Chapter 8 Incremental Rate of Return Analysis Click
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Chapter 8 - Incremental Rate of Return Analysis Click here for Streaming Audio To Accompany Presentation (optional) EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona EGR 403 - Cal Poly Pomona - SA 11
EGR 403 - The Big Picture • Framework: Accounting & Breakeven Analysis • “Time-value of money” concepts - Ch. 3, 4 • Analysis methods – Ch. 5 - Present Worth – Ch. 6 - Annual Worth – Ch. 7, 7 A, 8 - Rate of Return (incremental analysis) – Ch. 9 - Benefit Cost Ratio & other techniques • Refining the analysis – Ch. 10, 11 - Depreciation & Taxes – Ch. 12 - Replacement Analysis EGR 403 - Cal Poly Pomona - SA 11 2
Incremental Analysis • Required for examining three or more alternatives. • Defined as the examination of differences between alternatives to determine if the increased costs are justified by the increased benefits. High cost alt. - Low cost alt. = Difference between alt. EGR 403 - Cal Poly Pomona - SA 11 3
Elements of Rate of Return Analysis • Identify all acceptable alternatives that fulfill similar system outcomes. • Arrange the alternatives in ascending order of investment. • Compute the rate of return for each alternative. Discard alternatives where ROR < MARR. • Make a pair-wise analysis of the contender and present selection. For investment: – If DROR £ MARR select the contender. – If DROR ³ MARR keep the present selection. EGR 403 - Cal Poly Pomona - SA 11 4
Incremental Rate of Return Analysis Example 8 - 7 • PWB = A (P/A, 6%, 20) = A (11. 47) • MARR = 6% (given) • All projects are initially acceptable because IRR MARR EGR 403 - Cal Poly Pomona - SA 11 5
Incremental Analysis 1. Rank from lowest cost to highest cost 2. Start with two lowest cost alternatives 3. Compare increments using MARR criteria 4. Repeat until a “winner” is determined EGR 403 - Cal Poly Pomona - SA 11 6
Graphical Solutions PWB vs. PWC at MARR Above the 45 degree line projects are acceptable (NPW>0) EGR 403 - Cal Poly Pomona - SA 11 7
Graphical Solution • Projects B, A, C and E shown. • Incremental analysis looks at adjacent points on the Benefit. Cost Graph EGR 403 - Cal Poly Pomona - SA 11 8
Graphical Incremental Analysis If line between two alternatives is > 45 degrees, accept higher cost alternative. Alternative A wins. EGR 403 - Cal Poly Pomona - SA 11 9
Graphical Incremental Analysis • Graphical solution has a logical connection to NPW • Incremental analysis seeks out the alternative with highest NPW. Alternative A maximizes NPW. EGR 403 - Cal Poly Pomona - SA 11 10
Choosing an Analysis Method MARR Computations* Explanation PW Required for calculation Less Depends For comparison More Depends AW ROR *Not an issue when using a spreadsheet. Do what the Organization requires. Occasionally augment with alternate methods where the method adds beneficial information. EGR 403 - Cal Poly Pomona - SA 11 11