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ENGINEERING ECONOMY Fifth Edition Mc

Blank and Tarquin Graw
Hill
CHAPTER VIII
Rate of Return Analysis:

Multiple
p Alternatives
Blank & Tarquin: 5th Edition. Ch. 8 Authored by: Dr. Don Smith, Texas A&M University. 1 1
RATE OF RETURN ANALYSIS: SINGLE ALTERNATIVE (REVIEW)
7.1 Interpretation of a Rate of Return

Value
• In rate of return problems, you seek an unknown interest rate (i*)

that satisfies the following:
• PWi*(+ cash flows) – PWi*( - cash flows) = 0
• This means that the interest rate (i*), is an unknown parameter
and must be determined
• ROR is not the interest rate earned on the original loan amount
or investment amount
• The ROR is known by other names such as the internal rate of
return (IROR), which is the technically correct term, and return
on investment (ROI).
6
7.2 Trial and Error Approach
Iterative procedures require an initial guess for i*
One makes an educated first guess and calculates the
?
resultant PV at the guess rate.
If the NPV is not = 0, then another i* value is evaluated….

Until NPV “close” to “0”.
A negative NPV generally indicates the i* value is too high.

(Find this value closest to 0)
A positive NPV suggests that the i* value was too low. (Find
this value closest to 0)
Then interpolate between the two i* values

2
21
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7.4 Multiple Rate of Return 7.4 Multiple Rate of Return

1) CF Rule of Signs Test : Descartes 2) Norstrom’s Test (Cumulative CF sign test)
• The total number of real values i*’s is always less than or equal to the number
•Norstrom’s Test works with the cumulated cash flow
of sign changes in the original cash flow series.
•only one sign change in a series of cumulative CF, which start negatively indicates
• Follows from the analysis of a n-th degree polynomial
• A “0” value does not count as a sign change that there is one positive root to the polynomial relation
•For the example problem the accumulated cash flow (ACF) is….
• Consider Example 7.4
Year Cash Flow
Year Cash Flow Accum.
0 $2,000 + C.F
1 -$500 - 0 $2,000 $2,000 +
- 1 -$500 $1,500 +
2 -$8,100
2 -$8,100 -$6,600 -
3 $6,800 + 3 $6,800 $200 +
Result: 2 sign changes in the Cash Flow
Result 2 sign changes in the ACF.
• Means we can have a maximum of 2 real potential i* values for this problem
• Beware: This test is fairly weak and the second test must also be performed
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7.4 Multiple Rate of Return 7.4 Multiple Rate of Return

ACF Sign Test Statements: ACF Sign Test Statements:
•If the ACF value for year “N” is “0”, then an i* = 0% exists
•If the ACF value for year “N” is > 0, this suggests an i* > 0 Year Cash Flow Accum.
•If ACF value for year N is < 0, there may exist one or more negative i* values – C.F
but not always 0 $2,000 $2,000
•A sufficient but not necessary condition for a single positive i* value is: +
1 -$500 $1,500 +
•The ACF value for year “N” is > 0
2 -$8,100 -$6,600 -
•There is exactly one sign change in the ACF
3 $6,800 $200 +
•If the number of sign changes in the ACF is 2 or greater, this strongly suggests
that multiple rates of return exist. 2 Sign Changes here
Year Cash Flow Accum.

•Strong evidence that we have multiple i* values
C.F
0 $2,000 $2,000 •ACF(t=3) = $200 > 0 suggests positive i* (s)
1 -$500 $1,500
2 -$8,100 -$6,600 How many
3 $6,800 $200 sign changes?
3
4
ROR ANALYSIS ONLY FOR SINGLE ALTERNATIVE.

ROR ANALYSIS FOR MULTIPLE ALTERNATIVES?
5
8. Rate-of-Return Analysis: Multiple

Alternatives
1. Why Incremental Analysis?

