Rate of Return Analysis: Multiple Alternatives: Gra W Hill

ENGINEERING ECONOMY Sixth
Edition
Blank and
Tarquin
CHAPTER 8
Rate of Return Analysis:

Multiple Alternatives
M c
Gra
Hill
w
02/19/10 1
Learning Objectives
1. Why Incremental Analysis?

2. Incremental Cash Flows
3. Interpretation
4. Incremental ROR by PW
5. Incremental ROR by AW
6. Multiple Alternatives
02/19/10 Authored by Don Smith, Texas A&M University 2004 2

Section 8.1
Why Incremental Analysis is
Necessary
• Assume we have two or more
mutually exclusive alternative
•Objective: Which, if any of the
alternatives is preferred?
•Prior Chapters: Use the PW or AW
approach
•This chapter: We apply the ROR
approach
•Present Worth: Equal service lives
must
02/19/10 applyAuthored by Don Smith, Texas A&M University 2004 3
8.1 Ranking Inconsistency
• For some problems, PW and ROR may

rank the same problems differently.
Why?
•PW assumes reinvestment at the
MARR or discount rate.
•ROR assumes reinvestment at the i*
or i’ rate
•Two different reinvestment rate
assumptions apply
8.1 Review of Problem Types
•
INDEPENDENT AND MUTUALLY
EXCLUSIVE ALTERNATIVES
 INDEPENDENT - Selection of one
alternative does not effect the selection of
others. Example: select all projects with a
ROR> 20%
 MUTUALLY EXCLUSIVE - Selection on one

alternative precludes the selection of
others. Example: select the project with the
highest ROR.
8.1 An Example – Shows Ranking
Inconsistency Problem
• From Solomon {1956/59}

•Two Investments A and B
•Discount rate = 10%
•Each investment requires $100 at t =
0
•A is a 1-year investment
•B is a 5- year investment

8.1 Two Projects; A and B
•A $120
0 1 2 3 4
5
$100
$201.14
•B
0 1 2 3 4
5
$100

8.1 Example Problem
• i*A = 0.20 = 20% •Using ROR, A is

superior to B
• i*B = 0.15 = 15% •Using PW, B is
superior to A
•PWA(10%) = +$9.09 •Inconsistent
Rankings!
•PBB(10%) = +24.89

8.1 Example Problem - Rankings
• Using ROR Ranking

•A is superior to B (20% > 15%)
•Using a PW(10%) approach
•B is superior to A ($24.89 > $9.09)
•The two methods do not rank the
same?

8.1 Look at A and assume
Reinvestment forward to t = 5
• Reinvest the $120 out to t = 5
$120
0 1 2 3 4
5
$100
•Assume the +$120 can be reinvested

forward at the firm’s MARR rate of 10%/year
out to the end of year 5.

8.1 Look at A and assume
Reinvestment forward to t = 5
F5
• Find F5 for Alt. A =?
$120
0 1 2 3 4
5
$100
•F5 = 120(F/P,10%,4)=$175.69

8.1 ROR of A given reinvestment
• -100 +120(F/P,10%,4)(P/F,i*A, 5) = 0
•Solving for i*A
•(P/F, i*A,5) = 0.569
• i*A/reinvestment @10% = 0.1193
•i*A/c=10% = 11.93%

8.1 Now Compare A to B
• Compare revised A with

reinvestment at 10% to B
•i*A/c = 10% = 11.93%
•i*B = 15% as before
•ROR Rankings:
•B is superior to A (15% > 11.93%)

8.1 Ranking Consistency
• Now, PW(10%) and ROR with the

reinvestment imposed on the 1-year
project rank consistently.
•B is superior to A with both methods

8.1 Ranking Inconsistency…
• Occurs between ROR and PW

because
•Both methods have different
reinvestment rate assumptions
•Two different cash flows may not
generate funds at the same rate

Section 8.2
ROR for Mutual Exclusive
Projects
•Given Two or more alternatives

•Rank the investments based upon
their initial time t = 0 investment
requirements
•Summarize the investments in a
tabular format

8.2 Tabular Format
t Alt. A Alt. B B-A
0 $ $
1 $ $
2 $ $
… … …
Find the ROR of
N $this investment
$
which is
(B – A)
8.2 Ranking Rules
• Given two or more Mutually Exclusive

investments
•Select the first investment to be the
one with the lowest time t = 0
investment amount.
•The next investment is to be the one
with the largest investment at time t =
0

8.2 Example
• Two Investments: A and B

• A costs $30,000 at time t = 0
• B costs $50,000 at time t = 0
•MARR = 10%
•Life is 4 years

