Unit VII

Decision making
among alternatives

A decision criterion is a rule or procedure that

prescribes how to select investment

alternatives so that certain objectives can be
achieved.
Types of investment proposals : An
investment proposal is a single undertaking
or project being considered as an investment
possibility.
Whether proposals are independent of each
other or whether they are dependent in some
way determines the selection process by
which one proposal will be judged superior to
another proposal.

Independent proposals : A proposal is said to

be independent when the acceptance of a

proposal from a set has no effect on the
acceptance of any of the other proposals in
the set.
For example, proposals concerning the
purchase of a NC milling machine, a security
system, office furniture and fork lift trucks
would, under most circumstances, be
considered independent.
Dependent proposals:
For many decision situations, a group of
proposals will be related to one another in
such a way that the acceptance of one of
them will influence the acceptance of the

Proposals are said to be mutually exclusive if the

proposals contained in the set of proposals being

considered are related so that the acceptance of one
proposal from the set precludes (prevents) the
acceptance of any of the others.
Mutually exclusive proposals usually occur when a
decision maker is attempting to fulfill a need and there
are a variety of proposals, each of which will satisfy that
need.
A contingent (conditional) proposal is one whose
acceptance is dependent on the acceptance of some
prerequisite proposal , whose acceptance in turn is
independent of acceptance of the contingent proposal.
Thus the purchase of computer software is contingent on
the purchase of computer hardware.
The construction of the third floor of a building is
contingent on the construction of the first and second
floors.
A contingent relationship is a one way dependency
between proposals.

Investment alternative: it is important to

distinguish an investment proposal from an

investment alternative.
An investment alternative is a decision option
that represents a course of action.
Forming mutually exclusive alternatives:
Engineering proposals can be independent,
mutually exclusive, or contingent and
additional interdependencies among them
can exist if there is a limited amount of
money to invest.
To devise special rules to include each of
these different relationships in a decision
criterion would make the procedure
complicated and difficult to apply.

A general procedure for forming mutually

exclusive alternatives from a given set of

proposals is based on an enumeration of all
possible combinations of the proposals . For
example, if two proposals (P1 and P 2) are
being considered, four mutually exclusive
investment alternatives exist, as shown in
Table 7.1. Note that a binary variable, Xj =0
or 1 is used to indicate proposal rejection or
acceptance.
Table 7.1
Alternatives

Proposal P1

Proposal P2

Action

A0

Do nothing

A1

Accept P1

A2

Accept P2

A3

Accept P1 and

Generalization of the procedure used in Table

7.1 for k proposals, k=1,2,3 leads to a

number of alternatives A , given by A=2k .
A0-1 matrix exhibiting all possible
alternatives (row) is shown in Table 7.2
Let 1,2,3k-1,k designate proposals
( columns) from left to right.
Moving down P1, the first column (k=1), place
a single zero followed by a single one
alternating until all alternatives have been
assigned a zero or one.
Next, go to P2, the second column (k=2).
Move down the column and place 2(k-1) zeros
followed by 2(k-1) ones , alternating until
each alternative has an entry.

For the third column, P3, k=3 so that 2 (k-1)

=4
Thus moving down that column, place 4 zeros
followed by 4 ones, repeating until all
alternatives have an assigned value.
This process is repeated for each proposal
( column) and the results are presented in
Table 7.2
Since all the entries in row 1 will be zero, A0
represents the Do Nothing alternative.
The approach just presented makes possible
the consideration of a variety of proposal
relationships in a single form; the mutually
exclusive alternative.

TABLE 7.2
GENERAL 0-1 MATRIX OF INVESTMENT
ALTERNATIVES
Invest Propo Propo
Propo Propo Propo
ment sal
sal P2 sal P3 sal
sal
altern ,P1
P(k-1) P(k)
atives
A0

A1

A2

A3

A4

A5

A(2k
-2)

7.3 ELEMENTS OF DECISION CRITERIA;

7.3.1 Differences between alternatives: When

comparing mutually exclusive alternatives, it

is the difference between them that is
relevant for determining the economic
desirability of one compared to the other.
7.3.2 Minimum attractive rate of
return(MARR):The maximization of equivalent
profit, given that all investment alternatives
must yield a return that exceeds some
minimum attractive rate of return.
The minimum attractive rate of return (MARR)
is a cut off rate representing a yield on
investments that is considered minimally
acceptable.

