Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Chapter 8
Rate of Return Analysis: Multiple Alternatives

8.1 Why incremental analysis is necessary

Project ROR values do not provide the same ranking of alternatives as do PW and AW
analyses. This situation does not occur if we conduct an incremental ROR analysis.

8.2 Calculation of incremental cash flow for ROR analysis

The incremental ROR method requires that the equal-service requirement be met.
Therefore, the LCM (least common multiple) of lives for each pairwise comparison
must be used.
Incremental cash flow = cash flow B - cash flow A

Alternative types:
Revenue alternative: where there are both negative and positive cash flows
Cost alternative: where all cash flow estimates are negative

Example 8.1
A tool and die company in Hanover is considering the purchase of a drill press with
fuzzy-logic software to improve accuracy and reduce tool wear. The company has the
opportunity to buy a slightly used machine for $15,000 or a new one for $21,000.
Because the new machine is a more sophisticated model, its operating cost is expected to
be $7000 per year, while the used machine is expected to require $8200 per year. Each
machine is expected to have a 25-year life with a 5% salvage value. Tabulate the
incremental cash flow.

Solution

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

8.3 Interpretation of Rate of Return on the Extra Investment

If the rate of return available through the incremental cash flow equals or exceeds the
MARR, the alternative associated with the extra investment should be selected.

For multiple revenue alternatives, calculate the internal rate of return i* for each
alternative, and eliminate all alternatives that have an i* < MARR. Compare the
remaining alternatives incrementally.

8.4 Rate of Return Evaluation Using PW: Incremental and Breakeven

These three elements - incremental cash flow series, LCM, and multiple roots - are the
primary reasons that the ROR method is often applied incorrectly in engineering economy
analyses of multiple alternatives.

The complete procedure for an incremental ROR analysis for two alternatives is as
follows:

1. Order the alternatives by initial investment or cost, starting with the smaller one.

2. Develop the cash flow and incremental cash flow series using the LCM of years,
assuming reinvestment in alternatives.

3. Draw an incremental cash flow diagram, if needed.

4. Count the number of sign changes in the incremental cash flow series to determine if

multiple rates of return may be present.

5. Set up the PW = 0 equation and determine i*BA.

6. Select the economically better alternative as follows:

If i*BA < MARR, select alternative A.

If i*BA MARR, the extra investment is justified; select alternative B.

Example 8.2
Ford Motor Company retools an old truck assembly plant in Michigan to produce a fuel
efficient economy model, the Ford Focus. 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

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

moving parts. Two United States-based vendors make the required dies. Use per unit
estimates below and a MARR of 12% per year to select the more economical vendor bid.

Solution
1. Alternatives A and B are correctly ordered with the higher first-cost alternative in
column 2 of the Table

2. The cash flows for the LCM of 10 years are tabulated.

3. The incremental cash flow diagram

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.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

5. The rate of return equation based on the PW of incremental cash flows is

In order to resolve any multiple-root problem, we can assume that the investment rate ii in
the ROIC technique will equal the i* found by trial and error. i* is between 12% and
15%. By interpolation i*=12.65%.

6. 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.

The breakeven rate of return is the incremental i* value, i*, at which the PW (or AW)
value of the incremental cash flows is exactly zero. Equivalently, the breakeven ROR is
the i value, i*, at which the PW (or AW) values of two alternatives actual cash flows are
exactly equal to each other.

It shows the i* breakeven at 12.65%. The conclusions are that

For MARR < 12.65%, the extra investment for B is justified.

For MARR > 12.65%, the extra investment in B should not be made and vendor A is
selected.

If MARR is exactly 12.65%, the alternatives are equally attractive.

8.5 Rate of Return Evaluation Using AW

Comparing alternatives by the ROR method (correctly performed) always leads to the
same selection as PW and AW analyses, whether the ROR is determined using a PW-
based or an AW-based relation.

The same six-step procedure of the previous section (for PW-based calculation) is used,
except in step 5 the AW-based relation is developed.

0 = AWB - AWA

Example 8.3
Compare the alternatives of vendors A and B for Ford in Example 8.2, using an AW-
based incremental ROR method and the same MARR of 12% per year.

Solution

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

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%.

8.6 Incremental ROR Analysis of Multiple Alternatives

Example 8.4

Caterpillar Corporation wants to build a spare parts storage facility in the Phoenix,
Arizona, vicinity. A plant engineer has identified four different location options. The
initial cost of earthwork and prefab building and the annual net cash flow estimates are
detailed in the following table. The annual net cash flow series vary due to differences in
maintenance, labor costs, transportation charges, etc. If the MARR is 10%, use
incremental ROR analysis to select the one economically best location.

Solution

0 = -190,000 + 19,500(P/A, i*,30)

(P/A ,i*,30) = 9.7436 and ic* = 9.63%. Since 9.63% < 10%, location C is eliminated.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

Note: For cost alternatives, the incremental cash flow is the difference between costs for
two alternatives. There is no do-nothing alternative and no step 2 in the solution
procedure. Therefore, the lowest-investment alternative is the initial defender against the
next-lowest investment (challenger).

Example 8.5

The complete failure of an offshore platform and the resulting spillage of up to 800,000 to
1,000,000 gallons per day into the Gulf of Mexico in the spring of 2010 have made major
oil producers and transporters very conscious of the harm done to peoples livelihood and
all forms of aquatic life by spills of this magnitude. To address the specific danger to
birds that are shoreline feeders and dwellers, environmental engineers from several
international petroleum corporations and transport companies-Exxon-Mobil, BP, Shell,
and some transporters for OPEC producers-have developed a plan to strategically located
throughout the world newly developed equipment that is substantially more effective than
manual procedures in cleaning crude oil residue from bird feathers. The Sierra Club,
Greenpeace, and other international environmental interest groups are in favor of the
initiative. Alternative machines from manufacturers in Asia, America, Europe, and Africa
are available with the cost estimates in Table below. Annual cost estimates are expected
to be high to ensure readiness at any time. The company representatives have agreed to
use the average of the corporate MARR values, which results in MARR = 13.5%. Use a
spreadsheet and incremental ROR analysis to determine which manufacturer offers the
best economic choice.

Solution
1. The alternatives are already ordered by increasing first costs.

2. These are cost alternatives, so there is no comparison to DN, since i* values cannot be

calculated.

3. Machine 2 is the first challenger to machine 1; the incremental cash flow for the 2-to-1.

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Fundamentals of Engineering Economy Prepared by Mazyar Ghadirinejad

4. The 2-to-1 comparison results in i * = 14.57% by applying the IRR function.

5. This return exceeds MARR = 13.5%, so machine 2 is the new defender.

The comparison continues for 3-to-2, where the return is negative at i* = -18.77%;
machine 2 is retained as the defender. Finally the 4-to-2 comparison has an incremental
ROR of 13.60%, which is slightly larger than MARR = 13.5%. The conclusion is to
purchase machine 4 because the extra investment is (marginally) justified.