8.2 Example: A and B
• For this
problem, A is
superior to B
based on PW
and on ROR!
•A is ranked
first;
•B is ranked
second

8.2 Example: A and B
• Both
alternatives
have a PW > 0
and have i*’s
> MARR.
•Both are
feasible
alternatives
initially.

8.2 Form the Difference (B – A)
• For mutually exclusive alternatives…

•One should focus on the differences
between the alternatives
•“Differences” are illustrated best by
forming what is called the incremental
investment (B-A)

8.2 Incremental Investment
A B (B-A)
Find the
ROR of
this
Lowest Next investme
The
First Highest first
Cost
investment
Cost
investment
= Incremental
investment
nt

8.2 Incremental Investment
B-A
The incremental Investment

8.2 The logic….
• One would go with investment A

initially because it is the least
expensive alternative at time t = 0
•And it’s present worth is > 0.
•So, A is a feasible alternative to start

8.2 Explaining the Incremental
Investment
B-A
• Now, is it worth it to the firm to

consider investing (-$50,000 – (-
$30,000) =
-$20,000 to get the cash flows
indicated in the (B-A) cash flow series?

8.2 Explaining….continued
A B
(B-A)
The investment (B-A) represents the year-

by-year difference between A and B

8.2 Explaining…continued
•
A B (B-
A)
(B-A) is “additional” investment to move

from investing in A and moving on to invest
in B.

8.2 The Incremental Investment
• Investing $20,000 at time t = o

results in the following incremental
investment

8.2 Is it worth it?
• Now the question is….

•Is it worth spending an additional
$20,000 to move from investment A to
investment B?
•Answer: Compute the ROR or PW of
the incremental investment to see!

8.2 Analysis
• For this problem, NPV(10%) < 0

• and, no ROR could be found!

8.2 Analysis
• The incremental investment shows a

negative PW and no ROR is found
•Thus, the increment is rejected.
•Moving from A to B is not
economically worth it
•Stay with A!

8.2 Another Example
• Homework Problem 8.21 to illustrate

•Cash Flows are shown on the next
slide
• Two alternatives
•Semiautomatic machine vs.
•Automatic machine
•Assume a 6 year life for analysis

8.2 Example (Problem 8.21)
Year SemiAuto Auto (B-A)
A B
0 -$40,000 -$90,000 -$50,000
1 -100,000 -85,000 15,000
2 -100,000 -85,000 15,000
3 -135,000 -85,000 50,000
4 -100,000 -85,000 15,000
5 -100,000 -85,000 15,000
6 -95,000 -74,000 21,000

8.2 Analysis
• Computed PW
@ 18% shows
that B has the
lowest PW cost
and would be
preferred to A

8.2 Incremental Cash Flow
(B-A)
•Question?
0 -$50,000 •Is it worth spending an
1
additional $50,000 in the
15,000
automatic machine in
2 15,000 order to receive the
incremental savings
3 50,000 shown to the left?
4 15,000 •Compute the ROR of the
5 15,000 incremental Cash Flow
6 21,000

8.2 Incremental ROR = 35.95%

8.2 NPV Plot of A and B
• A is equivalent to B @ Incremental
ROR rate of 35.95%
NPV PLOT-INC. C.F.
0.00
00
10
20
30
40
50
60
70
80
90
00
10
20
30
40
50
60
70
80
90
00
-100000.00
0.
0.
0.
0.
0.
0.
0.
0.
0.
0.
1.
1.
1.
1.
1.
1.
1.
1.
1.
1.
2.
-200000.00
-300000.00
NPV(i%)
-400000.00
-500000.00
-600000.00
-700000.00
-800000.00
Disc. Rates

8.2 i* (B-A) = 35.95%
• The incremental i*(B-A) is greater than

the firm’s discount rate of 18%
•Since i*(B-A) > MARR, accept the

increment and go with Alternative B.
•Same results as PW(18%) shows
•B is clearly the winner

Section 8.3 Interpretations of
ROR
• The i*incremental is the ROR of the

additional or incremental investment
required to move from one project to
the next most costly project
•If the i*incremental value is < MARR the

increment is not worth it. Go with to
lower investment cash flow

8.3 Multiple Alternatives
• If Cost-Revenue Problem…
•Calculate the computed i*’s for each
alternative in the set
•Discard those alternatives whose i*
value is less than the MARR – they
would lose anyway!

8.3 Independent Projects
• If dealing with independent projects,

one does not compute incremental
investments among the candidate
projects
•Rule: Accept all projects whose ROR >
MARR and stay within any budget
limitations

8.3 The i* (B-A) value
• Given two mutually exclusive

alternatives, A and B.
•The i* (B-A) value also represents

the interest rate at which the two
alternatives are economically
equivalent.

