Rate of Return Analysis

(Mutually Exclusive Alternative)

 IRR Method for Mutually Exclusive
Alternatives
• Under the equivalent worth method (PW,FW and AW),
the mutually exclusive project with the highest worth
figure was preferred.
• In the case of rate of return method, the same
procedure cannot be applied, i.e the project with the
higher IRR may not be the preferred alternative.
 Let us Consider the two mutually exclusive
alternatives with 1 year of service life.
Period (n) A1 A2
0 -$1,000 -$5,000
1 $ 2,000 $7,000
IRR 100% 40%
PW (10%) $818 $1364

Can we rank the mutually exclusive projects by the

magnitude of IRR ??
Here, A2 is preferred over A1 , by the NPW measure.
A1 is preferred over A2, by the IRR measure.
 The inconsistency in ranking occurs because

• NPW,NFW,NAW are absolute (dollars/Rs)

measures of investment worth.
• Whereas IRR is a Relative (percentage) measure
and cannot be applied in the same way as PW, FW
and AW.
 INCREMENTAL ANALYSIS
• Incremental Analysis evaluates difference, or the
‘increment” between two or more mutually exclusive
alternatives.
• Steps:
1. Identify all the alternatives.
2. Compute the IRR of each alternative. Any alternative
with IRR<MARR should be rejected.
3. Order Alternative in increasing order of investment
cost to ensure that the increments have cash flow
corresponding to investments.
4. Establish a base Alternative
Alternative having least capital investment is
established as the base alternative and should have
been pre qualified i.e. IRR> MARR
5. Perform an incremental IRR analysis between the
base alternative and the alternative with the next
higher initial cost. If the incremental IRR >= MARR,
“reject” the base alternative and “accept” the higher
cost alternative and “retain” it as base alternative.
6. Select the next higher cost alternative and perform
the incremental analysis until all the alternatives
have been evaluated.

• Evaluation should always be done based on same

study period for all alternatives
 Decision Rule
IF IRR B-A > MARR , select B (higher first cost alternative)
IF IRR B-A = MARR , select either one
IF IRR B-A < MARR , select A (lower first cost alternative)
 Example
The cash flows for the two mutually exclusive alternatives are
given as follows:

Period (n) A B
0 -$3,000 -$12,000
1 $1,350 $4,200
2 $1,800 $6,225
3 $1,500 $6,330

Assuming that there is no do-nothing alternative,

Which project would be selected based on IRR criterion, at
MARR = 10%
Calculating the IRR of each alternatives.
IRRA = 25% > 10% (MARR) (Justified)
IRRB = 17.43% > 10% (MARR) (Justified)

Performing the incremental analysis.

Period (n) A B B–A

0 -$3,000 -$12,000 -$9,000

1 $1,350 $4,200 $2,850

2 $1,800 $6,225 $4,425
3 $1,500 $6,330 $4,830
IRR 25% 17.43% ?

Why did we choose increment B – A instead of A – B ??

The first flow of the incremental cash flow series should be
investment flow
Calculating IRR of the incremental Cash flow.

PW (i*) B – A = 0
- $9000 + $2850 (P/F, i*, 1) + $4425 (P/F, i*, 2) + $4830
(P/F, i*, 3) = 0
(i*) B – A = 15% > 10% (MARR)

Hence, Option B is selected

 Incremental Analysis for the
equal project lives
EXAMPLE
Consider the following two mutually exclusive
investment projects that require the same amount of
investment:
Period (n) C1 C2
0 -$9,000 -$9,000
1 $480 $5,800
2 $3,700 $3,250
3 $6,550 $2,000
4 $3,780 $1,561

Which project would you select, based on rate of return on

incremental investment, assuming that MARR = 12%?
(both projects are profitable at 12%.)
Solution
Calculating the IRR of the each project

Alternative C1

PW (i*) = -$9000 + $480 (P/F, i*, 1) + $3700 (P/F, i*, 2)

+ $6550 (P/F, i*, 3) + $3780 (P/F, i*, 4) = 0
= 18% > MARR (acceptable)

Alternative C2

PW (i*) = -$9000 + $5800 (P/F, i*, 1) + $3250 (P/F, i*, 2)

+ $2000 (P/F, i*, 3) + $1561 (P/F, i*, 4) = 0
= 20% > MARR (acceptable)
 Performing the incremental analysis

Taking Alternative C2 as the base alternative (alternative

having lowest investment)
Period (n) C1- C2
0 $0
1 - $5,320
2 $450
3 $4,550
4 $2,219

