Faculty of Engineering

and Technology

Engineering Economy

Lecture 5
Decision Making among
Alternatives
Dr. Mohamed Abdallah Bhlol
Lecture outline
Formulating Alternatives

Present Worth (PW) Method of Comparison

Future Worth (FW) Method

Annual Worth (AW) Method

Rate of return method

 Payback Period method

 Formulating Alternatives

 In most of the practical decision environments,

executives will be forced to select the best alternative from
a set of competing alternatives.

 There are several bases for comparing the worthiness

of the projects. These bases are:
1. Present worth method
2. Future worth method
3. Annual equivalent method
4. Rate of return method
5. Pay back period
 Present worth method
In this method of comparison, the cash flows of each
alternative will be reduced to time zero by assuming an
interest rate i. Then, depending on the type of decision, the
best alternative will be selected by comparing the present
worth amounts of the alternatives.

Present worth method is a process of obtaining the

equivalent worth of future cash flows BACK to some point in
time.

At an interest rate usually equal to or greater than the

Organization’s established (minimum attractive rate of return
MARR).
Present worth method
If the cash flow contains a mixture of positive and negative
cash flows – We calculate:
PW(+ Cash Flows) at i%;
PW( “-” Cash Flows) at i%;
Add the result!
 We can add the two results since the equivalent cash
flows occur at the same point in time

If PW(i%) > 0 then the project is deemed acceptable.

If PW(i%) < 0 then the project is deemed unacceptable

 If the net present worth = 0 then,The project earns

exactly i% return
 Present worth method
Comparing Alternatives Using PW

EXAMPLES
Present worth method
Equal Lives Alternatives
Present Worth is a method that assumes the project life
or time span of all alternatives are EQUAL.

Assume two projects, A and B.

Assume:
nA = 5 years;
nB = 7 Years;

You can compute PA and PB however;

The two amounts cannot be compared at t = 0
because of unequal lives
 Present worth method
Equal Lives Alternatives

Example 1: Three Alternatives Assume i = 10% per year

A1 A2 A3
Electric Power Gas Power Solar Power
First Cost: -2500 First Cost: -3500 First Cost: -6000
Ann. Op. Cost: -900 Ann. Op. Cost: -700 Ann. Op. Cost: -50
Sal. Value: +200 Sal. Value: +350 Sal. Value: +100
Life: 5 years Life: 5 years Life: 5 years

Which Alternative – if any, Should be selected based upon a

present worth analysis?
 Present worth method
Solution: Cash Flow Diagrams
FSV = 200
A1: Electric

0 1 2 3 4 5
-2500 A = -900/Yr.
FSV = 350
A2: Gas

0 1 2 3 4 5
A = -700/Yr.
-3500
A3:Solar FSV = 100

0 1 2 3 4 5
A = -50/Yr.

-6000 i = 10%/yr and n = 5

 Present worth method
Calculate the Present Worth's
 Present Worth's are:
1. PWElec. = -2500 - 900(P/A,10%,5) +
200(P/F,10%,5) = $-5788
2. PWGas = -3500 - 700(P/A,10%,5) +
350(P/F,10%,5) = $-5936
3. PWSolar = -6000 - 50(P/A,10%,5) +
100(P/F,10%,5) = $-6127
Select “Electric” which has the min. PW Cost!
 Present worth method
Example 2:
Consider the investment cash flows associated with the metal
fabrication project as shown in figure. If the firm’s MARR is
15%, compute the NPW of this project. Is this project
acceptable?
 Present worth method
Solution:
 Future worth method
In the future worth method of comparison of alternatives,
the future worth of various alternatives will be computed.

 Then, the alternative with the maximum future worth of net

revenue or with the minimum future worth of net cost will be
selected as the best alternative for implementation.

In some applications, management may prefer a future

worth analysis;
 Future worth method
Example 3: Consider the following two mutually exclusive
alternatives:

At i = 18%, select the best alternative based on future

worth method of comparison.
 Future worth method
Solution:
The cash flow diagram of alternative A

The future worth amount of alternative A is computed as

FWA(18%) = –5000,000(F/P, 18%, 4) + 2000,000(F/A, 18%, 4)
= –50,00,000(1.939) + 20,00,000(5.215)
= Rs. 7,35,000
 Future worth method
The cash flow diagram of alternative B

The future worth amount of alternative B is computed as

FWB(18%) = –45,00,000(F/P, 18%, 4) + 18,00,000 (F/A, 18%, 4)

= –45,00,000(1.939) + 18,00,000(5.215)
= Rs. 6,61,500
select alternative A
 Annual worth method

In the annual equivalent method of comparison, first the

annual equivalent cost or the revenue of each alternative
will be computed.

