Assignment EGR2302 - Ch08 PDF

Chapter 8:
Rate of Return Analysis: Multiple

Alternatives
Session 24, 25
Dr Abdelaziz Berrado
EGR2302-Engineering Economics 1
Al Akhawayn University
Topics to Be Covered in Today’s Lecture
Section8.1: Why Incremental Analysis is

Necessary?
Section8.2: Calculation of Incremental Cash Flows
For Analysis
Section8.3: Interpretation of Rate of Return on the
Extra Investment
Section8.4: ROR Evaluation by PW: Incremental
and Breakeven
Section8.5: ROR Evaluation Using AW
Section8.6: Incremental Analysis for the Analysis
of Multiple Alternatives
Section 8.1: Why Incremental Analysis
is Necessary?
• Assume we have two or more mutually
exclusive alternatives
•Objective: Which, if any of the alternatives is
preferred?
•Prior Chapters: Use the PW or AW approach
•This chapter: We apply the ROR approach
•Present Worth: Equal service lives must apply
8.1 Ranking Inconsistency
• For some problems, PW and ROR may rank the

same problems differently. Why?
•PW assumes reinvestment at the MARR or
discount rate.
•ROR assumes reinvestment at the i* or i’ rate
•Two different reinvestment rate assumptions
apply
8.1 An Example – Shows Ranking
Inconsistency Problem
•Two Investments A and B

•Discount rate = 10%
•Each investment requires $100 at t = 0
•A is a 1-year investment
•B is a 5- year investment
8.1 Two Projects; A and B
•A $120
0 1 2 3 4 5
$100
$201.14
•B
0 1 2 3 4 5
$100
8.1 Example Problem
• i*A = 0.20 = 20% •Using ROR, A is superior

to B
• i*B = 0.15 = 15%
•Using PW, B is superior
•PWA(10%) = +$9.09 to A
•Inconsistent Rankings!
•PBB(10%) = +24.89
• Using ROR Ranking
•A is superior to B (20% > 15%)
•Using a PW(10%) approach
•B is superior to A ($24.89 > $9.09)
•The two methods do not rank the same?
8.1 Look at A and assume Reinvestment
forward to t = 5
• Reinvest the $120 out to t = 5
$120
0 1 2 3 4 5
$100
•Assume the +$120 can be reinvested forward at the

firm’s MARR rate of 10%/year out to the end of year 5.
8.1 Look at A and assume Reinvestment
forward to t = 5
F5 = ?
• Find F5 for Alt. A
$120
0 1 2 3 4 5
$100
•F5 = 120(F/P,10%,4)=$175.69
8.1 ROR of A given reinvestment
• -100 +120(F/P,10%,4)(P/F,i*A,5) = 0
•Solving for i*A
•(P/F, i*A,5) = 0.569
• i*A/reinvestment @10% = 0.1193
•i*A/c=10% = 11.93%
8.1 Now Compare A to B
• Compare revised A with reinvestment at 10% to B
•i*A/C=10% = 11.93%
•i*B = 15% as before
•ROR Rankings:
•B is superior to A (15% > 11.93%)
•Now, PW(10%) and ROR with the reinvestment imposed

