ME 291

Engineering

ME-291 Engineering Economy

Economy
Lecture 23

ROR: Multiple Alternatives

Faculty of Mechanical Engineering

Ghulam Ishaq Khan Institute, Topi, Swabi
© Faculty of Mechanical Engineering, GIKI
 Importance

• When two or more mutually exclusive alternatives are

ME-291 Engineering Economy

evaluated, engineering economy can identify the one
that is the best economically. The PW and AW can be
used for this purpose. ROR can also be used for the
selection of the best alternative.
• Let us assume that a company uses a MARR of 16%
per year, that the company has $90,000 available for
investment and that two alternatives A and B are
being evaluated.
• Alternative A requires an investment of $50,000 and
has an internal rate of return i* of 35% per year.
Alternative B requires $85,000 and i* of 29% per year.
• The first decision may be to select alternative A
because it has higher rate of return. However, it is not
necessarily so.

© Faculty of Mechanical Engineering, GIKI

 • While A has higher projected return, it

ME-291 Engineering Economy

requires an initial investment that is much
less than the total money available. The
remaining investment or the excess funds
will be investmed at the company's MARR.
• Using this assumption it is possible to
determine the best alternative.
• If A is selected, $50,000 will return 35% per
year. The $40,000 left over will be invested
at the MARR of 16% per year. The rate of
return on the total capital available, then, will
be the weighted average.

© Faculty of Mechanical Engineering, GIKI

 IF alternative A is selected

ME-291 Engineering Economy

Overall RORA = (50,000(0.35) + 40,000(0.16))/90,000
RORA = 26.6%
Overall RORB = (85,000(0.29) + 5000(0.16))/90,000
RORB = 28.3%
So it shows that even though the i* for the alternative A is
higher, alternative B presents the better overall ROR
for the $90,000. if either a PW or AW comparison is
conducted using the MARR of 16% per year as i,
alternative B will be chosen.

© Faculty of Mechanical Engineering, GIKI

 Calculation for the Incremental Cash
Flows for ROR analysis

• It is necessary to prepare an incremental cash flow

ME-291 Engineering Economy

tabulation between two alternatives in preparation for
an incremental ROR analysis.
• The format is shown in figure.
• If the alternatives are of equal lives, the year column
will go from 0 to n. if the alternatives have unequal
lives, the year column will go from 0 to the LCM of the
two lives.

© Faculty of Mechanical Engineering, GIKI

 • For simplification keep the one with larger

ME-291 Engineering Economy

initial investment as alternative B.
• When LCM of lives is used, the salvage
value and reinvestment in each alternative
are shown at appropriate times.

• Incremental Cash Flow = CFB - CFA

© Faculty of Mechanical Engineering, GIKI

 Example 8.1

ME-291 Engineering Economy

© Faculty of Mechanical Engineering, GIKI
 Example 8.2

ME-291 Engineering Economy

© Faculty of Mechanical Engineering, GIKI
 ME-291 Engineering Economy
© Faculty of Mechanical Engineering, GIKI
 Interpretation on the Extra Investment

• The incremental cash flows in year 0 reflects

ME-291 Engineering Economy

the extra investment or cost required if the
alternative with the larger first cost is
selected.
• If the rate of return available through the
incremental cash flows equals or exceeds
the MARR, the alternative associated with
the extra investment should be selected.
• Incremental method is used only for the
revenue alternatives, because service
alternatives have only cost cash flows and
no i* can be determined.

© Faculty of Mechanical Engineering, GIKI

 Guideline for Using Incremental
Analysis

• For multiple alternatives, calculate the

ME-291 Engineering Economy

internal rate of return i* for each alternative.
• Eliminate all alternatives that have an
i* < MARR.
• Compare the remaining alternatives
incrementally.

© Faculty of Mechanical Engineering, GIKI

 For Independent Projects

• In case of the independent projects, there is

ME-291 Engineering Economy

no comparison on the extra investment. The
ROR value is used to accept all projects with
i* ≥ MARR, assuming there is no budget
limitation.

© Faculty of Mechanical Engineering, GIKI