Chapter 8

Rate of Return
Multiple Alternatives
Engineering Economy

Previous Lecture

What is IROR (i*)

Value range of IROR
how to calculate IROR (use PW until stated otherwise)
IROR compare with MARR for decision making
Most importantly, possibilities of having multiple IROR
values
Methods to solve multiple IROR problem

Chapter 8
We know how to calculate IROR for a given cash
flow and how to make a decision based on IROR
for a single project (check if IROR MARR)
If we have to compare more than one alternatives
based on IROR, we need to use a different
procedure for comparison
. Why ? What procedures ? That we study in
chapter 8

Contents of Chapter 8
1.

Why incremental analysis

2.

Incremental cash flow (CF) calculation

3.

Interpretation of IROR on incremental CF

4.

Select alternative by IROR based on PW relation

5.

Select alternative by IROR based on AW relation

6.

Select best from several alternatives using IROR method

Before I Start the chapter 8

Lets ask oneself following few questions :
1. Why there is a separate chapter on IROR for multiple alternatives ?
2. Why we cannot use IROR/ROR we learnt in last chapter for
comparison of multiple alternatives?
3. Why we need a slightly different technique ?

To answer these questionsLets start with a simple numerical

examples and search answers for these questions

Calculation of overall rate of return

from multiple investments
Lets start with a simple Numerical method.to learn how you can
calculate overall rate of return from two or more investments
Question: 8.7: If $80,000 is invested at 30% and another
$50,000 is invested at 20% per year, what is the overall rate of
return on the entire $130,000?
=

0.30 80,000 + 0.20(50,000)

130,000

= 26.2%

Example:
Overall Rate of Return
A company has $600,000 to invest. The company is considering three different
projects that will yield the following rates of return.
Project X: iX = 24% , Project Y: iY = 18% , Project Z: iZ = 30%
The initial investment required for each project is $100,000, $300,000, &
$200,000, respectively.
If company invests in all three projects, what rate of return will the company make?
Solution:

Overall ROR = [0.24(100,000)

+ 0.18(300,000)
+ 0.30(200,000)]
/600,000
= 0.23
= 23%

By the way thats

Problem No. 8.9

Similar problem: 8.8

A simple example
A company has $90,000 available for investment on two alternatives A and B and its
MARR = 16% per year.

Alternative A

Alternative B

Required investment = $ 50,000

RORA = 35%

Required investment = $ 80,000

RORB = 29%

Which Alternative company should select A or B ?

Alternative A because of its higher ROR value though both alternatives are
economically viable but since company has only 90,000 so A should be selected based
on ROR value
But there is a problem Alternative A need only $50,000 investment what
happens to remaining $40,000 ?
Or $10,000 in case if company want to undertake Alternative B ?
Theory says company will invest excess amount with MARR (16% in this case) ..

A simple example
To summarize the things: Total available amount is 90,000, with MARR=16% and if
company select either alternative then

Alternative A (RORA = 35%)

Alternative B (RORB = 29%)

Required investment = $ 50,000

Remaining amount = $40,000 invested
@ 16%

Required investment = $ 80,000

Remaining amount = 10,000 invested
@16%

What is the total Return to the company from each of alternative after one year ?

Alternative A
.

= 26.6%

Alternative B
=

= 28.3%

Which one you should select ?

Now B . it was A if only ROR
is considered

It shows that comparing two

alternatives ROR may have a
ranking inconsistent problem

Incremental ROR (or IROR)

Analysis
Under some circumstances (as was in previous example),
project IROR values do not provide the same ranking of
alternatives as do PW and AW analysis.
We need to do incremental IROR analysis to avoid
Ranking Inconsistency Problem
Before doing Incremental IROR Analysis for multiple
alternatives.one need to learn to calculate Incremental
Cash Flow

Calculation of
Incremental Cash Flow
Incremental cash flow = cash flowB cash flowA
where larger initial investment is Alternative B
Example: Tabulate the incremental cash flows from following two
alternatives CFs.
B

B-A

First cost, $

-40,000

- 60,000

-20,000

Annual cost, $/year

-25,000

-19,000

+6000

Salvage value, $

8,000

10,000

+2000

The incremental CF is shown in the (B-A) column

Interpretation of IROR on Extra

Investment
What does the incremental cash flows in Year 0 shows (the
first costsincremental CF)?

