Engineering Economics: Session 5
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 83
Page 1
Comparing Alternatives
• Projects are acceptable if:
– PW > 0 @ MARR
– AW > 0 @ MARR
– IRR > MARR
• What if you are considering multiple alternatives
which meet these criteria?
• How do you select among alternative projects?
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 84
Page 2
Ensuring Comparability
• Before comparing multiple options, consider
whether they are truly equivalent
• Attempt to monetize those factors which differ
• What about Useful Life?
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 85
Page 3
Tackling Alternatives with Different Useful Lives
• Study period (Planning Horizon) is the time
period over which alternatives are to be
compared
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 86
Page 4
Tackling Alternatives with Different Useful Lives
(cont)
• Decision Cases:
– Useful life of all alternatives = Study Period
• No adjustments required
– Useful life of at least one alternative ≠ Study
Period
• Repeatability
– The study period is either infinite or equal to a common
multiple of the useful lives of the alternatives
– The cash flows associated with the first useful life are
repeated throughout the study period
• Cotermination
– All alternatives are adjusted to reflect a common study
period
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 87
Page 5
Comparing Alternatives: Equivalent Worth
• If Useful Lives are equal to study period Æ
Alternative with greatest equivalent worth is
preferred
• Transitivity
– If PWA > PWB, then AWA > AWB
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 88
Page 6
Re-examining the Initial Example:
Where Should You Build? Far or Near
$
Where Should You Build?
Far or Near
BIG
DIG
$$$
Figure by MIT OCW.
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 89
Page 7
Example: Comparing Alternatives
MARR = 15%, Study Period = 120 Months
Cost
Cost to build @ site
Site A
Site B
$250,000
$750,000
Monthly Costs
Average Hauling Distance
10
3 miles
Hauling Expense
$5
$5 /mile
200
200 /month
Shipments
Monthly Cost
$10,000
Monthly Revenue
$20,000
Present Worth
$679k
$3,000
$20,000 /month
$614k
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technol
Technology
Department of Material
Materials Sci
Science & Engineeri
Engineering
Engineering Economic Analysis: Slide 90
Page 8
Near vs Far Cash Flows
$2,500
Near - Nominal
Aggregate Cash Flow
$2,000
Far - Nominal
$1,500
Near - PV
$1,000
Far - PV
$500
$0
($500)
0
20
40
60
80
100
120
($1,000)
Months
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 91
Page 9
Comparing Alternatives: IRR
• As for all alternatives, lower investment is
preferred, unless additional investment provides
sufficient returns
– Each increment of capital must produce a return >
MARR
– Select a higher investment only if the incremental
investment provides returns > MARR
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 92
Page 10
Comparing Alternatives IRR
•Do NOT compare the IRRs
of alternatives
•Only compare IRRs against MARR
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 93
Page 11
IRR Example 2 – Efficient Light Bulbs
• Are energy efficient light bulbs worth it?
• Bulb types
Incandescent
Expected
Lifetime
750
Lumens
585
Wattage
60
Purchase Cost
$0.50
Halogen
3,750
570
50
$3.25
Compact
Fluorescent
7,500
600
15
$13.50
Compact
Fluor2
7,500
600
14
$14.00
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technol
Technology
Department of Material
Materials Sci
Science & Engineeri
Engineering
Engineering Economic Analysis: Slide 94
Page 12
IRR Example 2 – Efficient Light Bulbs
Difference
CF-Incand
Difference
CF2-Incand
Year
Incandescent
Halogen
CF
CF2
Difference
Hal-Incand
0
$0.50
$3.25
$13.50
$15.00
-$2.75
-$13.00
-$14.50
1
$2.75
$1.88
$0.56
$0.53
$0.88
$2.19
$2.23
2
$2.75
$1.88
$0.56
$0.53
$0.88
$2.19
$2.23
3
$2.75
$1.88
$0.56
$0.53
$0.88
$2.19
$2.23
4
$2.75
$1.88
$0.56
$0.53
$0.88
$2.19
$2.23
5
$2.75
$5.13
$0.56
$0.53
-$2.38
$2.19
$2.23
6
$2.75
$1.88
$0.56
$0.53
$0.88
$2.19
$2.23
7
$2.75
$1.88
$0.56
$0.53
$0.88
$2.19
$2.23
8
$2.75
$1.88
$0.56
$0.53
$0.88
$2.19
$2.23
9
$2.75
$1.88
$0.56
$0.53
$0.88
$2.19
$2.23
10
$2.25
$1.88
$0.56
$0.53
$0.38
$1.69
$1.73
Assumptions: Usage = 750 hrs / year; Electricity = $0.10 / kWh; Study Period = 10 years
Massachusetts Institute of Technology
Department of Materials Science & Engineering
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Engineering Economic Analysis: Slide 95
Page 13
IRR Example – Efficient Light Bulbs, MARR = 5%
Net Cash Flows for
Compact Fluorescent
Net Cash Flows for
Compact Fluor2
$4
$4
$2.19 $2.19 $2.19 $2.19 $2.19 $2.19 $2.19 $2.19 $2.19
$2
$2.23 $2.23 $2.23 $2.23 $2.23 $2.23 $2.23 $2.23 $2.23
$1.69
$2
$1.73
$0
$0
0
1
2
3
4
5
6
7
8
9
10
0
1
2
3
4
5
6
7
8
9
10
($2)
($2)
($4)
($4)
($6)
($6)
($8)
($8)
($10)
($10)
($12)
($12)
($14)
($14)
$14.5
$13.0
($16)
Massachusetts Institute of Technology
Department of Materials Science & Engineering
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Engineering Economic Analysis: Slide 96
Page 14
IRR Example 2 – Efficient Light Bulbs
We found that PWCF>PWCF2
Also, IRRCF>IRRCF2
Does this mean that we always
prefer options with higher IRR?
Total Present Worth
$8
CF
$6
CF2
$4
IRR=10.5%
$2
$0
0%
($2)
5%
10%
15%
20%
IRR=8%
($4)
Discount Rate
Massachusetts Institute of Technology
Department of Materials Science & Engineering
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Engineering Economic Analysis: Slide 97
Page 15
IRR Ranking Does Not Always Match PW
Total Present Worth
$8
CF
$6
$4
CF2
$2
Halogen
10.5% 13.9%
$0
0%
($2)
5%
10%
15%
20%
IRR=8%
($4)
Discount Rate
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 98
Page 16
IRR Ranking Procedure
1) Rank acceptable (IRR>MARR) alternatives based on
investment
2) Find lowest investment acceptable (IRR>MARR)
alternative (Base Alternative)
3) Develop Incremental Cash Flow for Next Alternative
(i.e., in ranked list)
a) Next Alternative Cash Flow – Base Alternative Cash
Flow
4) Is Incremental Cash Flow acceptable (IRR>MARR)
a) If yes, this is new Base Alternative
b) If no, keep Base Alternative
5) Move to next alternative in ranked list and restart at 3
3.080 Econ & Enviro Issues In Materials Selection
Randolph Kirchain
Massachusetts Institute of Technology
Department of Materials Science & Engineering
Engineering Economic Analysis: Slide 99
Page 17