Rate of Return

Multiple Alternatives

Engineering Economics 1
 LEARNING OUTCOMES
1. Why incremental analysis is required in ROR
2. Incremental cash flow (CF) calculation
3. Interpretation of ROR on incremental CF
4. Select alternative by ROR based on PW
relation
5. Select alternative by ROR based on AW
relation
6. Select best from several alternatives using
ROR method

Engineering Economics 2
Why Incremental Analysis is Necessary

Selecting the alternative with highest ROR may not

yield highest return on available capital

Must consider weighted average of total capital available

Capital not invested in a project is assumed to earn at MARR

Engineering Economics 3
Example of weighted average of capital
Assume $90,000 is available for investment and MARR = 16% per year.
If alternative A would earn 35% per year on investment of $50,000,
and B would earn 29% per year on investment of $85,000
A earns more than B?
But, how about the remaining funds
A: 90000-50000 = 40000; B: 90000-85000 = 5000 after investment?

Overall RORA = [50,000(0.35) + 40,000(0.16)]/90,000 = 26.6%

Overall RORB = [85,000(0.29) + 5,000(0.16)]/90,000 = 28.3%

B actually earns more for the total of $90,000

Engineering Economics 4
Why Incremental Analysis is Necessary
If selection basis is higher ROR:
Select alternative A (wrong)

If selection basis is higher overall ROR (weighted):

Select alternative B

Conclusion: Must use an incremental ROR analysis to

make a consistently correct selection

Unlike PW, AW, and FW values, if not analyzed correctly, ROR

values can lead to an incorrect alternative selection. This is
called the ranking inconsistency problem (discussed later)
Engineering Economics 5
 Calculation of Incremental CF
Incremental cash flow = cash flowB – cash flowA
where larger initial investment is Alternative B

Example: Either of the cost alternatives shown below can be used in

a grinding process. Tabulate the incremental cash flows.

A 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

The ROR on the extra $20,000 investment (cost more) in B determines which alternative
to select (as discussed later)
Engineering Economics 6
 ROR Evaluation for Two ME Alternatives
(1) Order alternatives by increasing initial investment cost
(2) Develop incremental CF series using LCM of years
(3) Draw incremental cash flow diagram, if needed
(4) Count sign changes to see if multiple ∆i* values exist
(5) Set up PW, AW, or FW = 0 relation and find ∆i*B-A
Note: Incremental ROR 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 multiple ∆i* values exist, find EROR using either MIRR (Modified ROR) or
ROIC (Return on Invested Capital) approach.

Engineering Economics 7
 Example: Incremental ROR Evaluation
Either of the cost alternatives shown below can be used in a chemical
refining process. If the company’s MARR is 15% per year, determine
which should be selected on the basis of ROR analysis?

A B
First cost ,$ -40,000 -60,000
Annual cost, $/year -25,000 -19,000
Salvage value, $ 8,000 10,000
Life, years 5 5

Initial observations: mutually exclusive, cost alternatives with equal life

estimates and only one ROR value

Engineering Economics 8
Example: ROR Evaluation of Two Alternatives
Solution: using procedure:
A 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
Life, years 5 5

Order by first cost and find incremental cash flow B - A

Write ROR 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%
ROR on $20,000 extra investment is acceptable: Select B
Engineering Economics 9
Interpretation of ROR on Extra Investment
Based on concept that any avoidable investment that
does not yield at least the MARR should be avoided.
Once a lower-cost alternative has been economically justified, the
ROR on the extra investment (i.e., additional amount of money associated
with a higher first-cost alternative) must also yield a ROR ≥ MARR
(because the extra investment is avoidable by selecting the economically-justified
lower-cost alternative).

