Incremental Analysis

Lecture No. 28 Chapter 7 Contemporary Engineering Economics Copyright 2006

Contemporary Engineering Economics, 4th edition, 2007

Comparing Mutually Exclusive Alternatives Based on IRR

Issue: Can we rank the mutually exclusive projects by the magnitude of its IRR?
n 0 A1 -$1,000 A2 -$5,000

1
IRR PW (10%)

$2,000
100% >

$7,000
40%

$818

<

$1,364

Contemporary Engineering Economics, 4th edition, 2007

Who Got More Pay Raise?

Bill

Hillary

10%
Contemporary Engineering Economics, 4th edition, 2007

5%

Cant Compare without Knowing Their Base Salaries

Bill Hillary

Base Salary
Pay Raise (%) Pay Raise ($)

$50,000
10% $5,000

$200,000
5% $10,000

For the same reason, we cant compare mutually exclusive projects based on the magnitude of its IRR. We need to know the size of investment and its timing of when to occur.
Contemporary Engineering Economics, 4th edition, 2007

Incremental Investment
n 0 1
ROR PW(10%)

Project A1 -$1,000 $2,000 100% $818

Project A2 -$5,000 $7,000 40% $1,364

Incremental Investment (A2 A1) -$4,000 $5,000 25% $546

Assuming a MARR of 10%, you can always earn that rate from other
investment source, i.e., $4,400 at the end of one year for $4,000 investment. By investing the additional $4,000 in A2, you would make additional $5,000, which is equivalent to earning at the rate of 25%. Therefore, the incremental investment in A2 is justified.
Contemporary Engineering Economics, 4th edition, 2007

Incremental Analysis (Procedure)

Step 1: Compute the cash flow for the difference between the projects (A,B) by subtracting the cash flow of the lower investment cost project (A) from that of the higher investment cost project (B). Compute the IRR on this incremental investment (IRRB-A ). Accept the investment B if and only if IRR B-A > MARR
NOTE: Make sure that both IRRA and IRRB are greater than MARR.

Step 2: Step 3:

Contemporary Engineering Economics, 4th edition, 2007

Example 7.10 - Incremental Rate of Return

n 0 1 2 3 IRR B1 B2 B2 - B1 -$9,000 2,850 4,425 4,830 15%

-$3,000 -$12,000 1,350 4,200 1,800 6,225 1,500 6,330 25% 17.43%

Given MARR = 10%, which project is a better choice? Since IRRB2-B1=15% > 10%, and also IRRB2 > 10%, select B2.
Contemporary Engineering Economics, 4th edition, 2007

IRR on Increment Investment: Three Alternatives

n 0 1 2 D1 D2 D3 Step 1: Examine the IRR for each project to eliminate any project that fails to meet the MARR. Step 2: Compare D1 and D2 in pairs. IRRD1-D2=27.61% > 15%, so select D1. D1 becomes the current best. Step 3: Compare D1 and D3. IRRD3-D1= 8.8% < 15%, so select D1 again. Here, we conclude that D1 is the best alternative.
Contemporary Engineering Economics, 4th edition, 2007

-$2,000 -$1,000 -$3,000 1,500 1,000 800 500 1,500 2,000

3
IRR

800

500

1,000

34.37% 40.76% 24.81%

Practice Problem
You are considering four types of engineering designs. The project lasts 10 years with the following estimated cash flows. The interest rate (MARR) is 15%. Which of the four is more attractive? Project A
Initial cost Revenues/ Year Expenses/ Year IRR (%)
$150 $115 $70
27.32

B
$220 $125 $65
24.13

C
$300 $160 $60
31.11

D
$340 $185 $80
28.33

Contemporary Engineering Economics, 4th edition, 2007

Example 7.13 Incremental Analysis for Cost-Only Projects

Items Annual O&M costs: CMS Option FMS Option

Annual labor cost

Annual material cost Annual overhead cost

$1,169,600
832,320 3,150,000

$707,200
598,400 1,950,000

Annual tooling cost

Annual inventory cost Annual income taxes Total annual costs Investment Net salvage value

470,000
141,000 1,650,000 $7,412,920 $4,500,000 $500,000

300,000
31,500 1,917,000 $5,504,100 $12,500,000 $1,000,000

Contemporary Engineering Economics, 4th edition, 2007

Incremental Cash Flow (FMS CMS)

Incremental (FMS-CMS) -$8,000,000 1,908,820 1,908,820 1,908,820 1,908,820 1,908,820 $2,408,820

n 0 1 2 3 4 5 6 Salvage

CMS Option -$4,500,000 -7,412,920 -7,412,920 -7,412,920 -7,412,920 -7,412,920 -7,412,920 + $500,000

FMS Option -$12,500,000 -5,504,100 -5,504,100 -5,504,100 -5,504,100 -5,504,100 -5,504,100 + $1,000,000

Contemporary Engineering Economics, 4th edition, 2007

Solution:
PW (i) FMS CMS $8,000,000 $1,908,820( P / A, i,5) $2,408,820( P / F, i,6) 0 IRRFMS CMS 12.43% 15%, select CMS.

Contemporary Engineering Economics, 4th edition, 2007

Example 7.14 IRR Analysis for Projects with Different Lives

MARR = 15% The incremental cash flows (Model B Model A) result in a nonsimple and mixed investment. RICBA = 50.68% > 15% Select Model B

Contemporary Engineering Economics, 4th edition, 2007

Summary

Rate of return (ROR) is the interest rate earned on unrecovered project balances such that an investments cash receipts make the terminal project balance equal to zero. Rate of return is an intuitively familiar and understandable measure of project profitability that many managers prefer to NPW or other equivalence measures. Mathematically we can determine the rate of return for a given project cash flow series by locating an interest rate that equates the net present worth of its cash flows to zero. This break-even interest rate is denoted by the symbol i*.

Contemporary Engineering Economics, 4th edition, 2007

Internal rate of return (IRR) is another term for ROR that stresses the fact that we are concerned with the interest earned on the portion of the project that is internally invested, not those portions that are released by (borrowed from) the project. To apply rate of return analysis correctly, we need to classify an investment into either a simple or a nonsimple investment. A simple investment is defined as one in which the initial cash flows are negative and only one sign change occurs in the net cash flow, whereas a nonsimple investment is one for which more than one sign change occurs in the net cash flow series. Multiple i*s occur only in nonsimple investments. However, not all nonsimple investments will have multiple i*s either.

Contemporary Engineering Economics, 4th edition, 2007

For a pure investment, the solving rate of return (i*) is the rate of return internal to the project; so the decision rule is: If IRR > MARR, accept the project. If IRR = MARR, remain indifferent. If IRR < MARR, reject the project. IRR analysis yields results consistent with NPW and other equivalence methods. For a mixed investment, we need to calculate the true IRR, or known as the return on invested capital. However, if your objective is simply to make an accept or reject decision, it is recommended that either the NPW or AE analysis be used to make an accept/reject decision. To compare mutually exclusive alternatives by the IRR analysis, the incremental analysis must be adopted.

Contemporary Engineering Economics, 4th edition, 2007