Chapter 8 - Incremental

Rate of Return Analysis

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EGR 403 Capital Allocation Theory

Dr. Phillip R. Rosenkrantz
Industrial & Manufacturing Engineering Department
Cal Poly Pomona
 EGR 403 - The Big Picture
• Framework: Accounting & Breakeven Analysis
• “Time-value of money” concepts - Ch. 3, 4
• Analysis methods
– Ch. 5 - Present Worth
– Ch. 6 - Annual Worth
– Ch. 7,7A,8 - Rate of Return (incremental analysis)
– Ch. 9 - Benefit Cost Ratio & other techniques
• Refining the analysis
– Ch. 10, 11 - Depreciation & Taxes
– Ch. 12 - Replacement Analysis

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 Incremental Analysis

• Required for examining three or more

alternatives.
• Defined as the examination of differences
between alternatives to determine if the
increased costs are justified by the
increased benefits.
High cost alt. - Low cost alt. = Difference between alt.

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Elements of Rate of Return Analysis
• Identify all acceptable alternatives that fulfill
similar system outcomes.
• Arrange the alternatives in ascending order of
investment.
• Compute the rate of return for each alternative.
Discard alternatives where ROR  MARR.
• Make a pair-wise analysis of the contender and
present selection. For investment:
– If ROR  MARR select the contender.
– If ROR MARRkeep the present selection.

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Incremental Rate of Return Analysis
Example 8 - 7
•PWB = A (P/A, 6%, 20) = A (11.47)
•MARR = 6% (given)
•All projects are initially acceptable because IRR  MARR

A B C D E
Cost 4000 2000 6000 1000 9000
EUAB (A) 639 410 761 117 785
PWB 7330 4700 8730 1340 9000
IRR 15% 20% 11% 10% 6%
P/A 6.26 4.88 7.88 8.55 11.47

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 Incremental Analysis
1. Rank from lowest cost to highest cost
2. Start with two lowest cost alternatives
3. Compare increments using MARR criteria
4. Repeat until a “winner” is determined
D B A C E
Cost 1000 2000 4000 6000 9000
EUAB (A) 117 410 639 761 785

Increment B-D A-B C-A E-A

incr. Cost 1000 2000 2000 5000
incr. UAB 293 229 122 146
incr. ROR 29% 10% 2% < 0%
Keep B A A A
P/A 3.413 8.73 16.393 34.236
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 Graphical Solutions
PWB vs. PWC at MARR
Above the 45 degree line projects are acceptable (NPW>0)
Benefit-cost Graph
MARR 6.00 % Alternatives
30
POSITIVE NPW

25
Present Worth of Benefit

0.06

20

15
0 $26.42
0 $26.42
10

NEGATIVE NPW
0
0 5 10 15 20 25 30
Present Worth of Cost

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 Graphical Solution
• Projects B, A, C and E shown.
• Incremental analysis looks at adjacent points on the Benefit-
Cost Graph

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 Graphical Incremental Analysis
If line between two alternatives is > 45 degrees, accept higher
cost alternative. Alternative A wins.

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 Graphical Incremental Analysis
• Graphical solution has a logical connection to NPW
•Incremental analysis seeks out the alternative with highest
NPW. Alternative A maximizes NPW.

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 Choosing an Analysis Method
Method MARR Computations* Explanation
PW Required for Less Depends
calculation
AW Required for Less Depends
calculation
ROR For comparison More Depends

*Not an issue when using a spreadsheet.

Do what the Organization requires. Occasionally augment with

alternate methods where the method adds beneficial information.

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