EM 531 – Lecture8

RATE OF RETURN ANALYSİS

Rate of return measure for mutually exclusive
alternatives
Incremental investment analysis

EM 531 - Lecture Notes 8 Apr. 16, 2013

 rate of return measure for mutually exclusive
alternatives

We will compare two or more mutually exclusive projects

based on the rate of return measure.
 Alternatives with the same economic service life
 Alternatives that have unequal economic service lives.

EM 531 - Lecture Notes 8 2 Apr. 16, 2013

 Flaws in project ranking by IRR

Under NPW and AE analysis, the alternative with the

highest worth was preferred.
But in IRR analysis, the project with the highest IRR
may not be the preferred alternative.
Suppose there are two mutually exclusive alternatives,
each with one-year service life (as shown in the next
slide).

EM 531 - Lecture Notes 8 3 Apr. 16, 2013

 Flaws in project ranking by IRR

2,000 7,000

1
1,000
A1:
A2:
PW(10%)=$ 818
IRR=100% 5,000 PW(10%)=$1,364
IRR=40%

EM 531 - Lecture Notes 8 4 Apr. 16, 2013

 Flaws in project ranking by IRR
 If you have enough money in your investment pool to select
either one, would you prefer A1 because its IRR is higher? Based
on PW, A2 is the preferred alternative.
 This inconsistency in ranking occurs because PW, AE, and FW
are absolute ($) measures of investment worth, while IRR is a
relative (%) measure and cannot be applied in the same way; that
is, IRR ignores the scale of the investment.
 Therefore, A1 is not preferred.
Another approach is needed: INCREMENTAL ANALYSIS.

EM 531 - Lecture Notes 8 5 Apr. 16, 2013

 Incremental investment analysis

 Going on with the same example:

 If you invest in A1 alternative:

$ 1,000 will be drawn from the investment pool.
Remaining $ 4,000 will continue to earn 10% interest.
With an investment of 1,000 + 4,000 (=5,000), in year 1, you
will have FW(10%)=2,000+4,000(1+0.10)=$6,400.
Its PW(10%)=-5,000+6,400(P/F,10%,1)=$818.

EM 531 - Lecture Notes 8 6 Apr. 16, 2013

 Incremental investment analysis

 If you invest in A2 alternative:

$ 5,000 will be drawn from the investment pool, leaving no
money in the pool.
PW(10%)=-5,000+7,000(P/F,10%,1)=$1,364.

 In the second alternative, A2, by investing the additional

$4,000, you would make an additional $5,000, which is
equivalent to earning at the rate of 25%  the incremental
investment can be justified.

EM 531 - Lecture Notes 8 7 Apr. 16, 2013

 Incremental investment analysis

 For a pair of mutually exclusive projects (A and B, B being the

more costly alternative):
 B = A + (B-A)

the incremental component

 The only situation in which B is preferred to A is when the rate-

of-return on (B-A) ≥ MARR.
 Therefore, for two mutually exclusive projects, rate-of-return
analysis is made by computing the IRR on incremental
investment (IRR∆) between the projects.

EM 531 - Lecture Notes 8 8 Apr. 16, 2013

 Incremental investment analysis

 Then the decision rule :

 if IRRB-A > MARR, select B.
 if IRRB-A = MARR, select either one.
 if IRRB-A < MARR, select A.
 B-A: investment increment (negative cash flow).
 If a “do-nothing” alternative is allowed, the smaller cost option
must be profitable first (its IRR > MARR).
 This means: compute the IRR for each alternative in the
alternatives group, and then eliminate the alternatives whose
IRRs are less than MARR, before applying the incremental
analysis.

EM 531 - Lecture Notes 8 9 Apr. 16, 2013

 Incremental investment analysis

 Example: A small-scale painting business during off-school

hours.
 Two options: B1 and B2.
 B1: do most of the painting by himself by limiting his business to
only residential painting jobs.
 B2: purchase more painting equipment and hire some helpers to do
both residential and commercial painting jobs.
 In either case, he expects to fold up the business in 3 years when he
graduates from college.

EM 531 - Lecture Notes 8 10 Apr. 16, 2013

 Incremental investment analysis

 Example (cont’d):

n B1 B2 B2-B1
0 -3,000 -12,000 -9,000
1 1,350 4,200 2,850
2 1,800 6,225 4,425
3 1,500 6,330 4,830
IRR 25% 17.43%
 Both B1 and B2 are revenue projects. MARR= 10%.
 Both projects are profitable at 10%.
 Find IRRB2-B1.

