Chapter 4 – Comparing Alternatives

Engineering Economics

CHAPTER 5

COMPARING ALTERNATIVES

Most engineering and business projects can be accomplished by more than one method or alternative. This chapter
will deal with these types of problems. The fundamental principle on which alternative should be used is stated as
follows:
The alternative that requires the minimum investment of capital and will produce satisfactory functional result will
always be used unless there are definite reasons why an alternative requiring a larger investment should be adopted.

Method of Patterns in Comparing Alternatives

There are several methods for comparing alternatives, but only six patterns will be discussed.

The Rate of Return on Additional Investment Method

The formula for the rate of return on additional investment is,

Rate of Return on Additional Investment = annual net savings

additional investment

If the rate of return on additional investment is satisfactory, then, the alternative requiring a bigger investment is more
economical and should be chosen.

The Annual Cost (AC) Method

To apply this method, the annual cost of the alternatives including interest on investment is determined. The
alternative with the least annual cost is chosen. This pattern, like the rate of return on additional investment pattern,
applies only to alternatives which has a uniform cost data for each year and a single investment of capital at the
beginning of the first year of the project life.

The Equivalent Uniform Annual Cost (EUAC) Method

In this method, all cash flows (irregular or uniform) must be converted to an equivalent uniform annual cost, that is, a
year-end amount which is the same each year. The alternative with the least equivalent uniform annual cost is
preferred. When the EUAC method is used, the equivalent uniform annual cost of the alternatives must be calculated
for one life cycle only. This method is flexible and can be used for any type of alternative selection problems. The
method is a modification of the annual cost pattern.

The Present Worth Cost (PWC) Method

In comparing alternative by this method, determine the present worth of the net cash outflows for each alternative for
the same period of time. The alternative with the least present worth of cost is selected.

The Capitalized Method

The capitalized cost method is a variation of the present worth cost pattern. This method is used for alternatives
having long lives. To use the method, determine the capitalized cost of all the alternatives and choose that one with
the least capitalized cost.

1
Chapter 4 – Comparing Alternatives
Engineering Economics

Payback (Payout) Period Method

To use this method, the payback of each alternative is computed. The alternative with the shortest payback period is
adopted. This method is seldom used.
PROBLEM (5-1) A company is considering two types of equipment for its manufacturing plant. Pertinent data are as
follows:

Type A Type B
First Cost 200,000 300,000
Annual operating cost 32,000 24,000
Annual labor cost 50,000 32,000
Insurance ad property taxes 3% 3%
Payroll taxes 4% 4%
Estimated life 10 10

If the minimum required rate of return is 15%, which equipment should be selected?

Solution:

1. By the rate of return on additional investment method

Type A
Annual costs:
Depreciation = 200,000 Birr = 200,000 = 9,850 Birr
F/A, 15%, 10 20.3037
Operation = 32,000
Labor = 50,000
Payroll taxes = (50,000)(0.04) = 2,000
Taxes & insurance = (200,000)(0.03) = 6,000
Total annual cost = 99,850 Birr

Type B
Annual costs:
Depreciation = 300,000 Birr = 300,000 = 14,776 Birr
F/A, 15%, 10 20.3037
Operation = 24,000
Labor = 32,000
Payroll taxes = (32,000)(0.04) =1,280
Taxes & insurance = (200,000)(0.03) = 9,000
Total annual cost = 81,056 Birr

Annual savings = 99,850 – 81,056 = 18,794 Birr

Additional investment = 300,000 – 200,000 = 100,000 Birr
Rate of return on additional investment = 18,794 x 100 = 18.79 > 15%
100,000
Type B should be selected (Ans.)