CHAPTER 8
Section 8.4
ROR Using PW:
Incremental and
Breakeven
02/19/10 44
8.4 PW Approach – Mutually Exclusive
Case
• Given multiple alternatives

•If unequal lives – either establish
a common project life or,
•Apply the LCM of life approach
found in chapter 5

Case
• Order (rank) the alternatives by

their initial time t = 0 investment
cost
• Start with the smaller
investment alternative – refer to
it a “A”
•The next highest investment
cost is called “B”
Case
• Compute the incremental cash flow

(B-A)
• Given the MARR find the PW of (B-A)
investment
• If PW(MARR) of (B-A) is >0; accept the
increment – go with the higher
investment cost alternative.
•Else, reject the increment and go with
the lower investment cost option
8.4 ROR Case – Unique i* (B-A)
• Compose the incremental Cash Flow

•Examine that cash flow for sigh
changes and apply the Norstrom test
(from Chapter 7)
•If a unique i* (B-A) is indicated – solve
for it and compare it to the MARR
•If i* (B-A) > MARR, accept the increment
else reject
8.4 Example 8.3 Bell/GTE
•10 year project (merger)

•New equipment is required
•Two vendors
•MARR = 15%
•Which vendor should be selected
•Cost or Service Problem

8.4 Setup A vs. B PW(15%) shows
that A has the
lowest PW Cost
and should win!
•Note: No ROR for

A (all negative
signs) and B’s
cannot be
determined!

8.4 PW analysis
• We could stop because the PW(15%)

has signaled that A is the winner!
•Lowest PW cost
•Proceed with a ROR analysis BUT….
•ROR must be performed on the
incremental investment

8.4 Incremental Cash Flow Fig.
8-2

8.4 Inc. Cash Flow Results
i* (B-A) is less
Inc. PV(18%)
and is than the
negative. MARR of
Thus, reject 18%.
the Reject
increment
and go with increment
A! and go with
A!

8.4 So-called Breakeven ROR
• Recall, the incremental i*(B-A) is the

interest rate at which the two
alternatives are economically
equivalent.
•This special interest rate is called:
•Breakeven Interest Rate
•Fisherian Intersection Rate

8.4 Breakeven Rate Illustrated
• For Example 8.3 the NPV Plot is:

NPV PLOT-INC. C.F.
0.00
00
10
40
50
70
80
90
10
20
30
50
90
20
30
60
00
40
60
70
80
00
-5000.00
0.
0.
0.
0.
0.
0.
0.
0.
0.
0.
1.
1.
1.
1.
1.
1.
1.
1.
1.
1.
2.
-10000.00
-15000.00
-20000.00
NPV(i%)
-25000.00 i*(B-A) rate;Alternatives

-30000.00 are identical at this rate.
-35000.00
-40000.00
-45000.00
-50000.00
Disc. Rates

8.4 Conclusions i* (B-A) = 12.65%
• For MARR < 12.65% extra investment

is justified. Go with B
•For MARR > 12.65%, the extra
investment is not justified: Go with A
•If MARR = 12.65%, both options are
economically equivalent.
Recall: MARR = 18%

CHAPTER 8
Section 8.5
ROR Evaluation Using
Annual Worth
02/19/10 57
8.5 ROR Using AW
• ROR approach requires comparison

over an equal-service life
•When the lives are equal or unequal
set up the AW relationship for the cash
flows of each alternative
•Then solve 0 = AWB – AWA for the i*
value

8.5 ROR Using Annual Worth
• See Example 8.5

•Manual approach
•It is best to avoid this approach and
stay with either the PW or ROR over
the total life of the project or the LCM
life

Section 8.6
Incremental ROR
Analysis of Multiple,
Mutually Exclusive
Alternatives
02/19/10 60
8.6 Criteria
•Select the one alternative that:

•Requires the largest investment
•And indicates that the extra
investment over another acceptable
alternative is justified

8.6 Comparing Alternatives
• A given alternative should not be

compared with one alternative for
which the incremental investment is
not justified
•If a given alternative looses out in a
comparison, that alternative is
dropped from further consideration.