2. Incremental Cash Flows
3. Interpretation
4 Incremental ROR by PW
4.
5. Incremental ROR by AW
6. Multiple
p Alternatives
Section 8.2
Section
Calculations 8.1
of Incremental Cash
Why Incremental
Flows Analysis?
for ROR Analysis
Blank & Tarquin: 5th Edition. Ch. 8 Authored by: Dr. Don Smith, Texas A&M University. 17
7
8.1 Why Incremental Analysis Is

Necessary
• Assume we have two or more mutually

exclusive alternative
• Objective:
j Which,, if any
y of the
alternatives is preferred?
• Prior
P i Chapters:
Ch t U
Use the
th PW or AW
approach
• This chapter: We apply the ROR approach
• Present Worth: Equal service lives must
apply
8
8.1 Ranking Inconsistency
• For some problems, PW and ROR may

rank the same problems differently. Why?
• PW assumes reinvestment at the MARR or
discount rate.
• ROR assumes reinvestment
i t t att the
th i* or i’
rate
• Two different reinvestment rate
assumptions
ti apply
l
8.1 Review of Problem Types

yp
•
INDEPENDENT AND MUTUALLY
EXCLUSIVE ALTERNATIVES
INDEPENDENT - Selection of one alternative
does not affect the selection of others. Example:
select all p
projects
j with a ROR> 20%
MUTUALLY EXCLUSIVE - Selection

S l ti off one
alternative precludes the selection of others.
Example: select the project with the highest ROR
ROR.
8.1 An Example – Shows Ranking

I
Inconsistency
i t Problem
P bl
• From Solomon {1956/59}

• Two Investments A and B
• Discount
Di t rate
t = 10%
• Each investment requires $100 at t = 0
• A is a 1-year investment
• B is a 5- year investment
8.1 Two Projects;

j ; A and B
•A $120
0 1 2 3 4 5
$100
$201.14
•B
0 1 2 3 4 5
$100
8.1 Example
p Problem
• i*A = 0.20 = 20% • Using

g ROR,, A is
superior to B
• i*B = 0.15 = 15%
• Using PW
PW, B is
superior to A
• PWA((10%)) = +$9.09
$
• Inconsistent
• PBB((10%)) = +24.89 Rankings!
8.1 Example Problem – Rankings
• Using ROR Ranking

• A is superior to B (20% > 15%)
• Using a PW(10%) approach
• B is superior to A ($24.89
($24 89 > $9.09)
$9 09)
• The two methods do not rank the same?
8.1
8 1 Look at A and Assume Reinvestment
Forward to t = 5
• Reinvest the $120 out to t = 5
$120
0 1 2 3 4 5
$100
• Assume the +$120 can be reinvested forward at

the firm’s MARR rate of 10%/year out to the end
of year 5.
5
15
8.1 Look at A and assume Reinvestment

f
forward
d to t = 5
F5 = ?
• Find F5 for Alt. A
$120
0 1 2 3 4 5
$100
• F5 = 120(F/P,10%,4)
120(F/P,10%,4)=$175.69
$175.69
16
8.1 ROR of a Given Reinvestment
• -100 +120(F/P,10%,4)(P/F,i*A,5) = 0
• Solving for i*A
• (P/F, i*A,5) = 0.569
• i*A/reinvestment @10% = 0.1193
0 1193
A/c=10% = 11.93%
• ii*A/
8.1 Now Compare

p A to B
• Compare revised A with reinvestment at

10% to
t B
• ii*A/c = 10% = 11.93%
11 93%
• i*B = 15% as before
• ROR Rankings:
• B is superior to A (15% > 11.93%)
• B is superior to A (15% > 11.93%)
8.1 Ranking Consistency
• Now, PW (10%) and ROR with the
reinvestment
i t t imposed
i d on the
th 1-year
1 project
j t
8.1 Ranking
rank g Inconsistency…
consistently. y
• B is superior to A with both methods
• Occurs between ROR and PW because
• Both methods have different
reinvestment rate assumptions
• Two different cash flows may
y not
generate funds at the same rate
8.1 Ranking
g Inconsistency…
y
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:
• Occurs between ROR and PW because
• Both methods have different
Which investment is better, economically?
reinvestment rate assumptions
If selection basis is higher ROR:
• Two Adifferent
à Select alternative cash flows may
(wrong answer) y not
generate
If selection basis fundsROR:
is higher overall at the same rate
--> 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)5th Edition. Ch. 8 Authored by: Dr. Don Smith, Texas A&M University.
Blank & Tarquin: 16
20
Section 8.2
Calculations of Incremental Cash
Flows for ROR Analysis
21
8.2 Incremental Cash Flow for ROR
22
8 2 ROR for Mutual Exclusive Projects

