Engineering Economics Hand out

Chapter Three
Comparison of Alternatives

3.1. Introduction
For most of the engineering projects, equipments etc., there are more than one feasible alternative. It is
the duty of the project management team (comprising of engineers, designers, project managers etc.)
of the client organization to select the best alternative that involves less cost and results more revenue.
For this purpose, the economic comparison of the alternatives is made. The different cost elements and
other parameters to be considered while making the economic comparison of the alternatives are initial
cost, annual operating and maintenance cost, annual income or receipts, expected salvage value,
income tax benefit and the useful life. When only one, among the feasible alternatives is selected, the
alternatives are said to be mutually exclusive.

As already mentioned in chapter two, the cost or expenses are generally known as cash outflows
whereas revenue or incomes are generally considered as cash inflows. Thus in the economic
comparison of alternatives, cost or expenses are considered as negative cash flows. On the other hand
the income or revenues are considered as positive cash flows. From the view point of expenditure
incurred and revenue generated, some projects involve initial capital investment i.e. cash outflow at the
beginning and show increased income or revenue i.e. cash inflow in the subsequent years. The
alternatives having this type of cash flow are known as investment alternatives. So while comparing
the mutually exclusive investment alternatives, the alternative showing maximum positive cash flow is
generally selected. In this case, the investment is made at the beginning to gain profit at the future
period of time. Example for such type alternatives includes purchase of a dozer by a construction firm.
The construction firm will have different feasible alternatives for the dozer with each alternative
having its own initial investment, annual operating and maintenance cost, annual income depending
upon the production capacity, useful life, salvage values etc. Thus the alternative which will yield
more economic benefit will be selected by the construction firm. There are some other projects which
involve only costs or expenses throughout the useful life except the salvage value if any, at the end of
the useful life. The alternatives having this type of cash flows are known as cost alternatives. Thus
while comparing mutually exclusive cost alternatives; the alternative showing minimum negative cash
flow is generally selected. Example for such type alternatives includes construction of a government
funded national highway stretch between two regions. For this project there will be different feasible
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alternatives depending upon length of the stretch, type of pavement, related environmental, social and
regulatory aspects etc. Each alternative will have its initial cost of construction, annual repair and
maintenance cost and some major repair cost if any, at some future point of time. The alternative that
will exhibit lowest cost will be selected for the construction of the highway stretch.

The differences in different parameters namely initial capital investment, annual operation cost,
annually generated revenue, expected salvage value, useful life, magnitude of output and its quality,
performance and operational characteristics etc. may exist among the mutually exclusive alternatives.
Thus the economic analysis of the mutually exclusive alternatives is generally carried out on the
similar or equivalent basis since each of the feasible alternatives will meet the desired requirements of
the project, if selected.

The economic comparison of mutually exclusive alternatives can be carried out by different equivalent
worth methods namely present worth method, future worth method and annual worth method. In these
methods all the cash flows i.e. cash outflows and cash inflows are converted into equivalent present
worth, future worth or annual worth considering the time value of money at a given interest rate per
interest period.

3.2. Comparison of alternatives by present worth method

In the present worth method for comparison of mutually exclusive alternatives, the future amounts i.e.
expenditures and incomes occurring at future periods of time are converted into equivalent present
worth values at a certain rate of interest per interest period and are added to present worth occurring at
„0‟ time. The converted equivalent present worth values are always less than the respective future
amounts since the rate of interest is normally greater than zero. The cash flow of the mutually
exclusive alternatives may consist of future expenditures and incomes in different forms namely
randomly placed single amounts, uniform amount series commencing from end of year 1, randomly
placed uniform amount series i.e. commencing at time period other than end of year 1, positive and
negative uniform gradient series starting either from end of year 1 or at different time periods and
geometric gradient series etc. The different compound interest factors namely single payment present
worth factor, uniform series present worth factor and present worth factors for arithmetic and
geometric gradient series etc. will be used to convert the respective future amounts to the equivalent
present worth values for different alternatives.

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The methodology for the comparison of mutually exclusive alternatives by the present worth method
depends upon the magnitude of useful lives of the alternatives. There are two cases; a) the useful lives
of alternatives are equal and b) the useful lives of alternatives are not equal. The alternatives having
equal useful lives are designated as equal life span alternatives whereas the alternatives having unequal
life spans are referred as different life span alternatives.