It shows the extra investment or cost required if an

alternative with higher initial cost is selected
In Incremental IROR analysis we analyses the IROR earned
on the extra funds ..if return on extra funds is justified
we select the alternative (the one with higher initial
costs).otherwise not (instead we select the cheaper one)

Interpretation of IROR on Extra

Investment
The logic of decision making based on incremental IROR
is based on the following arguments:
The funds not invested in alternative (because of
lower initial costs) are assumed to be invested at
MARR
Now if the IROR for the extra cash(or incremental cash)
is equal to or greater than MARR the alternative
associated with extra investment should be selected

Interpretation of IROR on Extra

Investment
It is important to remember ..that not only return on
Extra investment must be higher than MARR
Also the investment on alternative should earn at
least MARR or higher (IROR MARR) if not.. you do
not consider that alterative for Incremental ROR
So before doing Incremental IROR analysisyou better
to check IROR of the alternatives. If IROR MARR*
than you can go for Incremental IROR

Interpretation of IROR on Extra

Investment
You must check.you may not need to do incremental
analysis at all.why ?
Check. all alternatives IROR values alternatives
having i* < MARR drop out automatically
Compare the remaining alternatives Incrementally
How ? (we will learn that later after some basic leanings)

Question: 8.3: Interpretation

of IROR on Extra Investment
An engineer is comparing three projects by the incremental IROR method.
There are revenue and cost cash flow estimates. He used the IROR function of
Excel to determine the IROR values for each project.
1. The first one is 3.5% above the MARR,
2. The second is 1.2% below the MARR,
3. The third is 2.4% above the MARR.
Which alternatives, if any, must he include in the incremental IROR analysis?
Solution
He must include the first and third alternatives in an incremental analysis because
the second alternative has IROR< MARR so it is not a feasible alterative.

Calculation of Incremental Cash Flow

Incremental cash flow = cash flowB cash flowA
where larger initial investment is Alternative B

Example: A company has to chose among two machines. The Cash

flows of both machines are given below:
New machine

Incremental CF
New - Old

Years

Used machine

$-15,000

$ -21,000

$-6,000

-8,200

-7,000

+1200

+10,50

+300

1-25
25

+750

The Incremental CF here is showing that it will cost $6000 extra to buy the new
machinebut it will save $1200 every year for 25 years plus $300 in 25 th year
consider Incremental CF as a new alternative with $6000 cost, $1200 per year
revenue/benefits and $300 salvage value in 25th year

Calculation of Incremental Cash Flow

Incremental cash flow = cash flowB cash flowA
where larger initial investment is Alternative B

Example: A company has to chose among two machines. The Cash

flows of both machines are given below:
New machine

Incremental CF
New - Old

Years

Used machine

$-15,000

$ -21,000

$-6,000

-8,200

-7,000

+1200

+10,50

+300

1-25
25

+750

The Incremental CF here is showing that it will cost $6000 extra to buy the new
machinebut it will save $1200 every year for 25 years plus $300 in 25 th year
consider Incremental CF as a new alternative with $6000 cost, $1200 per year
revenue/benefits and $300 salvage value in 25th year

How Incremental Cash can help ?

Incremental CF provide you a new cash flow ...having
initial cost value cash flows in full life of two alternatives
For comparing the economic viability of two
alternatives.You have to compare Incremental CF IROR
with extra cash invested some where else at MARR .
If you earn more some where elseyou select the
alternative that has lower initial costotherwise you select
alternative with higher cost.

Interpretation of ROR on Extra

Investment

The decision to chose Used machine or New machine is based on

the profitability of $6000 ..extra cash
If one chose alternative New machine then we save $1200 for 25
years plus 300 extra in 25th Year.
If one chose alternative Used machine then we are left with
6000(extra cash) and we can invest at MARR.
To chose one alternative .we have to compare saving from new
machine and earning from extra cash at MARR (by choosing cheaper
alternative) .we select the one which give greater return.