8.2
• Given two or more alternatives

• Rank the investments based upon their
initial time t = 0 investment requirements
• Summarize the investments in a tabular
format
8.2 Tabular Format
t Alt. A Alt. B B-A

0 $ $
1 $ $
2 $ $
… … …
Find the ROR of this
N $
investment $ is
which
(B – A)
8.2 Ranking Rules
• Given two or more Mutually Exclusive

i
investments
t t
• Select the first investment to be the one
with the lowest time t = 0 investment
amount.
amount
• The next investment is to be the one with
the largest investment at time t = 0
25
8.2 Example
• Two Investments: A and B

• A costs $30,000 at time t = 0
• B costs $50,000 at time t = 0
• MARR = 10%
• Life is 4 years
26
8.2 Example:
p A and B
• For this
problem,, A is
p
superior to B
based on PW
and on ROR!
•A is ranked
first;
•B is
i ranked
k d
second
8.2 Example:
8.2 Example:
p A
p A and
and B
B
•• Both
For this
alternatives
problem,, A is
p
have a PW
superior to>
B0
and
basedhave
on i*’s
PW >
MARR.
and on ROR!
•Both are
•A is ranked
feasible
first;
alternatives
•B is
i ranked
initially. k d
second
8.2 Form the Difference ((B – A))
• For mutually exclusive alternatives…

• One should focus on the differences
between the alternatives
• “Differences” are illustrated best by
y
forming what is called the incremental
investment (B
(B-A)
A)
29
8.2 Incremental Investment
A B (B A)
(B-A)
Find the
ROR of this
investment
Lowestt
L Nextt
N
The
First Highest first
Cost Cost = Incremental
investment
investment investment
30
8.2 Incremental Investment
B-A
The incremental Investment
8.2 The Logic….
• One would go with investment A initially

because it is the least-expensive alternative
at time t = 0
• And its present worth is > 0.
• So, A is a feasible alternative to start
8.2 Explaining the Incremental

Investment
B A
B-A
• Now, is it worth it to the firm to consider

investing (-$50,000 – (-$30,000) =
-$20,000
$20 000 to get the cash flows indicated in
the (B-A) cash flow series?
8.2 Explaining….Continued
p g
A B (
(B-A)
)
The investment (B
(B-A)
A) represents the year
year-by-
by
year difference between A and B
8.2 Explaining…Continued
•
A B (
(B-A)
)
(B A) is “additional”
(B-A) additional investment to move from
investing in A and moving on to invest in B.
8.2 The Incremental Investment
• Investing $20,000 at time t = o results in

th ffollowing
the ll i incremental
i t l investment
i t t
8.2 Is It Worth It?
• Now the question is….

• Is it worth spending an additional
$20 000 to move from investment A to
$20,000
investment B?
• Answer: Compute the ROR or PW of the
incremental investment to see!
8.2 Analysis
y
• For this problem, NPV(10%) < 0

• and, no ROR could be found!
8.2 Analysis
• The incremental investment shows a

negative
ti PW and d no ROR is
i found
f d
• Thus,
Thus the increment is rejected.
rejected
• Moving
g from A to B is not economically
y
worth it
• Stay with A!
39
8.2 Another Example