A) Equal life span alternative

The comparison of mutually exclusive alternatives having equal life spans by present worth method is
comparatively simpler than those having different life spans. In case of equal life span mutually
exclusive alternatives, the future amounts as already stated are converted into the equivalent present
worth values and are added to the present worth occurring at time zero. Then the alternative that
exhibits maximum positive equivalent present worth or minimum negative equivalent present worth is
selected from the considered feasible alternatives.

Example17: An engineer has two bids for an elevator to be installed in a new building. The details of
the bids for the elevators are as follows:
Initial cost Service life Annual operations &
(Rs.) (years) maintenance cost (Rs.)
Alpha Elevator 450,000 15 27,000
Beta Elevator 540,000 15 28,500

Determine which bid should be accepted, based on the present worth method of comparison assuming
15% interest rate, compounded annually.

Solution
Bid 1: Alpha Elevator
Initial cost, P = Rs. 450,000 Annual operation and maintenance cost, A = Rs. 27,000 Life = 15 years
Interest rate, i = 15%, compounded annually.

The cash flow diagram of bid 1 is shown in the figure below.

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Figure 3. 1: Cash flow diagram for bid 1

The present worth of the above cash flow diagram is computed as follows:

PW = 450,000 + 27,000(P/A, 15%, 15) = 450,000 + 27,000 * 5.8474 = 450,000 + 1,57,879.80

= Rs. 607,879.80

Bid 2: Beta Elevator

Initial cost, P = Rs. 540,000 Annual operation and maintenance cost, A = Rs. 28,500 Life = 15 years
Interest rate, i = 15%, compounded annually.

The cash flow diagram of bid 2 is shown in the figure below.

Figure 3. 2: Cash flow diagram for bid 2.

The present worth of the above cash flow diagram is computed as follows:
PW = 540,000 + 28,500(P/A, 15%, 15) = 540,000 + 28,500 * 5.8474 = 540,000 + 1,66,650.90
= Rs. 706,650.90

The total present worth cost of bid 1 is less than that of bid 2. Hence, bid 1 is to be selected for
implementation. That is, the elevator from Alpha Elevator is to be purchased and installed in the new
building.

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B) Different life span alternatives

In case of mutually exclusive alternatives, those have different life spans; the comparison is generally
made over the same number of years i.e. a common study period. This is because; the comparison of
the mutually exclusive alternatives over same period of time is required for unbiased economic
evaluation of the alternatives. If the comparison of the alternatives is not made over the same life span,
then the cost alternative having shorter life span will result in lower equivalent present worth i.e. lower
cost than the cost alternative having longer life span. Because in this case, the cost of the short span
alternative is considered only for a shorter period of time, even though this alternative may not be
economical. In case of mutually exclusive investment alternatives, the alternative with longer life span
will result in higher equivalent present worth i.e. higher positive equivalent worth, as the costs,
revenues, savings through reduced costs is considered over a longer period of time than the alternative
with shorter life span. Thus in order to minimize the effect of such kind of discrepancy on the selection
of best alternative from the considered feasible alternatives, the comparison is made over the same life
span.

The two approaches used for economic comparison of different life span alternatives are as follows; i)
Comparison of mutually exclusive alternatives over a time period that is equal to least common
multiple (LCM) of the individual life spans ii) Comparison of mutually exclusive alternatives over a
study period which is not necessarily equal to the life span of any of the alternatives.

In the first approach the comparison is made over a time period equal to the least common multiple of
the life spans of mutually exclusive alternatives. The cash flow of the alternatives i.e. cash flow of the
first cycle is repeated and the number of repetitions depends upon the value of least common multiple
of life spans between the mutually exclusive alternatives. It may be noted here that the cash flow i.e.
all the costs and revenues of the alternatives in the successive cycle will be exactly same as that in the
first cycle. For example if there are two alternatives with useful lives of 4 years and 5 years. Then the
alternatives will compared over a period of 20 years (least common multiple of life spans) at the given
rate of interest per year. Thus the cash flow of the alternative having the life span of 4 years will be
repeated 5 times including the first cycle whereas the cash flow of the alternative with life span of 5
years will be repeated 4 times including the first cycle. After that the most economical alternative will
be selected. Taking another example, there are two alternatives with life spans of 5 years and 10 years.
In this case the alternatives will be compared over a period of 10 years (LCM). Thus the alternative

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with life span of 5 years will be analyzed for 2 cycles whereas the alternative with 10 year life span
will be analyzed for one cycle only at the given rate of interest per year.