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Problem 8.11.. Incremental CF

Calculation
Prepare a tabulation of incremental cash flows for the two
machine alternatives below.

Solution
Years

$ -90,000

Y- X

$-35,000

1
2

-31,600
-31600-3500

-19,400
-19400

-55, 000
+12, 200
+47, 200

-31,600

-19,400

+12, 200

-31,600

-19,400+8000

+20, 200

Another Example
For the alternatives shown, determine the sum of the incremental
cash flows for Q P.

11

Years

Q- P

$-85,000

$ -50,000

1
2

43,000
43,000

13,400
13,400

43,000

43,000

13,400

+29, 600

43,000

13,400

+29, 600

13,400+3,000

+34, 600

43,000+8,000

-35, 000
+29, 600
+29, 600

13400-50,000+3,000

+76, 600

Sum = 194, 600

By the way that is Problem 8.12

Problems with applying IROR for

evaluating Multiple alternatives
There are three primary elements due to which mainly
IROR analysis are applied incorrectly in engineering
economy analysis:
1. Incremental Cash flow Series
2. LCM
3. Multiple roots (multiple IRR values)
It is advisable to use PW or AW analysis instead of IROR
when there is multiple IROR values

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IROR Evaluation Using PW:

Recall calculating IROR for single alternative you take
PW and equate it to zero to start with.
Similarly on PW-based relation is developed for the
incremental cash flows and set equal to zero
Using trial or error approach one can than calculate the
rate (iB-A) at which PW of incremental CF is zero.
Equal Life Comparison LCM method

Steps: IROR Evaluation for Two

Mutually Exclusive Alternatives
(1)
(2)
(3)
(4)
(5)

Order alternatives by increasing initial investment cost

Develop incremental CF series using LCM of years
Draw incremental cash flow diagram, if needed
Count sign changes to see if multiple i* values exist**
Set up PW, (or AW, or FW) = 0 relation and find i*B-A
Note: Incremental IROR analysis requires equal-service comparison.
The LCM of lives must be used in the relation

(6) If i*B-A < MARR, select A; otherwise, select B

If i*B-A MARR, the extra investment is justified; select
alternative B.
**If multiple i* values exist, find EROR using either Modified Rate
of Return or Return on Invested Capital approach.

13

IROR Evaluation Using AW (Optional):

Recall calculating IRR/ROR for single alternative you take PW or
AW and equate it to zero to start with.
Similarly to PW-based relation developed for the incremental cash
flows
AW-based relation can be developed for the incremental cash flows
and set equal to zero.
I will skip this method.because it provide same results as
based on PW. You must know its presences as an alternative. I
will not ask you for doing IROR evaluation based on AW.

Example: IROR Evaluation of Two

Alternatives at MARR 15%
B

B-A

First cost , $

-40,000

-60,000

-20,000

Annual cost, $/year

-25,000

-19,000

+6000

8,000

10,000

+2000

Salvage value, $
Life, years

Both A and B viable individually based on IROR

Order by first cost and find incremental cash flow B - A
Check sign change for possibility of Multiple IROR values
Write IROR equation (in terms of PW, AW, or FW) on incremental CF

0 = -20,000 + 6000(P/A,i*,5) + 2000(P/F,i*,5)

Solve for i* and compare to MARR
i*B-A = 17.2% > MARR of 15%
IROR on $20,000 extra investment is acceptable: Select B

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Practice: 10 Minutes time

Determine which of the two alternatives should be selected by
calculating the rate of return on the incremental investment. Assume the
companys MARR is 21% per year. (both alternatives individually are
viable based on IROR.

/ =

( + )

/ =

( + )
( + )

Practice: 10 Minutes time

Determine which of the two alternatives should be selected by calculating

the rate of return on the incremental investment. Assume the companys
MARR is 21% per year.
Calculate Incremental Cash Flow
Check Sign Change of Incremental CF
Write its PW relationship

0 = -45,000 + 15,000(P/A,i*,6) +
45,000(P/F,i*,3) + 6000(P/F,i*,6)
Solve for i* using trial and error
Which one should be selected ?
45.2% > MARR so selected the
Impregnated alternative

15

Factor Values for Untabulated i or n

Linear Interpolation
formula

Factor value
axis

Example

f2

( )

