Matakuliah: D0762 – Ekonomi Teknik Tahun: 2009 Selection Analysis Method Course Outline 9

Outline Mutually Exclusive Basic Concepts Method for Comparing Mutually Exclusive Alternatives Alternatives Selection Choice of MARR 2

Mutually Exclusive Engineering projects can be accomplished by more than one feasible design alternative Selection one of these alternatives excludes the choice of any of the others, the alternatives are called mutually exclusive. Sometimes alternatives may have different useful lives. 3

Basic Concepts For Comparing Develop the alternatives –The choice (decision) is among alternatives. The Alternatives need to be identified and then defined for subsequent analysis Focus on Differences –Only the differences in expected future outcomes among the alternatives are relevant to their comparison and should be considered in the decision Use a Consistent Viewpoint –The prospective outcomes of the alternatives, economic and other, should be consistently developed from a defined viewpoint Use a Common Unit of Measure –Using a common unit of measurement to enumerate as many of the prospective outcomes as possible will simplify the analysis of the alternatives 4

Basic Concepts For Comparing Consider All Relevant Criteria –Selection of a preferred alternative (decision making) requires the use of a criterion (or several criteria). The decision process should consider both the outcomes enumerated in the monetary unit and those expressed in some other unit of measurement or made explicit in a descriptive manner Make Risk and Uncertainty Explicit –Risk and uncertainty are inherent in estimating the future outcomes of the alternatives and should be recognized in their analysis and comparison Revisit Your Decision –Improved decision making result from an adaptive process; to the extent practicable, the initial projected outcomes of the selected alternative should be subsequently compared with actual result achieved. 5

Choosing Analysis Method We have now seen three major economic analysis techniques: 1.present worth analysis (PW analysis), 2.annual cash flow analysis (ACF analysis), 3.rate of return analysis (ROR analysis). Which method should be used for any particular problem? The following points are important: You must know the MARR to use PW analysis or ACF analysis. PW analysis and ACF are often simpler than ROR analysis. In some contexts, ROR is easiest to explain. In others, ACF analysis is easier to explain The company you work for may dictate the analysis method you must use. ROR analysis is most often used in industry. 6

7 Comparing Mutually Exclusive Alternatives Evaluation Period Type of AlternativesRecommended Method Series to evaluate Equal lives of alternativesRevenue or service Public Sector AW or PW B/C based on AW or PW Cash Flow Incremental Cash Flow Unequal lives of alternativesRevenue or service Public Sector AW B/C based on AW Cash Flow Incremental Cash Flow Study periodRevenue or service Public Sector AW or PW B/C based on AW or PW Updated Cash Flow Updated Incremental Cash Flow Long to infiniteRevenue or service Public Sector AW or PW B/C based on AW Cash Flow Incremental Cash Flow After choosing method, define interest rate best on evaluate method, show on next table

Evaluation Method for Selecting Alternatives 8 Evaluation Method Equivalence Relation Lives of Alternatives Time Periods for Analysis Series to Evaluate Rate of Return; Interest Rate Decision Guideline: Select* Present WorthPWEqualLivesCash flowMARR Numerically largest PW PWUnequalLCMCash flowMARR Numerically largest PW PWStudy period Updated cash flow MARR Numerically largest PW CCLong to infiniteInfinityCash flowMARR Numerically largest CC Future WorthFWSame as present worth for equal lives, unequal lives, and study period Numerically largest FW Annual WorthAWEqual Or unequal LivesCash flowMARR Numerically largest AW AWStudy period Updated cash flow MARR Numerically largest AW AWLong to infiniteInfinityCash flowMARR Numerically largest AW * Lowest equivalent cost or largest equivalent income

9 Evaluation Method Equivalence Relation Lives of Alternatives Time Periods for Analysis Series to Evaluate Rate of Return; Interest Rate Decision Guideline: Select* Rate of ReturnPW or AWEqualLives Incremental cash flow Find i*Last i*> MARR PW or AWUnequalLCM of pair Incremental cash flow Find i*Last i*> MARR AWUnequalLives Cash flow Find i*Last i*> MARR PW or AWStudy period Updated Incremental cash flow Find i*Last i*> MARR Benefit / CostPWEqual or Unequal LCM of pair Incremental cash flow Discount rate Last C > 1.0 AWEqual or Unequal Lives Incremental cash flow Discount rate Last C > 1.0 AW or PWLong to infiniteInfinity Incremental cash flow Discount rate Last C > 1.0 Evaluation Method for Selecting Alternatives * Lowest equivalent cost or largest equivalent income

Choice of MARR Or you can choose MARR based on: Choice of MARR when Project Financing is Known Choice of MARR when Project Financing is Unknown Choice of MARR under Capital Rationing 10

Choice of MARR when Project Financing is Known 11 When you find the Net present worth of the project, use cost of equity (i e ) as the discount rate. Explicit accounts For debt flows

Bina Nusantara Choice of MARR as a Function of Budget ProjectAOAO Cash Flow A1IRR 1-$10,000$12,00020% 2-10,00011, ,00011, ,00010, ,00010, ,00010,4004 Borrowing rate (k) = 10% Lending rate (r) = 6%

Bina Nusantara An Investment Opportunity Schedule $20,000$40,000$60,000 20%15%10%8%7% 4% Project 1 Project 2 Project 3 Project 4 Project 5 Project 6 Required capital budget Rate of return (%)

Bina Nusantara A Choice of MARR under Capital Rationing $20,000$40,000$60,000 20%15%10%8% 7% 4% Project 1 Project 2 Project 3 Project 4 Project 5Project 6 Required capital budget Rate of return (%) k = 10% r = 6% MARR Borrowing rate (k) = 10% Lending rate (r) = 6%

Bina Nusantara Capital Budgeting Evaluation of Multiple Investment Alternatives –Independent projects –Dependent projects Capital Budgeting Decisions with Limited Budgets

Bina Nusantara Independent Projects AlternativeDescriptionXaXa XbXb 1Reject A, Reject B00 2Accept A, Reject B10 3Reject A, Accept B01 4Accept A, Accept B11

Bina Nusantara Mutually Exclusive Projects Alternative(X A1, X A2 )(X B1,X B2 ) 1(0,0) 2(1,0)(0,0) 3(0,1)(0,0) 4 (1,0) 5(0,0)(0,1) 6(1,0) 7(0,1)(1,0) 8 (0,1) 9

Bina Nusantara Contingent Projects AlternativeXAXA XBXB XCXC

Bina Nusantara Four Energy Saving Projects under Budget Constraints (Budget Limit = $250,000) ProjectInvestmentAnnual O&M Cost Annual Savings (Energy) Annual Savings (Dollars) IRR 1$46,800$1,200151,000 kWh$11, % 2104,8501,050513,077 kWh40, % 3135,4801,3506,700,000 CF32, % 494, ,962 kWh30, %

Bina Nusantara Marginal Cost of Capital Schedule (MCC) and Investment Opportunity Schedule (OSC)

Bina Nusantara Optimal Capital Budget