lecture # 13 investment alternatives i

Lecture # 13

Investment Alternatives

PW and AW methods

1 Dr. A. Alim


• One of the important functions of financial

management and engineering is the creation

of “alternatives”.

• If there are no alternatives to consider then

there really is no problem to solve!

• Given a set of “feasible” alternatives,

engineering economy attempts to identify the

“best” economic approach to a given problem.

2

Material used in this lecture is sourced from “Engineering Economics”, 6th ed. McGraw Hill, © 2005 ,

by L. Blank and A. Tarquin, and also from Engineering Economics 4N04 class notes, McMaster

University © 2001-2007.

Assessing Alternatives

• Feasible Alternatives

Feasible Set

Mutually Exclusive Set Independent Set OR

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Four Types of Categories:

In addition to the two outcomes listed earlier:

• Mutually Exclusive Set

• Independent Project Set

We may also have two additional outcomes:

• The single Project.

• The “Do Nothing” (DN) option

4 Material used in this lecture is sourced from “Engineering Economics”, 6th ed. McGraw Hill, © 2005 ,



The Single Project

• Called “The Unconstrained” Project selection problem

• No comparison to competing or alternative projects

• Acceptance or Rejection is based upon specified criteria

5

Material used in this lecture is sourced from “Engineering Economics”, 6th ed. McGraw Hill, © 2005 , by

L. Blank and A. Tarquin, and also from Engineering Economics 4N04 class notes, McMaster University ©

2001-2007.

Do Nothing Option

• The firm may decide to reject all alternatives and decide to do nothing.

• Therefore, the do nothing is always “an option”.

• In that case, the company maintains the current approach and simply invest their funds at MARR (e.g. in a bank) until a decision is made at a future date.

• In projects involving safety or legal aspects, the do nothing is not considered.

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Independent Project Set

Funds exist to allow the selection of all

feasible alternatives.

Each project is judged independently of

the others, i.e. same as single project.

An interesting case of “partially

independent” project set occurs when

funds exist for some but not all feasible

alternatives. We will discuss this case

later, under optimization.

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2001-2007.

Mutually Exclusive (ME) Set

Only one of the feasible (viable)

projects can be funded.

Once selected, the others in the set

are “excluded”.

Each of the identified feasible

(viable) projects is (are) considered

an “alternative”.

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2001-2007.

Example

Distillation tower to separate

L-L extraction to separate

Solid adsorption to separate

Stream with mixed components

Funds exist for only one alternative !

Mutually Exclusive (ME) Set

9 Material used in this lecture is sourced from “Engineering Economics”, 6th ed. McGraw Hill, © 2005 , by


2001-2007.

Cash Flow Types for Projects

Revenue – each alternative generates costs and revenues over the estimated life of the project.

Selection criterion: Select the alternative that maximizes the economic measure of merit (PW or AW)

Service – each alternative has only current and future costs over the estimated life of the project.

Selection criterion: Select the alternative that minimizes the economic measure of merit, which is a cost-based measure (PW or AW)

10 Material used in this lecture is sourced from “Engineering Economics”, 6th ed. McGraw Hill, © 2005 , by L. Blank and A. Tarquin, and also from

Engineering Economics 4N04 class notes, McMaster University © 2001-2007.


How do we choose among alternatives ?

Basically, any of the profitability measurements could be used:

PW (or AW): * Reject a revenue project if PW (or AW) at

MARR is negative. Reject a service project

if PW of cost is more than a preset level.

* Select the project with the most favorable

PW or AW among alternatives.

PBP: * Reject a project if PBP>PBP (ref)

* Pick the shortest PBP among alternatives

* Not recommended, and must never be the

only method used.

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Examples

• Calculate PW of each alternative at MARR

• Selection criterion: Select alternative with most favorable PW value, that is,

numerically largest PW value (most positive)

PW1 PW2 Select

$-1,500 $-500 2

-2,500 500 2

2,500 1,500 1

Note : Not the absolute

value

12 Material used in this lecture is sourced from “Engineering Economics”, 6th ed. McGraw Hill, © 2005 , by L. Blank

and A. Tarquin, and also from Engineering Economics 4N04 class notes, McMaster University © 2001-2007.

Investment Alternatives How do we choose among alternatives ?

In addition, we can also use the ROI or DCFRR method :

ROI: Reject a project if ROI<MARR

DCFRR (IRR): Reject a project if DCFRR<MARR

Among alternatives, it is not always true that the highest ROI

or DCFRR is the most preferred. If we are to use the ROI or

the DCFRR methods then we must apply incremental analysis

among alternatives.




Investment Alternatives Summary - How do we choose among alternatives ?

PW or AW: Select the most positive (profit/cash

flow) or least negative (cost)

PBP : Not recommended as sole method.

ROI or DCFRR: May be used, but must apply

incremental analysis.

14

Material used in this lecture is sourced from “Engineering Economics”, 6th ed. McGraw Hill, ©

2005 , by L. Blank and A. Tarquin, and also from Engineering Economics 4N04 class notes,

McMaster University © 2001-2007.