2. By the annual cost method

Type A
Annual costs:
Depreciation = 200,000 Birr = 200,000 = 9,850 Birr
F/A, 15%, 10 20.3037

2
Chapter 4 – Comparing Alternatives
Engineering Economics

Operation = 32,000
Labor = 50,000
Payroll taxes = (50,000)(0.04) = 2,000
Taxes & insurance = (200,000)(0.03) = 6,000
Interest on capital = (200,000)(0.15) = 30,000
Total annual cost = 129,850 Birr

Type B
Annual costs:
Depreciation = 300,000 Birr = 300,000 = 14,776 Birr
F/A, 15%, 10 20.3037
Operation = 24,000
Labor = 32,000
Payroll taxes = (32,000)(0.04) = 1,280
Taxes & insurance = (300,000)(0.03) = 9,000
Interest on capital = (300,000)(0.15) = 45,000
Total annual cost = 126,056 Birr

Since ACB < ACA, type B should be selected (Ans.)

3. By the present worth cost method

Type A
Annual costs (excluding depreciation) = 32,000 + 50,000 + (50,000)(0.04) + (200,000)(0.03) = 90,000 Birr

0 1 2 9 10

90,000 90,000 90,000 90,000

200,000

PWCA = 200,000 + 90,000 (P/A, 15%, 10)

= 200,000 + (90,000)(5.0188) = 651,692 Birr

Type B
Annual costs (excluding depreciation) = 24,000 + 32,000 + (32,000)(0.04) + (300,000)(0.03) = 66,280 Birr

0 1 2 9 10

66,280 66,280 66,280 66,280

300,000

PWCB = 300,000 + 66,280 (P/A, 15%, 10)

= 300,000 + (66,280)(5.0188) = 632,646 Birr

Since PWCB < PWCA for the same period of time, type B should be selected. (Ans.)

4. By the equivalent uniform annual cost method.

3
Chapter 4 – Comparing Alternatives
Engineering Economics

Type A

0 1 2 10 0 1 2 10

90,000 90,000 90,000 EUACA EUACA EUACA

200,000
EUACA = 200,000(A/P, 15%, 10) + 90,000

= (200,000)(0.1993) + 90,000 = 129,860 Birr

` Type B

0 1 2 10 0 1 2 10

66,280 66,280 66,280 EUACB EUACB EUACB

300,000

EUACB = 300,000(A/P, 15%, 10) + 66,280

= (300,000)(0.1993) + 66,280 = 126,070 Birr

Since EUACB < EUACA, type B is more economical. (Ans.)

PROBLEM (5-2) Choose from the two machines which is more economical

Machine A Machine B
First cost 8,000 Birr 14,000 Birr
Salvage value 0 2,000
Annual operation 3,000 2,400
Annual maintenance 1,200 1,000
Taxes and insurance 3% 3%
Life, years 10 15

Money is worth at least 16%.

Solution:

1. By the rate of return on additional investment method

Machine A
Annual costs:
Depreciation = _8,000 Birr_ = _8,000_ = 375 Birr
F/A, 16%, 10 21.3215
Operation = 3,000
Labor = 1,200
Taxes & insurance = (8,000)(0.03) = _240
Total annual cost = 4,815 Birr

4
Chapter 4 – Comparing Alternatives
Engineering Economics

Machine B
Annual costs:
Depreciation = 12,000 Birr_ = 12,000_ = 232 Birr
F/A, 16%, 10 51.6595
Operation = 2,400
Labor = 1,000
Taxes & insurance = (200,000)(0.03) = _420
Total annual cost = 4,052 Birr

Annual savings = 4,815 – 4,052 = 763 Birr

Additional investment = 14,000 – 8,000 = 6,000 Birr
Rate of return on additional investment = _763 x 100 = 12.72 < 16%
6,000
Machine A is more economical (Ans.)

2. By the annual cost method

Machine A
Annual costs:
Depreciation = _8,000 Birr_ = _8,000_ = 375 Birr
F/A, 16%, 10 21.3215
Operation = 3,000
Maintenance = 1,200
Taxes & insurance = (8,000)(0.03) = 240
Interest on capital = (8,000)(0.16) = 1,280
Total annual cost = 6,095 Birr

Machine B
Annual costs:
Depreciation = 12,000 Birr_ = 12,000_ = 232 Birr
F/A, 16%, 10 51.6595
Operation = 2,400
Maintenance = 1,000
Taxes & insurance = (14,000)(0.03) = 420
Interest on capital = (14,000)(0.16) = 2,240
Total annual cost = 6,292 Birr

Since ACA < ACB, Machine A is more economical. (Ans.)

