Rate of Return Analysis: Multiple Alternatives Multiple Alternatives

Copyright © Professor Deok-Joo Lee(Kyunghee University, Korea), Permission required for reproduction or display.
CHAPTER VIII
Rate of Return Analysis:

Multiple Alternatives
Engineering Economics (KHU, 2011) 1

Section
S ti 8.1
81
Why Incremental Analysis?

Why Incremental Analysis Is

Necessary
• Assume we have two or more mutually

exclusive alternatives
• Objective:
j Which,, if any
y of the
alternatives is preferred?
• Prior Chapters: Use the PW or AW
approach
• This chapter: We apply the ROR approach

Si
Simple
l Example
E l 1
A B
Investment 10 100
Return 13 110
ROR 30% 10%
PV
2.28 4.76
(MARR=5%)

Si
Simple
l Example
E l 2

R ki
Ranking I
Inconsistency
i t
• For
F some problems,
bl PW and d ROR may
rank the same problems differently. Why?
-> Difference in the amount of (initial)
investment
•Need to analyze whether the incremental
(o e
(or extra)
t a) in
investment
estment is wotrhwhile?
ot h hile?
-> Incremental analysis
y !

Sect o 8
Section 8.2/8.3
/8 3
Incremental ROR Analysis

Incremental cash flow

• Given two or more alternatives
• Select the first investment to be the one
with
i h the
h lowest
l time
i t = 0 investment
i
amount.
• The next investment is to be the one with
the largest investment at time t = 0 and so
on
• Summarize
S i the
h iinvestments in
i a tabular
b l
format

Incremental cash flow
A B (
(B-A)
)
Lowest Next
The
First Highest first
Cost Cost = Incremental
Cash flows
investment investment

Incremenatal C.F. ((Tabular Format))
t Alt A
Alt. Alt B
Alt. B-A
0 $ $
1 $ $
2 $ $
… … …
Incremenatal cash
N $ flows
fl $
(B – A)

Is It Worth?
• Now the question is….

• Is it worth spending an additional
Investmant to move from investment A to
investment B?
• Answer: Compute the ROR (or PW) of the
incremental investment to see!

Incremenatal ROR
t Alt A
Alt. Alt B
Alt. B-A
0 $ $
1 $ $
2 $ $
… … …
Find the ROR of this
N (hypothetic)
$ investment
$
which is (B – A)

Interpretations of incremental ROR
• The ii*incremental
i l is the ROR of the additional
or incremental investment required to
move from
f one projectj to the
h next most-
costly project.
• If the i*incremental value is > MARR, the

increment is worth it. Go with to higher
investment cash flow.
• Otherwise, stay with lower investment

Interpretations of incremental ROR
• Given two mutually exclusive alternatives,

A and B.
• The i* (B A) value also represents the

(B-A)
interest rate at which the two alternatives
are economically equivalent.(called
equivalent (called the
break-even rate)

Before the incremental ROR analysis
• If Cost-Revenue Problem…
• Calculate the computed i*
i*’s
s for each
alternative in the set.
• Discard those alternatives whose i* value
is less than the MARR – they would lose
anyway!
• Do not apply the ROR analysis for Cost
Problem!

Independent Projects case
• If dealing with independent projects, one

does not have to compute
p incremental
investments among the candidate projects
• Rule: Accept all projects whose ROR>MARR
and stay within any budget limitations

Example
MARR 5%
MARR=5%
A B B-A
0 -10 -100
year
1 13 110
ROR

Example
• Incremental ROR analysis, Mutually Exclusive

• Alternative 1: Initial cost $1,000, Revenue $200/year, 7 Years
• Alternative 2: Initial cost $1,800,
$1 800 Revenue $350/year,
$350/year 7 Years
• No salvage value, MARR = 8%

Section
S ti 8.6
86
Incremental ROR Analysis with
Multiple, Mutually Excusive
Alternatives