PW (i*)C1-C2 = -$5,320 + $450(P / F,i,1) + $4,550(P / F, i,2)

+ $2,219(P / F,i,3) = 0.

i* = 14.71%, which is also an IRR, since the investment is a simple

investment. , we would select C1.
If we used PW analysis, we obtain PW(12%)C1 = $1,443 and PW(12%)
C2 = $1,443 , confirming the preference of C1 over C2.
 EXAMPLE
An engineering firm is considering the following
mutually exclusive alternatives

EOY PROJECTS
A1 A2 A3 A4
0 - $2500 - $1200 - $3600 - $2000
1 $1200 $400 $1700 $800
2 $1400 $800 $2000 $700
3 $1500 $1000 $1600 $850

Which project would you select based on IRR method.

Assuming MARR = 20% per year
Solution
Calculating the IRR of the each project
Alternative A1
PW (i*) = -$2500 + $1200 (P/F, i*, 1) + $2000 (P/F, i*, 2)
+ $1600 (P/F, i*, 3)
by trial and error ,
i* = 28.19%
Alternative A2
PW (i*) = -$2000 + $400 (P/F, i*, 1) + $800 (P/F, i*, 2)
+ $1000 (P/F, i*, 3)
by trial and error ,
i* = 31.84%
Alternative A3
PW (i*) = -$3600 + $1700 (P/F, i*, 1) + $1400 (P/F, i*, 2)
+ $1500 (P/F, i*, 3)
by trial and error ,
i* = 22.33%

Alternative A4
PW (i*) = -$2000 + $800 (P/F, i*, 1) + $700 (P/F, i*, 2)
+ $850 (P/F, i*, 3)
by trial and error ,
i* = 8.43%
Alternative A1, i* = 28.19 > MARR (20%), accepted
Alternative A2, i* = 31.84 > MARR (20%), accepted
Alternative A3, i* = 22.33 > MARR (20%), accepted
Alternative A4, i* = 8.43 <MARR (20%), rejected
Performing the incremental analysis

Taking Alternative A2 as the base alternative

(alternative having lowest investment)
EOY A2 A1-A2 A3-A1
0 -$1200 -$1300 -$1100
1 $400 $800 $500
2 $800 $600 $600
3 $1000 $500 $100
Incremental IRR 31.84% 23.87% 5.39%
Is increment Yes Yes No
justified

Select project A1
 Incremental Analysis for the
Unequal project lives
• The IRR measure can also be used to compare
projects with unequal lives, as long as we establish a
common analysis period.
• This can be performed by using the Repeatability as
well as co-terminated assumptions.
 Example
Consider the following mutually exclusive investment projects
A and B. Recommend the best project.

Project A B

Investment (Rs) 3,50,000 5,00,000

Annual Revenues (Rs) 1,90,000 2,50,000
Annual Cost (Rs) 64,500 1,38,300
Useful life 4 yrs 8 yrs
MARR 10%
Solution
Study Period = LCM of 4 and 8 = 8 years
$1,90,000

0 1 2 3 4 5 6 7 8
$64,500 $64,500
$3,50,000 $3,50,000 Alternative A

PWA (i*%) = 0
-350,000 + (190,000-64500) {P/A, i*%, 8) – 350000 ( P/F,
i*%,4) = 0
i* = 16.2> MARR (10%) (accepted)
 $2,50,000

0 1 2 3 4 5 6 7 8
$1,38,300
$5,00,000 Alternative B

PWB (i* %) = 0
-500000 + (250,000-138300) {P/A, i*%, 8)
i* = 15.10 > MARR (10%) (accepted)
Performing the incremental analysis

Taking Alternative A as the base alternative

$3,50,000

$60,000 $60,000

0 1 2 3 4 5 6 7 8
$73,800 $73,800
$1,50,000

Incremental cash flow diagram (B-A)

IRRB-A = 12.70 > MARR (10%)

Select Project B
 Example
Consider the Two mutually exclusive projects

Period (n) A B
0 -$12,500 -$15,000
1 - $5,000 - $4,000
2 - $5,000 -$4,000
3 -5,000+$2000 -$4,000

