ENGINEERING

ECONOMY
COMPARING
ALTERNATIVES
Continuation...

Engr. Armando C. Emata PME3045

March 7, 2017
TOPIC OBJECTIVES:
 Comparison of alternatives by the Payout
(Payback) period
◦ Sample problem on the Payout Period method
 Solve more sample problems using the following
methods:
◦ Rate of Return
◦ Annual Cost (AC) Method
◦ Present Worth Cost (PWC) Method
◦ Equivalent Uniform Annual Cost (EUAC) Method
 Assignment for next meeting
COMPARISON OF ALTERNATIVES BY
THE PAYOUT PERIOD
 Although some people persist comparing alternatives by
the payout period method, it should be realized that in
many cases this procedure gives misleading or
erroneous results.
 This is the main reason why payback period method
should be avoided except as a supplement to analysis by
a correct method.
 If the life of each alternative is the same and the risks
are comparable, this method does rank the alternatives
relative to each other correctly.
COMPARISON OF ALTERNATIVES BY
THE PAYOUT PERIOD
 As might be expected, this very simple type of analysis is
apt to produce misleading results when it is applied to
more complex situations.
 Despite this fact, it is used frequently without a
realization that incorrect results may be obtained.
 For example, a recent study revealed that small
companies make rather extensive use of the payout
period method in comparing alternatives that have
different expected lives.
 The following example is a typical case.
 COMPARISON OF ALTERNATIVES BY
THE PAYOUT PERIOD
A B C
Required investments $5,000 $5,000 $6,000
Estimated useful life (L) 8 years 5 years 13 years
Available for payout (annual revenue
minus out-of-pocket costs) $2,250 $2,500 $3,000
Payout period = investment/available for
payout 2.2 years 2.0 years 2.0 years

 By this analysis, alternative B would undoubtedly be

selected since it has a shorter payout period than
alternative A and requires less capital than C.
 COMPARISON OF ALTERNATIVES BY
THE PAYOUT PERIOD
 If, however, the three alternatives are compared on the
basis of the rate of return, with proper consideration
given to the estimated lives, the results will be:
A B C
Required investments $2,250 $2,500 $3,000

Less Annual depreciation:

Investment (A/F, 8%, L) 470 853 414
Annual profit $1,780.00 $1,647.00 $2,586.00
E.R.R. = annual profit/investment 35 ½% 33% 43%

 By this analysis, alternative B is found to be the least

desirable of the three, and, if capital is available,
alternative C is more desirable than either A or B.
COMPARISON OF ALTERNATIVES BY
THE PAYOUT PERIOD
 The reasons for the extensive use of the payout period
method of analysis have been found to be as follows:
1. It is a very simple procedure.
2. No consideration of depreciation is required.
3. The company managers desired to recover capital as
soon as possible so they could use it to undertake other
projects.

 As shown by the example, there is no advantage in two

successive shorter lived alternatives that will each
produce a return of 30% when one longer lived
alternative will produce a 40% return.
COMPARISON OF ALTERNATIVES BY
THE PAYOUT PERIOD
 Therefore, inasmuch as the payout period method does
not take expected life into account, its use is not
recommended for comparing alternatives having
different lives.
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #1:
Choose from the two machines which is more
economical.

MACHINE A MACHINE B
First cost P8,000 P14,000
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

Money is worth at least 16%.

MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #1 cont’d:
Solution:
By the rate of return on additional investment method
MACHINE A
Annual costs:
P8,000 P8,000
Depreciation = ---------------- = ----------- = P 375
F/A, 16%, 10 21.3215

Operation = 3,000
Maintenance = 1,200
Taxes and insurance = (P8,000)(0.03) = 240
Total annual cost P 4,815
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #1 cont’d:
Solution cont’d:
MACHINE B
Annual costs:
P24,000 P24,000
Depreciation = ---------------- = ------------ = P 232
F/A, 16%, 15 51.6595

Operation = 2,400
Maintenance = 1,000
Taxes and insurance = (P24,000)(0.03) = 420
Total annual cost P 4,052
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #1 cont’d:
Solution cont’d:
Annual savings = P4,815 – P4,052 = P763
Additional investment = P14,000 – P8000 = P6,000

P763
Rate of return on additional investment = --------- x 100
P6,000

= 12.72%<16%
Machine A is more economical.
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #1 cont’d:
Solution cont’d:
By the Annual cost method
MACHINE A
Annual costs:
P8,000 P8,000
Depreciation = ---------------- = ----------- = P 375
F/A, 16%, 10 21.3215

