Engineering Economy

Learning outcomes
ME2045
8 • State why the ROR method of comparing alternatives requires an incremental cash
flow analysis.
• Calculate the incremental cash flow series for two alternatives.
• Interpret the meaning of the incremental ROR (Δi*) determined from the incremental
Rate of Return Analysis: Multiple Alternatives cash flow series.
• Based on a PW relation, select the better of two alternatives using incremental ROR
Assoc. Prof. Dr. Le Ngoc Quynh Lam analysis or a breakeven ROR value.
• Select the better of two alternatives using incremental ROR analysis based on an AW
relation.
• Select the best from several alternatives using incremental ROR analysis.
• Use a single spreadsheet to perform PW, AW, ROR, and incremental ROR analyses
for mutually exclusive and independent alternatives.

8.1 Why Incremental Analysis Is

Necessary 8.1 Ranking Inconsistency
• Assume we have two or more mutually exclusive alternatives • For some problems, PW and ROR may rank the same problems
differently. Why?
• Objective: Which, if any of the alternatives is preferred?
• PW assumes reinvestment at the MARR or discount rate.
• Prior Chapters: Use the PW or AW approach
• ROR assumes reinvestment at the i* or i’ rate
• Last chapter: We apply the ROR approach
• Two different reinvestment rate assumptions apply
• Present Worth: Equal service lives must apply

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8.1 Ranking Inconsistency Problem
8.1 Two Projects; A and B
• Two Investments A and B
•A $120
• Discount rate = 10%
0 1 2 3 4 5
• Each investment requires $100 at t = 0
$100
• A is a 1-year investment $201.14

• B is a 5- year investment •B
0 1 2 3 4 5

$100

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8.1 Example Problem 8.1 Another example Problem

• Let’s assume that a company uses a MARR of 16% per year,
• i*A = 0.20 = 20% that the company has $90,000 available for investment, and
• Using ROR, A is superior to B that two alternatives (A and B) are being evaluated.
• i*B = 0.15 = 15% • Using PW, B is superior to A • Alternative A requires an investment of $50,000 and has an
• PWA(10%) = +$9.09 • Inconsistent Rankings! internal rate of return iA* of 35% per year.
• Alternative B requires $85,000 and has an i*B of 29% per year.
• PWB(10%) = +24.89

• Intuitively we may conclude that the better alternative is the one

that has the larger return, A in this case.

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8.1 Another example Problem 8.1 Why Incremental Analysis Is Necessary
• These calculations show that even though the i* for alternative A
is higher, alternative B presents the better overall ROR for the
$90,000. Under some circumstances, project ROR values do not provide
the same ranking of alternatives as do PW and AW analyses.
This situation does not occur if we conduct an incremental ROR
analysis

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8.2 Calculation of Incremental Cash Flows 8.2 Calculation of Incremental Cash Flows
for ROR Analysis for ROR Analysis
• Given two or more alternatives • Given two or more alternatives
• Rank the investments based upon their initial time t = 0 • Rank the investments based upon their initial time t = 0
investment requirements investment requirements
• Summarize the investments in a tabular format • Summarize the investments in a tabular format

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8.2 Calculation of Incremental Cash Flows for ROR Analysis EXAMPLE 8.1

Revenue alternative, where there are both negative and positive cash flows
Cost alternative, where all cash flow estimates are negative

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EXAMPLE 8.1 EXAMPLE 8.2

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 8.3 Interpretation of Rate of Return on the
EXAMPLE 8.2 Extra Investment

• 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.