In the second approach, a study period is selected over which the economic comparison of mutually
exclusive alternatives is carried out. The length of the study period will depend on the overall benefit
of the project i.e. it may be shorter or longer (as compared to useful lives of the individual alternatives)
depending upon the short-term or long-term benefits as desired for the project. Thus the cash flows of
the alternatives occurring during the study period are only considered for the economic comparison.
However if any alternative possesses salvage value at the end of its useful life and that occurs after the
study period, then its equivalent value must be included in the economic analysis. The values of
equivalent present worth of the mutually exclusive alternatives are calculated over the selected study
period and the alternative showing maximum positive equivalent present worth or minimum negative
equivalent present worth is selected.

Example18: A material testing laboratory has two alternatives for purchasing a compression testing
machine which will be used for determining the compressive strength of different construction
materials. The alternatives are from two different manufacturing companies. The cash flow details of
the alternatives are as follows;
Alternative-1: Initial purchase price = Rs.1000000, Annual operating cost = Rs.10000, Expected
annual income to be generated from testing of different construction materials = Rs.175000, Expected
salvage value = Rs.200000, Useful life = 10 years.

Alternative-2: Initial purchase price = Rs.700000, Annual operating cost = Rs.15000, Expected annual
income to be generated from testing of different construction materials = Rs.165000, Expected salvage
value = Rs.250000, Useful life = 5 years. Using present worth method, find out the most economical
alternative at the interest rate of 10% per year.

Solution:
The alternatives have different life spans i.e. 10 years and 5 years. Thus the comparison will be made
over a time period equal to the least common multiple of the life spans of the alternatives. In this case
the least common multiple of the life spans is 10 years. Thus the cash flow of Alternative-1 will be
analyzed for one cycle (duration of 10 years) whereas the cash flow of Alternative-2 will be analyzed

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for two cycles (duration of 5 years for each cycle). The cash flow of the Alternative-2 for the second
cycle will be exactly same as that in the first cycle.

The cash flow diagram of Alternative-1 is shown in Fig. below

Figure 3. 3: Cash flow diagram of Alternative-1

The equivalent present worth PW1 (in Rs.) of Alternative-1 is calculated as follows;

PW1 = - 1000000 - 10000(P/A, i, n) + 175000(P/A, i, n) + 200000(P/F, i, n)

PW1 = - 1000000 - 10000(P/A, 10%, 10) + 175000(P/A, 10%, 10) + 200000(P/F, 10%, 10)
PW1 = - 1000000 + (175000 - 10000) (P/A, 10%, 10) + 200000(P/F, 10%, 10)

Putting the values of different compound interest factors in the above expression for PW1;
PW1 = - 1000000 + 165000 * 6.1446 + 200000 * 0.3855
PW1 = - 1000000 + 1013859 + 77100
PW1 = Rs.90959

The cash flow diagram of Alternative-2 is shown in Fig. below. As the least common multiple of the
life spans of the alternatives is 10 years, the cash flow of Alternative-2 is shown for two cycles with
each cycle of duration 5 years.

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Figure 3. 4: Cash flow diagram of Alternative-2 for two cycles

In the cash flow diagram of Alternative-2, the initial purchase price of Rs.700000 is again located at
the end of year „5‟ i.e. at the end of first cycle or the beginning of the second cycle. In addition the
annual operating cost and the annual income are also repeated in the second cycle from end of year „6‟
till end of year „10‟. Further the salvage value of Rs.250000 is also located at end of year „10‟ i.e. at
the end of second cycle.

The equivalent present worth PW2 (in Rs.) of Alternative-2 is determined as follows;

PW2 = - 700000 - 15000(P/A, 10%, 10) + 165000(P/A, 10%, 10) + 250000(P/F, 10%, 5) -
700000(P/F, 10%, 5) + 250000(P/F, 10%, 10)
PW2 = - 700000 + (165000 - 15000) (P/A, 10%, 10) - (700000 – 250000) (P/F, 10%, 5) + 250000(P/F,
10%, 10)

Putting the values of different compound interest factors in the above expression for PW2 results in the
following;
PW2 = - 700000 + 150000 * 6.1446 – 450000 * 0.6209 + 250000 * 0.3855
PW2 = - 700000 + 921690 - 279405 + 96375
PW2 = Rs.38660

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Thus from the comparison of equivalent present worth of the alternatives, it is evident that Alternative-
1 will be selected for purchase of the compression testing machine as it shows the higher positive
equivalent present worth.