p
• Homework Problem 8.21 to illustrate

• Cash Flows are shown on the next slide
• Two alternatives
• Semiautomatic machine vs.
vs
• Automatic machine
• Assume a 6-year
y life for analysis
y
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8.2
8.2 Example
Example (Problem
(Problem 8.21)
8.21)
Year
Year SemiAuto
SemiAuto Auto
Auto (B-A)
(B-A)
AA BB
00 -$40,000
-$40,000 -$90,000
-$90,000 -$50,000
-$50,000
11 -100,000
100,000
-100,000
100,000 -85,000
85,000
-85,000
85,000 15,000
15,000
22 -100,000
-100,000 -85,000
-85,000 15,000
15,000
33 -135,000
-135,000 -85,000
-85,000 50,000
50,000
44 -100,000
-100,000 -85,000
-85,000 15,000
15,000
55 -100,000
-100
-100 000
-100,000
000 -85,000
-85
-85 000
-85,000
000 15,000
15
15 000
15,000
000
66 -95,000
-95,000 -74,000
-74,000 21,000
21,000
Blank
Blank&&Tarquin:
Tarquin:5th
5thEdition.
Edition.Ch.
Ch.88Authored
Authoredby:
by:Dr.
Dr.Don
DonSmith,
Smith,Texas
TexasA&M
A&MUniversity.
University. 36
36
41
8.2 Analysis
y
• Computed PW
@ 18% shows
that B has the
l
lowestt PW costt
and would be
preferred to A
8.2 Incremental Cash Flow
(B-A)
• Question?
0 -$50 000
-$50,000 • Is it worth spending an
additional $50,000 in the
1 15,000 automatic machine in order
2 15,000 to receive the incremental
savings shown to the left?
3 50,000
• Compute the ROR of the
4 15 000
15,000 incremental Cash Flow
5 15,000
6 21,000
8.2 Incremental ROR = 35.95%
8.2 NPV Plot of A and B
• A is equivalent to B @ Incremental ROR

rate
t off 35.95%
35 95%
NPV PLOT-INC. C.F.
0.00
00
10
20
30
40
50
60
70
80
90
00
10
20
30
40
50
60
70
80
90
00
-100000.00
0.
0.
0.
0.
0.
0.
0.
0.
0.
0.
1.
1.
1.
1.
1.
1.
1.
1.
1.
1.
2.
-200000.00
-300000.00
PV(i%)
-400000.00
NP
-500000.00
-600000.00
-700000.00
-800000.00
Disc. Rates
45
8.2 i* (B-A) = 35.95%
• The incremental i*(B-A) is greater than the

firm’s discount rate of 18%
• Since i*(B-A) > MARR, accept the increment

and go with Alternative B.
• Same results as PW(18%) shows
• B is clearly
y the winner
Section 8
8.3
3
Interpretation
p of Rate of Return on
the Extra Investment
8.3 Interpretations
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)
48
8.3 Interpretations
• The i*incremental is the ROR of the additional

or incremental investment required to
move from one project to the next most most-
costly project.
• If the i*incremental value is < MARR, the

increment is not worth it. Go with to lower
investment cash flow.
49
8.3 Multiple
p Alternatives
• If Cost-Revenue Problem…
• Calculate the computed i*’s for each
alternative in the set.
set
• Discard those alternatives whose i* value
is less than the MARR – they would lose
anyway!
50
8.3 Independent Projects
• If dealing with independent projects, one

d
does nott compute
t incremental
i t l investments
i t t
among the candidate projects
• Rule: Accept all projects whose ROR >
MARR and stay within any budget
limitations
51
8.3 The i* (B-A) Value
• Given two mutually exclusive alternatives,

A and B.
• The i* (B-A) value also represents the

interest rate at which the two alternatives
are economically equivalent.
52
Section 8
8.4
4
ROR Usingg PW:
Incremental and Breakeven
8.4 Incremental ROR by PW
• There are three primary element due to which mainly ROR
analyses are applied incorrectly in engineering economic
analysis:
1. Incremental Cash Flow Series
2. LCM
3. Multiple ROR values
• It is advisable to use PW or AW analysis instead of ROR when there

is multiple ROR values
• Recall, calculating ROR for single alternative, you take PW and
equate it to zero to start with
• Similarly, PW-based relation is developed for the incremental cash
flows and set equal to zero
• Using trial and error approach, calculate the rate ( ∆𝑖!"# ) at which
PW of incremental CF is zero
• Equal Life Comparison by using LCM method
54
8.4 PW Approach – Mutually Exclusive

Case
• Given multiple alternatives

• If unequal lives – either establish a
common project
j life,
lif or
• Apply
A l the
th LCM off lif
life approach
h ffound
d
in C
Chapter
apte 5

Case
• Order (rank) the alternatives by

their initial time t = 0 investment cost
• Start
S with
i h the
h smaller
ll iinvestment
alternative – refer to it as “A”
A
• The
e next-highest
e t g est investment
est e t cost is
s
called “B”
56