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8.3 Interpretation of Rate of Return on the 8.3 Interpretation of Rate of Return on the
Extra Investment Extra Investment
• Let’s consider the ROR on the incremental cash flow series between two
alternatives B and A. The incremental ROR value, identified as i*B–A, and
discussed further below, has a predictable relation to individual alternative • Given two mutually exclusive alternatives, A and B.
ROR values in weighted average calculations like those presented in
Section 8.1. • The i* (B-A) value also represents the interest rate at which
• Alternative B has a larger initial investment than A: the two alternatives are economically equivalent.
• RORB <ROR A, then i*B–A < RORB.
• RORB > RORA, then i*B–A > RORB

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 8.4 Rate of Return Evaluation Using PW:
8.3 Interpretation of Rate of Return on the Extra Incremental and Breakeven (Two Alternatives)
Investment
• Given multiple alternatives
• If Cost-Revenue Problem…
• Calculate the computed i*’s for each alternative in the set. • If unequal lives – either establish a common project life, or
• Discard those alternatives whose i* values are less than the MARR – they • Apply the LCM of life approach found in Chapter 5
would lose anyway!
•No need to compute incremental investments among the candidate projects
• Rule: Accept all projects whose ROR > MARR and stay within any budget
limitations

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8.4 Rate of Return Evaluation Using PW:

Incremental and Breakeven (Two Alternatives) EXAMPLE 8.3

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EXAMPLE 8.3 EXAMPLE 8.3
• Step 1 • Step 3
Alternatives A and B are correctly ordered with the higher first-cost alternative in
column 2 of Table 8–4
• Step 2
The cash flows for the LCM of 10 years are tabulated

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8.4 Rate of Return Evaluation Using PW:

EXAMPLE 8.3 Incremental and Breakeven (Two Alternatives)
• Step 4, 5, 6 Breakeven rate of return
• 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

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Recall example 8.3 8.5 Rate of Return Evaluation Using AW
• Recall: MARR = 18% • ROR approach requires comparison over an equal-service life
• For MARR < 12.65% extra • When the lives are equal or unequal set up the AW relationship
investment is justified. Go for the cash flows of each alternative
with B • Then solve 0 = AWB – AWA for the i* value
• For MARR > 12.65%, the
extra investment is not
justified: Go with A
• If MARR = 12.65%, both
options are economically
equivalent.

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8.6 Incremental ROR Analysis of Multiple

8.5 Rate of Return Evaluation Using AW
(More than Two) Alternatives
• Select the one alternative that:
• Requires the largest investment
• And indicates that the extra investment over another
acceptable alternative is justified

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8.6 Incremental ROR Analysis of Multiple 8.6 Incremental ROR Analysis of Multiple
(More than Two) Alternatives (More than Two) Alternatives

1. Order the alternatives from smallest to largest initial

• A given alternative should not be compared with one alternative
investment.
for which the incremental investment is not justified
2. Compute the cash flows for each alternative (assume or
• If a given alternative loses out in a comparison, that alternative
create equal lives).
is dropped from further consideration.
3. If the alternatives are revenue-cost alternatives do the
following…

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8.6 Incremental ROR Analysis of Multiple 8.6 Incremental ROR Analysis of Multiple
(More than Two) Alternatives (More than Two) Alternatives
• Calculate i* for the first alternative
4. Compute the i* value for all alternatives in the considered
set. • The first alternative is called the DEFENDER

• If any alternative has an i* < MARR, drop it from further consideration • The second (next higher investment cost) alternative is
• The candidate set will be those alternatives with computed i* values > called the CHALLENGER
MARR.
• Compute the incremental cash flow as
• Call this the FEASIBLE set
(Challenger – Defender)

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8.6 Incremental ROR Analysis of Multiple 8.6 Incremental ROR Analysis of Multiple
(More than Two) Alternatives (More than Two) Alternatives
4. Compute i*Challenger – Defender
• If i*Challenger – Defender > MARR, drop the defender and the challenger • 6. This process continues until there are no more challengers
wins the current round. remaining.
• The alternative that remains after all alternatives have been
5. If i* Challenger – Defender < MARR, drop the challenger and the defender
evaluated is the final winner.
moves on to the next comparison round
• 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

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Example 8.7

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