3.2. Comparison of alternatives by future worth method

In the future worth method for comparison of mutually exclusive alternatives, the equivalent future
worth (i.e. value at the end of the useful lives of alternatives) of all the expenditures and incomes
occurring at different periods of time are determined at the given interest rate per interest period. As
already mentioned, the cash flow of the mutually exclusive alternatives may consist of expenditures
and incomes in different forms. Therefore the equivalent future worth of these expenditures and
incomes will be determined using different compound interest factors namely single payment
compound amount factor, uniform series compound amount factor and future worth factors for
arithmetic and geometric gradient series etc.

The use of future worth method for comparison of mutually exclusive alternatives will be illustrated in
the following examples. Similar to present worth method, first the comparison of equal life span
alternatives by future worth method will be illustrated followed by comparison of different life span
alternatives. Some of the examples already worked out by the present worth method will be illustrated
using the future worth method in addition to some other examples.

Example19: There are two alternatives for purchasing a concrete mixer. Both the alternatives have
same useful life. The cash flow details of alternatives are as follows;

Alternative-1: Initial purchase cost = Rs.300000, Annual operating and maintenance cost = Rs.20000,
Expected salvage value = Rs.125000, Useful life = 5 years.

Alternative-2: Initial purchase cost = Rs.200000, Annual operating and maintenance cost = Rs.35000,
Expected salvage value = Rs.70000, Useful life = 5 years. Using future worth method, find out which
alternative should be selected, if the rate of interest is 10% per year.

Solution:
The future worth of the mutually exclusive alternatives will be compared over a period of 5 years. The
equivalent future worth of the alternatives can be obtained either by multiplying the equivalent present
worth of each alternative already obtained by present worth method with the single payment

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compound amount factor or determining the future worth of expenditures and incomes individually
and adding them to get the equivalent future worth of each alternative.

The equivalent future worth of Alternative-1 is obtained as follows;

FW1 = PW1(F/P, i, n)

PW1 is the equivalent present worth of Alternative-1 which is equal to - Rs.298203. (F/P, i, n) is the
single payment compound amount factor.

FW1 = -298203(F/P, 10%, 5)

Now putting the value of single payment compound amount factor in the above expression;

FW1 = -298203 * 1.6105

FW1 = -Rs.480255

The equivalent future worth of Alternative-1 can also be determined in the following manner

Now putting the values of different compound interest factors in the above expression;

FW1 = -Rs.480252

Now it can be seen that the calculated future worth of Alternative-1 by both ways is same. The minor
difference between the values is due to the effect of decimal points in the calculations.

The equivalent future worth of Alternative-2 is calculated as follows;

PW2 is the equivalent present worth of Alternative-2 which is equal to - Rs.289215

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Now putting the value of single payment compound amount factor in the above expression;

FW2 = -Rs.465781

The equivalent future worth of Alternative-2 can also be determined in the same manner as in case of
Alternative-1 and is presented as follows

Now putting the values of different compound interest factors in the above expression;

FW2 = -Rs.465779
Thus the future worth of Alternative-2 obtained by both methods is same. In this case also the minor
difference between the values is due to the effect of the decimal points in the calculations.
Comparing the equivalent future worth of both the alternatives, it is observed that Alternative-2 will be
selected as it shows lower negative equivalent future worth as compared to Alternative-1. This
outcome of the comparison of the alternatives by future worth method is same as that obtained from
the present worth method. This is due to the equivalency relationship between present worth and future
worth through compound interest factors at the given rate of interest per interest period.

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Example20: A material testing laboratory has two alternatives for purchasing a compression testing
machine which will be used for determining the compressive strength of different construction
materials. The alternatives are from two different manufacturing companies. The cash flow details of
the alternatives are as follows;
Alternative-1: Initial purchase price = Rs.1000000, Annual operating cost = Rs.10000, Expected
annual income to be generated from testing of different construction materials = Rs.175000, Expected
salvage value = Rs.200000, Useful life = 10 years.

Alternative-2: Initial purchase price = Rs.700000, Annual operating cost = Rs.15000, Expected annual
income to be generated from testing of different construction materials = Rs.165000, Expected salvage
value = Rs.250000, Useful life = 5 years. Find out the most economical alternative at interest rate of
10% per year by future worth method.