15

Material used in this lecture is sourced from “Engineering Economics”, 6th ed. McGraw Hill, ©

2005 , by L. Blank and A. Tarquin, and also from Engineering Economics 4N04 class notes,

McMaster University © 2001-2007.

Let’s discuss details of PW and AW in this class. Next class we will address the ROI and the DCFRR approaches and the concept of incremental analysis.

PW analysis of Investment Alternatives

• Alternatives must be compared at the same project life. • For Alternatives with unequal lives, we apply the “lowest common multiple” • LCM – Evaluate the alternatives over the lowest common multiple of lives, e.g. lives of 4 and 6 years, use n=12 and assume re-investment at same cash flow estimates.

16 Material used in this lecture is sourced from “Engineering Economics”, 6th ed. McGraw Hill, © 2005 , by


2001-2007.

LCM Approach The assumptions for the analysis of

different-life alternatives are a follows:

1. The service provided by the alternatives will be needed for the LCM of years or more.

2. The selected alternative will be repeated over each life cycle of the LCM in exactly the same manner.

3. The cash flow estimates will be the same in every life cycle.




LCM Example – Cost projects Example 5.14, page 246, Contemporary Engineering Economics, C.S.Park, 4th edition, Pearson Prentice Hall, 2007.

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A certain mail-order firms wants to install an automatic mailing system to handle product Announcements and invoices. The firm has a choice between two different types of machines. The two machines are designed differently, but have identical capacities and Do exactly the same job. The $12,500 semiautomatic model A will last three years. The Fully automatic model B will cost $15,000 and last four years. The expected cash flows for the two machines including maintenance, salvage, and tax Effects, are as follows: model A model B Number of years 3 4 Initial cost $12,500 $15,000 Annual expenses $5,000 $4,000 Salvage value $2,000 $1,500 If the MARR is 15%, using the PW method, which machine should the firm purchase? NOTE: This is a service project with two alternatives having different service lives.

20 Clearly, model B is the better choice.

The use of Annual Worth (AW) for selecting among alternatives

• AW may be used instead of PW to select among alternatives!

• Recall the criterion discussed earlier, depending on type of cash flows in the project.

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Cash Flow Types for Projects

Revenue – each alternative generates costs and revenues over the estimated life of the project.

Selection criterion: Select the alternative that maximizes the economic measure of merit (PW or AW)

Service – each alternative has only current and future costs over the estimated life of the project.

Selection criterion: Select the alternative that minimizes the economic measure of merit, which is a cost-based measure (PW or AW)

24

Material used in this lecture is sourced from “Engineering Economics”, 6th ed. McGraw Hill, © 2005 , by L. Blank and A. Tarquin, and also from


The use of Annual Worth for selecting among alternatives

• Popular Analysis Technique

• Easily understood-results are reported in $/time period

– Eliminates the LCM problem associated with the present worth method

– Only have to evaluate only one life cycle of a project

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Previous example – Solution using the AW method

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Recall we calculated PW for one cycle for each model: For model A, PW(15%) = - $22,601 Hence AW = -$22,601(A/P,15%,3) = -$9,899 For model B, PW(15%) = - $25,562 Hence AW = -$25,562(A/P,15%,4) = -$8,953 Hence, model B is the better choice

• 3 investments. Need to evaluate profitability of each.

• Use ROI, PBP, NPV, and DCFRR.

• Assume straight line depreciation.

• Tax rate is 35%

• MARR is 15%

• Use MARR as interest rate for time value of money.

• Ignore land value.

Example (Evaluating alternatives using AW):

Modified example 8-3, Peters, page 331

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Investment #

Fixed capital

$

Working capital

$

Salvage value

$

Service life, years

GI – E

$

1 100,000 10,000 10,000 5 See yearly tabulation

2 170,000 10,000 15,000 7 64,615

(constant)

3 210,000 15,000 20,000 8 73,846

(constant)

For investment # 1:

Year 1 2 3 4 5

GI – E

$

46,154 47,692 55,385 61,539 66,154

26

Material used in this lecture is sourced from “Engineering Economics”, 6th ed. McGraw Hill, © 2005 , by L. Blank and A. Tarquin, and also

from Engineering Economics 4N04 class notes, McMaster University © 2001-2007.

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Comparing investments 1,2, and 3 on AW basis:

PW of CFAT (one cycle) n years AW of CFAT

Investment 1 38,509.00$ 5 $11,487.83

Investment 2 36,378.00$ 7 $8,743.83

Investment 3 39,133.00$ 8 $8,720.79

Investment 1 has the highest AW, hence we select it.

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(Evaluating alternatives using AW), Example 6.4 page 157, Blank and

Tarquin, 7th ed. McGraw Hill, 2012.:

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Advantages of AW

* Easier to calculate, uses only one cycle. No need for LCM calculation.

* Applicable to a variety of engineering economy studies:

– Breakeven Analysis

– Economic Value Added analysis (EVA)

– Asset Replacement

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lecture # 13 investment alternatives i

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