Chapter 6
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Outline
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Outlineconti
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LearningObjectives
4.1 Given stated alternatives, form mutually exclusive alternatives.
4.2 For alternatives with equal useful life, use equivalent worth
methods to compare them directly.
4.3 Explain the Inconsistent Ranking problem when rate of return
methods are applied directly to compare alternatives.
4.4 Apply incremental analysis to compare alternatives using rate of
return methods or equivalent worth methods.
4.5 When alternatives have different useful lives, identify which
assumption is appropriate between Repeatability assumption
and Coterminated assumption, and being able to adjust cash
flow appropriately under each assumption.
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LearningObjectives
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Formingalternatives
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PlanningHorizon
The selected time period over which mutually
exclusive alternatives are compared -- study period
May be influenced by factors including:
service period required
useful life of the shorter-lived alternative
useful life of the longer-lived alternative
company policy
It is key that the study period be appropriate for the
decision situation under investigation
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Alternatives
Investment Alternatives:
those alternatives with initial capital investments that
produce positive cash flows from increased revenue,
savings through reduced costs, or both.
both benefit and cost of an alternative is stated.
Cost Alternatives:
those alternatives with negative cash flows except for a
possible positive cash flow element from disposal of assets
at the end of the projects useful life.
only the cost of an alternative is stated.
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Exampleofinvestmentalternative
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Exampleofcostalternative
Engineers at SeaWorld has completed an
innovation on an existing water sports ride to make
it more exciting. The modification costs only $8000
and is expected to last 6 years with a $1300 salvage
value for the solenoid mechanisms. The
maintenance cost is expected to be high at $1700
the first year, increasing by 11% per year thereafter.
Determine the equivalent present worth of the
modification and maintenance cost. The interest rate
is 8% per year.
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1.Equalusefullives
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1A.Equalusefullives:EquivalentWorthMethods
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1B.Equalusefullives:RORmethods
A B (B-A)
Capital $60,000 $73,000 $13,000
Annual net 22,000 26,225 4,225
cash flow
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PW --i
$25,000.00
$20,000.00
$15,000.00
PW A
PW
$10,000.00
PW B
$5,000.00
$0.00
0.00% 5.00% 10.00% 15.00% 20.00%
($5,000.00)
i
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1B.InconsistentRankingProblem
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1B.RORmethods:Incrementalanalysis
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1B.RORmethods:Incrementalanalysis
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1B:Incrementalanalysisexample
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1B:Incrementalanalysisexamplecost
alternatives
year design A design B design C
Three preliminary design
alternatives for a heavy- 0 -85600 -63200 -71800
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1B:Incrementalanalysis
P B1 B2 B3
Improve One-story Two-story Three-story
parking lot building building building
Capital $200,000 $4,000,000 $5,550,000 $7,500,000
investment
Net annual 22,000 600,000 720,000 960,000
income
Residual 100,000 2,000,000 2,775,000 3,750,000
value
IRR 9.3% 13.8% 11.6% 11.4%
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1B.Incrementalanalysis
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2.UnequalUsefulLives
EXAMPLE
Machine A Machine B
First Cost $11,000 $18,000
Annual Operating Cost 3,500 3,100
Salvage Value 1,000 2,000
Life 6 years 9 years
i=15%peryear
Note:Wherecostsdominateaproblemitiscustomarytoassigna
positivevaluetocostandnegativetoinflows
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2.ExampleUnequalUsefulLives
Acommonmistakeisto
computethepresent
worthofthe6yearproject
andcompareittothe
presentworthofthe9
yearproject.
NO!NO!NO!
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2.UnequalUsefulLives
MachineA F6=$1,000
0123456
A16=$3,500
$11,000 F9=$2,000
0123456789
A19=$3,100
MachineB
i=15%peryear
$18,000
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2.UnequalUsefulLives
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2A.RepeatabilityAssumption
The study period over which the alternatives are
being considered is either indefinitely long or equal
to a common multiple of the lives of the alternatives.
