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Unformatted text preview: CHAPTER 6 CHAPTER COMPARISON AND COMPARISON SELECTION AMONG ALTERNATIVES ALTERNATIVES FEASIBLE DESIGN ALTERNATIVES FEASIBLE Alternatives may be mutually exclusive (i.e., choice if one excludes the choice of any other alternative) because : alternative) • The alternatives being considered may require The different amounts of capital investment different • The alternatives may have different useful 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 ). • The alternative requiring the least investment The is the base alternative. base • Rule ensures that as much capital as possible Rule is invested at a rate of return equal to or greater than the MARR. greater ENSURING COMPARABLE BASIS FOR SELECTING MUTUALLY-EXCLUSIVE ALTERNATIVES ALTERNATIVES Include any economic impacts of alternative differences in Include estimated cash flows – Two Rules: Two Rule 1. When revenues and other economic benefits are present, select alternative that has greatest positive present select equivalent worth at i = MARR and satisfies project requirements. Rule 2. When revenues and economic benefits are not Rule present, , select alternative that minimizes cost. present INVESTMENT INVESTMENT ALTERNATIVES ALTERNATIVES Those alternatives with initial (i.e., front-end) capital investments(s) that ___________ investments(s) ____________________________ ____________________________ ____________________________ COST ALTERNATIVES COST Those alternatives with initial (i.e., Those front-end) capital investments(s) that produce positive cash flows positive from___________________________ from _______________________________ _______________________________ ___________________ PLANNING HORIZON PLANNING • The selected time period over which mutually The exclusive alternatives are compared -- study period period • May be influenced by factors including: – – – – service period required 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 appropriate for It the decision situation under investigation the USEFUL LIFE USEFUL • Useful life of an asset is the time period during Useful which it is kept in productive use in a trade or business. business. 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 for all finite alternatives alternatives • This planning horizon, combined with This appropriate adjustments to the estimated cash flows, puts the alternatives on a common and comparable basis comparable • Used when repeatability assumption is not Used applicable applicable • Approach most frequently used in engineering Approach practice practice 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 must a. Cost 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 original b. investment alternatives -- assume all cash b. investment flows reinvested in other opportunities at MARR to end of study period COTERMINATED ASSUMPTION COTERMINATED Guidelines when useful life(s) different in length Guidelines than study period than • Useful life > study period Truncate the alternative at the end of the study Truncate period using an estimated market value. This method assumes disposable assets will be sold at the end of the study period at that value the 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 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, AW method, or FW method, the PW AW FW alternative that is least negative is most economically desirable. economically • 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 producing Each a sufficient rate of return on that increment. 2. 2. Compare a higher investment alternative against a 2. 2. lower investment alternative only when the latter is acceptable . acceptable 3. Select the alternative that requires the largest investment Select 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. MARR. INCONSISTENT RANKING PROBLEM INCONSISTENT • Ranking errors can occur when a selection among Ranking 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 opposed • 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 an alternative that maximizes the IRR of its total cash flow, because flow, -- the IRR method assumes reinvestment of cash flows at the calculated rate(s) of return flows -- 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 flows) 3. between alternatives until no more alternatives exist between 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 one b. for which the incremental cash flow was acceptable for THREE ERRORS COMMON TO INCREMENTAL INVESTMENT ANALYSIS PROCEDURE APPLIED TO IRR PROCEDURE 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 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 8 8 8 • 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%, ) %, N --> --> 8 ( 1+i )N - 1 1+ = A lim ------------i ( 1 + i )N = A(1/i) 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 between 3. Contingent : The choice of the project is conditional on the choice of one or more other projects of ...
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This note was uploaded on 01/24/2012 for the course ECON 421 taught by Professor Balch during the Summer '11 term at USC.

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