Chapter 5

Comparing Alternatives
Prepared by:
COMPARING ALTERNATIVES
• Most engineering and business projects can be
accomplished by more than one method or
alternative. This chapter will deal with these types
of problems. The fundamental principle on which
alternative should be used is stated as follows:
• The alternative that requires the minimum
investment of capital and will produce satisfactory
functional result will always be used unless there are
definite reasons why an alternative requiring a
larger investment should be adopted.
Method of Patterns in Comparing
Alternatives
• There are several methods for comparing
alternatives, but only six patterns will be
discussed.
▫ Rate of Return on Additional Investment
▫ Annual Cost Method
▫ Equivalent Uniform Annual Cost Method
▫ Present Worth Cost Method
▫ Capitalized Cost Method
▫ Payback (Payout) Period Method
The Rate of Return on Additional
Investment Method
• The formula for the rate of return on additional
investment is,

Rate of Return on Additional Investment

= annual net savings_
additional investment

• If the rate of return on additional investment is

satisfactory, then, the alternative requiring a bigger
investment is more economical and should be
chosen.
The Annual Cost (AC) Method
• To apply this method, the annual cost of the
alternatives including interest on investment is
determined. The alternative with the least
annual cost is chosen. This pattern, like the rate
of return on additional investment pattern,
applies only to alternatives which has a uniform
cost data for each year and a single investment
of capital at the beginning of the first year of the
project life.
The Equivalent Uniform Annual Cost
(EUAC) Method
• In this method, all cash flows (irregular or uniform)
must be converted to an equivalent uniform annual
cost, that is, a year-end amount which is the same
each year. The alternative with the least equivalent
uniform annual cost is preferred. When the EUAC
method is used, the equivalent uniform annual cost
of the alternatives must be calculated for one life
cycle only. This method is flexible and can be used
for any type of alternative selection problems. The
method is a modification of the annual cost pattern.
The Present Worth Cost (PWC)
Method
• In comparing alternative by this method,
determine the present worth of the net cash
outflows for each alternative for the same period
of time. The alternative with the least present
worth of cost is selected.
The Capitalized Method
• The capitalized cost method is a variation of the
present worth cost pattern. This method is used
for alternatives having long lives. To use the
method, determine the capitalized cost of all the
alternatives and choose that one with the least
capitalized cost.
Payback (Payout) Period Method
• To use this method, the payback of each
alternative is computed. The alternative with
the shortest payback period is adopted. This
method is seldom used.
Problem 5-1
• A company is considering two types of equipment for its
manufacturing plant. Pertinent data are as follows:
Type A Type B
First Cost 200,000 300,000
Annual operating cost 32,000 24,000
Annual labor cost 50,000 32,000
Insurance ad property taxes 3% 3%
Payroll taxes 4% 4%
Estimated life 10 10

• If the minimum required rate of return is 15%, which

equipment should be selected?
Solution
1. By the rate of return on additional investment
method
Type A
Annual costs:

Depreciation = 200,000 Birr = 200,000 = 9,850 Birr

F/A, 15%, 10 20.3037
Operation = 32,000
Labor = 50,000
Payroll taxes = (50,000)(0.04) = 2,000
Taxes & insurance = (200,000)(0.03) = 6,000
Total annual cost = 99,850 Birr
Type B Annual Costs:
Depreciation = 300,000 Birr = 300,000 = 14,776 Birr
F/A, 15%, 10 20.3037
Operation = 24,000
Labor = 32,000
Payroll taxes = (32,000)(0.04) =1,280
Taxes & insurance = (200,000)(0.03) = 9,000
Total annual cost = 81,056 Birr

Annual savings = 99,850 – 81,056 = 18,794 Birr

Additional investment = 300,000 – 200,000 = 100,000 Birr
Rate of return on additional investment = 18,794 x 100 = 18.79 > 15%
100,000
Type B should be selected (Ans.)
2. By the annual cost method
Type A
Annual costs:
Depreciation = 200,000 Birr = 200,000 = 9,850 Birr
F/A, 15%, 10 20.3037
Operation = 32,000
Labor = 50,000
Payroll taxes = (50,000)(0.04) = 2,000
Taxes & insurance = (200,000)(0.03) = 6,000
Interest on capital = (200,000)(0.15) = 30,000
Total annual cost = 129,850 Birr
Type B Annual costs:
Depreciation = 300,000 Birr = 300,000 = 14,776 Birr
F/A, 15%, 10 20.3037
Operation = 24,000
Labor = 32,000
Payroll taxes = (32,000)(0.04) = 1,280
Taxes & insurance = (300,000)(0.03) = 9,000
Interest on capital = (300,000)(0.15) = 45,000
Total annual cost = 126,056 Birr

Since ACB < ACA, type B should be selected (Ans.)