Determine the value of (F/P, 8.3%, 10)

We have value of 8% and 9% only in Tables
Linear
assumption

unknown

f1

X1

Required
X

i or n axis

X2

from Factor Tables for F/P

x
... f
8 % ... 2.1589
8.3% .. unknown
9 % ... 2.3674
=
+
( )

= 2.1589 +

(2.3674 2.1589)

= 2.2215

Absolute Error = 2.2215 2.2197

= 0.0018

Multiple Alternative Comparison Using IROR

Technique

16

Main points before applying

the method

Comparison for multiple alternatives based on IROR is pairwise and done

by using Incremental Cash Flow

Start..ordering alternatives based on Initial Investment /Initial costs

Alternatives that having IRR <MARR is out of comparison automatically
Alternative with lowest Initial cost is named as Defender (A in our
previous example cases) and Second Lowest as Challenger(B in our
case)We start with DN as defender and lowest initial cost alt as challenger
Make the CF of defender and Challenger ..check Incremental Cash flow
.if its economical viable select challenger .it become now defender
and you take next higher Initial cost as Challengerthis process continue
until you are left with only one alternative

ROR Analysis Multiple

Alternatives
Six-Step Procedure for Mutually Exclusive Alternatives
(1) Order alternatives from smallest to largest initial investment
(2) For revenue alts, calculate i* (vs. DN) and eliminate all with i* < MARR;
remaining alternative with lowest cost is defender. For cost alternatives, go to
step (3)
(3) Determine incremental CF between defender and next lowest-cost alternative
(known as the challenger). Set up IROR relation(based on PW or AW)
(4) Calculate i* on incremental CF between two alternatives from step (3)
(5) If i* MARR, eliminate defender and challenger becomes new defender
against next alternative on list
(6) Repeat steps (3) through (5) until only one alternative remains. Select it.
For Independent Projects
Compare each alternative vs. DN and select all with IROR MARR

17

Important!!!!
For cost alternatives, the incremental cash flow
is the difference between costs for two
alternatives.
There is no do-nothing alternative and no step 2
(of previous slide) in the solution procedure.
Therefore, the lowest-investment alternative is
the initial defender against the next-lowest
investment (challenger).

Example: 8.6: Evaluation Based

on ROR Analysis

If MARR is 10% evaluate the alternatives based on IROR

1st Step: Arrange the alternatives from Lowest to higher Initial costs
2nd Step: Revenue
or Cost Alternative ?

3rd Step: Defender

and Challenger?

4th Step:
calculate i*
5th

Step: select one alternative

6th Step: Repeat process until one

alternative is left

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More Examples: Evaluation of 4 Cost Alternatives

Using ROR and MARR 13.5%

Which two alternatives we should compare first ?

Its cost
alternatives, so
no comparison
with DN

Class Practice: 5 Minutes Time

The five alternatives shown here are being evaluated by the rate of return
method.

a.

If the alternatives are mutually exclusive & MARR is 26% per year,
which alternative should be selected?

b. If the alternatives are mutually exclusive & MARR is 15% per year,
which alternative should be selected?
c.

If the alternatives are independent & MARR is 15% per year, which
alternative(s) should be selected?

19

Answer (a)

The five alternatives shown here are being evaluated by the rate of return
method.

a.

If the alternatives are mutually exclusive & MARR is 26% per year,
which alternative should be selected?
None have an overall ROR to MARR; select Do-nothing or Select no
Altneratives

Answer (b)

The five alternatives shown here are being evaluated by the rate of return
method.

b. If the alternatives are mutually exclusive & MARR is 15% per year,
which alternative should be selected?
Only B, D and E .. Must be selected A, C drop out because MARR<15%
Compare B and D Incrementally . IROR for ICF is 38.5% > MARR Select D
Compare D and E Incrementally . IROR for ICF is 6.8% < MARR Select D

20

Answer (c)

The five alternatives shown here are being evaluated by the rate of return
method.

c. If the alternatives are independent & MARR is 15% per year, which
alternative(s) should be selected?
Only B, D and E .. Must be selected A, C drop out because MARR<15%

THANK YOU

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