E421-5a - CHAPTER 5 CHAPTER COMPARING COMPARING...

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Unformatted text preview: CHAPTER 5 CHAPTER COMPARING COMPARING ALTERNATIVES ALTERNATIVES FEASIBLE DESIGN ALTERNATIVES FEASIBLE Alternatives may be mutually exclusive (i.e., choice if one excludes the choice of any other alternative) because : other • The alternatives being considered may The require different amounts of capital investment investment • The alternatives may have different useful The lives lives The subject of this section will help: • analyze and compare feasible alternatives • select the preferred alternative CASH FLOW ANALYSIS METHODS METHODS The cash-flow analysis methods (previously The described) used in this process: described) • Present Worth ( PW ) • Annual Worth ( AW ) • Future Worth ( FW ) • Internal Rate of Return ( IRR ) • External Rate of Return ( ERR ) RULE FOR CHOOSING AMONG ALTERNATIVES ALTERNATIVES • The alternative that requires the minimum The investment and produces satisfactory functional results will be chosen unless the incremental capital associated with an alternative having a larger investment can be justified with respect to its incremental savings (or benefits ). its • The alternative requiring the least investment is The the base alternative. base • Rule ensures that as much capital as possible is Rule invested at a rate of return equal to or greater than the MARR. the ENSURING COMPARABLE BASIS FOR SELECTING MUTUALLY-EXCLUSIVE ALTERNATIVES ALTERNATIVES Include any economic impacts of alternative Include differences in estimated cash flows – Two Rules: Two Rule 1. When revenues and other economic benefits are present, select alternative that has are select greatest positive equivalent worth at ι = MARR and satisfies project requirements. and Rule 2. When revenues and economic benefits are not present, select alternative that minimizes not select cost. cost. INVESTMENT INVESTMENT ALTERNATIVES ALTERNATIVES Those alternatives with initial Those (i.e., front-end) capital investments(s) that produce positive cash flows from positive increased revenue, savings through reduced costs, or both. through COST ALTERNATIVES COST Those alternatives with negative Those cash flows except for a possible cash positive cash flow element from disposal of assets at the end of the project’s useful life. project’s PLANNING HORIZON PLANNING • The selected time period over which The mutually exclusive alternatives are compared -- study period compared • May be influenced by factors including: – – – – service period required service useful life of the shorter-lived alternative useful useful life of the longer-lived alternative useful company policy company • It is key that the study period be It appropriate for the decision situation under investigation investigation USEFUL LIFE • Useful life of an asset is the time Useful period during which it is kept in productive use in a trade or business. productive REPEATABILITY ASSUMPTION REPEATABILITY • The study period over which the alternatives are The being considered is either indefinitely long or equal to a common multiple of the lives of the alternatives. alternatives. • The economic consequences that are estimated The to happen in an alternative’s initial useful life span will also happen in all succeeding life spans (replacements) (replacements) Actual situations in engineering practice seldom meet both conditions both COTERMINATED ASSUMPTION COTERMINATED • A finite and identical study period is used finite for all alternatives for • This planning horizon, combined with This appropriate adjustments to the estimated cash flows, puts the alternatives on a common and comparable basis common • Used when repeatability assumption is not Used applicable applicable • Approach most frequently used in Approach engineering practice engineering COTERMINATED ASSUMPTION COTERMINATED Guidelines when useful life(s) different in Guidelines length than study period length • Useful life < study period a. Cost alternatives -- each cost alternative a. Cost must provide same level of service as study period : 1) contract for service or lease equipment for remaining time; 2) repeat part of useful life of original alternative until study period ends alternative b. investment alternatives -- assume all b. investment cash flows reinvested in other COTERMINATED ASSUMPTION COTERMINATED Guidelines when useful life(s) different in Guidelines length than study period length • Useful life > study period Truncate the alternative at the end of the Truncate study period using an estimated market value. This method assumes disposable assets will be sold at the end of the study period at that value period SELECT THE EQUIVALENT WORTH ALTERNATIVE WITH THE GREATER WORTH ALTERNATIVE • If : PWA (i) < PWB (i) then • PWA (i) ( A / P,i,N ) < PWB (i) ( A / P,i,N ) and • AWA (i) < AWB (i) similarly • PWA (i) ( F / P, i, N ) < PWB (i) ( F / P, i, N ) P, P, and and • FWA (i) < FWB (i) Select alternative B COMPARING COST ALTERNATIVES ALTERNATIVES • For cost alternatives that are compared using the For cost PW method, the alternative that has the least PW negative PW is most economically desirable. PW • For cost alternatives that are compared using the For cost AW method, the alternative that has the least AW negative AW is most economically desirable. AW • For cost alternatives that are compared using the For cost FW method, the alternative that has the least FW negative FW is most economically desirable. FW USING RATE OF RETURN METHODS TO EVALUATE MUTUALLY EXCLUSIVE ALTERNATIVES ALTERNATIVES The best alternative produces satisfactory functional results and requires the minimum investment of capital, unless a larger investment can be justified with respect to the incremental costs and benefits it produces RATE OF RETURN METHOD RULES RULES 1. Each increment of capital must justify itself by 1. producing a sufficient rate of return on that increment. increment. 