3. By the present worth cost method
Type A
Annual costs (excluding depreciation) = 32,000 + 50,000 +
(50,000)(0.04) + (200,000)(0.03) = 90,000 Birr

PWCA = 200,000 + 90,000 (P/A, 15%, 10)

= 200,000 + (90,000)(5.0188) = 651,692 Birr

Type B
Annual costs (excluding depreciation) = 24,000 + 32,000
+ (32,000)(0.04) + (300,000)(0.03) = 66,280 Birr

PWCB = 300,000 + 66,280 (P/A, 15%, 10)

= 300,000 + (66,280)(5.0188) = 632,646 Birr

Since PWCB < PWCA for the same period of time,

type B should be selected. (Ans.)
4. By the equivalent uniform annual
cost method

EUACA = 200,000(A/P, 15%, 10) + 90,000

= (200,000)(0.1993) + 90,000 = 129,860 Birr
EUACB = 300,000(A/P, 15%, 10) + 66,280
= (300,000)(0.1993) + 66,280 = 126,070 Birr

Since EUACB < EUACA, type B is more

economical. (Ans.)
Problem 5-2
• Choose from the two machines which is more
economical
Machine A Machine B
First cost 8,000 Birr 14,000 Birr
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

• Money is worth at least 16%.

Solution
Machine A
Annual costs:
Depreciation = _8,000 Birr_ = _8,000_ = 375 Birr
F/A, 16%, 10 21.3215
Operation = 3,000
Labor = 1,200
Taxes & insurance = (8,000)(0.03) = _240
Total annual cost = 4,815
Birr
Machine B Annual costs:
Depreciation = 12,000 Birr_= 12,000_ = 232 Birr
F/A, 16%, 10 51.6595
Operation = 2,400
Labor = 1,000
Taxes & insurance = (200,000)(0.03) = _420
Total annual cost = 4,052 Birr

Annual savings = 4,815 – 4,052 = 763 Birr

Additional investment = 14,000 – 8,000 = 6,000 Birr
ROR on additional investment = _763 x 100 = 12.72 < 16%
6,000
Machine A is more economical (Ans.)
2. By the annual cost method
Machine A
Annual costs:
Depreciation = _8,000 Birr_ = _8,000_ = 375 Birr
F/A, 16%, 10 21.3215
Operation = 3,000
Maintenance = 1,200
Taxes & insurance = (8,000)(0.03) = 240
Interest on capital = (8,000)(0.16) = 1,280
Total annual cost = 6,095
Birr
Machine B
Annual costs:
Depreciation = 12,000 Birr_ = 12,000_ = 232 Birr
F/A, 16%, 10 51.6595
Operation = 2,400
Maintenance = 1,000
Taxes & insurance = (14,000)(0.03) = 420
Interest on capital = (14,000)(0.16) = 2,240
Total annual cost = 6,292
Birr

Since ACA < ACB, Machine A is more economical.

(Ans.)
3. By the present worth cost method.
Use 30-year study period, which is the
least common multiple of 10 and 15
Machine A
Annual costs = 3,000 + 1,200 + (8,000)(0.03) = 4,440 Birr

PWCA = 8,000 + 4,440 (P/A, 16%, 30) + 8,000 (P/F, 16%, 10) +
8,000 (P/F, 16%, 20) = 37,652 Birr
Machine B
Annual costs = 2,400 + 1,000 + (14,000)(0.03) = 3,820 Birr

PWCB = 14,000 + 3,820 (P/A, 16%, 30) + 12,000 (P/F, 16%, 15) –
2,000 (P/F, 16%, 30) = 38,869 Birr

Machine A should be chosen, since PWCA < PWCB (Ans.)