4 -$4000+1,500

Study period is LCM of 3 and 4 i.e. 12 years

 0 1 2 3 4 5 6 7 8 9 10 11 12 Years

Rs.3,000
Rs.3,000 Rs.3,000
Rs.3,000
Rs.5,000 Rs.5,000 Rs.5,000 Rs.5,000

Rs.12,500 Rs.12,500 Rs.12,500 Rs.12,500

Project A

0 1 2 3 4 5 6 7 8 9 10 11 12
Years

Rs.2,500 Rs. 2,500

Rs. 2,500
Rs. 4,000 Rs. 4,000
Rs. 4,000
Rs.15,000
Rs.15,000 Rs.15,000

Project B
 $ 11,500 $ 11,500 $ 11,500

$ 1,000 $ 1,000 $ 1,000 $ 1,000

$ 500

0 4 8
1 2 3 5 6 7 9 10 11 12

$ 2,500

$ 12,500 $ 12,500

Fig; Incremental Cash flow (Project B – Project A)

Period Project A Project B Project B – Project A
(n)
0 -$12,500 -$15,000 -$2,500
1 -$5,000 -$4,000 $1,000
2 -$5,000 -$4,000 $1,000
3 -$12,500 -$3,000 -$,4000 $11,500
4 -$5,000 -$15,000 -$2,500 -$12,500
5 -$5,000 -$,4000 $1,000
6 -$12,500 -$3,000 -$4,000 $11,500
7 -$5000 -$,4000 $1,000
8 -$5,000 -$15,000 -$2,500 -$12,500
9 -$12,500 -$3,000 -$4000 $11,500
10 -$5,000 -$4,000 $1,000
11 -$5,000 -$4,000 $1,000
12 -$3,000 -$2,500 $500
• Here, Five sign changes in the incremental cash flow,
indicating non-simple investment. This results in the
multiple rate of return.
• We abandon the rate of return analysis and use the
PW criterion to evaluate the project.

PW (15%)B-A = -$2,500 + $1,000(P/F, 15%, 1)

+…………… + $500(P/F, 15%,12)
= $5,123 > 0

This indicates that PW(15%)B > PW(15%)A

Select Project B
 Example
• Consider the following three set of mutually exclusive
alternatives
Alternatives

EOY D1 D2 D3
0 -2000 -1000 -3000
1 1500 800 1500
2 1000 500 2000
3 800 500 1000
Which project would you select based on rate of
return on incremental investment assuming that
MARR = 15%?
 Calculating the IRR of each alternative
• IRRA = 34.37% > MARR
• IRRB = 40.76% > MARR
• IRRC = 24.81% > MARR

Performing the incremental analysis (D2 as base alternative)

EOY D2 D1-D2 D3-D1

0 -1000 -1000 -1000
1 800 700 0
2 500 500 1000
3 500 300 200
Incremental IRR 34.37% 27.61% 8.8%
Is increment justified Yes Yes No

Select project D1
 Simple Accept if
i* = IRR
Investment i* > MARR

Single Project Abandon IRR

Non Simple
i* ≠ IRR approach,
Investment
Use NPW
criterion

Mutually
Incremental Compute If i*B-A> MARR
Exclusive
Project analysis Incremental (select B)
IRR
If i*B-A< MARR
(select A)
 Example
Recommend the best project. MARR =12%

A B

Equipment cost (Rs) 65,00,000 58,00,000

Installation Cost (Rs) 15,00,000 20,00,000

Annual maintenance 1,00,000 1,25,000

cost (Rs)
Annual extra cost (Rs) 0 50,000

Life (years) 40 35
 SUMMARY
• Present worth is an equivalence method of analysis
in which a project’s cash flows are discounted to a
single present value.
• MARR is the interest rate at which a firm can always
earn or borrow money.
• The Capital Recovery is the annual equivalent cost
of capital cost. CR = I(A/P, I, N) – S (A/f, I,N).
• AW (i) = R – E – CR
• Comparison of Mutually exclusive project with
unequal life can be done by using
Repeatability assumption and co-terminated
assumption.
• Capitalized cost is the present worth of the
alternatives having perpetual study period or having
long study period(>40 years). CC = AW/i
• Payback period is the time period for recovering the
investment.
• Simple payback = doesn’t consider time value of
money.
• Discounted payback = considers time value of money.
• IRR is the interest rate charged on un-recovered
project balance, such that when the project
terminates the un-recovered balance would be zero.
PW (i*) = 0
PW inflow – PW outflow = 0
• For comparing the mutually exclusive projects by
IRR, Incremental Analysis should be done.
• For the case of non simple investment, where
multiple rate of return exits, the analysis is carried
out by the Equivalent worth method.