on the 1-year project rank consistently.
•B is superior to A with both methods
8.1 Ranking Inconsistency…
• Occurs between ROR and PW because
•Both methods have different reinvestment
rate assumptions
•Two different cash flows may not generate
funds at the same rate
Section 8.2: ROR for Mutually
Exclusive Projects
•Given Two or more alternatives
•Rank the investments based upon their initial
time t = 0 investment requirements
•Summarize the investments in a tabular format
8.2 Tabular Format
t Alt. A Alt. B B-A
0 $ $
1 $ $
2 $ $
… … …
Find the ROR of this
N $
investment $ is
which
(B – A)
8.2 Ranking Rules
• Given two or more Mutually Exclusive
investments
•Select the first investment to be the one with the
lowest time t = 0 investment amount.
•The next investment is to be the one with the
largest investment at time t = 0
8.2 Example
• Two Investments: A and B
• A costs $30,000 at time t = 0
• B costs $50,000 at time t = 0
•MARR = 10%
•Life is 4 years
8.2 Example: A and B
• For this problem, A
is superior to B based
on PW and on ROR!
•A is ranked first;
•B is ranked second
•Both alternatives have
a PW > 0 and have i*’s
> MARR.
•Both are feasible
alternatives initially.
8.2 Form the Difference (B – A)
• For mutually exclusive alternatives…
•One should focus on the differences between the
alternatives
•“Differences” are illustrated best by forming
what is called the incremental investment (B-A)
8.2 Incremental Investment
A B (B-A)
Find the
ROR of this
investment
Lowest Next
The
First Highest first
Cost Cost = Incremental
investment
investment investment
8.2 Incremental Investment
B-A
The incremental Investment
8.2 The logic….
• One would go with investment A initially

because it is the least expensive alternative at
time t = 0
•And it’s present worth is > 0.
•So, A is a feasible alternative to start
8.2 Explaining the Incremental Investment
B-A
• Now, is it worth it to the firm to consider

investing (-$50,000 – (-$30,000) =
-$20,000 to get the cash flows indicated in the
(B-A) cash flow series?
8.2 Explaining….continued
A B (B-A)
The investment (B-A) represents the year-by-year

difference between A and B
(B-A) is “additional” investment to move from

investing in A and moving on to invest in B.
8.2 The Incremental Investment
• Investing $20,000 at time t = 0 results in the
following incremental investment
8.2 Is it worth it?
• Now the question is….
•Is it worth spending an additional $20,000 to
move from investment A to investment B?
•Answer: Compute the ROR or PW of the
incremental investment to see!
8.2 Analysis
• For this problem, NPV(10%) < 0
• and, no ROR could be found!
•The incremental investment shows a negative PW and no

ROR is found
•Thus, the increment is rejected.
•Moving from A to B is not economically worth it
•Stay with A!
8.2 Another Example
•Cash Flows are shown on the next slide
• Two alternatives
•Semiautomatic machine vs.
•Automatic machine
•Assume a 6 year life for analysis
8.2 Example
Year SemiAuto Auto (B-A)
A B
0 -$40,000 -$90,000 -$50,000
1 -100,000 -85,000 15,000
2 -100,000 -85,000 15,000
3 -135,000 -85,000 50,000
4 -100,000 -85,000 15,000
5 -100,000 -85,000 15,000
6 -95,000 -74,000 21,000
8.2 Analysis
• Computed PW @
18% shows that B
has the lowest PW
cost and would be
preferred to A
8.2 Incremental
(B-A)
Cash Flow
•Question?
0 -$50,000 •Is it worth spending an
additional $50,000 in the
1 15,000
automatic machine in order to
2 15,000 receive the incremental savings
shown to the left?
3 50,000
•Compute the ROR of the
4 15,000 incremental Cash Flow
5 15,000
6 21,000
8.2 Incremental ROR = 35.95%
8.2: NPV Plot of A and B
• A is equivalent to B @ Incremental ROR rate of
35.95%
NPV PLOT-INC. C.F.
0.00
00
10
20
30
40
50
60
70
80
90
00
10
20
30
40
50
60
70
80
90
00
0.
0.
0.
0.
0.
0.
0.
0.
0.
0.
1.
1.
1.
1.
1.
1.
1.
1.
1.
1.
2.
-100000.00
-200000.00
-300000.00
NPV(i%)
-400000.00
-500000.00
-600000.00
-700000.00
-800000.00
Disc. Rates
8.2: i* (B-A) = 35.95%
• The incremental i*(B-A) is greater than the firm’s
discount rate of 18%
•Since i*(B-A) > MARR, accept the increment and

go with Alternative B.
•Same results as PW(18%) shows
•B is clearly the winner
Section 8.3 Interpretations of ROR
• The i*incremental is the ROR of the additional or
incremental investment required to move from
one project to the next most costly project
•If the i*incremental value is < MARR the increment

