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**Incremental Rate of Return Analysis
**

Elements in Incremental Analysis

Choosing an Analysis Method

1

13} And have: A=B+C Higher-cost alternative = lower-cost alternative + difference In this chapter. we saw if we had projects A and B with CFD’s: saw. we will expand our analysis to include three or more alternatives The approach is called incremental analysis. 2 . CFD s: A = {-20. There. we could define: C = A – B = {{-10. B = {-10. alternatives.28}.15}. Incremental analysis can be examined either graphically or numerically. The incremental solution presented in chapter 7 was limited to two alternatives.13} 10.I Incremental l Analysis A l i Incremental analysis was presented earlier in chapter 7 and was defined as the examination of the differences between alternatives. analysis and builds on the analysis performed in Chapter 7.

26.15}. as points in the PWC-PWB graph 3 . we could define: C = A – B = {-10. i=6% calculate corresponding PWC and PWB for alternative and then we can plot Alt.14.13} We first consider a graphical approach to incremental analysis. A = (20. B = {-10. For a given i=6%.Incremental Analysis Using Graphical approach Again.42). consider projects A and B with CFD’s: A = {-20.15).28}. Alt. B = (10.

B PWC=PWB NPW = 0 PWC 4 . plotted B = {-10. plotted as (10. A p as ((20.15) Alt.42)) A = {{-20.Incremental c e e a Analysis a ys s Us Using g Graphical G ap ca app approach oac PWB Alt. 14.15} .28}} . 26.

(i e NPW = 0) divides the graph into areas of desirable and undesirable alternatives. ► At the chosen interest rate. ► An A alternative l i plotted l d below b l the h line li is i undesirable d i bl since i its i PW off benefits is less than its PW of costs (negative NPW). alternatives ► Note that the line will be a 45o line if the vertical and horizontal scales are identical.Incremental Analysis Using Graphical approach ►This graph is called the benefit-cost graph. ► An alternative plotted above the line is desirable since its PW of benefits exceeds its PW of costs (positive NPW).e. 5 . rate the line at which PWB = PWC (i.

{20 28} its IRR is 40%. 40% 6 .15} Since Alt. B = ((20. Suppose we construct a line L from the origin through point Alt.28}. A PWC=PWB NPW = 0 Alt B Alt.Incremental Analysis y Using g Graphical p approach pp L A = {-20.06)= =26. PWC 20 We can associate the line L with all one-year projects h i a CFD with having ith an IRR off 40%. B = {-10. 26. Alt A has CFD2 = {20.28}. PWB 28/(1+0.42 Alt.321.42). ) the p Note L has slope m = 1..

let (PWC.321 1 321 PWC. Thus (0. This means PWB/PWC = 1. This means the CFS {{-x.PWB) is PWB/PWC = 1. so b = 1. b) Conversely.4). ) This means PWC = a. Let {-a.4 a. Alt.9434)b (0 9434)b = (0.(a).Incremental Analysis a) If {-a.06). PWB = (0. so PWB = 1.y} for this alternative has an IRR of 40%.PWB). b} be the CFD resulting in ((PWC.PWB) lying on the line L are the ones whose CFD’s generate a 40% IRR.y} x.06 0 06 )-1 b = (0.4)(PWC) = (1. and PWB = (1+i )-1 b = (1+ 0. PWC Thus the slope of the line joining the origin and (PWC.PWB) lies on the line L.321 a. PWC = a. Conclusion.321. 2 has IRR = 40%.9434) b = b/(1. b} is any CFD with an IRR of 40%.321 PWC. The projects with points (PWC. In particular.4 4 a) = 1. 7 .9434) (0 9434) (1 (1.9434) b = 1.321 1 321 a = 1. PWB) lies on the line L.321. Thus (PWC. since the IRR = 40% ►► b = (1.

The projects with their (PWC. B it would correspond to the projects whose CFS’s generate a 50% IRR. L40% PWB Alt. Al B.L50% Incremental Analysis A = {-20. B L6% PWC=PWB NPW = 0 PWC Summary The projects with their (PWC (PWC. B had IRR = 50%. The projects with their (PWC.28}.PWB) lying on the 40% line L40% are the ones that have CFD’s with a 40% IRR IRR. A Alt. 8 .PWB) lying on the line NPW = 0 are the ones that have CFD’s with a 6% IRR.PWB) PWB) lying on the 50% line L50% are the ones that have CFD’s with a 50% IRR.15} Recall Alt. If we plot a line L50% from the origin through h h the h point i for f Alt. B = {-10.