Case
• Compute the incremental cash flow (B-A)

• Given the MARR find the PW of (B-A)
investment
• If PW (MARR) of ((B-A)) is >0,, accept
p the
increment – go with the higher investment
cost alternative.
• Else,, reject
j the increment and go
g with the
lower investment cost option
8.4 ROR Case – Unique i* (B-A)

( )
• Compose the incremental Cash Flow

• Examine
E i that
th t cash
h flow
fl for
f signi changes
h
and apply
pp y the Norstrom test (from
( Chapter
p
7)
• If a unique i* (B-A) is indicated, solve for it
and compare it to the MARR
• If i* (B-A) > MARR,, accept
p the increment,,
else reject
8.4 ROR Evaluation for Two ME Alternatives
(1) Order alternatives by increasing initial investment cost

(2) Develop incremental CF series using LCM of years
(3) Draw incremental cash flow diagram, if needed
(4) Count sign changes to see if multiple ∆i* values exist
(5) 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.
59
8.4. Example: ROR for Two ME Alternatives
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 B-A
First cost, $ -40,000 - 60,000 -20,000
Annual cost, $/year -25,000 -19,000 +6000
Salvage value, $ 8,000 10,000 +2000
Life, year 5 5
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) 60
8.4 Example: ROR Evaluation for Two ME Alternatives
Solution, using procedure:

A B B-A
First cost , $ -40,000 -60,000 -20,000
Annual cost, $/year -25,000 -19,000 +6000
Salvage value, $ 8,000 10,000 +2000
Life, years 5 5
1) Order by first cost and find incremental cash flow B - A

2) Write ROR equation (in terms of PW) on incremental CF
0 = -20,000 + 6000(P/A,∆i*,5) + 2000(P/F,∆i*,5)
3) Solve for ∆i* and compare to MARR

∆i*B-A = 17.2% > MARR of 15%
4) ROR on $20,000 extra investment is acceptable: Select B
8.4 Example: ROR for Two ME Alternatives (#2)
As Ford Motor Company of Europe retools an old assembly plant in the United Kingdom to
produce a fuel-efficient economy model automobile, Ford and its suppliers are seeking additional
sources for light, long-life transmissions. Automatic transmission component manufacturers use
highly finished dies for precision forming of internal gears and other moving parts. Two
international vendors make the required dies. Use the per unit estimates below and a MARR of
12% per year to select the more economical vendor bid. Show both hand and spreadsheet
solutions.
These are cost alternatives, since all cash

flows are costs. Use the procedure
described above to determine Δi*(B–A).
1) Alternatives A and B are correctly
ordered with the higher first-cost
alternative in column 2 of the Table 8-4.
2) The cash flows for the LCM of 10 years
are tabulated.
62
-
+
-
+
+
3) The incremental cash flow diagram is shown in Figure above.

4) There are three sign changes in the incremental cash flow series, indicating as many as
three roots. There are also three sign changes in the cumulative incremental series, which
starts negatively at S0 = $−5000 and continues to S10 = $+5000, indicating that more than
one positive root may exist.
5) The rate of return equation based on the PW of incremental cash flows is
0 = −5000 + 1900(P∕A,Δi*,10) − 11,000(P∕F,Δi*,5) + 2000(P∕F,Δi*,10)
6) In order to resolve any multiple-root problem, we can assume that the investment rate ii
in the ROIC technique will equal the Δi* found by trial and error. Solution of Equation [8.2]
for the first root discovered results in Δi* between 12% and 15%. By interpolation Δi* =
12.65%. Since the rate of return of 12.65% on the extra investment is greater than the 12%
MARR, the higher-cost vendor B is selected.
63

8.4 Example 8.3 Bell/GTE
• 10-year project (merger)

• New equipment is required
• Two vendors
• MARR = 15%
• Which vendor should be selected
• Cost or Service Problem
8.4 Setup A vs. B

PW(15%) shows
that A has the
lowest PW Cost and
should win!
•Note: No ROR for A

(all negative signs)
and B’s
B s cannot be
determined!
8.4 PW Analysis
• We could stop because the PW (15%) has

signaled
i l d th
thatt A is
i the
th winner!
i !
• Lowest PW cost
• Proceed with a ROR analysis,
y , BUT….
• ROR must be performed on the
incremental investment
66
8.4 Incremental Cash Flow ((Fig.