is not worth it. Go with to lower investment cash
flow
8.3 Multiple Alternatives
• If Cost-Revenue Problem…
•Calculate the computed i*’s for each alternative
in the set
•Discard those alternatives whose i* value is less
than the MARR – they would lose anyway!
8.3 Independent Projects
• If dealing with independent projects, one
does not compute incremental investments
among the candidate projects
•Rule: Accept all projects whose ROR > MARR
and stay within any budget limitations
8.3 The i* (B-A) value
• Given two mutually exclusive alternatives,
A and B.
•The i* value also represents the

(B-A)
interest rate at which the two alternatives
are economically equivalent.
8.4 ROR Using PW: Incremental
and Breakeven– Mutually Exclusive Case
• Selection between multiple mutually
exclusive alternatives by the IROR method.
•If unequal lives – either establish a
common project life or,
•Apply the LCM of life approach found in
chapter 5
8.4 PW Approach – Mutually
Exclusive Case
• Order (rank) the alternatives by their

initial time t = 0 investment cost
• Start with the smaller investment
alternative – refer to it as “A”
•The next highest investment cost is called
“B”
8.4 PW Approach – Mutually
Exclusive Case
• Compute the incremental cash flow (B-A)
• Given the MARR find the PW of (B-A)
investment
• If PW(MARR) of (B-A) is >0; accept the
increment – go with the higher investment
cost alternative.
•Else, reject the increment and go with the
lower investment cost option
8.4 ROR Case – Unique i* (B-A)
• Compose the incremental Cash Flow
•Examine that cash flow for sign changes and
apply the Norstrom test (from Chapter 7)
•If a unique i* (B-A) is indicated – solve for it
and compare it to the MARR
•If i* (B-A) > MARR, accept the increment else
reject
8.4 Example 8.3 Bell/GTE
•10 year project (merger)
•New equipment is required
•Two vendors
•MARR = 15%
•Which vendor should be selected
•Cost or Service Problem
8.4 Setup A vs.PW(15%)
B shows
that A has the
lowest PW Cost and
should win!
•Note: No ROR for A

(all negative signs)
and B’s cannot be
determined!
8.4 PW analysis
• We could stop because the PW(15%) has
signaled that A is the winner!
•Lowest PW cost
•Proceed with a ROR analysis BUT….
•ROR must be performed on the incremental
investment
8.4 Incremental Cash Flow Fig. 8-2
8.4 Inc. Cash Flow Results
i* (B-A) is less
Inc. PV(15%)
and is than the
negative. MARR of
Thus, reject 15%.
the increment Reject
and go with A! increment
and go with
A!
8.4 So-called Breakeven ROR
• Recall, the incremental i*(B-A) is the interest rate
at which the two alternatives are economically
equivalent.
•This special interest rate is called:
•Breakeven Interest Rate
•Fisherian Intersection Rate
8.4 Breakeven Rate Illustrated
• For Example 8.3 the NPV Plot is:
NPV PLOT-INC. C.F.
0.00
0
0
-5000.00
0
0
0.
0.
0.
0.
0.
0.
0.
0.
0.
0.
1.
1.
1.
1.
1.
1.
1.
1.
1.
1.
2.
-10000.00
-15000.00
-20000.00
NPV(i%)
-25000.00 i*(B-A) rate;Alternatives are

-30000.00 identical at this rate.
-35000.00
-40000.00
-45000.00
-50000.00
Disc. Rates
8.4 Conclusions i* (B-A) = 12.65%
• For MARR < 12.65% extra investment is
justified. Go with B
•For MARR > 12.65%, the extra investment is not
justified: Go with A
•If MARR = 12.65%, both options are
economically equivalent.
Recall: MARR = 15%
8.5 ROR Evaluation Using Annual
Worth based relation
• ROR approach requires comparison over an
equal-service life
•When the lives are equal or unequal (Must use
LCM), set up the AW relationship for the cash
flows of each alternative
•Then solve 0 = AWB – AWA for the i* value
8.5 ROR Using Annual Worth
• See Example 8.5
•Manual approach
•It is best to avoid this approach and stay with
either the PW or ROR over the total life of the
project or the LCM life
8.6 Incremental ROR Analysis of Multiple,
Mutually Exclusive Alternatives: Criteria
•Select the one alternative that:

