Note: These PowerPoints were developed to

support the US edition of the text. In some

cases, figure numbers, variables, and other
items may not correspond to the
international edition.

ENGINEERING
Newnan, Lavelle, and Eschenbach
ECONOMIC
ANALYSIS, 12/e Copyright © 2014 by Oxford University Press
 Chapter 8

Choosing the Best Alternative

Copyright Oxford University Press 2014

 Chapter Outline

• Incremental Analysis
• Graphical Technique in solving problems
with mutually exclusive alternatives
• Using Spreadsheets in Incremental
Analysis

Copyright Oxford University Press 2014

 Learning Objectives

• Define incremental analysis

• Apply Graphical Technique in solving
problems with mutually exclusive
alternatives
• Use Spreadsheets in Incremental Analysis

Copyright Oxford University Press 2014

 Mutually Exclusive Alternatives

• Only one alternative may be implemented

• All alternatives serve the same purpose
• Objective of incremental analysis is to
select the best of these mutually exclusive
alternatives

Copyright Oxford University Press 2014

 Incremental Analysis

• Could be applied to rate of return (IRR), present worth (PW),

equivalent uniform annual cost (EUAC), or equivalent
uniform annual worth (EUAW) approaches.
• [Higher-cost Alternative] = [Lower-cost Alternative] +
[Increment between them]
• The “defender” is the best alternative identified so far in the
process, and “challenger” is the next higher-cost alternative
to be evaluated.
• For a set of N mutually exclusive alternatives, (𝑁 − 1)
“challenger/defender” comparisons must be made from
[𝑁(𝑁 − 1)/2] possibilities.

Copyright Oxford University Press 2014

 Example 8-7 Incremental Analysis
using Pair-wise Comparisons
A B C D E
Initial Cost $4000 $2000 $6000 $1000 $9000
Uniform Annual Benefit 639 410 761 117 785

1. Rearrange the alternatives in order of increasing cost

D B A C E
Initial Cost $1000 $2000 $4000 $6000 $9000
Uniform Annual Benefit 117 410 639 761 785

2. Calculate IRR of the least expensive alternative to see if it

is better than “Do Nothing” at MARR of 10%
PWD = 0 = -$1000 + $117 (P/A, IRRD, 20)
IRRD = 9.94% < 10%
“Do Nothing” is preferred, and is still the “Defender.”
Copyright Oxford University Press 2014
 Example 8-7 Incremental Analysis
using Pair-wise Comparisons
3. Calculate IRR of the next alternative, B, to see if it is better
than “Do Nothing” at MARR of 10%
PWB = 0 = -$2000 + $410 (P/A, IRRB, 20)
IRRB = 19.96% > 10%
“Alternative B” is preferred, and is the new “Defender.”

4. Compare Defender B with the next alternative, A. This

comparison must be made incrementally.
PWA-B = 0 = -($4000-$2000)+(639-410)(P/A, IRRA-B,20)
IRRA-B = 9.63% < 10%
“Alternative B” is preferred, and is still the “Defender.”

Copyright Oxford University Press 2014

 Example 8-7 Incremental Analysis
using Pair-wise Comparisons
5. Compare Defender B with the next alternative, C. This
comparison must be made incrementally.
PWC-B = 0 = -($6000-$2000)+(761-410)(P/A, IRRC-B,20)
IRRC-B = 6.08% < 10%
“Alternative B” is preferred, and is still the “Defender.”

6. Compare Defender B with the next alternative, E. This

comparison must be made incrementally.
PWE-B = 0 = -($9000-$2000)+(785-410)(P/A, IRRE-B,20)
IRRE-B = 0.67% < 10%
“Alternative B” is preferred, and is the final selection.

Copyright Oxford University Press 2014

 Elements in Comparing
Mutually Exclusive Alternatives
1. Identify all alternatives.
2. Construct an NPW or EUAW graph showing all
alternatives on the same axes.
3. Examine the line of maximum values and
determine which alternative create it, and over
what range.
4. Determine the changeover point.
5. Create a choice table to summarize the
information.

Copyright Oxford University Press 2014

 Choosing an Analysis Method

• All analysis methods provide consistent solutions.

• Rate of Return Analysis
• Easier to explain
• Most frequently used
• More difficult to calculate (without spreadsheet)
• Does not require a Minimum Attractive Rate of
Return in calculation
• Present Worth or Annual Cash Flow Analysis
• Require a known Minimum Attractive Rate of Return
in calculation
• Easier to calculate (without spreadsheet)

Copyright Oxford University Press 2014

 Incremental Rate of Return
Analysis
Example 8 - 7
•PWB = A (P/A, 6%, 20) = A (11.47)
•MARR = 6% (given)
•All projects are initially acceptable because IRR MARR

A B C D E
Cost 4000 2000 6000 1000 9000
EUAB (A) 639 410 761 117 785
PWB 7330 4700 8730 1340 9000
IRR 15% 20% 11% 10% 6%
P/A 6.26 4.88 7.88 8.55 11.47

12
 Incremental Analysis
1. Rank from lowest cost to highest cost
2. Start with two lowest cost alternatives
3. Compare increments using MARR criteria
4. Repeat until a “winner” is determined
D B A C E
Cost 1000 2000 4000 6000 9000
EUAB (A) 117 410 639 761 785

Increment B-D A-B C-A E-A

incr. Cost 1000 2000 2000 5000
incr. UAB 293 229 122 146
incr. ROR 29% 10% 2% < 0%
Keep B A A A
P/A 3.413 8.73 16.393 34.236
13
 Graphical Solutions
PWB vs. PWC at MARR
Above the 45 degree line projects are acceptable (NPW>0)
Benefit-cost Graph
MARR 6.00 % Alternatives
30
POSITIVE NPW

25
Present Worth of Benefit

0.06

20

15
0 $26.42
0 $26.42
10

NEGATIVE NPW
0
0 5 10 15 20 25 30
Present Worth of Cost

14
 Graphical Solution
• Projects B, A, C and E shown.
• Incremental analysis looks at adjacent points on the Benefit-Cost Graph

15
 Graphical Incremental Analysis
If line between two alternatives is > 45 degrees, accept
higher cost alternative. Alternative A wins.

16
Graphical Incremental Analysis
• Graphical solution has a logical connection to NPW
•Incremental analysis seeks out the alternative with highest NPW.
Alternative A maximizes NPW.

17
 Choosing an Analysis Method
Method MARR Computations* Explanation

PW Required for Less Depends

calculation

AW Required for Less Depends

calculation

ROR For comparison More Depends

*Not an issue when using a spreadsheet.

Do what the Organization requires. Occasionally augment

with alternate methods where the method adds beneficial
information.
18
 Spreadsheet and
Incremental Analysis
Excel Functions Purpose
Rate (n, A, -P, [F], [Type], [guess]) To find rate of return or incremental
rate of return given n, P, and A
IRR (range, [guess]) To find internal rate of return (or
incremental rate of return) of a series
of cash flow (or incremental cash flow)

Excel Tools Purpose

Goal Seek It varies the value in one specific cell until a formula that's
dependent on that cell returns the wanted result.
Solver Solver adjusts the values in the changing cells to produce
the result from the target cell formula. Constraints are
applied to restrict the values Solver can use in the model.

Copyright Oxford University Press 2014