Solution:
As the alternatives have different life spans i.e. 10 years and 5 years, the comparison will be made over
a time period equal to the least common multiple of the life spans of the alternatives i.e. 10 years. Thus
the cash flow of Alternative-1 is analyzed for one cycle (duration of 10 years) whereas that of cash
flow of Alternative-2 is analyzed for two cycles of duration 5 years each.

The cash flow diagram of Alternative-1 is shown here again for ready reference.

Figure 3. 5: Cash flow diagram of Alternative-1

The equivalent future worth FW1 (in Rs.) of Alternative-1 is determined as follows

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Putting the values of different compound interest factors in the above expression;

FW1 = Rs.235971

The cash flow diagram of Alternative-2 is shown here again for ready reference. The equivalent future
worth FW2 (in Rs.) of Alternative-2 is determined as follows;

Figure 3. 6: Cash flow diagram of Alternative-2 for two cycles

Putting the values of different compound interest factors in the above expression for FW2 results in the
following;

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FW2 = Rs.100295

Thus Alternative-1 will be selected for purchase of the compression testing machine, as it shows the
higher positive equivalent future worth as compared to Alternative-2.

3.3. Comparison of alternatives by annual worth method

In this method, the mutually exclusive alternatives are compared on the basis of equivalent uniform
annual worth. The equivalent uniform annual worth represents the annual equivalent value of all the
cash inflows and cash outflows of the alternatives at the given rate of interest per interest period. In
this method of comparison, the equivalent uniform annual worth of all expenditures and incomes of
the alternatives are determined using different compound interest factors namely capital recovery
factor, sinking fund factor and annual worth factors for arithmetic and geometric gradient series etc.
Since equivalent uniform annual worth of the alternatives over the useful life are determined, same
procedure is followed irrespective of the life spans of the alternatives i.e. whether it is the comparison
of equal life span alternatives or that of different life span alternatives. In other words, in case of
comparison of different life span alternatives by annual worth method, the comparison is not made
over the least common multiple of the life spans as is done in case of present worth and future worth
method. The reason is that even if the comparison is made over the least common multiple of years,
the equivalent uniform annual worth of the alternative for more than one cycle of cash flow will be
exactly same as that of the first cycle provided the cash flow i.e. the costs and incomes of the
alternative in the successive cycles is exactly same as that in the first cycle. Thus the comparison is
made only for one cycle of cash flow of the alternatives. This serves as one of greater advantages of
using this method over other methods of comparison of alternatives. However if the cash flows of the
alternatives in the successive cycles are not the same as that in the first cycle, then a study period is
selected and then the equivalent uniform annual worth of the cash flows of the alternatives are
computed over the study period.

Now the comparison of mutually exclusive alternatives by annual worth method will be illustrated in
the following examples.

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Example21: There are two alternatives for purchasing a concrete mixer and following are the cash
flow details;
Alternative-1: Initial purchase cost = Rs.300000, Annual operating and maintenance cost = Rs.20000,
Expected salvage value = Rs.125000, Useful life = 5 years.

Alternative-2: Initial purchase cost = Rs.200000, Annual operating and maintenance cost = Rs.35000,
Expected salvage value = Rs.70000, Useful life = 5 years. The annual revenue to be generated from
production of concrete (by concrete mixer) from Alternative-1 and Alternative-2 are Rs.50000 and
Rs.45000 respectively. Compute the equivalent uniform annual worth of the alternatives at the interest
rate of 10% per year and find out the economical alternative.

Solution:
The cash flow diagram of Alternative-1 is shown in Fig. below

Figure 3. 7: Cash flow diagram of Alternative -1

The equivalent uniform annual worth of Alternative-1 i.e. AW1 is computed as follows;

Here Rs.20000 and Rs.50000 are annual amounts. Now putting the values of different compound
interest factors;

AW1 = - Rs.28665

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The cash flow diagram of Alternative-2 is shown here again for ready reference.

Figure 3. 8: Cash flow diagram of Alternative -2

Now the equivalent uniform annual worth of Alternative-2 i.e. AW2 is calculated as follows;

For alternative-2, Rs.35000 and Rs.45000 are annual amounts. Now putting the values of different
compound interest factors in the above expression;

AW2 = - Rs.31294

From this comparison, it is observed that Alternative-1 will be selected as it shows lower negative
equivalent uniform annual worth compared to Alternative-2.

Now the comparison of alternatives with cash flows involving gradient series and randomly placed
single amount by annual worth method will be illustrated followed by the comparison of different life
span alternatives.

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