•Requires the largest investment
•And indicates that the extra investment over
another acceptable alternative is justified
8.6 Comparing Alternatives
• A given alternative should not be compared

with one alternative for which the incremental
investment is not justified
•If a given alternative looses out in a comparison,
that alternative is dropped from further
consideration.
8.6 Ranking Rules - Ordering
1. Order the alternatives from smallest to largest
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…
8.6 Revenue-Cost Problems
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
8.6 Revenue-Cost - Approach
• 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)
8.6 Revenue-Cost
4. Compute i*Challenger – Defender
•If i*Challenger – Defender > MARR drop the defender
and the challenger wins the current round.
5. If i* Challenger – Defender < MARR, drop the
challenger and the defender moves on to the next
comparison round
8.6 Revenue-Cost
• 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
8.6 Revenue-Cost
6. This process continues until there are no
more challengers remaining.
•The alternative that remains after all alternatives
have been evaluated is the final winner.
8.6 Potential Problems
• See Example 8.6 for the potential problems that
can occur using ROR
•Pitfalls often exist when one uses the ROR
approach for the analysis of alternatives
8.6 Cost Problems
• Remember
•Cost problems do not have computed ROR’s
since there are more cost amounts than revenue
amounts (salvage values may exist)
•Thus there are no feasible i*’s for each
alternative
8.6 Cost Problems - Rules
• Rank the alternatives according to their
investment requirements (low to high)
•For the first round compare:
•Challenger – Defender Cash Flow
•Compute i*Challenger – Defender
•If i* Challenger – Defender > MARR, Challenger

wins; else Defender wins
8.6 Cost Problems
• The current winner now becomes the defender
for the next round.
•Compare the current defender to the next
challenger and compute i* Challenger – Defender
•The winner becomes the current champion and
moves to the next round as the defender
•Repeat until all alternatives have been
compared.
Chapter 8 Summary
•PW and AW methods are preferred methods for
evaluating alternatives
•ROR can be used but care must be taken
•If ROR, must perform an incremental analysis
•Two at a time (paired comparison) is required
Assignments and Announcements
Homework7 (Chapter8 due April 26th)

Assignments due at the beginning of next
class:
Online Quizzes for chapter 8 Due
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Chapter 8:

Rate of Return Analysis: Multiple

Section8.1: Why Incremental Analysis is

• For some problems, PW and ROR may rank the

•Two Investments A and B

• i*A = 0.20 = 20% •Using ROR, A is superior

•Assume the +$120 can be reinvested forward at the

•Now, PW(10%) and ROR with the reinvestment imposed

The incremental Investment

• One would go with investment A initially

• Now, is it worth it to the firm to consider

The investment (B-A) represents the year-by-year

(B-A) is “additional” investment to move from

•The incremental investment shows a negative PW and no

1 -100,000 -85,000 15,000

2 -100,000 -85,000 15,000

3 -135,000 -85,000 50,000

4 -100,000 -85,000 15,000

5 -100,000 -85,000 15,000

6 -95,000 -74,000 21,000

•Since i*(B-A) > MARR, accept the increment and

•Same results as PW(18%) shows

•B is clearly the winner

•If the i*incremental value is < MARR the increment

•The i* value also represents the

• Order (rank) the alternatives by their

•Note: No ROR for A

-25000.00 i*(B-A) rate;Alternatives are

•Select the one alternative that:

• A given alternative should not be compared

•If i* Challenger – Defender > MARR, Challenger

Homework7 (Chapter8 due April 26th)

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