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

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

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

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

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,

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

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

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

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

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

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

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