

but plans to purchase specialized equipment expected to be operational for 10 years.
For analysis purposes, the anticipated market value after 5 years is a salvage value
in the PW equation, and any cash flows after year 5 are ignored.
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EXAMPLE 4.3: A project engineer with Environ Care is assigned to start
up a new office in a city where a 6-year contract has been finalized to
collect and analyze ozone-level readings. Two lease options are
available, each with a first cost, annual lease cost, and deposit-return
estimates shown below. The MARR is 15% per year.

a. Environ Care has a practice of evaluating all projects over a 5-year

period. If the deposit returns are not expected to change, which
location should be selected?
b. Perform the analysis using an 8-year planning horizon.
c. Determine which lease option should be selected on the basis of a
present worth comparison using the LCM.
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 Least Common Multiple (LCM) Method
This approach can result in unrealistic assumptions since equal service
comparison is achieved by assuming:

 The same service is needed for the LCM number of

years. For example, the LCM of 5- and 9-year lives
presumes the same need for 45 years!
 Cash flow estimates are initially expected to remain the
same over each life cycle, which is correct only when
changes in future cash flows exactly match the inflation or
deflation rate.
 Each alternative is available for multiple life cycles,
something that is usually not true.

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 For The Same previous Example

Determine which lease option should be selected on the basis of a

present worth comparison using the LCM.

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 3- CAPITALIZED COST ANALYSIS
Capitalized cost (CC) is the present worth of an alternative that
will last “forever.” Public sector projects such as bridges, dams,
irrigation systems, and railroads fall into this category, since they
have useful lives of 30, 40, and more years.

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 EXAMPLE 4.4: The property appraisal district for Marin County has just installed
new software to track residential market values for property tax computations.
The manager wants to know the total equivalent cost of all future costs incurred
when the three county judges agreed to purchase the software system. If the new
system will be used for the indefinite future, find the equivalent value (a) now and,
(b) for each year hereafter. The system has an installed cost of $150,000 and an
additional cost of $50,000 after 10 years. The annual software maintenance
contract cost is $5000 for the first 4 years and $8000 thereafter. In addition, there
is expected to be a recurring major upgrade cost of $15,000 every 13 years.
Assume that i = 5% per year for county funds.

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 EVALUATION OF INDEPENDENT PROJECTS

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EXAMPLE 4.7: Marshall Aqua Technologies has four separate projects it
can pursue over the next several years. The required amounts to start
each project (initial investments) now and the anticipated cash flows over
the expected lives are estimated by the Project Engineering Department.
At MARR 15% per year, determine which projects should be pursued if
initial funding is (a) not limited, and (b) limited to no more than $15,000.

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