The economic consequences that are estimated to
happen in an alternatives initial useful life span will
also happen in all succeeding life spans
(replacements)
Actual situations in engineering practice seldom meet both
conditions
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2A:UnequalLives:2Alternatives
MachineA
6years 6years 6years
MachineB
9years 9years
Cycle1forB Cycle2forB
18years
i=15%peryear
LCM(6,9)=18yearstudyperiodwillapplyforprojectworth
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2A:Example:UnequalLivesSolving
LCM = 18 years
PA=11,000+3,500(P|A,0.15,6)
1,000(P|F,0.15,6)
=11,000+3,500(3.7845)1,000(0.4323)
=$23,813,whichoccursattime0,6and12
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2A:Example:UnequalLives
MachineA
061218
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2A:UnequalLivesExample:MachineB
F9=$2,000
0123456789
A19=$3,100
$18,000
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2A:9YearCycleforB
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2A:AlternativeB2Cycles
MachineA:PW=$38,558
0918
$32,223 $32,223
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2A:AWmethodexample
Calculate the AW of Machine As 6-year cycle
AW(15%)A=11,000(A/P,15%,6)+3,500-
1,000(A/F,15%,6) =11000*0.2642+3500-
1000*0.1142 =6,292
Calculate the AW of Machine As 18-year cycle
AW(15%)=PW(15%)(A/P,15%,18)=38,558*0.1632=6,292.6
Calculate the AW of Machine Bs 9-year cycle
AW(15%)B=18000*(A/P,15%,9)+3100-
2000*(A/F,15%,9)=18000*0.2096+3100-2000*0.0596=6753.6
Calculate the AW of Machine Bs 18-year cycle
AW(15%)=PW(15%)*(A/P,15%,18)=41384*0.1632=6753.8
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2A.IRRmethodunderRepeatability
assumption
IRRB-A: Form incremental cash flow of B-A for 18
years by repeating A three times and B two times
and then solve for AWB-A(i%)=0
Equivalent to solve for AW 6(i%)=AW 9(i%)
A B
Use linear interpolation:
AW (5%)=11000(A/P,5%,6)+3500-1000(A/F,5%,6)
A
=11000*0.1970+3500-1000*0.1470 =5520
AW (5%)=18000(A/P,5%,9)+3100-2000*(A/F,5%,9)
B
=18000*0.1407+3100-2000*0.0907=5451.2
Use AWA(15%)=6292, AWB(15%)=6754 and linear
interpolation, we find i%=6.37%.
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2B.CoterminatedAssumption
A finite and identical study period is used for all
alternatives
This planning horizon, combined with appropriate
adjustments to the estimated cash flows, puts the
alternatives on a common and comparable basis
Used when repeatability assumption is not
applicable
Approach most frequently used in engineering
practice
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2B.CoterminatedAssumption
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2B.CoterminatedAssumptioncostalternatives
Suppose the study period is 9 years
MachineA F6=$1,000
0123456
A16=$3,500
$11,000 F6=$2,000
0123456789
A19=$3,100
MachineB
i=15%peryear
$18,000
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2B.Exampleinvestmentalternatives
Coterminated A B
assumption with an six-
year study period Capital $3,500 $5,000
(alternative A would not investment
be repeated). Annual 1,255 1,480
MARR=10% cash flow
Useful life 4 6
(years
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2B.CoterminatedAssumption
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2B.Example
Coterminated A B
assumption with an
four-year study period Capital $3,500 $5,000
MARR=10% investment
Useful life 4 6
(years
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2B.Coterminatedassumption:theImputed
MarketValuetechnique
If the equipment can be sold, use the price as its
market value (salvage value) when the project is
terminated.
If its impossible to obtain an estimate for its market
price, you may use the imputed market value
technique.
MVT=[PW at the end of year T of remaining capital
recovery amounts] + [PW at the end of year T of
original market value at the end of useful life]
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2B.Imputedmarketvaluetechnique
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3.CapitalizedWorthMethod
Capitalized Worth (CW) method -- Determining the
present worth of all revenues and / or expenses
over an infinite length of time
Capitalized cost -- Determining the present worth of
expenses only over an infinite length of time
Capitalized worth or capitalized cost is a convenient
basis for comparing mutually exclusive alternatives
when a period of needed services is indefinitely long
and the repeatability assumption is applicable
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3.CapitalizedWorthMethod
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3.DerivationforCapitalizedWorth
(1 + i ) 1 N
P = A N
i (1 + i )
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3.DerivationContinued
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3.DerivationContinued
1 A
P = A =
i i
Or,
CW(i%)=A/i
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3.Example:CapitalizedCost
Assumeyouarecalledontomaintaina
cemeterysiteforeveriftheinterestrate=4%
and$50/yearisrequiredtomaintainthesite.
12345.. N=inf.
..
A=$50/yr
P=?
FindthePWofaninfiniteannuityflow
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3.Example:CapitalizedCost
P0 = $50[1/0.04]
P0 = $50[25] = $1,250.00
Invest $1,250 into an account that earns 4%
per year will yield $50 of interest forever if the
fund is not touched and the i-rate stays
constant.
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3.CapitalizedCost:Endowments
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3.CapitalizedCost:EndowedChair
P=$200,000/0.08=$2,500,000
If$2,500,000isinvestedat8%thentheinterestper
year=$200,000
The$200,000istransferredtothedepartment,but
theprincipalsumstaysintheinvestmentto
continuetogeneratetherequired$200,000
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3.CapitalizedCostmoreexample
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3. Cash Flow Diagram
i=15%/YR
012345671530
$4,000
$8,000
$15,000 $15,000 $15,000 $15,000
$150,000
N=
Howmuch$$att=0isrequiredtofundthisproject?
Thecapitalizedcostisthetotalamountof$att=0,
wheninvestedattheinterestrate,willprovideannual
interestthatcoversthefutureneedsoftheproject.
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3.CapitalizedCostExampleContinued
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3.CAPITALIZEDCOST:OneCycle
Take any 15-year period and find the equivalent annuity for that
period using the A/F factor
.
015304560..
$15,000
Afora15yearperiod
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3.CAPITALIZEDCOST
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3.CAPITALIZEDCOST
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