4. By the equivalent uniform annual
cost method
Machine A

EUACA = 8,000(A/P, 16%, 10) + 4,440 = 6,095 Birr

Machine B

EUACB = 14,000(A/P, 16%, 15) +3,820 –

2,000 (A/F, 16%, 15) = 6,292 Birr

Machine A should be chosen, since EUACA < EUACB

(Ans.)
Problem 5-3
• A company is going to buy a new machine for manufacturing its
product. Four different machines are available. Cost, operating and
other expenses are as follows:
A B C D
First cost 24,000 30,000 49,600 52,000
Power per year 1,300 1,360 2,400 2,020
Labor per year 11,600 9,320 4,200 2,000
Maintenance per year 2,800 1,900 1,300 700
Taxes and insurance 3% 3% 3% 3%
Life, years 5 5 5 5

• Money is worth 17% before taxes to the company. Which machine

should be chosen?
Solution
1. By the annual cost method
Depreciation:
Machine A = __24,000 = 24,000 = 3,422 Birr
F/A, 17%, 5 7.0144

Machine B = 30,000 = 4,277 Birr

7.0144

Machine C = 49,600 = 7,071 Birr

7.0144

Machine D = 52,000 = 7,413 Birr

7.0144
Comparative Total Annual Cost for Four
Machines
A B C D
Power 1,300 1,360 2,400 2,020
Labor 11,600 9,320 4,200 2,00
Maintenance 2,800 1,900 1,300 700
Taxes and insurance (3%) 720 900 1,488 1,560
Depreciation 3,422 4,277 7,071 7,413
Interest on capital (17%) 3,422 4,277 7,071 7,413
Total annual cost 23,922 22,857 24,891 22,533

• The economical criterion is to choose that alternative with the

minimum annual cost, which is machine D. however, it should be
noted that machine B is very close, showing a total annual cost of
only 22,857 – 22,533 = 324 Birr more than machine D.(Ans)
2. By the rate or return on additional
investment method
A B C D

Power 1,300 1,360 2,400 2,020

Labor 11,600 9,320 4,200 2,00

Maintenance 2,800 1,900 1,300 700

Taxes and insurance (3%) 720 900 1,488 1,560

Depreciation 3,422 4,277 7,071 7,413

Total annual cost 19,842 17,757 16,459 13,693

Comparing Machine A with Machine B.

ROR on additional investment on B

= (100) = 34.75% > 17%

Machine B is economical than Machine A.

Comparing Machine B with Machine C.

ROR on additional investment on C

= (100) = 6.62% > 17%
Machine B is economical than Machine C

Comparing Machine B with Machine D.

ROR on additional investment on

D= (100) = 18.47% > 17%

Machine D is economical than Machine B,

choose Machine D.(Ans)
PROBLEM 5-4
• An untreated electric wooden pole that will last
10 years under certain soil condition costs
20,000 Birr. It a treated pole will last for 20
years, what is the maximum justifiable amount
that can be paid for the treated pole, if the
maximum justifiable amount that can be paid
for the treated pole, if the maximum return on
investment is 20%. Consider annual taxes and
insurance amount to be 1% of first cost.
SOLUTION
1. Let C = maximum amount that can be invested on the
treated pole.

Untreated Pole
Annual Costs:
Depreciation = __20,000___ = 20,000_ = 770
F/A, 20%, 10 25.9587
Taxes and insurance = (20,000)(0.01) = 200
Interest on capital = (20,000)(0.20) = 4,000
Total annual cost = 4,970
Treated Pole
Annual Costs:
Depreciation = ____C_____ = __C___ = 0.005356C
F/A, 20%, 10 25.9587
Taxes and insurance = (C)(0.01) = 0.01C
Interest on capital = (C)(0.20) =0.20C____
Total annual cost = 0.215356C

Equating annual cost,

0.215356C = 4,970 Birr
C = 23,078 Birr (Ans.)
Problem 5-5
• A company manufacturing acids, upon inspection of
the roofing of the plant, found out that it is badly
corroded form the acids fumes and would need to be
replaced. To try to get some more life out of the
roofing, the company consulted a roofing coating
contractor who presented the company with two
options. The first option is a coating that will cost
20,000 Birr which would extend the life of the
roofing for 3 years from the date of application, and
the second option will cost 30,000 and which would
extend the life of the roofing for 5 years from the
date of application. At what rate of return are the
two investments equal?
Solution
1. First Option

EUACA = 20,000(A/P,i%,3)
2. Second Option

• EUACB = 30,000(A/P,i%,5)
 For the two alternatives to be equally
economical, EUACA = EUACB
20,000(A/P,i%,3) = 30,000(A/P,i%,5)
A/P,i%,5 = 20,000
A/P,i%,3 30,000

1-(1+i)-3 = 0.6667
1-(1+i)-5
Try i=12%
1-(1.12)-3 = 0.6667
1-(1.12)-5

0.6662 = 0.6667

Rate of return = 12% (Ans.)

