Lecture 8 - Selection Between Alternatives Part 1

# Lecture 8 - Selection Between Alternatives Part 1 - CE 395...

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Unformatted text preview: CE 395 Engineering Economics Spring 2005 W. Hitchcock 1. IRR and ERR Review 2. Selection Between Alternatives Part 1 External Rate Of Return Analysis 3 Step Process To perform ERR a net cash flow table must be developed. Analysis is in three steps: 1. Discount all net cash outflows to the present using the known external rate of return. 2. Compound all net cash inflows to the future (end of the last period of the analysis) 3. Determine the rate of return such that the PW of the outflows equals the FW of the inflows. Example ERR (external i = 8%) Time 0 1 2 3 4 5 Cost -\$20,000 -\$10,000 \$11,000 \$11,000 \$11,000 \$11,000 Benefit Comparing Mutually Exclusive Alternatives Financial Analysis Comparing Mutually Exclusive Alternatives If investment capital is limited, companies want to prioritize investment opportunities so as to maximize the return on capital available for investment. To make the best financial decision, a selection criteria must be utilized in logical and consistent way Alternative Decision Making A Logical Procedure 1. Define the Problem: a. Important to uncouple issues for a decision to the lowest level of alternatives for analysis b. Complex problems should be subdivided into manageable problems for decision. 2. Decisions are among established known alternatives: a. Alternatives should defined with common terminology and perspective (viewpoint) b. Be creative in establishing all feasible alternatives c. Be sure to focus on "the differences" between alternatives d. "Doing Nothing" is often a viable option Alternative Decision Making A Logical Procedure - Continued 1. Establish a metric for comparison a. If possible, establish numerical measures b. In the end it is the difference between alternatives that really matters (more attractive or less attractive) 2. The decision is based on future events a. Develop projected cash and performance profiles for each alternative b. Clearly recognize and note the uncertainties c. Complexity arises when alternatives have different life cycles Alternative Decision Making A Logical Procedure - Continued 1. Establish criteria for comparison of alternatives (sometimes a primary and secondary are useful) 2. Alternative selection: a. Each competing alternative is evaluated according to the established criteria. b. The most attractive alternative is selected 3. Audit results and improve process Financial Analysis Application of Criteria The five basic analysis approaches are used to evaluate a single option or choose between multiple alternatives are typically called: Present Worth Analysis Future Worth analysis Annual Cash Flow Analysis Rate of Return Analysis Benefit/Cost Ratio Present Worth Analysis Criteria Application Case Fixed Input Situation Input Fixed Choice Criteria Maximize PW of benefits Minimize PW of costs or other inputs Maximize NPW Fixed Output Fixed use requirement or benefits Neither the input or other costs or the benefits are fixed Neither Fixed Future Worth Analysis Criteria Application Case Fixed Input Situation Input Fixed Choice Criteria Maximize FW of benefits Minimize FW of costs or other inputs Maximize NFW Fixed Output Fixed use requirement or benefits Neither the input or other costs or the benefits are fixed Neither Fixed Annual Cash Flow Analysis Criteria Application Case Fixed Input Fixed Output Situation Input Fixed Fixed use requirement or benefits Neither the input or other costs or the benefits are fixed Choice Criteria Maximize EUAB Minimize EUAC Neither Fixed Maximize EUAB - EUAC Rate of Return Analysis Criteria Application Case Fixed Input Fixed Output Neither Fixed Situation Input Fixed Fixed use requirement or benefits Neither the input or other costs or the benefits are fixed Choice Criteria Maximize ROR Maximize ROR If 2 alternatives: Compute the ROR. If the ROR is ok choose higher cost alternative. Multiple Alternatives: Use comparative ROR between alternatives Note: Before performing incremental ROR analysis, insure that each alternative's ROR is acceptable Benefit/Cost Ratio Analysis Criteria Application Case Fixed Input Fixed Output Neither Fixed Situation Input Fixed Fixed use requirement or benefits Neither the input or other costs or the benefits are fixed Choice Criteria Maximize B/C Maximize B/C If 2 alternatives: Compute the B/C. If the B/C is greater than 1.0, choose higher cost alternative. Multiple Alternatives: Use comparative B/C between alternatives Note: Before performing incremental B/C ratios, insure that each alternative's B/C is > 1.0 Demonstration Examples We will only use four methods Since NPW and NFW are directly proportional, we will only consider NPW analysis. Financial Comparative Analysis Examples Fixed Input Consider the three investment alternatives: A Initial Cost Annual Benefits 1st 5 years Annual Benefits years 6 to 10 \$600 \$100 \$50 B \$600 \$120 \$100 C \$600 \$110 \$120 D \$600 \$150 \$50 Determine the best alternative using the four methods of analysis. An MARR of 9% is used by the company A company must decide between three equipment options listed below: Initial Cost Annual Maint Costs first 5 years Annual Maint Costs 2nd 5 years A \$13,000 \$200 \$300 B \$10,000 \$300 \$450 C \$15,000 \$150 \$150 Financing Comparative Analysis Examples Fixed Output Salvage Value at \$1,000 \$0 \$4,000 end of yr 10 Determine the best alternative using the four methods of analysis. An MARR of 9% is used by the company Financing Comparative Analysis 2 Options Neither Input or Output Fixed A company has the opportunity to choose between two equipment purchases both believed to increase profits over the existing equipment being used. Consider the information below: Machine A Initial Cost Increased Annual Benefit Salvage Value after 12 years \$350 \$98 \$65 Machine B \$700 \$120 \$150 Determine the best alternative using the four methods of analysis. An MARR of 12% is used by the company ...
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## This note was uploaded on 09/26/2008 for the course CE 395 taught by Professor Hitchcock during the Summer '05 term at University of Alabama at Birmingham.

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