Rate of Return Analysis

ISE 182112 – Ekonomi Teknik

References
Newnan, D.G, Eschenbach, T.G & Lavelle, J.P (2012) Engineering
Economic Analysis, 11th edition, Oxford University Press, New York.
Chapter 7 and 8.
Rate of Return Analysis for Two Alternatives:
Incremental Analysis
Step 1
Be sure that all the alternatives have IRR  MARR (alternatives with IRR
< MARR will automatically be rejected).

Step 2
Calculate the difference between alternatives.
Difference = Higher cost alt. – Lower cost alt.
Rate of Return Analysis for Two
Alternatives: Incremental Analysis (2)
Step 3
Compute the incremental rate of return (ROR).
→ IRR of the ‘difference’ cash flow.

Step 4:
Compare ROR with MARR :
ROR  MARR The incremental is profitable.
Choose the higher cost alternative.

ROR < MARR The incremental is NOT profitable.

Choose the lower cost alternative.
Example 6
You must select one of two mutually exclusive alternatives
Year Alt. 1 Alt. 2
IRR1 = 50%
0 -$10 -$20
IRR2 = 40%
1 $15 $28
With a 6% MARR, which alternative should be selected?

Step 1
Be sure that all the alternatives have IRR  MARR (alternatives with IRR < MARR will automatically be rejected).

Step 2
Calculate the difference between alternatives.

Year higher cost alt. – lower cost alt. (= Alt. 2 – Alt. 1)

0 -$20 - (-$10) = -$10
1 $28 - $15 = $13
 Year higher cost alt. – lower cost alt. (= Alt. 2 – Alt. 1)
0 -$20 - (-$10) = -$10
1 $28 - $15 = $13
Step 3
Compute the incremental rate of return (ROR).
→ ROR = IRR of the ‘difference’ cash flow.
$13(P/F,i,1) - $10 = 0 → ROR = 30%
Step 4
Compare ROR with MARR.
ROR  MARR The incremental is profitable.
Choose the higher cost alternative.
ROR < MARR The incremental is NOT profitable.
Choose the lower cost alternative.

ROR > 6% → Accept the increment : the additional $10 to obtain Alt. 2 is superior to
investing $10 elsewhere at 6%. Choose higher cost alternative.→ Select Alternative 2
Example 7
Year Alt. 1 Alt. 2
0 -$10 -$20 IRR1 = 50%
1 $15 $28 IRR2 = 40%
MARR = 6%. If we compute the difference as Alt. 1 – Alt. 2, what is the ROR?
How can we interpret the results?

❑ Step 1 : Done.

❑ Step 2 : Calculate the difference:

Year higher cost alt. – lower cost alt. (= Alt. 1 – Alt. 2)
0 -$10 - (-$20) = $10
1 $15 - $28 = -$13
Example 7
❑ Step 2 : Calculate the difference:
Year higher cost alt. – lower cost alt. (= Alt. 1 – Alt. 2)
0 $10
1 -$13

❑ Step 3 : Compute ROR:

-$13(P/F,i,1) + $10 = 0 → ROR = 30%
❑ Step 4 : Compare ROR with MARR:

The cash flow represents a loan. Is this a desirable borrowing? → It is reasonable

to assume our max. interest rate on borrowing would be the MARR on
investments (i ≤ MARR → The increment is acceptable)
The borrowing is undesirable (30% > 6%), select the ‘lower cost’ alternative
→ Select Alternative 2
 increments of investment
or
increments of borrowing
?

To avoid much of the possible confusion → examine increments of

investment
Example 8
If an electromagnet is installed on the input conveyor of a coal-processing plant, it
will pick up scrap metal in the coal. Removing this scrap will save an estimated
$1200 per year in costs associated with machinery damage. The electromagnetic
equipment has an estimated useful life of 5 years and no salvage value. Two
suppliers have been contacted:
❑ Leaseco will provide the equipment in return for three beginning-of-year
annual payments of $1000 each;
❑ Saleco will provide the equipment for $2783.