3. By the present worth cost method. Use 30-year study period, which is the least common multiple of 10 and 15.
Machine A
Annual costs = 3,000 + 1,200 + (8,000)(0.03) = 4,440 Birr

0 1 10 11 20 21 10

4,440 4,440 4,440 4,440 4,440 4,440

8,000 Birr

8,000 8,000

5
Chapter 4 – Comparing Alternatives
Engineering Economics

PWCA = 8,000 + 4,440 (P/A, 16%, 30) + 8,000 (P/F, 16%, 10) + 8,000 (P/F, 16%, 20) = 37,652 Birr

Machine B
Annual costs = 2,400 + 1,000 + (14,000)(0.03) = 3,820 Birr

2,000 2,000

0 1 15 16 30

3,820 3,820 3,820 3,820

14,000

14,000

PWCB = 14,000 + 3,820 (P/A, 16%, 30) + 12,000 (P/F, 16%, 15) – 2,000 (P/F, 16%, 30) = 38,869 Birr

Machine A should be chosen, since PWCA < PWCB (Ans.)

4. By the equivalent uniform annual cost method.

Machine A

0 1 2 10 0 1 2 10

4,440 4,440 4,440 EUACA EUACA EUACA

8,000

EUACA = 8,000(A/P, 16%, 10) + 4,440 = 6,095 Birr

Machine B
2,000

0 1 2 15 0 1 2 15

3,820 3,820 3,820 EUACB EUACB EUACB

14,000

EUACB = 14,000(A/P, 16%, 15) +3,820 – 2,000 (A/F, 16%, 15) = 6,292 Birr

6
Chapter 4 – Comparing Alternatives
Engineering Economics

Machine A should be chosen, since EUACA < EUACB (Ans.)

PROBLEM (5-3) A company is going to buy a new machine for manufacturing its product. Four different machines are
available. Cost, operating and other expenses are as follows:

A B C D
First cost 24,000 30,000 49,600 52,000
Power per year 1,300 1,360 2,400 2,020
Labor per year 11,600 9,320 4,200 2,000
Maintenance per year 2,800 1,900 1,300 700
Taxes and insurance 3% 3% 3% 3%
Life, years 5 5 5 5

Money is worth 17% before taxes to the company. Which machine should be chosen?

Solution:
1. By the annual cost method
Depreciation:
Machine A = __24,000 = 24,000 = 3,422 Birr
F/A, 17%, 5 7.0144

Machine B = 30,000 = 4,277 Birr

7.0144

Machine C = 49,600 = 7,071 Birr

7.0144

Machine = 52,000 = 7,413 Birr

7.0144

Comparative Total Annual Cost for Four Machines

A B C D
Power 1,300 1,360 2,400 2,020
Labor 11,600 9,320 4,200 2,00
Maintenance 2,800 1,900 1,300 700
Taxes and insurance (3%) 720 900 1,488 1,560
Depreciation 3,422 4,277 7,071 7,413
Interest on capital (17%) 3,422 4,277 7,071 7,413
Total annual cost 23,922 22,857 24,891 22,533

The economical criterion is to choose that alternative with the minimum annual cost, which is machine D. however,
it should be noted that machine B is very close, showing a total annual cost of only 22,857 – 22,533 = 324 Birr more
than machine D.(Ans)

2. By the rate or return on additional investment method

7
Chapter 4 – Comparing Alternatives
Engineering Economics

A B C D
Power 1,300 1,360 2,400 2,020
Labor 11,600 9,320 4,200 2,00
Maintenance 2,800 1,900 1,300 700
Taxes and insurance (3%) 720 900 1,488 1,560
Depreciation 3,422 4,277 7,071 7,413
Total annual cost 19,842 17,757 16,459 13,693

Comparing Machine A with Machine B.

