COMPARISON OF ALTERNATIVES

Comparison of alternatives deals with situations in which one has more than one choice and using
engineering economic principles, one needs to decide the alternatives so as to go with the one that is
most economically justified.
A cash flow typically consists of an investment at time 0, a salvage value(income) at the end of
the life of the alternative, a series of operating costs and perhaps revenues at each period.

BASIC METHODS

A. Rate of Return (ROR) Method

-if the rate of return on additional investment is satisfactory, then, the alternative requiring a
bigger investment is more economical and should be chose,

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝑃𝑏

𝑅𝑂𝑅 = = 𝑥 100
𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝐶
Pattern:
Required Capital investment = C
Annual Income = G
Annual Expenses:
Operation and Maintenance = O + M
Depreciation = D
Net profit before income taxes = Pb=G-(O+M+D)

If ROR≥MARR, the investment is justified

B. Annual Worth (AW) method

-interest on the original investment is included as a cost. If the excess of annual cash inflows
over annual cash outflows is not less than zero, the propose investment is justified.

Pattern:
Required Capital investment = C
Annual Income = G
Annual Expenses:
Operation and Maintenance = O + M
Depreciation = D
Minimum Required profit = Ci
Net profit before income taxes =G-(O+M+D + Ci)

C. Present worth (PW) method

-all cash flows for investments are calculated for some base time which is the present. Present
worth (PW) method
-if the present worth of the next cash flows is equal to or greater than zero, the project is
justified economically
-depreciation is excluded in the computation for the present worth of the cash outflow.
 D. Future Worth (FW) Method
-all cash inflows and outflows are computed forward to a reference point in time called the
future.
- if the future worth of the next cash flows is equal to or greater than zero, the project is
justified economically.

E. Payback (payout) period

-the length of time required to recover the first cost of an investment from the net cash flows
produced by that investment for an interest rate of zero.

𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒 𝐶 − 𝑉𝑠

𝑃𝑎𝑦𝑜𝑢𝑡 𝑝𝑒𝑟𝑜𝑑 (𝑦𝑒𝑎𝑟𝑠) = =
𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝐺 − (𝑂 + 𝑀 + 𝑇)

Example:
1. It is estimated that insulation of steam pipes in a factory will reduce the fuel bill by as much as
20%. The cost of the insulation is P120,000, and the annual cost of taxes and insurance is 5% of
the initial cost. Without the insulation, the annual fuel bill is P190,000. If the insulation is
worthless after 6 years, and a minimum return is 12% , would it be worthwhile to invest in the
insulation? What is the payback period of the investment?
2. A company is considering two types of equipment for its manufacturing plant. If the minimum
required rate of return is 15%, which equipment should be selected using (a) ROR (b) PWM (c)
FWM (d) AWM (e) PP

TYPE A
First cost 200,000
Annual operating cost 32,000
Annual labor cost 50,000
Taxes and insurance 3%
Payroll taxes 4%
Life, years 10

METHODS OF COMPARISON

1. ROR on Additional Investment

𝑛𝑒𝑡 𝑎𝑛𝑛𝑢𝑎𝑙 𝑠𝑎𝑣𝑖𝑛𝑔𝑠
𝑅𝑂𝑅 =
𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

If the rate of return is satisfactory, then the alternative requiring a bigger investment is more
economical and should be chosen.

2. Annual Worth (AW) method

-the annual cost of the alternatives including interest on the investment is determined. The
alternative with the least annual cost is chosen.

3. Present worth (PW) method

 -involves finding the equivalent value of each alternative at the present time, identified as time
0
-If only costs are involved, select the alternative with the smallest present worth of costs
-if costs and revenues are involved, select the alternative with the greatest present worth of net
revenues.
-can only be used when the alternatives have the same lives
-if alternatives have different lives, use the least common multiple study period
-if alternatives have the same present worth, choose the one with greatest investment.
4. Equivalent Uniform Annual Cost Method
-the equivalent end-of period value of all cash flows for each alternative

5. Capitalized Cost
-the amount you have to invest so that the company will have a continuous operating life.
-this method is useful for alternatives having long life

𝑆 𝐴
𝐶𝐶 = 𝐹𝐶 + 𝑘
+
(1 + 𝑖) − 1 𝑖

6. Payback (payout) period

-the alternative with the shortest payback is adopted.

Example:

A company is considering two types of equipment for its manufacturing plant. Capital is at least
16%.

TYPE A TYPE B
First cost 8,000 14,000
Salvage value 0 2,000
Annual operation 3,000 2,400
Annual maintenance 1,200 1,000
Taxes and insurance 3% 3%
Life, years 10 15