g 8-2))
8.4 Incremental Cash Flow Results
i* (B-A) is less
Inc. PV(18%)
than the
and is
negative. MARR of
Thus, reject 18%.
the increment Reject
and go with A! increment and
go with A!
68
8.4 So-Called Breakeven ROR
• Recall, the incremental i*(B-A) is the

i t
interest
t rate
t att which
hi h the
th two
t alternatives
lt ti
are economically equivalent.
• This special interest rate is called:
• Breakeven Interest Rate
• Fisherian Intersection Rate
8.4 Breakeven Rate Illustrated
• For Example 8.3

#3 the NPV Plot is:
NPV PLOT-INC. C.F.
0.00
00
10
20
30
40
50
60
70
80
90
00
10
20
30
40
50
60
70
80
90
00
-5000.00
0.
0.
0.
0.
0.
0.
0.
0.
0.
0.
1.
1.
1.
1.
1.
1.
1.
1.
1.
1.
2.
-10000.00
-15000.00
-20000.00
NPV(i%)
-25000.00 i*(B-A) rate;Alternatives are

identical at this rate.
rate
N
-30000.00
-35000.00
-40000.00
-45000.00
-50000.00
Disc. Rates
8.4 Breakeven ROR Values
An ROR at which the PW,

AW or FW values:
v Of cash flows for two

alternatives are exactly
equal. This is the i* value
v Of incremental cash flows

between two alternatives
are exactly equal.
This is the ∆i* value
If MARR > breakeven ROR,

select lower-investment
alternative
8.4 Conclusions i* (B-A) = 12.65%
• For MARR < 12.65% extra investment is

j tifi d G
justified. Go with
ith B
• For MARR > 12.65%,
12 65% the extra
investment is not justified: Go with A
• If MARR = 12.65%, both options are
economically equivalent.
Recall: MARR = 18%
Section 8
8.5
5
ROR Evaluation Using Annual Worth
73
8.5 Incremental ROR by AW
• Recall, calculating IROR/ROR for single

alternative, take PW or AW and equate it to
zero to start with
• Like PW-based relation developed for the
incremental cash flows
Copyright © The McGraw-Hill Companies, Inc. Permission required for reproduction or display. Copyright
8.5 ROR Usingg AW 8.5 ROR U

• AW-based relation can be developed for the
incremental cash flows and set equal to zero
• ROR approach requires comparison over • See Exam
an equal-service
l i life
lif
• Manual a
• When the lives are equal or unequal set
• It is bes
up the AW relationship for the cash flows of
with eithe
each alternative
life of the
• Then solve 0 = AWB – AWA for the ii* value
74
8.6 Criteria
• Select the one alternative that:

• Requires the largest investment
• And indicates that the extra investment
p
over another acceptable alternative is
justified
8.6 Comparing
p g Alternatives
• A given alternative should not be

compared d with
ith one alternative
lt ti for
f which
hi h
the incremental investment is not justified
• If a given alternative loses out in a
comparison that alternative is dropped
comparison,
from further consideration.
8.6 Ranking Rules – Ordering
1. Order the alternatives from smallest to

l
largest
t initial
i iti l investment.
i t t
2 Compute the cash flows for each
2.
alternative (assume or create equal
lives).
lives)
3. If the alternatives are revenue
revenue-cost
cost
alternatives do the following…
8.6 Revenue-Cost Problems
4. Compute the i* value for all alternatives

i the
in th considered
id d set.
t
• If any alternative has an ii* < MARR
MARR, drop
it from further consideration
• The candidate set will be those
alternatives with computed ii* values >
MARR.
• Call this the FEASIBLE set
8.6 Revenue-Cost – Approach

pp
• Calculate i* for the first alternative

• The first alternative is called the
DEFENDER
• The second ((next higher
g investment cost))
alternative is called the CHALLENGER
• Compute the incremental cash flow as
• (Challenger – Defender)
8.6 Revenue – Cost
4. Compute i*Challenger – Defender

