CHAPTER 8

INCREMENTAL RATE OF RETURN

ANALYSIS

COMPILED BY
ENGR. ABAID ULLAH
abaid.ullah@uettaxila.edu.pk
• Framework: Accounting & Breakeven Analysis

• “Time-value of money” concepts - Ch. 3, 4

• Analysis methods
• Ch. 5 - Present Worth
• Ch. 6 - Annual Worth
• Ch. 7,7A,8 - Rate of Return (incremental analysis)

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 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.

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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  MARR keep the present selection.

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 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

A B C D E
Cost 4000 2000 6000 1000 9000
EUAB (A) 639 410 761 117 785
PWB 7330 4700 8730 1340 9000
IRR 15% 20% 11% 10% 6%
P/A 6.26 4.88 7.88 8.55 11.47

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 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.
D B A C E
Cost 1000 2000 4000 6000 9000
EUAB (A) 117 410 639 761 785

Increment B-D A-B C-A E-A

incr. Cost 1000 2000 2000 5000
incr. UAB 293 229 122 146
incr. ROR 29% 10% 2% < 0%
Keep B A A A
P/A 3.413 8.73 16.393 34.236

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GRAPHICAL SOLUTIONS
PWB vs. PWC at MARR
Above the 45 degree line projects are acceptable (NPW>0)

Benefit-cost Graph
MARR 6.00 % Alternatives
30
POSITIVE NPW

25
Present Worth of Benefit
0.06

20

15
0 $26.42
0 $26.42
10

NEGATIVE NPW
0
0 10 20 30
Present Worth of Cost

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 GRAPHICAL SOLUTION
• Projects B, A, C and E shown.
• Incremental analysis looks at adjacent points on the Benefit-Cost Graph

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Graphical Incremental Analysis
If line between two alternatives is > 45 degrees, accept higher cost alternative.
Alternative A wins.

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 GRAPHICAL INCREMENTAL ANALYSIS
• Graphical solution has a logical connection to NPW
•Incremental analysis seeks out the alternative with highest NPW.
Alternative A maximizes NPW.

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 CHOOSING AN ANALYSIS METHOD

Method MARR Computations* Explanation

PW Required for Less Depends
calculation
AW Required for Less Depends
calculation
ROR For comparison More Depends

*Not an issue when using a spreadsheet.

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QUESTIONS WILL BE VERY
MUCH APPRECIATED

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 THANKS

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