7.3.3 The Do Nothing Alternative: It means that

the investor will do noting about the projects

being considered and the funds made available
by not investing will be placed in investments
that yield an IRR equal to the MARR.
For the Do Nothing alternative their result of
these assumptions is summarized as i* A0
=MARR
Because the IRR is defined as the interest rate
that causes the present worth, annual
equivalent, or future worth amounts to equal
zero, for the Do Nothing alternative it follows
that
PW(MARR)A0=0
AE(MARR)A0 =0

FW(MARR)A0=0
These expressions indicate that when the Do

Nothing alternative is evaluated at the MARR,

its equivalent profit is always zero.
7.6 COMPARISONS BASED ON TOTAL
INVESTMENT:
7.6.1 Present worth on Total investment: The
present worth on total investment criterion is
one of the most frequently used methods for
selecting an investment alternative from a set
of mutually exclusive alternatives
Since the stated objective is to choose the
alternative with the maximum present worth,
the rules for this criterion are rather simple.
If PW(i)A2>PW(i)A1;accept A2

PW(i)A2<PW(i)A1:accept A1
7.6.2 Annual equivalent and future worth on total

investment:
It was shown earlier that the PW(i), AE(i) and the
FW(i) are consistent bases for comparing
alternatives. Therefore, if
AE(i)A2>AE(i) A1 : accept A2
AE(i)A2<AE(i)A1:accept A1 and if
FW(i)A2>FW(i)A1:accept A2
FW(i)A2<FW(i)A1:accept A1
7.6.3 Rank on rate of return and its Deficiencies: The
IRR is calculated for each proposal and then the
proposals are ranked in descending order of IRR.
The decision rule is to move down the ranked
proposals, accepting each until there are no more
proposals with an IRR greater than the
MARR(Minimum Attractive Rate of Return)

7.6.4 Considering inflation: When comparing

alternatives that are expected to be pursued

during periods of inflation, the methods
described in Unit V should be applied.
Suppose the cash flows for some alternatives
have been estimated in terms of constant
dollars. If the inflation rate is 9% the cash flows
for investments have to be transformed into
actual dollars at the 9% rate.
7.7 Comparing alternatives with unequal lives:
When comparing alternatives with unequal
lives, the principle that all alternatives under
consideration must be compared over the same
time span, is basic to sound decision making.

The time period over which the alternatives are

to be compared is usually referred to as the

study period or planning horizon.
This study period, denoted by n* may be set by
company policy or it may be determined by the
time span over which reasonably accurate cash
flow estimates can be made.
Also length of the lives of the alternatives being
studied can be a basis for determining the
study period.
Service alternatives are described by their
capital costs and their other cost cash flows. It
is assumed that each service alternative
provides over its life time an identical service
on a per-year basis and thus the revenue cash
flows are not usually shown.

Revenue alternatives are described by all the

revenue and cost cash flows associated with that

alternative.
Method 1( estimation of required cash flows)
- appropriate for service alternatives and revenue
alternatives.
-n*>0 ( the study period may be selected to be any
time span)
Assumption : Actual costs and revenue will equal the
values estimated.
Method 2( calculate the AE(i) of the Capital costs
and the AE(i) of all other costs and revenues over
each alternatives life.
- appropriate for service alternatives and revenue
alternatives.
-n>0 ( the study period may be selected to be any
time span.

Method 3 : ( calculate the PW(i) or FW(i) of each

alternative over its particular life.)

Appropriate for revenue alternatives only
n*>life of longest lived alternative. (alternatives
must have lives shorter than or equal to the
study period.)
Assumption : all cash flows will be reinvested at
an interest rate, i, until the end of the study
period.
KEY POINTS:
All investment options can be rearranged into
mutually exclusive alternatives.
The fundamental rule, on which the comparison
of mutually exclusive alternatives is based,
requires that the difference between alternatives
be evaluated.

The minimum attractive rate of return (MARR) is

a cut-off rate that represents the yield on

investments the firm considers minimally
acceptable.
The rate should reflect the opportunity to invest
if the investments under consideration are not
undertaken.
The Do Nothing alternative, A0, represents the
option to invest at an interest equal to the
MARR .Thus the PW(MARR) A0=0
PW(i), AE(i), and FW(i) can be correctly applied
on total investment or incremental investment.
The internal rate of return , i*, will provide the
same results as the investment criteria just
mentioned only if it is applied on incremental
investment.

When comparing alternatives with unequal

lives the comparison must be made over

equal periods of time
Three different methods are presented for
placing such alternatives over equal periods
Each method is based on a different set of
assumptions and there is no assurance that
the three methods will provide the same
conclusions.
THE END