• If i*Challenger – Defender > MARR, drop the
defender and the challenger wins the
current round.
5. If i* Challenger – Defender < MARR, drop the
challenger and the defender moves on to
the next comparison round
80
• At each round, a winner is determined

• Either be the current Defender or the
current challenger
• The winner of a g
given round moves to the
next round and becomes the current
DEFENDER and is compared to the next
challenger
6. This process continues until there are

no more challengers
h ll remaining.
i i
• The alternative that remains after all
alternatives have been evaluated is the
final winner
winner.
8.6 Potential Problems
• See Example 8.6 for the potential

problems
bl that
th t can occur using
i RoR
R R
• Pitfalls often exist when one uses the ROR
approach for the analysis of alternatives
8.6 Cost Problems
• Remember
• Cost problems do not have computed
RoR’s
RoR s since there are more cost amounts
than revenue amounts (salvage values may
exist)
•Thus, there are no feasible ii*’s
s for each
alternative
8.6 Cost Problems – Rules
• Rank the alternatives according to their

i
investment
t t requirements
i t (low
(l to
t high)
hi h)
• For the first round compare:
• Challenger
g – Defender Cash Flow
• Compute i*Challenger – Defender
•If i* Challenger – Defender > MARR, Challenger
wins else Defender wins
wins,
8.6 Cost Problems
• The current winner now becomes the

d f d ffor th
defender the nextt round.
d
• Compare the current defender to the next
challenger and compute i* Challenger – Defender
• The winner becomes the current
champion and moves to the next round as
the defender
• Repeat until all alternatives have been
compared.
86
8.5 Example: ROR for Two ME Alternatives using AW

8.5 ROR Using Annual Worth
• See Example 8.5

• Manual approach
• It is best to avoid this approach and stay
• The ROR evaluation using PW shoes that
with either the PW orvendor
ROR over
B should the with
be selected total
Δi* =
life of the project or the LCM life
12.65%.
For the AW relation, there are two equivalent solution approaches.

1) Write an AW-based relation on the incremental cash flow series over the LCM of 10 years
à 0 = AWB − AWA for the two actual cash flow series over one life cycle of each alternative.
à 0 = −5000(A∕P,Δi*,10) − 11,000(P∕F,Δi*,5)(A∕P,Δi*,10) + 2000(A∕F,Δi*,10) + 1900
2) It is easy to enter the incremental cash flows onto a spreadsheet, use the = IRR(:) function to display
Δi* = 12.65%. For the second method, the ROR is found using the actual cash flows and the
respective lives of 10 years for A and 5 years for B. AWA = −8000(A∕P,i,10) − 3500 AWB =
−13,000(A∕P,i,5) + 2000(A∕F,i,5) − 1600 Now develop 0 = AWB − AWA. 0 = −13,000(A∕P,i*,5) +
2000(A∕F,i*,5) + 8000(A∕P,i*,10) + 1900 Solution again yields i* = 12.65%. 87
8.6 ROR Evaluation for Multiple Alternatives
Six-Step Procedure for Mutually Exclusive Alternatives
(1) Order alternatives from smallest to largest initial investment

(2) For revenue alts, calculate i* 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
88
8.6 ROR Evaluation for Multiple ME Alternatives
Two-Alternative Analysis
A
Better
B Better
C Best of 4
Alternatives
89
8.6 Example: ROR for Multiple ME Alternatives (#1)
• Consider the 3 mutually alternatives below
A B C
Initial cost $2000 $4000 $5000
Uniform annual benefit 410 639 700
Each alternative has a 20-year life and no salvage value. If the MARR
is 6%, which alternative should be selected.
Annual Benefits:
- A = $ 410
- B = $ 639
- C = $ 700
0 20
Initial cost:
- A = $2,000
- B = $4,000
- C = $5,000 90
Alternative A: Alternative C:
2,000 = 410 (P/A,i,20) 5000 = 700 (P/A,i,20)
(P/A,i,20) = 2,000 / 410 = 4.878 (P/A,i,20) = 5000 / 700 = 7.143
i = 20% i = is between 12% and 15%
i = 12% + [(7.469-7.143) / (7.469 - 6.259)]
Alternative B: i = 12.8%
4,000 = 639 (P/A,i,20)
As the 3 alternatives exceed the MARR of 6%,
(P/A,i,20) = 4,000 / 639 = 6.259
therefore they are all acceptable.
i = 15%
91
Arrange the 3 alternatives in order of increasing initial cost
A B C
Initial cost $2000 $4000 $5000
Uniform annual benefit 410 639 700
Rate of Return 20% 15% 12.8%
Using A as the baseline, calculate the incremental cost, incremental uniform annual benefit,
and then incremental ROR
Increment B-A
Incremental cost $4000 - $2000 = $2000
Incremental Uniform annual benefit 639 – 410 = 229
Incremental ROR for B-A:

