ME 291

Engineering
Economy

ME-291 Engineering
Economy
Lecture 16

Comparison on the Basis of CC and

Payback Period Analysis

Faculty of Mechanical Engineering

Ghulam Ishaq Khan Institute, Topi, Swabi
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 Comparison on the Basis of CC

• For the comparison of two or more alternatives on the basis

of capitalized cost, find the CCT of each alternative.

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• Since a capitalized cost represents the total present worth of
financing and maintaining a given alternative forever, the
alternatives will automatically be compared for the same

Economy
number of years (i.e. infinity).
• The alternative with the smaller capitalized cost will
represent the more economical one.

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 Example 5.5

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Economy
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 Comparison of Finite life alternative
with an infinite life alternative

• Capitalized cost can be used for the

comparison of finite life alternative (e.g. 5

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years) to one with indefinite or very long life.
• To determine capitalized cost for the

Economy
alternative with a finite life, calculate the
equivalent A value for one life cycle and
divide by the interest rate.

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 Example 5.6

APSco, a large electronics subcontractor for the Air Force,

needs to immediately acquire 10 soldering machines with
specially prepared jigs for assembling components onto

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printed circuit boards. More machines may be needed in the
future. The lead production engineer has outlined below two
simplified, but viable, alternatives. The company’s MARR is
15% per year.

Economy
• Alternative LT (long-term). For $8 million now, a contractor
will provide the necessary number of machines (up to a
maximum of 20), now and in the future, for as long as
APSco needs them. The annual contract fee is a total of
$2500 worth no additional per-machine annual cost. There
is no time limit placed on the contract, and the costs do no
escalate.
• Alternative ST (short-term). APSco buys its own machines
for $275,000 each and expends an estimated $12,000 per
machine in annual operating cost (AOC). The useful life of a
soldering system is 5 years.
Perform a capitalized cost evaluation.

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 Payback Period Analysis

• Also called the Payout analysis, is another extension of the

present worth method.

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• Got two forms
• i > 0% (called discounted payback analysis)
• i = 0% (Called the simple payback analysis)

Economy
• The payback period np is the estimated time, usually in
years, it will take for the estimated revenues and other
economic benefits to recover the initial investment and a
stated rate of return.
• The payback period should never be used as the primary
measure of worth to select an alternative. Rather, it should
be determined in order to provide initial screening or
supplemental information in conjunction with an analysis
performed using present worth or another method.

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 np (Continued……)

• In practice the payback period is determined with a no-return

requirement (i=0%) to initially screen a project and
determine whether it warrants further consideration.

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• For i > 0%, calculate the years np that make the following
expression correct.

Economy
P is the initial investment and NCF is the Net Cash Flow, If the
NCF values are expected to be equal each year, the P/A factor
may be used

For i = 0%, the equation becomes

np can be found using

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 np (Continued……)

• It is very important to realize that in payback analysis all net

cash flows occurring after np years are neglected.

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• It is incorrect to use the no-return payback period to make
final alternative selections because it:
– Neglects any required return, since the time value of

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money is omitted.
– Neglects all net cash flows after time np, including
positive cash flows that may contribute to the return on
the investment.

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 Example 5.7

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Economy
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 Payback Period Analysis

• If two or more alternatives are evaluated,

using PP Analysis – 2nd short-coming of PP

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analysis may lead to an economically
incorrect decision.

Economy
• When CFs that occur after np are neglected,
it is possible to favor short-lived assets even
when longer-lived assets produce a higher
return
• Example follows

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 Example 5.8

• Two equivalent pieces of quality inspection

equipment are being considered for purchase

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by Square D electric. Machine 2 is expected to
be versatile and technologically advanced
enough to provide net income longer than

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machine 1.

Machine 1 Machine 2
First Cost, $ 12, 000 8, 000
Annual NCF, $ 3, 000 1, 000 (years 1-5)
3, 000 (years 6-14)

Maximum life, years 7 14

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