8.6 Ranking Rules - Ordering
1. Order the alternatives from

smallest to largest initial investment
2. Compute the cash flows for each
alternative (assume or create equal
lives)
3. If the alternatives are revenue-cost
alternatives do the following…

8.6 Revenue-Cost Problems
4. Compute the i* value for all

alternatives in the considered set.
•If any alternative has an i* < MARR
drop it from further consideration
•The candidate set will be those
alternatives with computed i* values >
MARR.
•Call this the FEASIBLE set

8.6 Revenue-Cost - Approach
• Calculate i* for the first alternative

•The first alternative is called the
DEFENDER
•The second (next higher investment
cost) alternative is called the
CHALLENGER
•Compute the incremental cash flow as
•(Challenger – Defender)
8.6 Revenue-Cost
4. Compute i*Challenger–Defender
•If i*Challenger–Defender > MARR drop the

defender and the challenger wins the
current round.
5. If i* Challenger–Defender < MARR, drop the
challenger and the defender moves on
to the next comparison round

8.6 Revenue-Cost
• At each round, a winner is

determined
•Either be the current Defender or the
current challenger
•The winner of a given round moves to
the next round and becomes the
current DEFENDER and is compared to
the next challenger

8.6 Revenue-Cost
6. This process continues until there

are no more challengers remaining.
•The alternative that remains after all
alternatives have been evaluated is
the final winner.

8.6 Potential Problems
• See Example 8.6 for the potential

problems that can occur using RoR
•Pitfalls often exist when one uses the
ROR approach for the analysis of
alternatives

8.6 Cost Problems
• Remember
•Cost problems do not have computed
RoR’s since there are more cost
amounts that revenue amounts
(salvage values may exist)
•Thus there are no feasible i*’s for
each alternative

8.6 Cost Problems - Rules
• Rank the alternatives according to

their investment requirements (low to
high)
•For the first round compare:
•Challenger – Defender Cash Flow
•Compute i*Challenger–Defender
•If i* > MARR,

Challenger–Defender
Challenger wins; else Defender wins
8.6 Cost Problems
• The current winner now becomes the

defender for the next round.
•Compare the current defender to the
next challenger and compute i* Challenger–
Defender
•The winner becomes the current

champion and moves to the next round
as the defender
•Repeat until all alternatives have
been compared.
Section 8.7
Spreadsheet Applications
• Use the E-solve software for PW-AW,

and ROR Analysis
•Study and evaluate example 8.8
•Create your own spreadsheet from
scratch and employ the built in
financial functions.

Chapter 8 Summary
•PW and AW methods are preferred

methods for evaluating alternatives
•ROR can be used but care must be
taken
•If ROR, must perform an incremental
analysis
•Two at a time (paired comparison) is
required

ENGINEERING ECONOMY Sixth
Edition
Blank and
Tarquin
End of Chapter 8 Slide

Set
Mc
Gra
Hill
w
02/19/10 75

Rate of Return Analysis: Multiple Alternatives: Gra W Hill

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ENGINEERING ECONOMY Sixth

Rate of Return Analysis:

1. Why Incremental Analysis?

02/19/10 Authored by Don Smith, Texas A&M University 2004 2

• For some problems, PW and ROR may

 MUTUALLY EXCLUSIVE - Selection on one

• From Solomon {1956/59}

02/19/10 Authored by Don Smith, Texas A&M University 2004 6

02/19/10 Authored by Don Smith, Texas A&M University 2004 7

• i*A = 0.20 = 20% •Using ROR, A is

02/19/10 Authored by Don Smith, Texas A&M University 2004 8

• Using ROR Ranking

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•Assume the +$120 can be reinvested

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02/19/10 Authored by Don Smith, Texas A&M University 2004 11

02/19/10 Authored by Don Smith, Texas A&M University 2004 12

• Compare revised A with

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• Now, PW(10%) and ROR with the

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• Occurs between ROR and PW

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•Given Two or more alternatives

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• Given two or more Mutually Exclusive

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• Two Investments: A and B

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• For mutually exclusive alternatives…

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The incremental Investment

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• One would go with investment A

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• Now, is it worth it to the firm to

02/19/10 Authored by Don Smith, Texas A&M University 2004 26

The investment (B-A) represents the year-

02/19/10 Authored by Don Smith, Texas A&M University 2004 27

(B-A) is “additional” investment to move

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• Investing $20,000 at time t = o

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• Now the question is….

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• For this problem, NPV(10%) < 0

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• The incremental investment shows a

02/19/10 Authored by Don Smith, Texas A&M University 2004 32

• Homework Problem 8.21 to illustrate

02/19/10 Authored by Don Smith, Texas A&M University 2004 33

1 -100,000 -85,000 15,000

2 -100,000 -85,000 15,000

3 -135,000 -85,000 50,000

4 -100,000 -85,000 15,000

5 -100,000 -85,000 15,000

6 -95,000 -74,000 21,000

02/19/10 Authored by Don Smith, Texas A&M University 2004 34

02/19/10 Authored by Don Smith, Texas A&M University 2004 35