2000 = 229 (P/A,i,20)
(P/A,i,20) = 2000 / 229 = 8.734
DROR = 9.6%
92
As DROR > MARR, therefore A is discarded and B is selected, and then

is used as baseline for comparing alternative C
Increment C-B
Incremental cost $5000 - $4000 = $1000
Incremental Uniform annual benefit 700 – 639 = 61
Incremental ROR for C-B:

1,000 = 61 (P/A,i,20)
(P/A,i,20) = 1000 / 61 = 16.393
DROR = 2.0%
As DROR < MARR

Therefore, C is discarded and B is still a better alternative, which means the
best of the 3 alternatives
93
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%.
A B C D E_
First cost, $ millions -20 -40 -35 -90 -70
Annual M&O cost, $ millions -2 -1.5 -1.9 -1.1 -1.3
A C B E D_
First cost, $ millions -20 -35 -40 -70 -90
Annual M&O cost, $ millions -2 -1.9 -1.5 -1.3 -1.1
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 94
Chapter
p Summary
y
• PW and AW methods are preferred

methods
th d for
f evaluating
l ti alternatives
lt ti
• ROR can be used but care must be taken
• If ROR,, must perform
p an incremental
analysis
• Two at a time (paired comparison) is
q
required
95

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ENGINEERING ECONOMY Fifth Edition Mc

Rate of Return Analysis:

7.1 Interpretation of a Rate of Return

• In rate of return problems, you seek an unknown interest rate (i*)

Iterative procedures require an initial guess for i*

One makes an educated first guess and calculates the

If the NPV is not = 0, then another i* value is evaluated….

A negative NPV generally indicates the i* value is too high.

Then interpolate between the two i* values

7.4 Multiple Rate of Return 7.4 Multiple Rate of Return

7.4 Multiple Rate of Return 7.4 Multiple Rate of Return

Year Cash Flow Accum.

ROR ANALYSIS ONLY FOR SINGLE ALTERNATIVE.

8. Rate-of-Return Analysis: Multiple

1. Why Incremental Analysis?

8.1 Why Incremental Analysis Is

• Assume we have two or more mutually

8.1 Ranking Inconsistency

• For some problems, PW and ROR may

8.1 Review of Problem Types

MUTUALLY EXCLUSIVE - Selection

8.1 An Example – Shows Ranking

• From Solomon {1956/59}

8.1 Two Projects;

• i*A = 0.20 = 20% • Using

8.1 Example Problem – Rankings

• Using ROR Ranking

• Assume the +$120 can be reinvested forward at

8.1 Look at A and assume Reinvestment

8.1 ROR of a Given Reinvestment

8.1 Now Compare

• Compare revised A with reinvestment at

8.1 Ranking Consistency

Conclusion: Must use an incremental ROR analysis to make a consistently

8 2 ROR for Mutual Exclusive Projects

• Given two or more alternatives

8.2 Tabular Format

t Alt. A Alt. B B-A

8.2 Ranking Rules

• Given two or more Mutually Exclusive

• Two Investments: A and B

8.2 Form the Difference ((B – A))

• For mutually exclusive alternatives…

8.2 Incremental Investment

8.2 Incremental Investment

The incremental Investment

8.2 The Logic….

• One would go with investment A initially

8.2 Explaining the Incremental

• Now, is it worth it to the firm to consider

8.2 The Incremental Investment

• Investing $20,000 at time t = o results in

8.2 Is It Worth It?

• Now the question is….

• For this problem, NPV(10%) < 0

• The incremental investment shows a

8.2 Another Example

0 = -20,000 + 6000(P/A,∆i,5) + 2000(P/F,∆i,5)