Operation = 3,000
Maintenance = 1,200
Taxes and insurance = (P8,000)(0.03) = 240
Interest on capital = (P8000)(0.16) = 1,280
Total annual cost P 6,095
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #1 cont’d:
Solution cont’d:
MACHINE B
Annual costs:
P14,000 P14,000
Depreciation = ---------------- = ----------- = P 232
F/A, 16%, 15 51.6595

Operation = 2,400
Maintenance = 1,000
Taxes and insurance = (P14,000)(0.03) = 420
Interest on capital = (P14000)(0.16) = 2,240
Total annual cost P 6,292
Since ACA < ACB , Machine A is more economical.
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #1 cont’d:
Solution cont’d:
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 = P3,000 + P1,200 + (P8,000)(0.03) = P4,440
0 1 10 11 20 21 30

P4,440 P4,440 P4,440 P4,440 P4,440 P4,440

P8,000
P8,000 P8,000
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #1 cont’d:
Solution cont’d:
PWCA = P8,000 + P4,440(P/A,16%,30) + P8,000(P/F, 16%,10)
+ P8,000(P/F, 16%, 20)
= P37,652 P2,000
P2,000

0 1 15 16 30

P3,820 P3,820 P3,820 P3,820

P14,000
P14,000
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #1 cont’d:
Solution cont’d:
PWCB = P14000 + P3,820(P/A, 16%, 30) + P12,000
(P/F, 16%, 15) + P2,000(P/F, 16%, 30)
= P38,869

Machine A should be chosen since PWCA < PWCB .

MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #1 cont’d:
Solution cont’d:
By the equivalent uniform annual cost method
MACHINE A

0 1 2 10 0 1 2 10

P4,440 P4,440 P4,440 EUACA EUACA EUACA

P8,000

EUACA = P8,000(A/P, 16%, 10) + P4,440 = P6,095

MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #1 cont’d:
Solution cont’d:
P2,000
MACHINE B

0 1 2 15 0 1 2 15

P3,820 P3,820 P3,820 EUACB EUACB EUACB

P14,000

EUACB = P14,000(A/P, 16%, 15) + P3,820 – P2,000(A/F, 16%,

15) = P6,292
Machine A should be chosen since EUACA < EUACB
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #2:
A company manufacturing acids, upon inspection of the
roofing plant, found out that it is badly corroded from the
acid 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 P20,000 which
would extend the life of the roofing for 3 years from date of
application, the second option will cost P30,000 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?
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #2 cont’d:
Solution:
First option:

0 1 2 3 0 1 2 3

EUACA EUACA EUACA

P20,000

EUACA = P20,000 (A/P, i%, 3)

MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #2 cont’d:
Solution cont’d:
Second option:

0 1 2 5 0 1 2 5

EUACB EUACB EUACB

P30,000

EUACB = P30,000 (A/P, i%, 5)

MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #2 cont’d:
Solution cont’d:
For the two alternatives to be equally economical,
EUACA = EUACB
P20,000(A/P, i%, 3)= P30,000(A/P, i%, 5)

A/P, i%, 3 P20,000

-------------- = -------------
A/P, i%, 5 P30,000
1 – (1 + i)– 3
---------------
–5
= 0.667
1 – (1 + i)
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #2 cont’d:
Solution cont’d:
Try i = 12%

1 – (1 + 0.12)– 3
------------------- = 0.667
1 – (1 + 0.12)– 5

0.6662 = 0.667

Rate of return = 12%

MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #3:
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 P200,000 now with
a prospective salvage value of 20% of the first cost 20 years
hence. The operation and maintenance disbursements are
estimated to be P15,000 a year and taxes will be 2% of first
cost.
Plan “B” calls for an immediate investment of P140,000 and a
second investment of P160,000 eight years later. The
operation and maintenance disbursements will be P9,000 a
year for the initial installation and P8,000 a year for the
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #3 cont’d:
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:
By the present worth cost method
PLAN “A”
Annual costs = P15,000 + (P200,000)(0.20) = P19,000
Salvage value = (P200,000)(0.20) = P40,000
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #3 cont’d: P40,000
Solution cont’d:

0 1 2 3 20

P19,000 P19,000 P19,000 P19,000

P200,000

PWCA = P200,000 + (19,000)(P/A, 12%, 20) –

(40,000)(P/F, 12%, 20)
= P337,771
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #3 cont’d:
Solution cont’d:
PLAN “B”
Annual costs = P9,000 + (140,000)(0.02) = P11,800
Additional annual costs = P8,000 + (P160,000)(0.20)
after 8 years
= P11,200
Salvage value = (P140,000 + P160,000)(0.20)
= P60,000
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #3 cont’d:
Solution cont’d:
P60,000

0 1 2 8 9 20

P11,800 P11,800 P11,800 P11,800 P11,800

P140,000 P11,200 P11,200

P160,000
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #3 cont’d:
Solution cont’d:

PWCB = P140,000 + P11,800(P/A, 12%, 20) + P160,000

(P/F, 12%, 8) + P11,200(P/A, 12%, 12)(P/F, 12%, 8) –
P60,000(P/F, 12%, 20)
= P314, 564

Plan “B” is more economical.

MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #3 cont’d:
Solution cont’d:
By the equivalent uniform annual cost method
EUACA = P200,000(A/P, 12%, 20) + P19,000 –
P40,000(A/F, 12%, 20)
= P45,224
EUACB = P140,000(A/P, 12%, 20) + P11,800 +
P160,000(P/F, 12%, 8)(A/P, 12%, 20)
+ P11,200(F/A, 12%, 12)(A/F, 12%, 20)
– P60,000(A/F, 12%, 20)
= P34,019
Plan “B” is more economical.
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #4:
The national government is planning to construct a bridge. At
present, a 4-lane bridge will be built, but it 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 P8,100,000. A
single 4-lane bridge can be built now for P5,500,000. Annual
upkeep on each 4-lane bridge would be P91,500 and for the
8-lane bridge would be P115, 000. Money to build the bridge
will cost 12%.
Assume 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.
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #4 cont’d:
Solution:
8-lane bridge
0 1 2 50

P115,000 P115,000 P115,000

P8,100,000

PWC8 = P8,100,000 + P115,000(P/A, 12%, 50)

= P9,055,000
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #4 cont’d:
Solution cont’d:
4-lane bridge
0 1 2 n n+ 1 50

P91,500 P91,500 P91,500

P183,000 P183,000
P5,500,000
P8,000,000

PWC = P5,500,000 + P91,500(P/A, 12%, n)

P8,000,000(P/f, 12%, n) + P183,000
[P/A, 12%, (50 – n)](P/F, 12%, n)
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #4 cont’d:
Solution cont’d:

When n = 10

= P5,500,000 + P91,500(P/A, 12%, 10) + P8,000,000

(P/F, 12%, 10) + P183,000(P/A, 12%, 40)(P/F, 12%, 10)
= P9,079,000

They’ll be equally economical in 10 years.

MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #5:
A plant to provide the company’s present needs can be
constructed for P2,800,000 with annual operating
disbursements of P600,000. It is expected that at the end of
5 years the production requirement could be doubled, which
will necessitate the addition of an extension costing
P2,400,000.The disbursements after 5 years will likewise
double. A plan to provide the entire expected capacity can be
constructed for P4,000,000 and its operating disbursements
will be P640,000 when operating on half capacity (for the
first 5 years) and P900,000 on full capacity. The plants are
predicted to have indeterminately long life. The required rate
of return is 20%. What would you recommend?
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #5 cont’d:
Solution cont’d:
Deferred expansion
0 1 2 3 4 5 6 7

P600K P600K P600K P600K P600K

P1.200M P1.200M
P2,800,000
P2,400,000
Capitalized cost = P2,800,000 + P600,000(P/A, 20%, 5) +

P1,200,000 (P/F, 20%, 5)

P2,400,000(P/F, 20%, 5) + -----------------
0.20
= P7,970,152
MORE SAMPLE PROBLEMS ON BASIC
METHODS
 PROBLEM #5 cont’d:
Solution cont’d:
Full-size Plant
0 1 2 3 4 5 6 7

P640K P640K P640K P640K P640K

P900K P900K

P4,000,000
P900,000
Capitalized cost = P4,000,000 + P640,000(P/A, 20%, 5) + -------------
0.20
(P/F, 20%, 5)
= PHP7,722,444
The full-size plant should be constructed.
Assignment – March 9, 2017
 For next meeting, submit in one sheet of bond paper.Write your name,
subject/section, date and write the problem statement. Please write legibly.
Non-compliance will mean non-acceptance of your assignment.
1. A cable television company must purchase a new truck,
equipped with a hydraulic crane which will carry a
workman up to a height of 10 meters. Bids for three types
of equipment have been received. The required investment
and the estimated out-of-pocket disbursements for the first
year are as follows:
A B C
Investment $7,500 $10,000 $14,500
Out-of-pocket costs $4,500 $4,000 $2,500

Continued next page >>>

Assignment – March 9, 2017
 For next meeting, submit in one sheet of bond paper.Write your name,
subject/section, date and write the problem statement. Please write legibly.
Non-compliance will mean non-acceptance of your assignment.

The company believes that the out-of-pocket

disbursements each year will be 10% more than for the
previous year. It wants a write-off period of not over 5
years to be used on such equipment and a before-tax
return of at least 15% on its capital.
Which type of equipment should be purchased? Assume
$1,000 salvage value for each type of equipment.