PROBLEM (5-6)
• The engineer of a medium scale industry was instructed to
prepare at least two plans which is to be considered by
management for the improvement of their operations. Plan
“A” calls for an initial investment of 200,000 Birr now with a
prospective salvage value of 20% of the first cost 20 years
hence. The operation and maintenance disbursements are
estimated to be 15,000 Birr a year and taxes will be 2% of first
cost. Plan “B” calls for an immediate investment of 140,000
and a second investment of 160,000 eight years later. The
operation and maintenance disbursements are estimated to
be 9,000 a year for the initial installation, and 8,000 a year
for the second installation. At the end of 20 years the salvage
value shall be 20% of the investments. Taxes will be 2% of the
first cost. If money is worth 12%, which plan would you
recommend?
Solution:
1. By the present worth cost method
Plan A
Annual cost = 15,000 + (2,000)(0.02) = 19,000 Birr
Salvage Value = (200,000)(0.20) = 40,000
PWCA = 200,000 + (19,000)(P/A,12%,20) –
(40,000)(P/F,12%,20)
= 337,771 Birr

Plan B:
Annual Costs = 9,000 + (140,000)(0.02)
= 11,800
Additional annual costs after 8 years = 8,000 +
(160,000)(0.02) = 11,200
Salvage Value = (140,000 + 160,000)(0.02)
= 60,000
PWCB = 140,000 + 11,800(P/A,12%,20) +
160,0009P/F,12%,8) +
11,200(P/A,12%,12)(P/F,12%,8)
- 60,000(P/F,12%,20) = 314,564 Birr

Plan B is more economical.

By the equivalent uniform annual cost
method
EUACC = 200,000(A/P,12%,20) + 19,000 –
40,000(A/F,12%,20) = 45,224 Birr
EUACB = 140,000(A/P,12%,20) + 11,800 +
160,000(P/F,12%,80(A/P,12%,20) +
11,200(F/A,12%,12)(A/F,12%,20)
- 60,000(A/F,12%,20) = 34,019 Birr

Plan B is more economical.

PROBLEM (5-7)
• The National Government is planning to construct a
bridge. At present a 4-lane bridge will be built, but is
expected that at a later date a second 4-lane bridge will
be added. If an 8-lane bridge is built now, it will cost
8,100,000 Birr. A single 4-lane bridge can be built now
for 5,500,000 Birr. It is estimated that a second 4-lane
bridge at a later date will cost 8,000,000 Birr. Annual
upkeep on each 4-lane bridge would be 91,500 Birr, and
for the 8-lane bridge would be 115,000 Birr. Money to
build will cost 12%. Assumes a 50-year functional life for
the project and determine the earliest time at which the
additional 4 lanes would be required to make it equally
economical to build the 8-lane bridge immediately.
Solution:
1. 8-lane bridge

PWC8 = 8,100,000 + 115,000(P/A,12%,50) = 9,055,000

2. 4-lane bridge

PWC4 = 5,500,000 + 91,500(P/A,12%,n0)+ 8,000,000(p/f,12%,n) +

183,000[(P/A,12%,(50-n)](P/F,12%,n)
When n = 10
= 5,500,000 + 91,500(P/A,12%,10) + 8,000,000(P/F,12%,10)
+ 183,000(P/A,12%,40)(P/F,12%,10)
= 9,070,000 Birr, 10 years
PROBLEM (5-8)
• A plant to provide the company’s present needs can be
constructed for 2,800,000 Birr with annual operating
disbursements of 600,000 Birr. It is expected that at the
end of 5 years the production requirements could be
doubled, which will necessitate the addition of an
extension costing 2,400,000 Birr. The disbursements
after 5 years will likewise double. A plan to provide the
entire expected capacity can be constructed for
4,000,000 and its operating disbursements will be
640,000 Birr when operating on half capacity (for the
first 5 years) and 900,000 Birr on full capacity. The
plants are predicted to have indeterminately long life.
The required rate of return is 20%. What would you
recommend?
Solution:
Deferred Expansion

Capitalized cost = 2,800,000 + 600(P/A,20%,5) +

2,400,00(P/F,20%,5) + 1,200,000(P/F,20%,5)
0.20
Capitalized cost = 7,722,444 Birr (Ans.)
The full-size plant should be constructed.
End of Chapter 5