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Chapter 8 - ROR Analysis For Multiple Alternatives

NM

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88 views

Chapter 8 - ROR Analysis For Multiple Alternatives

NM

Uploaded by

Dejene Hailu
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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Chapter 8

Rate of Return
Multiple
Alternatives
Lecture slides to accompany

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin

8-1

2012 by McGraw-Hill

All Rights Reserved

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 8-2
2012 by McGraw-Hill

All Rights Reserved

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
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:
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?
8-3

2012 by McGraw-Hill

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Why Incremental Analysis is Necessary


If selection basis is higher ROR:

Select alternative A

(wrong answer)

If selection basis is higher overall ROR:

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)
8-4

2012 by McGraw-Hill

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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-A

First cost, $

-40,000

- 60,000

-20,000

Annual cost, $/year

-25,000

-19,000

+6000

8,000

10,000

+2000

Salvage value, $

The incremental CF is shown in the (B-A) column


The ROR on the extra $20,000 investment in B determines which alternative
to select (as discussed later)
8-5

2012 by McGraw-Hill

All Rights Reserved

Interpretation of ROR on Extra Investment


Based on 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 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)
8-6

2012 by McGraw-Hill

All Rights Reserved

ROR Evaluation for Two ME Alternatives


(1)
(2)
(3)
(4)
(5)

Order alternatives by increasing initial investment cost


Develop incremental CF series using LCM of years
Draw incremental cash flow diagram, if needed
Count sign changes to see if multiple i* values exist
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 or ROIC approach.

8-7

2012 by McGraw-Hill

All Rights Reserved

Example: Incremental ROR Evaluation


Either of the cost alternatives shown below can be used in a
chemical refining process. If the companys MARR is 15% per year,
determine which should be selected on the basis of ROR analysis?

First cost ,$
Annual cost, $/year
Salvage value, $
Life, years

-40,000
-25,000

-60,000
-19,000

8,000
5

10,000
5

Initial observations: ME, cost alternatives with equal life estimates


and no multiple ROR values indicated
8-8

2012 by McGraw-Hill

All Rights Reserved

Example: ROR Evaluation of Two Alternatives


Solution, using procedure:
First cost , $
Annual cost, $/year
Salvage value, $
Life, years

B-A

-40,000
-25,000

-60,000
-19,000

8,000
5

10,000
5

-20,000
+6000
+2000

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
8-9

2012 by McGraw-Hill

All Rights Reserved

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 MARR > breakeven ROR,
select lower-investment
alternative
2012 by McGraw-Hill

All Rights Reserved

8-10

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. DN and select all with ROR MARR
8-11

2012 by McGraw-Hill

All Rights Reserved

Example: ROR for Multiple Alternatives


The five mutually exclusive alternatives shown below are under consideration
for improving visitor safety and access to additional areas of a national park. If
all alternatives are considered to last indefinitely, determine which should be
selected on the basis of a rate of return analysis using an interest rate of 10%.
First cost, $ millions
Annual M&O cost, $ millions

A
-20
-2

B
-40
-1.5

C
-35
-1.9

D
-90
-1.1

E_
-70
-1.3

Solution: Rank on the basis of initial cost: A,C,B,E,D; calculate CC values


C vs. A: 0 = -15 + 0.1/0.1
i* = 6.7% (eliminate C)
B vs. A: 0 = -20 + 0.5/0.1
i* = 25% (eliminate A)
E vs. B: 0 = -30 + 0.2/0.1
i* = 6.7% (eliminate E)
D vs. B: 0 = -50 + 0.4/0.1
i* = 8% (eliminate D)
Select alternative B
8-12

2012 by McGraw-Hill

All Rights Reserved

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
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
8-13

2012 by McGraw-Hill

All Rights Reserved

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