19,482−17,757
ROR on additional investment on B = (100) = 34.75% > 17%
30,000−24000

Machine B is economical than Machine A.

Comparing Machine B with Machine C.

17,757−16,459
ROR on additional investment on C = (100) = 6.62% > 17%
49,600−30,000

Machine B is economical than Machine C

Comparing Machine B with Machine D.

17,757−13,693
ROR on additional investment on D = (100) = 18.47% > 17%
52,000−30,000

Machine D is economical than Machine B, choose Machine D.(Ans)

PROBLEM (5-4) An untreated electric wooden pole that will last 10 years under certain soil condition costs 20,000 Birr.
It a treated pole will last for 20 years, what is the maximum justifiable amount that can be paid for the treated pole, if
the maximum justifiable amount that can be paid for the treated pole, if the maximum return on investment is 20%.
Consider annual taxes and insurance amount to be 1% of first cost.

Solution:

1. Let C = maximum amount that can be invested on the treated pole.

Untreated Pole
Annual Costs:
Depreciation = __20,000___ = 20,000_ = 770
F/A, 20%, 10 25.9587
Taxes and insurance = (20,000)(0.01) = 200
Interest on capital = (20,000)(0.20) = 4,000
Total annual cost = 4,970

Treated Pole
Annual Costs:
Depreciation = ____C_____ = __C___ = 0.005356C
F/A, 20%, 10 25.9587
Taxes and insurance = (C)(0.01) = 0.01C
Interest on capital = (C)(0.20) =0.20C____

8
Chapter 4 – Comparing Alternatives
Engineering Economics

Total annual cost = 0.215356C

Equating annual cost,

0.215356C = 4,970 Birr

C = 23,078 Birr (Ans.)

PROBLEM (5-5) A company manufacturing acids, upon inspection of the roofing of the plant, found out that it is badly
corroded form the acids fumes and would need to be replaced. To try to get some more life out of the roofing, the
company consulted a roofing coating contractor who presented the company with two options. The first option is a
coating that will cost 20,000 Birr which would extend the life of the roofing for 3 years from the date of application, and
the second option will cost 30,000 and which would extend the life of the roofing for 5 years from the date of
application. At what rate of return are the two investments equal?

Solution:
1. First Option

0 1 2 3 0 1 2 3

EUACA EUACA EUACA

20,000

EUACA = 20,000(A/P,i%,3)

2. Second Option

0 1 2 5 0 1 2 5

EUACB EUACB EUACB

30,000

EUACB = 30,000(A/P,i%,5)

For the two alternatives to be equally economical, EUACA = EUACB

20,000(A/P,i%,3) = 30,000(A/P,i%,5)

A/P,i%,5 = 20,000
A/P,i%,3 30,000

-3
1-(1+i) = 0.6667
-5
1-(1+i)

9
Chapter 4 – Comparing Alternatives
Engineering Economics

Try i=12%
-3
1-(1.12) = 0.6667
-5
1-(1.12)

0.6662 = 0.6667

Rate of return = 12% (Ans.)

PROBLEM (5-6) The engineer of a medium scale industry was instructed to prepare at least two plans which is to be
considered by management for the improvement of their operations. Plan “A” calls for an initial investment of 200,000
Birr now with a prospective salvage value of 20% of the first cost 20 years hence. The operation and maintenance
disbursements are estimated to be 15,000 Birr a year and taxes will be 2% of first cost.

Plan “B” calls for an immediate investment of 140,000 and a second investment of 160,000 eight years later. The
operation and maintenance disbursements are estimated to be 9,000 a year for the initial installation, and 8,000 a year
for the second installation. At the end of 20 years the salvage value shall be 20% of the investments. Taxes will be 2%
of the first cost.

If money is worth 12%, which plan would you recommend?