Then the alternative with the maximum annual equivalent

revenue in the case of revenue-based comparison or with
the minimum annual equivalent cost in the case of cost
based comparison will be selected as the best alternative.
 Annual worth method

Example 4
A company is planning to purchase an advanced machine
centre. Three original manufacturers have responded to its
tender whose particulars are tabulated as follows:

Determine the best alternative based on the annual

equivalent method by assuming i = 20%, compounded
annually.
 Annual worth method
Solution:
Alternative 1

AW1(20%) = 5,00,000(A/P, 20%, 15) + 2,00,000

= 5,00,000(0.2139) + 2,00,000
= 3,06,950
 Annual worth method
Solution:
Alternative 2

AW2(20%) = 4,00,000(A/P, 20%, 15) + 3,00,000

= 4,00,000(0.2139) + 3,00,000
= Rs. 3,85,560.
 Annual worth method
Solution:
Alternative 3

AW3(20%) = 6,00,000(A/P, 20%, 15) + 1,50,000

= 6,00,000(0.2139) + 1,50,000 = Rs. 2,78,340.
The annual equivalent cost of manufacturer 3 is less than
that of manufacturer 1 and manufacturer 2. Therefore, the
company should buy the advanced machine centre from
manufacturer 3.
 Return on Investment (ROI)

Return on investment (ROI) is calculated by subtracting

the project costs from the benefits and then dividing by the
costs.
total discounted benefits  total discounted cos ts
ROI 
discounted cos ts

The higher the ROI, the better

Many organizations have a required rate of return or

minimum acceptable rate of return (MARR) on an
investment.
Internal rate of return (IRR) can by calculated by setting
the NPV to zero.
 Return on Investment (ROI)
The internal rate of return of a project is known as the rate
of return where the particular project’s net present value
equals to zero.

Formula:
CF 1 CF 2 CF 3
[    ]  Initial Investment  0
(1  i )1
(1  i ) 2
(1  i ) 3

Where:
– CF: Cash Flow
– i: Internal Rate of Return (IRR)
 Return on Investment (ROI)

Decision Rule: Accept the project if the IRR is greater

than the required return.

Computing IRR For The Project is becomes a trial and

error process.
 Return on Investment (ROI)

Example:
 Suppose an investment will cost $16,000 initially and
will generate the following cash flows:
 Year 1: 3,000
 Year 2: 4,000
 Year 3: 5,000
 Year 4: 7,000
 Year 5: 7,000
 Year 6: 8,000
 The required return is 15%.
 Should we accept or reject the project?
 Return on Investment (ROI)

Solution:
 Using try and error
 Try i = 15 %

 NPV   N .CF n

(1  i ) n
3000 4000 5000 7000
 NPV  16000  ( 1
)  ( 2
)  ( 3
)  ( 4
)
(1.15) (1.15) (1.15) (1.15)
7000 8000
( 5
)  ( 6
)  3862
(1.15) (1.15)

 Try i = 25 %

 NPV  1221.88
 Return on Investment (ROI)

Solution:
 i = 15 % -------- NPV =+3862 c
a
b  i=X% -------- NPV = 0 d
 i = 25 % -------- NPV = -1221.88

 Using interpolation a c
 
b d
X  15 0  3862
 
25  15  1221.88  3862

i  X  22.59%

 i = X= 22.59 > MARR (15%) ----- Accept the project

 Payback Analysis

Another important financial consideration is payback

analysis

The payback period is the amount of time it will take to

recoup, in the form of net cash inflows, the net dollars
invested in a project

Payback occurs when the cumulative discounted benefits

and costs are greater than zero

 Decision Rule :
 Accept if the payback period is less than some preset
limit.
 Payback Analysis
For the previous example: Is the project acceptable in the
case of 5 years longest acceptable Payback (PB) Period?
At n =0 NPV)0 = -16000
3000
 NPV 1 16000  ( 1
)  13391.3
(1.15)
3000 4000
 NPV 2 16000  ( 1
)  ( 2
)  10366.7
(1.15) (1.15)
3000 4000 5000
 NPV 3 16000  ( 1
)  ( 2
)  ( 3
)  7079.12
(1.15) (1.15) (1.15)
3000 4000 5000 7000
 NPV 4 16000  ( 1
)  ( 2
)  ( 3
)  ( 4
)  3076.84
(1.15) (1.15) (1.15) (1.15)

3000 4000 5000 7000

 NPV 5 16000  ( )  ( )  ( )  ( )
(1.15)1 (1.15) 2 (1.15)3 (1.15) 4
7000
( )  403.39
(1.15)5
 Payback Analysis

Solution:
 n = 4 -------- NPV =-3076.84 c
a
b  n = X -------- NPV = 0 d
 n = 5 -------- NPV = 403.39

 Using interpolation a c
 
b d
X 4 0  ( 3076.84)
 
54 403.39  ( 3076.84)

 n  X  4.88 years

 n = X= 4.88 < nacceptable (5 years) ----- Accept the

project