EM 531 - Lecture Notes 8 11 Apr. 16, 2013

 Incremental investment analysis

 Example (cont’d):
 n B1 B2 B2-B1
0 -3,000 -12,000 -9,000
1 1,350 4,200 2,850
2 1,800 6,225 4,425
3 1,500 6,330 4,830
IRR 25% 17.43%
 -9,000+2,850(P/F,i,1)+4,425(P/F,i,2)+4,830(P/F,i,3)=0
 if i*B2-B1=15%.
 The incremental cash flow indicates that it is a simple investment.
Therefore, IRRB2-B1=i*B2-B1=15% > MARR.
 select B2.

EM 531 - Lecture Notes 8 12 Apr. 16, 2013

 Incremental investment analysis

 Example (cont’d):

At MARR ≥ 25%,
neither project
is acceptable.

EM 531 - Lecture Notes 8 13 Apr. 16, 2013

 Incremental investment analysis
 Example:
n C1 C2
0 -9,000 -9,000
1 480 5,800
2 3,700 3,250
3 6,550 2,000
4 3,780 1,561
IRR 18% 20%
 MARR= 12%.
 Both projects are profitable at 12%.

EM 531 - Lecture Notes 8 14 Apr. 16, 2013

 Incremental investment analysis

 Example:

n C1-C2
0 0
1 -5,320
2 450
3 4,550
4 2,219
 The initial investments are equal. The first non-zero flow (investment)
occurs at t=1.
 -5,320+450(P/F,i,1)+4,550(P/F,i,2)+2,219(P/F,i,3)=0.
 i*=14.71%. i*=IRR (simple investment)
 Since IRRC1-C2=14.71% > MARR, select C1.
 Using NPW; PW(12%)C1=1,443 and PW(12%)C2=1,185.

EM 531 - Lecture Notes 8 15 Apr. 16, 2013

 Incremental investment analysis
 If we have more than two mutually exclusive alternatives, we will
compare them in pairs by successive examination.
 Example:
n D1 D2 D3
0 -2,000 -1,000 -3,000
1 1,500 800 1,500
2 1,000 500 2,000
3 800 500 1,000
IRR 34.37% 40.76% 24.81%
MARR=15%

EM 531 - Lecture Notes 8 16 Apr. 16, 2013

 Incremental investment analysis

 Example (cont’d):
n D1 D2 D3
0 -2,000 -1,000 -3,000
1 1,500 800 1,500
2 1,000 500 2,000
3 800 500 1,000
IRR 34.37% 40.76% 24.81%
Step 1: Examine the IRR for each alternative. Eliminate any
alternative that fails to meet MARR. None is eliminated in this
example.
Step 2: Compare D1 and D2 in pairs. Compute IRRD1-D2. (If faced
with many alternatives, arrange them in order of increasing initial
cost).

EM 531 - Lecture Notes 8 17 Apr. 16, 2013

 Incremental investment analysis
 Example (cont’d):
n D1-D2
0 -1,000
1 700
2 500
3 300
simple investment.
-1,000+700(P/F,i,1)+500(P/F,i,2)+300(P/F,i,3)=0
solving for i*D1-D2=27.61% > MARR. Therefore, D1 is preferred over D2.
Step 3: Compare D1 and D3. Examine (D3-D1) increment.
n D3-D1
0 -1,000 Simple investment.
1 0 i*D3-D1=8.8% < MARR.
2 1,000
Therefore, D1 is preferred over D3.
3 200
 D1 is the best alternative.

EM 531 - Lecture Notes 8 18 Apr. 16, 2013

 Incremental investment analysis
 Example: Incremental analysis for cost-only projects.
Two types of manufacturing systems to produce shaft couplings over 6 years.
MARR=15%
(1) a cellular manufacturing system (CMS)
(2) a flexible manufacturing system (FMS)
production volume: 544,000 units/year.
cost items CMS FMS
AO&M costs
annual labor 1,169,600 707,200
annual material 832,320 598,400
annual overhead 3,150,000 1,950,000
annual tooling 470,000 300,000
annual inventory 141,000 31,500
annual income tax 1,650,000 1,917,000
Total annual cost 7,412,920 5,504,100
Investment 4,500,000 12,500,000
net salvage value 500,000 1,000,000

EM 531 - Lecture Notes 8 19 Apr. 16, 2013

 Incremental investment analysis
 Example (cont’d):
 The two alternatives provide the same level of revenues. Therefore, we can compare them
based on cost only (service projects).
Without knowing the revenue figures, it is not possible to compute the IRR for each alternative.
But we can still calculate the IRR on incremental cash flows.
n CMS FMS (FMS-CMS)
0 -4,500,000 -12,500,000 -8,000,000
1 -7,412,920 -5,504,100 1,908,820
2 -7,412,920 -5,504,100 1,908,820
3 -7,412,920 -5,504,100 1,908,820
4 -7,412,920 -5,504,100 1,908,820
5 -7,412,920 -5,504,100 1,908,820
6 -6,912,920 -4,504,100 2,408,820
PW(i)FMS-CMS = -8,000,000+1,908,820(P/A,i,5)+2,408,820(P/F,i,6)=0
 i*=12.43 % by trial-and-error. Since i* < 15%, select CMS.
 The annual savings of $1,908,820 by FMS do not justify the incremental investment of $
8,000,000.