06)=14.26.) From earlier incremental analysis. since its slope is greater than that of the 6% line.Incremental Analysis PWB Alt A Alt. 1 just by observing that the slope of the line segment S is greater t th than th the slope l off th the 6% li line.42 A = {-20. 9 .06)=26. 2 – Alt.27 PWC=PWB NPW = 0 Alt. NPW = 0.15} 15} On the p plot: A = (20.15 PWC 10 Difference = Alt. we know that Alt. we could discover that S has the same slope as a 30% line.14. We can thus conclude that Alt. 1 if the incremental rate of return exceeds the MARR. 2 is preferable to Alt. In this case. 2 is preferable to Alt.42). 28/(1+0. 30% > 6%.28}. Thus the difference alternative has an incremental rate of return of more than 6%. (Indeed.15) L 30% line 12 27 12. 20 10 6% line We know that the slopes of lines correspond to the IRR’s of CFS’s of alternatives. S represents a “difference” alternative. B = {{-10 10. 1 = (10. 12. B = (10.27). and has a slope corresponding to an IRR of more than 6%. B 15/(1+0.

A Initial cost $2000 Uniform annual benefit 410 B C $4000 $5000 639 700 Which Project should you choose? Table 2 A $2000 410 $4703 $2703 Initial cost UAB PW of benefits NPW PW of benefits = (UAB)(P/A. 6% line PWC 10 . The project with the greatest NPW is thus the one with the longest line dropped from it to the 45-degree line. with no salvage value. MARR = 6%.Example p 8-3 Three alternatives ranked in order of increasing cost. B is the best (the ( last line in table 2)) PWB B B $4000 639 $7329 $3329 C $5000 700 $8029 $3029 C A Conclusion. all have a 20-year life.470) NPW analysis y shows that Alt.20) = UAB (11. Each line length from an Alternative point to the 45-degree 45 degree line is the NPW of the Alternative Alternative.6%.

If one or more alternatives has a ROR at least as l large as the h MARR. choose Y. and the next alternative from the list created in step 3. Proceed with another two-alternative comparison. 11 . including the do-nothing alternative. If not. Arrange the remaining alternatives in ascending order of investment.Incremental Analysis Using Numerical Approach 1. Each difference we analyze should be a higher-cost alternative minus a lower-cost alternative. Be sure all the alternatives are identified. If not. choose X. (Optional) Compute the IRR for each alternative. 4. it is unacceptable. then h we can discard di d those h with i h ROR < MARR. Make a two-alternative analysis of the first two alternatives. Incremental Analysis With Unlimited Alternatives. If ROR MARR. 3. 5. Alternatives ►► We will skip this section section. identified Note: What if two alternatives have the same cost? This anomalous situation can occur in step 4. X) + (Y-X) Compute ROR for (Y-X). the increment of investment. 6. the criterion is If ROR MARR. Continue until all alternatives have been examined and the best of the multiple alternatives has been identified. Y) = (Lower-cost Alt. ►► Choose the one so that the difference represents an increment of investment (check example 7-9) In situations where an increment of borrowing is examined. 2. the increment is acceptable. Reject the alternative not chosen Take the preferred alternative from step 4. (Higher-cost Alt. We must have all the mutually exclusive alternatives tabulated.

Example p 8-4 Use the same data as in example 8-3 except that alternative A has a UAB of $122 instead of $410. A Initial cost $2000 Uniform annual benefit 122 B C $4000 $5000 639 700 Which Project j should you y choose? 12 .

A Initial cost $2000 Uniform annual benefit 410 B C $4000 $5000 639 700 13 .Example p 8-6 Use the incremental rate of return to solve example 8-3 mathematically.

A Initial cost $2000 Uniform annual benefit 122 B C $4000 $5000 639 700 14 .Example p 8-7 Use the incremental rate of return to solve example 8-4 mathematically.

8-8 in your text) A B C D E Cost $4000 $2000 $6000 $1000 $9000 UAB $639 $410 $761 $117 $785 Rate of return 15% 20% 11% 10% 6% PWB (calculated from line 2) $7330 $4700 $8730 $1340 $9000 NPV ((to check)) 3330 2700 1730 340 0 15 .Example p 8-8 The following five alternatives have 20-year useful life. Which alternative should be selected using the incremental rate of return analysis? a)) Mathematically h i ll b) Graphically (solution in Fig.

16 .

PW analysis and ACF are often simpler than ROR analysis analysis. In some contexts. In others. ROR is easiest to explain. ROR analysis is most often used in industry. annual cash flow analysis (ACF analysis). 2. ACF analysis is easier to explain Th company you workk for The f may dictate di the h analysis l i method h d you must use. 17 . 3. rate of return analysis (ROR analysis).Choosing an Analysis Method We have now seen three major economic analysis techniques: 1. 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. present worth analysis (PW analysis).

3. Important steps in incremental ROR analysis 1. 18 . Arrange remaining alternatives in ascending order of investment. Alternatives with ROR < MARR can be immediately rejected.Chapter Summary (mathematical approach) A benefit-cost graph (PW of benefits vs. 2. PW of cost) can help with incremental analysis to choose between alternatives. Check to see all alternatives are identified. M k a ttwo-alternative lt ti analysis l i for f the th first fi t two t alternatives. lt ti 5. ((Optional) p ) Compute p the RR for each alternative. Take the preferred alternative from Step 4. 4 Make 4. Proceed with another two-alternative comparison. and the next alternative from the list in Stepp 3.

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