Engineering Economics & Management

MS490
Chapter 8
Rate of Return Analysis: Multiple Alternatives

Muhammad Ullah
Assistant Professor
Department of Management Sciences GIKI
Chapter 7 – Recap
• IRR of a single project
• Problem of multiple IRRs
• External Rate of Return
– Modified ROR
Ch 8: Learning Outcomes
• Why incremental analysis is required in ROR?
• Incremental cash flow (CF) calculation
• Interpretation of ROR on incremental CF
• Select alternative by ROR based on PW relation
• Select alternative by ROR based on AW relation
• Select best from several alternatives using ROR method
Example
Suppose:
RORA = 35% and RORB = 29%

Which investment is better, economically?

Is it possible that B could be better

alternative?

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Example
• 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, the weighted averages are:
Given RORA = 35% and RORB = 29%
• Considering return on available capital
– 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%

Which investment is better, economically? 5

Decision?
• Selection based on higher ROR:
Select alternative A (wrong answer)
• Selection based on higher overall ROR:
Select alternative B
• Conclusion: Incremental ROR analysis must be used 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.
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Why Incremental Analysis?
• Selecting the alternative with highest ROR may not yield
highest return on available capital.
• Must consider weighted average of total capital
available.
=> in other words, consider the overall ROR
• Capital not invested in a project is assumed to earn at
MARR.

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Why Incremental Analysis?
• What does the incremental cash flows show?

A B B-A
First Cost, $ -40,000 -60,000 -20,000
Annual Cost, $ -25,000 -19,000 6,000
Salvage Value, $ 8,000 10,000 2,000

Project Life in 5 5
years

• It shows the “extra investment or cost” required if an

alternative with higher initial cost is selected.
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Why Incremental Analysis?
• In Incremental IRR analysis, we analyze the IRR earned on
the “extra funds”. If return on extra funds is justified, we
select the alternative (the one with higher initial costs),
otherwise not (instead we select the cheaper one).
• Because firm can save this extra cost and can invest at
higher rate somewhere else.

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Interpretation of ROR on Extra Investment
• Based on the concept that any avoidable investment that does
not yield at least the MARR should not be made.
• 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 (because the extra investment is avoidable by selecting
the economically-justified lower-cost alternative)
• This incremental ROR is identified as
• For independent projects, select all projects that have (no
incremental analysis is necessary)
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Problems with Applying IRR
• There are three primary elements due to which mainly IRR
analysis are applied incorrectly in engineering economic
analysis:
1. Incremental Cash flow Series
2. LCM
3. Multiple roots (multiple IRR values)
• It is advisable to use PW or AW analysis instead of IRR
when there is multiple IRR values.

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IRR Evaluation using PW
• Single alternative: For IRR put PW of the cash flow = 0.
• Multiple alternatives: For IRR put the PW of incremental
cash flows = 0. Using trial and error approach, calculate
the rate (ΔiB-A) at which PW of incremental CF is zero.
• Equal Life Comparison by using LCM method.

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IRR Evaluation for Two Mutually Exclusive
Alternatives
1. Order alternatives by increasing initial investment cost.
2. Develop incremental cash flow 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 , select B; otherwise, select A

If multiple ∆i* values exist, find EROR using either Modified Rate
of Return or Return on Invested Capital approach.
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Example
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 no multiple ROR values
indicated.
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Solution
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

Quick Check
Determine which of the two alternatives should be selected
by calculating the rate of return on the incremental
investment. Assume the company’s MARR is 21% per year.
(both alternatives individually are viable based on IRR.
A B
First Cost, $ -50,000 -95,000

Annual Cost, -100,000 -85,000

$
Salvage 5,000 11,000
Value, $
Life, Years 3 6 16
 Solution using LCM Method
Project 0 1 2 3 4 5 6
A cycle#1 - -100,000 -100,000 -100,000
50,000 5,000

A -50,000 -100,000 -100,000 -100,000

cycle#2 5,000

B - -85,000 -85,000 -85,000 -85,000 -85,000 -85,000

95,000 11,000

Incremental - 15,000 15,000 15,000 15,000 15,000 15,000

(B-A) 45,000 45,000 6,000

0 = -45,000 + 15,000(P/A,Δi*,6) + 45,000(P/F,Δi*,3) +

6000(P/F,Δi*,6)
Solve for using trial and error

So, select B alternative

ROR for Multiple ME Alternatives
• Pairwise comparison of alternatives
• Order alternatives based on Initial Investment/Initial costs.
• => B is out of comparison
• Alternative
– Alternative Lowest Initial Investment = “Defender”
– Alternative with Second Lowest a= “Challenger.
NOTE: We start with DN as defender and the next lowest initial cost alternative as
challenger.