EM 531 - Lecture Notes 8 20 Apr. 16, 2013

 Incremental borrowing analysis
 Subtracting the less costly alternative from the more costly one is not absolutely
necessary in incremental analysis. In fact, we can examine the difference
between the two projects A and B, as either an (A-B) or a (B-A) increment.
 If the difference in flow (B-A) represents an increment of investment, then (A-B)
is an increment of borrowing.
 When considering an increment of borrowing, i* for borrowing is called the
borrowing rate of return, BRR.
 The decision rule in this case is reversed:
 If BRRB-A < MARR, select B.
If BRRB-A = MARR, select either one.
If BRRB-A > MARR, select A.
where B-A is a borrowing increment (positive first cash flow).

EM 531 - Lecture Notes 8 21 Apr. 16, 2013

 Incremental borrowing analysis
 Example:
 n B1 B2 B1-B2
0 -3,000 -12,000 +9,000
1 1,350 4,200 -2,850
2 1,800 6,225 -4,425
3 1,500 6,330 -4,830
MARR=10%.
We had found i*B1-B2=i*B2-B1=15% before.
 But we are borrowing $ 9,000, 15% interest rate is what we are losing, or paying, by not
investing the $ 9,000 in B2.
 If we invest in B1, we are saving $ 9,000, but we are giving up 2,850, 4,425, and 4,830 at the
end of years 1, 2, and 3, respectively.
 This corresponds to borrowing $ 9,000 with the repayment series of (2,850, 4,425, and 4,830);
that is, we are paying 15% interest on a borrowed sum.
 Since MARR is 10%, our maximum interest rate for borrowing should be 10%.
 Since 15% > 10%, we should reject B1.
 Incremental investment and incremental borrowing methods yield the same result.

EM 531 - Lecture Notes 8 22 Apr. 16, 2013

 Incremental investment analysis – unequal
service lives
 The IRR measure can be used as a base to compare projects with
unequal service lives.
 The problem is the computational burden due to multiple roots
(because of high LCM of years).
 Example: two alternatives: E1 and E2.
 E1 - life: 3 years.

 E2 - life: 1 year. (can be repeated with the same costs and benefits).
 n E1 E2
0 -2,000 -3,000
1 1,000 4,000
2 1,000
3 1,000

EM 531 - Lecture Notes 8 23 Apr. 16, 2013

 Incremental investment analysis – unequal
service lives
 Example (cont’d): MARR=10%. Required service period is indefinite.

 3 repetitions of E2.
n E1 E2 E2-E1
0 -2,000 -3,000 -1,000
1 1,000 1,000 0
2 1,000 1,000 0 the increment is a simple
3 1,000 4,000 3,000 investment.

 To compute i*E2-E1: 1,000=3,000 / (1+i)3  i*E2-E1=44.22 % > 10 %.

Therefore select E2.

EM 531 - Lecture Notes 8 24 Apr. 16, 2013

 Incremental investment analysis – unequal
service lives
 Example: models A and B. MARR=15%. LCM=12 years. In the
incremental cash flows, 5 sign changes occur.
 n Model B – model A
0 -2,500
1 1,000
2 1,000
3 11,500
4 -12,500
5 1,000
6 11,500 Increment is a nonsimple investment.
7 1,000
8 -12,500
9 11,500
10 1,000
11 1,000
12 500

EM 531 - Lecture Notes 8 25 Apr. 16, 2013

 Incremental investment analysis – unequal
service lives
 Example (cont’d):
 There is only one positive i*=63.12 %. But it is not a pure investment. Try
i=20%.
 PB(20%,15%)0= -2,500
 PB(20%,15%)1= -2,500(1.20)+1,000= -2,000
 PB(20%,15%)2= -2,000(1.20)+1,000= -1,400
 PB(20%,15%)3= -1,400(1.20)+11,500= 9,820.
 ... ... ...
 PB(20%,15%)12= 25,966.93 > 0, then the guessed 20% is not the IRR. Increase
the value of i.
 IRR=50.68%. Model B should be selected.

EM 531 - Lecture Notes 8 26 Apr. 16, 2013