If the MARR is 10%, should the project be done, and if so, which supplier should be
selected?

Before we analyze which supplier should be selected, we must decide

whether the do-nothing alternative would be a better choice.
Compare Leaseco with doing nothing. This is the same as finding the PW or IRR of
the Leaseco investment.
A = 1200

PW = PW of benefits - PW of cost = 0
0 = 1200 (P/A, i, 5) - 1000 - 1000 (P/A, i, 2) 0 1 2 3 4 5

1000 1000 1000

Try i = 45% → PW = 86.2

Try i = 50% → PW = -26.6

Interpolate to find the interest rate for each period.

i = 48.82% > MARR 10 %, investment is worth on Leaseco.
Find the IRR of the Saleco investment.
Step 1
Be sure that all the alternatives have IRR  MARR (alternatives with IRR < MARR will automatically
be rejected).
A = 1200
PW = PW of benefits - PW of cost =0
0 = 1200 (P/A, i, 5) - 2783
0 1 2 3 4 5

2783
Try i = 30% → PW = 140.2
Try i = 35% → PW = -119

Interpolate to find the interest rate for each period.

i = 32.70% > MARR 10 %, investment is worth on Saleco.
To compare Saleco and Leaseco → both equipment have the same useful life and benefits.
Step 2
Calculate the difference between alternatives.

Step 3
Compute the incremental rate of return (ROR)= IRR of the ‘difference’ cash flow.
PW = PW of benefits - PW of cost = 0
0 = 1000 (P/A, i, 2) - 1783
Step 3
Compute the incremental rate of return (ROR)= IRR of the ‘difference’ cash flow.

0 = 1000 (P/A, i, 2) – 1783

Try i = 7% → PW = 25
Try i = 8% → PW = 0 → ROR = 8%

Step 4
Compare ROR with MARR.

ROR  MARR The incremental is profitable.

Choose the higher cost alternative.
ROR < MARR The incremental is NOT profitable.
Choose the lower cost alternative.

The incremental rate of return of selecting Saleco rather than Leaseco is 8% (ROR < less than
MARR 10%) → Reject the increment : Choose lower cost alternative. → Select Leaseco
Analysis Period
❑ The solution method for two alternatives is to examine the
differences between the alternatives.
❑ Clearly, the examination must cover the selected analysis period.
❑ The analysis period is a least common multiple of the alternative
service lives and identical replacement is assumed.
❑ This problem illustrates an analysis of the differences between the
alternatives over the analysis period.
Example 8
Two machines are being considered for purchase. If the MARR is 10%, which
machine should be bought? Use an IRR analysis comparison.
The solution is based on a 12-year analysis
period and a replacement machine X that is
identical to the present machine X.

The cash flow for the differences between the

alternatives, is as follows:

PW = PW of benefits - PW of cost =0
0 = 25 (P/A, i, 12) + 150 (P/F, i, 6) + 100 (P/F, i, 12) - 500
PW = PW of benefits - PW of cost = 0
0 = 25 (P/A, i, 12) + 100 (P/F, i, 6) + 100 (P/F, i, 12) - 500

Try i = 1% → PW= 11.415

Try i = 1.25% → PW= 2.355
Try i = 1.5% → PW= -6.51

Interpolate to find the interest rate for each period.

i = 1.316 %

❑ The internal rate of return on the Y − X increment, IRRY−X, is about 1.3%, far
below the 10% MARR.
❑ The additional investment to obtain Machine Y yields an unsatisfactory rate of
return, therefore X is the preferred alternative.
Exercise 5
A firm is considering two alternatives :
A B
Initial cost $10,700 $5,500
Uniform annual benefits $2,100 $1,800
Salvage value 0 0
Useful life, in years 8 4

At the end of 4th years, another B may be purchased with the same cost, benefits, and so forth.
Compute the rate of return for each alternative! If the MARR is 10%, which alternative should be
selected?
(For reference, see Example 7-9 page 178)
(Answer: IRRA = 11.3%, IRRB = 11.7%, ROR = 10.8% → Choose Alt. A)
Incremental Rate of Return Analysis
for Multiple Alternatives

1. Be sure that all the alternatives have IRR  MARR (alternatives with IRR < MARR will be
rejected) or all the alternatives are identified (including do-nothing alternative!).

