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Lecture6 - Comparison and Selection among Alternatives...

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Comparison and Selection among Alternatives SEEM5740/ECLT5930 1
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We have learned how to evaluate the economic merit of a single alternative using various measures (PW, AW, FW, IRR, ERR). We will learn how to use these measures to compare multiple alternatives and select the best one. SEEM5740/ECLT5930 2
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Mutually exclusive and independent alternatives Mutually exclusive alternatives: selection of one alternative excludes the selection of another. We can select only one. Independent alternatives: selection of one alternative does not preclude another. We will first study mutually exclusive alternatives. SEEM5740/ECLT5930 3
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Study period and useful lives Useful life of an alternative: the time period it will last. Case 1. Equal useful lives for all alternatives Case 2. Unequal useful lives Rule: Compare alternatives over the same time period, which is called study period. Study period depends on several factors: the service period required useful life of shorter-lived alternative and useful life of longer-lived alternative company policy We will first consider case 1. SEEM5740/ECLT5930 4
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Investment alternatives Investment alternatives: initial capital investment that produce positive cash flows from revenue or savings. Implicit alternative : do nothing, i.e. do not select any of the alternatives under consideration if all of them are not acceptable. In this case, if all the candidate projects are worse than an investment with MARR, the company should not invest at all! SEEM5740/ECLT5930 5
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Cost alternatives Cost alternatives: all negative cash flows except for a possible cash-flow from disposal of assets at the end of the project’s useful life. Example: In order to test a new drug, a pharmaceutical company has to buy new equipment: initial purchase cost, annual maintenance cost, salvage value when the test ends. In cost alternatives selection, we do not have the option do-nothing , because the equipment must be bought for a certain task. SEEM5740/ECLT5930 6
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Basic idea for comparison Two alternatives: A and B. A requires less investment than B, but B has additional benefits. Principle for comparison: focus on the difference. We ask this question: can the additional investment for B be justified by the additional benefits (incremental analysis)? To answer this question, we can use the measures we learned for evaluation of a single project. If the answer is “yes”, then B should be selected. SEEM5740/ECLT5930 7
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Example 6.1: investment alternatives Consider projects A and B, both last for 4 years. MARR = 10 % . A B Δ( B - A ) Capital investment -60,000 -73,000 -13,000 Annual revenues minus expenses 22,000 26,225 4,225 PW(10%) 9,738 10,131 393 PW A ( 10 %) > 0 , PW B ( 10 %) > 0 suggest that both A and B are better than do-nothing. PW Δ( B - A ) ( 10 %) > 0 implies additional investment in B is justified, and B is better than A. SEEM5740/ECLT5930 8
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Example 6.1 We note that PW B = PW A + PW Δ( B - A ) . In general, PW (FW and AW) have the following additivity property ( X , Y represent two projects): PW X + Y ( i ) = PW X ( i ) + PW Y ( i ) .
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