Chapter 6: Comparing Mutually Exclusive Alternatives

By Justin J. Boutilier
Based off the textbook Contemporary Engineering Economics: A Canadian Perspective
Motivation
Example: It is the year 2055 and you are an advisor to the planning council of The Musk Mars
Space Colony. The council is considering proposals for its first community centre and it is your
job to determine the most profitable option, if any. The revenues and costs (in millions)
associated with each proposal are:
Option 1

Option 2

Option 3

Option 4

Initial cost

$1,500

$1,000

$2,000

$750

Annual
revenues

$200

$140

$200

$110

Annual costs

$30

$20

$50

$10

Salvage value

$20

$15

$25

$10

The community centre is expected to last for 50 years and the planning council has a MARR of
8%.
Learning Objectives
By the end of this chapter, you will have learned:
1. How to compare mutually exclusive alternatives using the total investment approach
2. How to compare mutually exclusive alternatives using incremental investment analysis
3. How to compare projects with different lives and analysis periods
Recap

Mutually Exclusive Projects: defined as projects that fulfill the same need and therefore
the selection of one alternative implies that all others will be excluded.
E.g., For UofT, deciding to build a new library or new engineering building on the
same St. George Street lot are mutually exclusive projects because choosing one
implies the other cannot be chosen.

The Do Nothing Option

For many engineering applications, the do nothing alternative may exist

o E.g., Whether or not to upgrade a functioning machine will have a do nothing
option. In other words, we will only choose to upgrade the machine if it is
economically beneficial. Otherwise, we do nothing.

The do nothing option assumes that any funds will be invested at the MARR (i.e.,
investment pool concept)
o E.g., Assume upgrading a machine costs $10,000. If we choose the project, then
we earn some return according to the project cash flows. If we choose to do
nothing, then we earn interest on our $10,000 at the MARR

In some cases, replacements or upgrades are required to continue operation, implying that
do nothing is not a feasible option

Example: A project presented to the planning council of the Musk Mars Space Colony proposes
to upgrade the software for monitoring air content. The new software requires an initial
investment of $100 million and will provide annual profits of $7.5 million for the next 25 years.
Should the Musk Mars Space Colony upgrade the air content monitoring software or not?
Assume a MARR of 8%.

Service Projects vs. Revenue Projects

Service project: a project where the revenues do not depend on the choice of alternative
i.e., all options must produce the same revenue
o We choose the project with the lowest costs (i.e., we do not need to consider
revenues)

Revenue project: a project where the revenue is different for each alternative
o We choose the project with the highest net profit or NPW

Total Investment Approach

The total investment approach for comparing mutually exclusive alternatives is the
same as for independent projects
o Determine the NPW, NFW, or AEW for each project and choose the project with
the largest value
Mutually exclusive projects cannot be compared using traditional rate of return analysis
(see below)

Example: Consider the example introduced in the motivation section. Determine the NPW, NFW,
and AEW for each option. Which option should the planning council choose, if any?
.

Incremental Investment Analysis

Incremental investment analysis: must be used to compare alternatives using rate of

return analysis
Can also be used for NPW, NFW, and AEW analysis

Example: Suppose you are offered two investment options. For Option A you are required to
invest $1000 today and you will receive $2000 after 1 year. For Option B you are required to
invest $5000 today and you will receive $7000 after 1 year. You have a MARR of 10%. Which
option will you choose?
The NPW and IRR for each option are shown below:
Option A

Option B

NPW

$818

$1364

IRR

100%

40%

According to IRR, you should choose Option A but according to NPW, you should choose Option
B. I will briefly explain why the NPW approach is correct.
Assume you have exactly $5000 in your investment pool.
If you invest in Option A, you will withdraw $1000 and the remaining $4000 will earn
interest at 10%. After 1 year you will have $2000 from the outside investment and $4400
from the investment pool. Therefore, for an investment of $5000 you will have a total of
$6400 after 1 year.
If you invest in Option B, you will withdraw all $5000. After 1 year, you will have $7000
from your investment. Therefore, for a $5000 investment you will have a total of $7000
after 1 year. This is clearly better than Option A. Another way to consider this is, for the
additional $4000 investment, you earn an additional $5000, which is equivalent to an
IRR of 25%. This suggests that the incremental investment of $4000 is worth it at a
MARR of 10%.
In summary, IRR cannot be used to compare projects because it is a relative measure and does
not consider the scale of the investment. For this reason, incremental investment analysis is
needed. The procedure for conducting incremental investment analysis is as follows:
1. Order the alternatives from smallest to largest according to the initial investment
2. Determine the NPW of each alternative using the MARR and discard any alternative(s)
with NPW < 0
3. Determine the incremental investment (B-A) between the two projects with the smallest
(A) and second smallest (B) initial cost
4. Compute IRRB-A the rate of return on the incremental investment between A and B
5. Choose an alternative according to the incremental IRR criterion:
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If IRRB-A > MARR, then select B

If IRRB-A = MARR, then select A or B
If IRRB-A < MARR, then select A
6. Repeat steps 3-5 until only a single alternative remains
Example: Consider the following two options, each with a 10 year lifespan.
Option A

Option B

Initial cost

$40,000

$65,000

Annual profit

$10,000

$15,000

Salvage value

$7,500

$10,000

Use incremental investment analysis to determine which option to choose at a MARR of 7%.
Solution:

Interpretation:
Incremental investment analysis tells us the rate of return or net worth of the additional
investment needed to purchase B
o In particular, we determine if it is more profitable to invest this additional money
at the MARR (i.e., through an investment pool) and purchase Option A or use the
money to purchase Option B
Incremental investment criterion can be applied to NPW, NFW, and AEW
o For example:
If NPWB-A > MARR, then select B
If NPWB-A = MARR, then select A or B
If NPWB-A < MARR, then select A

Incremental investment analysis can be used to compare any number of alternatives

Example: Consider the example introduced in the motivation. Use incremental investment
analysis to determine the best option to choose.

