Session 21

Incremental IRR, Comparing Alternatives with Unequal Useful Lives

7/16/2014

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

Rate of Return Method

Using rates of return is another way to compare alternatives.
The return on investment (rate of return) is a popular measure of investment
performance.

Selecting the alternative with the largest rate of return can lead to
incorrect decisions DO NOT compare the IRR of one alternative to
the IRR of another alternative. The only legitimate comparison is the
IRR to the MARR.
Remember, the base alternative must be attractive (rate of return
greater than the MARR), and the additional investment in other
alternatives must itself make a satisfactory rate of return on that
increment.
7/16/2014

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

Incremental IRR Method

Arrange (rank order) the feasible alternatives based on increasing
capital investment.
Establish a base alternative.
Cost alternativesthe first alternative is the base.
Investment alternativesthe first acceptable alternative (IRR>MARR) is the
base.

Iteratively evaluate differences (incremental cash flows) between

alternatives until all have been considered.
7/16/2014

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

Incremental IRR Method

Work up the order of ranked alternatives smallest to largest.
Subtract cash flows of the lower ranked alternative from the higher
ranked.
Determine if the incremental initial investment in the higher ranked
alternative is attractive (e.g., IRR>MARR, PW, FW, AW all >0). If it is
attractive, it is the winner. If not, the lower ranked alternative is the
winner. The loser from this comparison is removed from
consideration. Continue until all alternatives have been considered.
This works for both cost and investment alternatives.
7/16/2014

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

Incremental IRR Method (example)

Which is preferred using a 5 year study period and MARR=10%?

Initial cost
Net annual income
IRR on total cash flow

Alt. A

Alt. B

-$25,000

-$35,000

$7,500

$10,200

Calculate the IRR of both alternatives using Excel.

7/16/2014

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

Incremental IRR Method (example)

Which is preferred using a 5 year study period and MARR=10%?

Initial cost
Net annual income
IRR on total cash flow

Alt. A

Alt. B

-$25,000

-$35,000

$7,500

$10,200

15%

14%

Alt. B-Alt. A

Choosing Alternative A because of its larger IRR would be an incorrect

decision!
7/16/2014

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

Incremental IRR Method (example)

Which is preferred using a 5 year study period and MARR=10%?

Initial cost
Net annual income
IRR on total cash flow

Alt. A

Alt. B

Alt. B-Alt. A

-$25,000

-$35,000

-$10,000

$7,500

$10,200

$2,700

15%

14%

11%

The incremental IRR from Alt. A to Alt. B is 11% which is GREATER

than the MARR.
7/16/2014

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

Incremental IRR Method (example)

Both alternatives A and B are acceptableeach one has a rate of
return that exceeds the MARR. By examining the incremental cash
flows we see that the extra amount invested in Alternative B earns a
return that exceeds the IRRso B is preferred to A.
Also note:

7/16/2014

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

Incremental IRR Method

7/16/2014

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

Study Periods with Unequal Useful Lives

Unequal lives are handled using either the Repeatability or
Coterminated assumption:
Repeatability assumption
The study period is either indefinitely long or equal to a common multiple of
the lives of the MEAs.
The economic consequences expected during the MEAs life spans will also
happen in succeeding life spans (replacements).

Coterminated assumption: uses a finite and identical study period for

all MEAs. Cash flow adjustments may be made to satisfy alternative
performance needs over the study period.
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IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

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MEAs with Unequal Useful Lives

The repeatability assumption, when applicable, is a simplified
comparison of alternatives.
If repeatability cannot be used, an appropriate study period must be
selected (the coterminated assumption). This is most often used in
engineering practice because product life cycles are becoming
shorter.

7/16/2014

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

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Useful Life < Study Period

Cost alternatives
Contracting or leasing for remaining years may be appropriate
Repeat part of the useful life and use an estimated market value to truncate

Investment alternatives
Cash flows reinvested at the MARR to the end of the study period
Replace with another asset, with possibly different cash flows, after the study
period

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IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

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Useful Life > Study Period

Truncate the alternative at the end of the study period, using an
estimated market value.
The underlying principle in all such analysis is to compare the MEAs in
a decision situation over the same study (analysis) period.

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IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

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MEAs with Unequal Useful Lives

If repeatability can be assumed, the MEAs are most easily compared
by finding the annual worth (AW) of each alternative over its own
useful life, and recommending the one having the most economical
value.
For cotermination, use any equivalent worth method using the cash
flows available for the study period.

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IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

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Unequal Useful Lives (Repeatability example)

Note that the least common multiple of the useful lives of Alt. A and B
is 12 years. Use repeatability and PW Method to solve.
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IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

15

Unequal Useful Lives (Repeatability example)

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IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

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MEAs with Unequal Useful Lives (example)

We can use Incremental IRR on MEAs with unequal lives.
Equate the MEAs annual worth values (AW) over their respective
lives:
Capital Investment
Annual Cash Flow
Useful Live (years)

7/16/2014

A
$3,500
$1,255
4

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

B
$5,000
$1,480
6

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MEAs with Unequal Useful Lives (example)

Capital Investment
Annual Cash Flow

A
$3,500
$1,255

B
$5,000
$1,480

Useful Live (years)

Solving, we find i*=26% (which is greater than the MARR), so the

increment is justified and Alt. B is preferred.
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IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

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MEAs with Unequal Useful Lives (example)

A company must choose between two machines, whose economic
data are listed below. Use a MARR of 10% and make decisions using
PW Analysis. The company uses a 10 year analysis period.

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Alternative A

Alternative B

Initial Cost

$50,000

$75,000

Annual Revenue

$5,000

$5,000

Salvage Value at end of useful life

$10,000

$12,000

Useful life, in years

13

Market Value at end of 10 years

$20,000

$15,000

IE 343, Summer 2014, Engineering Economy (Sullivan, 16th)

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