Procedure
ocedu e
1. Order the alternatives from smallest to

largest
g initial investment.
2. Compute the cash flows for each
alternative (assume or create equal
lives).
3. If the alternatives are revenue-cost
alternatives do the following…

Procedure
ocedu e
4. Compute the i* value for all alternatives

in the considered set.
• If any alternative has an i* < MARR,
drop it from further consideration
• The candidate set will be those
alternatives with computed i* values >
MARR.
• Call this the FEASIBLE set

Procedure
ocedu e
• Calculate i* for the first alternative

• The first alternative is called the
DEFENDER
• The second (next higher investment
cost) alternative is called the
CHALLENGER
• Compute the incremental cash flow as
(Challenger – Defender)

Procedure
ocedu e
5. Compute i*Challenger – Defender
• Iff i*Challenger – Defender > MARR, drop

d the
h
defender and the challenger wins the
current round.
• If i* Challenger – Defender < MARR, drop the

g and the defender moves on to
challenger
the next comparison round

Procedure
ocedu e
• At each round, a winner is determined

• Either be the current Defender or the
current challenger
• The winner of a given round moves to
the next round and becomes the current
DEFENDER and is compared to the next
challenger

Procedure
ocedu e
6. This process continues until there are

no more challengers
g remaining.
g
• The alternative that remains after all
alternatives have been evaluated is the
final winner.

Example
MARR 7% n=10
MARR=7%, 10 years, Mutually
M t ll exclusive
l i
Alt. A B C D
Initial cost 3,000 2,000 5,000 4,000
Annual income 447 259 885 651
ROR

Example

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Rate of Return Analysis:

Engineering Economics (KHU, 2011) 1

Engineering Economics (KHU, 2011) 2

Why Incremental Analysis Is

• Assume we have two or more mutually

Engineering Economics (KHU, 2011) 3

ROR 30% 10%

Engineering Economics (KHU, 2011) 4

Engineering Economics (KHU, 2011) 5

Engineering Economics (KHU, 2011) 6

Engineering Economics (KHU, 2011) 7

Incremental cash flow

Engineering Economics (KHU, 2011) 8

Incremental cash flow

Engineering Economics (KHU, 2011) 9

Incremenatal C.F. ((Tabular Format))

Engineering Economics (KHU, 2011) 10

• Now the question is….

Engineering Economics (KHU, 2011) 11

Engineering Economics (KHU, 2011) 12

Interpretations of incremental ROR

• If the i*incremental value is > MARR, the

• Otherwise, stay with lower investment

Engineering Economics (KHU, 2011) 13

Interpretations of incremental ROR

• Given two mutually exclusive alternatives,

• The i* (B A) value also represents the

Engineering Economics (KHU, 2011) 14

Before the incremental ROR analysis

Engineering Economics (KHU, 2011) 15

Independent Projects case

• If dealing with independent projects, one

Engineering Economics (KHU, 2011) 16

Engineering Economics (KHU, 2011) 17

• Incremental ROR analysis, Mutually Exclusive

Engineering Economics (KHU, 2011) 18

Engineering Economics (KHU, 2011) 19

1. Order the alternatives from smallest to

Engineering Economics (KHU, 2011) 20

4. Compute the i* value for all alternatives

Engineering Economics (KHU, 2011) 21

• Calculate i* for the first alternative

Engineering Economics (KHU, 2011) 22

5. Compute i*Challenger – Defender

• Iff i*Challenger – Defender > MARR, drop

• If i* Challenger – Defender < MARR, drop the

Engineering Economics (KHU, 2011) 23

• At each round, a winner is determined

Engineering Economics (KHU, 2011) 24

6. This process continues until there are

Engineering Economics (KHU, 2011) 25

Initial cost 3,000 2,000 5,000 4,000

Annual income 447 259 885 651

Engineering Economics (KHU, 2011) 26

Engineering Economics (KHU, 2011) 27

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