2. Compare a higher investment alternative against 2. a lower investment alternative only when the latter is acceptable. is 3. Select the alternative that requires the largest 3. investment of capital as long as the incremental investment is justified by benefits that earn at least the MARR. This maximizes equivalent worth on total investment at i = MARR. on INCONSISTENT RANKING PROBLEM INCONSISTENT • Ranking errors can occur when a selection Ranking among mutually exclusive alternatives is based wrongly on maximization of IRR on the total cash flow, as opposed to the PW of the total cash flow flow, • When the MARR is less than the IRR of the When difference between alternative cash flows, an incorrect choice will be made by selecting an alternative that maximizes the IRR of its total cash flow, because cash -- the IRR method assumes reinvestment of cash flows at the calculated rate(s) of return the -- the PW method assumes reinvestment at the MARR INCREMENTAL INVESTMENT ANALYSIS PROCEDURE PROCEDURE ( Helps avoid incorrect ranking problem ) 1. Order the feasible alternatives. 2. Establish a base alternative a. Cost alternatives -- The first alternative is the base b. Investment alternatives - If the first alternative is b. acceptable, select as base. If the first alternative is not acceptable, choose the next alternative acceptable, 3. Use iteration to evaluate differences (incremental cash 3. flows) between alternatives until no more alternatives exist exist a. If incremental cash flow between next alternative and a. current alternative is acceptable, choose the next current b. Repeat, and select as the preferred alternative the last b. one for which the incremental cash flow was THREE ERRORS COMMON TO INCREMENTAL INVESTMENT ANALYSIS PROCEDURE APPLIED TO IRR Choosing the feasible Alternative with: Choosing 1. the highest overall IRR on total cash flow 2. the highest IRR on an incremental capital 2. investment investment 3. the largest capital investment that has an 3. IRR greater than or equal to the MARR IRR Incremental analysis must be used with rate of Incremental return methods to ensure the best alternative is selected selected INCREMENTAL ANALYSIS PROCEDURE USED WITH EQUIVALENT WORTH METHODS USED • Equivalent worth methods may also be applied using the Equivalent incremental analysis procedure to compare mutually exclusive alternatives exclusive • Alternative ranking will be consistent with equivalent Alternative worth values based on total investment of each alternative worth • Ranking will be consistent with ROR methods when using Ranking incremental analysis • When equivalent worth of investment cash flow When > 0 at i = MARR, its IRR > MARR at • Equivalent worth methods using incremental investment Equivalent analysis can be used as a screening method for the IRR method IMPUTED MARKET VALUE TECHNIQUE TECHNIQUE • When current marketplace data is unavailable for When an asset, it is sometimes necessary to estimate estimate the market value of an asset the • Referred to as an imputed or implied market value • Estimating is based on logical assumptions about Estimating the remaining life for the asset the MVT = [ EW at the end of year T of remaining capital recovery amounts ] + [ EW at the end of year T of original market value at the end of useful life ] original T < useful life EW is equivalent worth at i = MARR COMPARING ALTERNATIVES USING THE CAPITALIZED WORTH METHOD THE • Capitalized Worth (CW) method -- Determining the present worth of all revenues and / or expenses over an infinite length of time over • Capitalized cost -- Determining the present worth of expenses only over an infinite length of time of • Capitalized worth or capitalized cost is a Capitalized convenient basis for comparing mutually exclusive alternatives when a period of needed services is indefinitely long and the repeatability assumption is applicable assumption CAPITALIZED WORTH METHOD CAPITALIZED • Capitalized worth of a perpetual series of Capitalized end-of-period uniform payments, A, with interest i% per period: interest A ( P /A, i%, ) /A, CW = PWN --> = A ( P / A, i%, ) %, 8 N --> --> 8 ( 1+i )N - 1 1+ = A lim ------------i ( 1 + i )N 8 = A(1/i) 8 THREE GROUPS OF MAJOR INVESTMENT ALTERNATIVES ALTERNATIVES 1. Mutually exclusive : At most one project out of the group can be chosen At 2. Independent : The choice of a project is independent of the choice of any other project in the group, so that all or none of the projects may be selected or some number in between projects 3. Contingent : The choice of the project is conditional on the choice of one or more other projects one ...
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This note was uploaded on 10/24/2009 for the course ENGM 400 taught by Professor Blank during the Spring '09 term at American University of Beirut.

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