2. Arrange the remaining alternatives in ascending order.

3. Make a two-alternatives analysis of the first two alternatives.

4. Take the preferred alternative from Step 3, and the next alternative from the list
created in Step 2.

5. Continue until all alternatives have been examined.

 A
(lowest cost)

D
The best alternative

E
(highest cost)

Step 45
Step 2
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or all in Step 2. have IRR  MARR (alternatives with IRR<MARR will
the alternatives
be rejected).
Example 6
A B C
Initial cost $2000 $4000 $5000
Annual benefit $410 $639 $700
MARR = 6%, n = 20 years. Which alternative should be selected?

❑ Compute IRR for each alternative:

IRRA = 20%
IRRB = 15% All alternatives exceed MARR.

IRRC = 12.8%

❑ Arrange the remaining alternatives in ascending order: Alternative A-B-C.

Example 6
A B C
Initial cost $2000 $4000 $5000
Annual benefit $410 $639 $700
MARR = 6%, n = 20 years. Which alternative should be selected?

❑ Make a two-alternatives analysis of alternative A and B.

Alt. B - Alt. A
Cost $2000 ROR = 9.6%.
Annual benefit $229

Accept the incremental : choose Alt. B

 A B C
Initial cost $2000 $4000 $5000
Annual benefit $41 $639 $700

❑ Make a two-alternatives analysis of alternative B and C.

Alt. C - Alt. B
Cost $1000
Annual benefit $61 ROR = 2.0%.

Reject the incremental :

choose Alt.B
→ The best alternative : B
Exercise 6
A B C
Initial cost, $ 6000 7000 9000
Salvage value, $ 0 200 300
Annual benefit, $ 2000 3000 3000
Life, years 3 4 6
Which one is the best alternative? Use 15% MARR.

Remember: Alternatives must be compared over the same number of years →

use Least Common Multiple procedure in each of the two-alternatives analysis.

❑ Do nothing alternative vs Alt. A : ROR = 0%

→ Reject the increment, choose do nothing.
❑ Do nothing alternative vs Alt. B : ROR = 26.4%

→ Accept the increment, choose Alt. B.

❑ Alt. B vs Alt. C (whether using PW formula or AW formula → use 12 yrs analysis period):
Year Alt. B ($) Alt. C ($) Alt.C – Alt.B ($)
0 -7000 -9000 -2000
1 +3000 +3000 0
2 +3000 +3000 0
3 +3000 +3000 0
4 +3000+200 +3000 +6800
-7000
5 +3000 +3000 0
6 +3000 +3000+300 -8700
-9000
7 +3000 +3000 0
8 +3000+200 +3000 +6800
-7000
9 +3000 +3000 0
10 +3000 +3000 0
11 +3000 +3000 0
12 +3000+200 +3000+300 +100
ROR = 19.4% → Accept the increment, choose Alt. C.
PW, AW & ROR Analysis
❑ Present Worth, Annual Worth and Rate of Return analysis will
always yield the same solution in selecting the best alternative
among mutually exclusive alternatives.
❑ Consider these statements:
1. The net present value on the project is $32,000.
2. The annual worth on the project is $2,800.
3. The project will produce a 23% rate of return.

Rate of return analysis gives a measure of desirability of the project in

terms that are widely understood.
Thank You….
Yani Herawati
Program Studi Teknik Industri
UNPAR
[email protected]