Analysis Period

Analysis period: time span over which the economic effects of an investment will be
evaluated
Project life: useful life of an investment project
NPW should not be used to compare alternatives with different project lives
Investment alternatives must be compared using an equal time span
It is rare that a projects life will coincide with the analysis period and we will develop
techniques for handling each case

1. Project life equals analysis period

In the real world, it is rare that the life of a project will be exactly equal to the analysis
period
See all previous examples in this chapter
2. Project life longer than analysis period
This is common in the real world, especially in construction where the life of each
machine is typically longer than a single job
To account for this, we estimate some salvage value (i.e., worth) of the machine at the
end of the analysis period
o This can be for analysis purposes only (i.e., we will keep the machine) or it can be
because we will actually sell the machine

Example: The Musk Mars Space Colony requires a new crane to build larger developments and
has a MARR of 11%. The specific project under consideration will take 7 years, however the
useful life of both crane options is 35 years. To account for this, the analyst estimates that the
crane will decrease by an equal amount each year until it reaches $0 at the end of year 35. The
cash flows for the next 7 years associated with the two crane models under consideration are:

*all values in millions

Model C

Model CX

Initial cost

$90

$110

Annual revenue

$40

$45

Annual cost

$5

$7

Salvage value

??

??

Estimate the salvage value of each crane and determine which option to choose using NFW at
the end of year 7.

3. Project life shorter than analysis period

We first decide how to satisfy the remaining analysis period time/requirements either
with replacement projects, leasing equipment, or subcontracting
For analysis purposes, it is common to assume the project repeats until the end of the
analysis period
o In the real world, we make this assumption initially and reevaluate as we obtain
more accurate estimates
Example: The Musk Mars Space Colony requires industrial batteries for an exploratory mining
mission. The batteries only last 2 years while the mission is expected to last 5 years. The first set
of batteries has already been purchased (i.e., years 1 and 2). The company has two options for
the final 3 years:
1. Buy 2 more sets of batteries (i.e., at end of year 2 and year 4). Note that the half used set
of batteries at the end of year 5 will have no salvage value
2. Buy 1 set of batteries at the end of year 2 and buy oil to run an existing generator for the
final year.
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The cost of a set of batteries is $42 million and requires no maintenance. The cost of an annual
supply of oil is $21 million and the maintenance associated with operating the generator is $21
million. Assume a MARR of 11% and determine the option with minimal cost.

Aside:
In some cases, the project life analysis period relationship does not matter
o E.g., Extracting a set amount of a natural resource; once retrieved, the project is
done
o In this case, we compare projects with different lives. Projects that finish earlier
are benefited by the time value of money
Example: You, an engineer at the Musk Mars Space Colony, have discovered an ice deposit deep
underground. The deposit contains over 1,000,000,00L of water. The planning council is
considering proposals to extract and sell the water:
*initial cost in millions

Option A

Option B

Option C

Time period

11

13

17

Initial cost

$84

$82

$77

Price per litre

$2.20

$2.05

$1.90

Cost per litre

$0.35

$0.25

$0.20

An equal amount of water will be sold each year. Determine which proposal is the most
economical using AEW with a MARR of 9%.

4. Analysis period not specified

In many cases, the analysis period is not specified
In this case, we the analyst must choose an appropriate period
o This is easy if all the projects have the same life
If not, we must find a common service period to compare alternatives
There are two approaches for this:
a. Lowest common multiple approach
In this case, we compare projects using the lowest common multiple of project lives
o Remember that the lowest common multiple of a and b is the lowest number that
can be divided by both a and b
This approach implicitly assumes that the projects can be repeated indefinitely
o This is typically used for very long analysis periods

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Example: The Musk Mars Space Colony is considering proposals for a new agriculture facility.
The facility is expected to operate for the foreseeable future and two proposals are under
consideration:
*all values in millions

Proposal 1

Proposal 2

Project life

10 years

15 years

Initial cost

$650

$860

Annual revenue

$130

$131

Annual cost

$25

$22

Assume that each proposal can be repeated indefinitely and a MARR of 8%. Determine the NPW
for both proposals.

b. AEW approach
AEW provides some computational advantages if we assume
1. The service of the chosen project is required on a continuous basis (i.e., all the
time)
2. Each alternative will be replaced by an identical asset for the foreseeable
future
Given these assumptions, we can simply solve for the AEW of each project individually
over its life and compare them
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Example: The Musk Mars Space Colony is considering proposals for a self-driving public
transportation system. Three proposals have been presented by three of earths best universities,
with all values in millions. The cash flows for the Great North Universitys self-driving system
are cyclical, repeating every 3 years with mandatory maintenance and upgrades:
Year

Cash flow

-$1,550

$650

$890

$1,280

The cash flows for the University of Americas self-driving system are cyclical, repeating every 2
years with mandatory maintenance and upgrades:
Year

Cash flow

-$900

$780

$810

The cash flows for Technology Universitys self-driving system are cyclical, repeating every 4
years with mandatory maintenance and upgrades:
Year

Cash flow

-$1,405

$704

$1,011

$965

$204

Assume that each alternative can be replaced by an identical asset and that service is required
for the foreseeable future. Use AEW analysis to determine which proposal to accept with a
MARR of 16%.
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