ComparingAlternativeswithRateof

Return
UseIncrementalAnalysis

Topics
In this section, we
recall the definition of ROR,
discuss decision situations for multiple
alternatives, and
discuss the appropriate decision
methodology for each situation

Rate of Return

Recall that the ROR of an investment is the

interest rate that makes
NPW = 0
NAW = 0
PW Benefits = PW Costs
AW Benefits = AW Costs
For a single project, accept if ROR MARR.

Decisions Involving Multiple

Projects
Given a set of possible projects,
any subset of the projects may be
selected.
only one may be selected, but one must
be chosen.
only one may be selected, but it is OK to
choose none.

Non-Mutually Exclusive
Alternatives

Suppose we can select any subset of the

projects.
Solution Methodology:
Compute the ROR of each alternative
Select each alternative for which ROR MARR

Example 1:

MARR = 13%
Alternative

Investment

$100,000

A nnual Annual Life

Income
Cost
$50,000 $30,000 9

$85,000

$44,000

$20,000

$60,000

$30,000

$12,000

Analysis
ROR of A = 13.7%
ROR of B = 12.7%
ROR of C = 15.3%

Both A and C have ROR larger than our

MARR. Therefore, select both A and C.

Mutually Exclusive Alternatives

Suppose we must select one, only one, but

at least one, alternative.
Solution Methodology:
Each increment of investment must yield the
MARR.
Perform Incremental Analysis:

Recall Incremental Analysis

1. Rank the alternatives in increasing order of
investment.
2. Select as the defenderthe alternative with
the smallest investment.
3. Let the challenger be the alternative with
the next higher investment.
4. Accept or reject the challenger on the basis
of the return on the extra investment. The
winner becomes the defender.
5. If the highest level of investment has been
reached, stop. Otherwise return to step 3.

Example 2: Comparing cost

alternatives
Alternative

Investment

Operating Cost

$5000

$240

$3000

$875

$4000

$500

$2500

$1000

Ranked Alternatives

MARR = 15%
Alternatives: All have five-year life and no
salvage
Ranked Alternatives : Rank by order of
increasing investment: D, B, C, A.
Alternative

Investment

Operating Cost

$2500

$1000

$3000

$875

$4000

$500

$5000

$240

Example 2: Incremental
Analysis

Defender: Project D.
Next greater investment (Challenger):
Project B.
Is the extra investment in B over D
justified?
Incremental Investment:
-$500
Incremental Benefit:
$125
NAW= -500 (A/P, i, 5) + 125 => ROR = 8% <
MARR
Decision: Reject Challenger, Project B.

Example 2: Incremental
Analysis (contd)

Defender: Project D.
Next greater investment (Challenger):
Project C.
Is the extra investment in C over D justified?
Incremental Investment:
-$1500
Incremental Benefit:
$500
NAW= -1500 (A/P, i, 5) + 500 => ROR = 20% >
MARR
Decision: Accept Challenger, Project C.

Example 2: Incremental
Analysis (contd)

Defender: Project C.
Next greater investment (Challenger):
Project A.
Is the extra investment in A over C justified?
Incremental Investment: -$1000
Incremental Benefit:
$260
NAW= -1000 (A/P, i, 5) + 260 => ROR = 9% <
MARR
Decision: Reject Challenger,

Keep Defender, Project C

Example 3: Projects with

Benefits

Choose one of the three

Alternative

Investment

Life

$100,000

Net Annual
Benefits
$20,000

A
B

$85,000

$24,000

$60,000

$18,000

Example 3 (contd)

MARR = 13% (select one and only one)

Ranked Projects: C, B, A
Alternative

Investment

Life

$60,000

Net Annual
Benefits
$18,000

C
B

$85,000

$24,000

$100,000

$20,000

Example 3: Incremental
Analysis

Defender: Project C
Challenger: Project B
Is the extra investment in B over C
justified?
Incremental Investment:
-$25,000
Incremental Benefit:
$6000
NAW= -25 (A/P, i, 5) + 6 => ROR = 6.4% <
MARR
Decision: Reject Challenger, Keep Project C

Example 3: Incremental
Analysis (contd)

Defender: Project C
Challenger: Project A
Is the extra investment in A over C
justified?
Incremental Investment:
-$40,000
Incremental Benefit:
$2000
Useful Life:
Project lives are different!!

Example 3: Incremental
Analysis (contd)

Select a common study period, say 45

years.

20,000

A
100,000
18,000

C
60,000

10

20

30

40

Example 3: Incremental
Analysis (contd)

Compute the incremental cash flows.

60,000

2,000

A-C

10

20

30

40

40,000
60,000

The cash flows of A-C represent a nonsimple investment.

Example 3: Incremental
Analysis (contd)

We must verify graphically (or with

another method) that the interest found
correspond to a rate of return. Luckily, it
does. The rate of return of the incremental
cash flows is 11.6%.

Therefore reject the challenger, project A

and accept C.

An Easier way for Different

Lives

Find ROR of A - C
NAW(A - C) = NAW(A) - NAW(C) = 0
-100(A/P, i, 9) + 20 - [-60(A/P, i, 5) + 18]
-100(A/P, i, 9) + 60(A/P, i, 5) + 2 = 0
i
NAW(A - C)
0%
2889
5%
1789
10%
463
15%
-1058
12%
-123
ROR of A - C is 11.6%. Reject A - C and choose C

Mutually Exclusive Alternatives

with a Do-Nothing Alternative

Suppose we can select one alternative or

no alternative
Solution Methodology:

Compute ROR of each alternative

Reject any alternatives that do not yield the
MARR
If only one remains, choose that alternative
If more than one remains, do incremental
analysis to select the best

Example 4

MARR = 13% (select one or none)

Alternative Investment
A

$100,000

Net
Income
$20,000

Life

ROR

Life

13.7%

$85,000

$24,000

12.7%

$60,000

$18,000

15.3%

Example 4 (contd)

Since B does not return 13% it can be

discarded.
We most compare A and C, by computing
the rate of return of the extra investment
of A over C.
The rate of return of A over C is 11.6%.
Since the return on the extra investment is
less than 13% (the MARR) reject the extra
investment.
We should choose option C.

Conclusion:

Measure of merit is the ROR (a

percentage)
For a single alternative, accept if ROR
MARR
For multiple alternatives: Accept an
increment if the ROR for the increment
MARR