Solution:

1. By the present worth cost method

Plan A
Annual cost = 15,000 + (2,000)(0.02) = 19,000 Birr
Salvage Value = (200,000)(0.20) = 40,000

40,000

0 1 2 3 20

19,000 19,000 19,000 19,000

200,000

PWCA = 200,000 + (19,000)(P/A,12%,20) – (40,000)(P/F,12%,20)

= 337,771 Birr

Plan B:

Annual Costs = 9,000 + (140,000)(0.02) = 11,800

Additional annual costs after 8 years = 8,000 + (160,000)(0.02) = 11,200
Salvage Value = (140,000 + 160,000)(0.02) = 60,000

60,000

10
Chapter 4 – Comparing Alternatives
Engineering Economics

0 1 2 8 9 20

11,800 11,800 11,800 11,800 11,800

140,000

160,000 11,200 11,200

PWCB = 140,000 + 11,800(P/A,12%,20) + 160,0009P/F,12%,8) + 11,200(P/A,12%,12)(P/F,12%,8)

- 60,000(P/F,12%,20) = 314,564 Birr

Plan B is more economical.

2. By the equivalent uniform annual cost method

EUACC = 200,000(A/P,12%,20) + 19,000 – 40,000(A/F,12%,20) = 45,224 Birr

EUACB = 140,000(A/P,12%,20) + 11,800 + 160,000(P/F,12%,80(A/P,12%,20) + 11,200(F/A,12%,12)(A/F,12%,20)
- 60,000(A/F,12%,20) = 34,019 Birr

Plan B is more economical.

PROBLEM (5-7) The National Government is planning to construct a bridge. At present a 4-lane bridge will be built, but
is expected that at a later date a second 4-lane bridge will be added.
If an 8-lane bridge is built now, it will cost 8,100,000 Birr. A single 4-lane bridge can be built now for 5,500,000 Birr. It
is estimated that a second 4-lane bridge at a later date will cost 8,000,000 Birr. Annual upkeep on each 4-lane bridge
would be 91,500 Birr, and for the 8-lane bridge would be 115,000 Birr. Money to build will cost 12%.
Assumes a 50-year functional life for the project and determine the earliest time at which the additional 4 lanes would
be required to make it equally economical to build the 8-lane bridge immediately.

Solution:

1. 8-lane bridge

0 1 2 50

8,100,000 115,000 115,000 115,000

PWC8 = 8,100,000 + 115,000(P/A,12%,50) = 9,055,000

2. 4-lane bridge

0 1 2 n n+1 50

5,500,000 91,500 91,500 91,500 183,000 183,000

11
Chapter 4 – Comparing Alternatives
Engineering Economics

PWC4 = 5,500,000 + 91,500(P/A,12%,n0)+ 8,000,000(p/f,12%,n) + 183,000[(P/A,12%,(50-n)](P/F,12%,n)

When n = 10

= 5,500,000 + 91,500(P/A,12%,10) + 8,000,000(P/F,12%,10) + 183,000(P/A,12%,40)(P/F,12%,10)

= 9,070,000 Birr, 10 years

PROBLEM (5-8) A plant to provide the company’s present needs can be constructed for 2,800,000 Birr with annual
operating disbursements of 600,000 Birr. It is expected that at the end of 5 years the production requirements could
be doubled, which will necessitate the addition of an extension costing 2,400,000 Birr. The disbursements after 5 years
will likewise double. A plan to provide the entire expected capacity can be constructed for 4,000,000 and its operating
disbursements will be 640,000 Birr when operating on half capacity (for the first 5 years) and 900,000 Birr on full
capacity. The plants are predicted to have indeterminately long life. The required rate of return is 20%. What would
you recommend?

Solution:

Deferred Expansion

0 1 2 3 4 5 6 7

60k 60k 60k 60k 60k 1.2M 1.2M

2,800,000
2.4M

Capitalized cost = 2,800,000 + 600(P/A,20%,5) + 2,400,00(P/F,20%,5) + 1,200,000(P/F,20%,5)

0.20

Capitalized cost = 7,722,444 Birr (Ans.)

The full-size plant should be constructed.

12