This incremental ROR is identified as ∆i*

For independent projects, select all that have ROR ≥ MARR

(no incremental analysis is necessary)

Engineering Economics 10
Practice: Incremental Analysis
Ford Motor would like to select from two kinds of gears. The two
vendors provide bids as follows. Select the more economical vendor as
MARR=12% per year.
Per unit A B
Initial Cost, $ -8000 -13000
Annual Cost, $ per year -3500 -1600
Salvage Value, $ 0 2000
Life, years 10 5

Engineering Economics 11
Practice: Incremental Analysis

0 = -5,000 + 1900(P/A,∆i*,10) - 11000(P/F,∆i*,5) + 2000(P/F,∆i*,10)

Solve for ∆i* and compare to MARR
∆i*B-A = 12.65% > MARR of 12%
ROR on $20,000 extra investment is acceptable: Select B
Engineering Economics 12
Practice: Incremental Analysis (spreadsheet)

-11000-1600-(-3500) = -11000 + 1900

Engineering Economics 13
 Breakeven ROR Value
An ROR at which the PW, AW or
FW values:

❖ Of cash flows for two alternatives

are exactly equal. This is the i* value

❖ Of incremental cash flows between

two alternatives are exactly equal.
This is the ∆i* value

If breakeven ROR > MARR,

select higher-investment
alternative
14
Practice: Ranking Inconsistent
Two filter systems may be used for removing air pollution. Choose the
more economical system, using MARR=15% per year

Filter 1 Filter 2
Initial Cost, $ -1000 -1500
Estimated Saving, $ per year 375 700 in year 1, deceasing by 100 per year
Life, years 5 5

Engineering Economics 15
Practice: Ranking Inconsistent
If we consider ROR, which one is
better?

25.41% > 23.57%, Filter 1 seems

better(?)

Yet, from the incremental

analysis, ∆i*=16.89% > 15%

Thus, select higher-investment

alternative: Filter 2

Engineering Economics 16
Review: ROR
• The ROR can be defined as the discount rate which, when applied to
the cash flows of a project, produces a net present value (NPV)=0.
• If the ROR is greater than MARR, the project is accepted. If the ROR is
less than MARR, the project is rejected.
• DO NOT use ROR to compare mutually exclusive alternatives. This is
because ROR overstates the annual rate of return by assuming
reinvestment of cash flows of the project at the same rates of return
as the initial investment, which rarely holds true for large projects.

Engineering Economics 17
Practice: Ranking Inconsistent
#2≻#1 #1≻#2

=15%

Both PW=0

#2-#1

=15%

Engineering Economics 18
Rate of Return Using AW (method 1)
Solve for i* using incremental analysis
Use the AW-based incremental ROR method to compare vendor A
and B with MARR=12% per year
Solution:
Method 1:
0 = -5000(A/P,∆i*,10) - 11000(P/F,∆i*,5) (A/P,∆i*,10) +
2000(A/F, ,∆i*,10) + 1900

Solve for ∆i* = 12.65%

same as PW approach

Engineering Economics 19
Rate of Return Using AW (method 2)
Solve for i*, let AWB – AWA = 0
Use the AW-based incremental ROR method to compare vendor A
and B with MARR=12% per year
Solution:
Method 2:
AWA = -8000(A/P,i*,10) – 3500
AWB = -13000(A/P,i*,5) + 2000(A/F,i*,5) -1600

Let AWB = AWA

Solve for i* = 12.65%

Engineering Economics 20
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 ROR relation
(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. Do-Nothing and select all with ROR ≥ MARR

Engineering Economics 21
Practice: ROR Analysis – Multiple Alternatives
A corporation wants to build a parts storage facility. The plant manager
has identified 4 location options. Each location has the initial cost and
annual cost as follows. If MARR=10%, use incremental ROR analysis to
select one economically best location

Engineering Economics 22
Practice: ROR Analysis – Multiple Alternatives

MARR=10%

Engineering Economics 23
 Summary of Important Points
Must consider incremental cash flows for mutually exclusive alternatives
Incremental cash flow = cash flowB – cash flowA
where alternative with larger initial investment is Alternative B

Eliminate B if incremental ROR ∆i* < MARR; otherwise, eliminate A

Do Not compare ROR for mutually exclusive alternatives

Breakeven ROR is i* between project cash flows of two alternatives, or ∆i* between
incremental cash flows of two alternatives

For multiple mutually exclusive alternatives, compare two at a time and eliminate
alternatives until only one remains

For independent alternatives, compare each against DN and select all that have
ROR ≥ MARR
Engineering Economics 24