• Make the cash flow of Defender and Challenger, check Incremental Cash
flow. If it is economically viable, select challenger. Now, it becomes the
Defender and you take next higher Initial cost as Challenger. This process
will continue until you are left with only one alternative.
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ROR for M.E Multiple Alternatives
1. Order alternatives from smallest to largest initial investment.
2. For revenue alternatives, 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 (based on PW or AW).
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. DN and select all with
ROR ≥ MARR
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Example: ROR for Multiple Alternatives
Caterpillar Corporation wants to build a spare parts storage facility in Arizona.
A plant engineer has identified four different location options. The initial cost
of earthwork and prefab building and the annual net cash flow estimates are
given below. The annual net cash flow series vary due to differences in
maintenance, labor costs, transportation charges, etc. If the MARR is 10%, use
incremental ROR analysis to select the one economically best location.

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 Solution

All sites have a 30-year life, and they are revenue

alternatives. The procedure outlined above is applied.
1. The alternatives are ordered by increasing initial cost.
2. Compare C with the do-nothing (DN) alternative. The ROR
relation includes only the P/A factor.
0 = - 190,000 + 19,500( P/A , Δi*,30)
Column 1, presents the calculated (P/A,i*,30) factor value of
9.7436 and Δic*=9.63%. Since 9.63%<10% => C is
eliminated. Now the comparison is A to DN, and column 2
shows that ΔiA*=10.49%. This eliminates the DN alternative;
the defender is now A and the challenger is B.
The incremental cash flow series, column 3, and Δi* for B to A
comparison are determined from
0 = -75,000 +13,000( P/A , Δi*,30)
• From the interest tables, look up the P/A factor at the
MARR, which is (P/A,10%,30)=9.4269. Now, any P/A value
greater than 9.4269 indicates that the Δi* will be less than
10% and is unacceptable.
• The P/A factor is 5.7692, so B is acceptable. For
reference purposes, Δi* = 17.28%.
• Comparison D - B (steps 3 and 4) results in the PW relation
0 = -75,000 + 7000( P/A , Δi*,30)
and a P/A value of 10.7143 (Δi* = 8.55%)
• Location D is eliminated, and only alternative B
remains; it is selected.
 Example 8.3: Using AW fort IRR A B B-A
0 -8000 -13000 -5000
1 -3500 -1600 1900
2 -3500 -1600 1900
3 -3500 -1600 1900
4 -3500 -1600 1900
5 -3500 -1600 1900
Solution: 2000 -11000
Method#1: Use AW relation for incremental cash flows -13000
0 = -5000(A/P,∆i∗,10) - 11000(P/F, ∆i∗,5)(A/P, ∆i∗,10)
+2000(A/F, ∆i∗,10)+1900
6 -3500 -1600 1900
Solve for IRR; => ∆i∗=12.65% 7 -3500 -1600 1900
Method#2: Use AW relation for actual cash flows 8 -3500 -1600 1900
AWA=-8000(A/P, i,10)-3500
AWB=-13000(A/P,i,5)+2000(A/F,i,5)-1600
9 -3500 -1600 1900
Now develop AWB-AWA=0 10 -3500 -1600 1900
-13000(A/P, i∗,5)+2000(A/F, i∗,5)+ 8000(A/P, 2000 2000
i∗,10)+1900=0 26
Solve for IRR; => i∗=12.65%
As groundwater wells age, they sometimes begin to pump sand (and they become
known as “sanders”), and this can cause damage to downstream desalting
equipment. This situation can be dealt with by drilling a new well at a cost of
$1,000,000 or by installing a tank and self-cleaning screen ahead of the desalting
equipment. The tank and screen will cost $230,000 to install and $61,000 per year
to operate and maintain. A new well will have a pump that is more efficient than the
old one, and it will require almost no maintenance, so its operating cost will be only
$18,000 per year. If the salvage values are estimated at 10% of the first cost, use a
present worth relation to ( a ) calculate the incremental rate of return and ( b )
determine which alternative is better at a MARR of 6% per year over a 20-year
study period.
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 (a) The incremental ROR equation is:

0 = - 770,000 + 43,000(P/A, Δi*,20) + 77,000(P/F, Δi*,20)

Solve for Δi* by trial and error or spreadsheet

Δi* = 1.8% per year (RATE function on spreadsheet)

(b) Install the tank and screen since 1.8% < MARR = 6%

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 Thank You

Any Questions?
Email:
[email protected]
References
• Engineering Economy 7th Edition by Leland Blank, Anthony
Tarquin [ISBN-10: 0073376302] and accompanying
PowerPoint slides

• Videos from Dragon’s Den are copy righted. We are using it

only for educational purposes.

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