Rate of Return Analysis:

Multiple Alternatives
Chapter 8
Learning Objectives

2
 WHY INCREMENTAL ANALYSIS IS NECESSARY

This chapter presents methods where 2 or

more alternatives can be evaluated using
a rate of return (ROR) comparison based
on methods of the previous chapter.
The ROR evaluation correctly performed
will result in the same selection as the PW,
AW and FW analyses, but the
computational procedure is considerably
different for ROR evaluations.

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 Assume that a company uses a MARR of 16% per year, has
$90,000 available for investment, and that two alternatives (A and B)
are being evaluated.
Alternative A requires an investment of $50,000 and has an internal
rate of return iA* of 35% per year.
Alternative B requires $85,000 and has an iB* of 29% per year.
Intuitively we may conclude that the better alternative is the one that
has the larger return, A in this case.
However, this is not necessarily so. While A has the higher projected
return, it requires an initial investment that is much less than the
total money available ($90,000).
What happens to the investment capital that is left over? It is
generally assumed that excess funds will be invested at the
companys MARR. Using this assumption, it is possible to determine
the consequences of the alternative investments.
If alternative A is selected, $50,000 will return 35% per year. The
remaining $40,000 will be invested at the MARR of 16% per year.
The rate of return on the total capital available, then, will be the
weighted average. 4
 A tool and die company in Pittsburgh 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.

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 Solution
Incremental cash flow is tabulated in Table 82. Using Equation
[8.1], the subtraction performed is (new - used) since the new
machine has a larger initial cost.
The salvage values in year 25 are separated from ordinary cash flow
for clarity. When disbursements are the same for a number of
consecutive years, it saves time to make a single cash flow listing,
as is done for years 1 to 25. This approach cannot be used for
spreadsheets (Excel).
Incremental cash flow = cash flowB - cash flowA [8.1]

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 Sandersen Meat Processors has asked its lead
process engineer to evaluate two different
types of conveyors for the bacon curing line.
Type A has an initial cost of $70,000 and a life
of 8 years.
Type B has an initial cost of $95,000 and a life
expectancy of 12 years.
The annual operating cost (AOC) for type A is
expected to be $9000, while the AOC for type B
is expected to be $7000.
If the salvage values are $5000 and $10,000 for
type A and type B, respectively, tabulate the
incremental cash flow using their LCM.
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Solution
The LCM of 8 and 12 is 24 years. In the incremental cash flow tabulation for
24 years (Table 83) note that the reinvestment and salvage values are
shown in years 8 and 16 for type A and in year 12 for type B.

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 INTERPRETATION OF RATE OF RETURN
ON THE EXTRA INVESTMENT
The incremental cash flows in year 0 of Tables 82 and 83 reflect the extra investment
or cost required if the alternative with the larger first cost is selected. This is important in
an incremental ROR analysis to determine the ROR earned on the extra funds
expended for the larger-investment alternative.
If the incremental cash flows of the larger investment dont justify it, we must select the
cheaper one. In Example 8.1 the new drill press requires an extra investment of $6000
(Table 82). If the new machine is purchased, there will be a savings of $1200 per
year for 25 years, plus an extra $300 in year 25. The decision to buy the used or new
machine can be made on the basis of the profitability of investing the extra $6000 in the
new machine.
If the equivalent worth of the savings is greater than the equivalent worth of the extra
investment at the MARR, the extra investment should be made (i.e., the larger first-cost
proposal should be accepted).
On the other hand, if the extra investment is not justified by the savings, select the
lower-investment proposal.
It is important to recognize that the rationale for making the selection decision is the
same as if only one alternative were under consideration, that alternative being the one
represented by the incremental cash flow series. When viewed in this manner, it is
obvious that unless this investment yields a rate of return equal to or greater than the
MARR, the extra investment should not be made.
As further clarification of this extra-investment rationale, consider the following: The rate
of return attainable through the incremental cash flow is an alternative to investing at the
MARR. Section 8.1 states that any excess funds not invested in the alternative are
assumed to be invested at the MARR.
The conclusion: 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. 9
 RATE OF RETURN EVALUATION USING PRESENT WORTH:
INCREMENTAL AND BREAKEVEN

In 2000, Bell Atlantic and GTE merged to form a giant

telecommunications corporation named Verizon
Communications. As expected, some equipment
incompatibilities had to be rectified, especially for long
distance and international wireless and video services.
One item had two suppliers - a U.S. firm (A) and an
Asian firm (B). Approximately 3000 units of this
equipment were needed. Estimates for vendors A and B
are given for each unit.

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 Determine which vendor should be selected if the MARR is 15% per year.
These are service alternatives, since all cash flows are costs.
Alternatives A and B are correctly ordered with the higher first-cost alternative
in column (2).
The cash flows for the LCM of 10 years are shown in Table 84.
The incremental cash flow diagram is shown in Figure 81 (next page).
There are 3 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 that starts negatively at S0 = - $5000 and continues to S10 =
+$5000, indicating that more than one positive root may exist.
The rate of return equation based on the PW of incremental cash flows is

0 = - 5000 +1900(P/A, i,10) - 11,000(P/F, i, 5) + 2000 (P/F, i, 10) [8.2] 11

 0 = - 5000 +1900(P/A, i,10) - 11,000(P/F, i, 5) + 2000 (P/F, i, 10) [8.2]

Assume that the reinvestment rate is equal to the resulting i*BA (or i* for a shortened
symbol).
Solution of Equation [8.2] for the first root finds results for i* between 12 and 15%.
By interpolation i* = 12.65%.
Since the rate of return of 12.65% on the extra investment is less than the 15%
MARR, the lower-cost vendor A is selected.
The extra investment of $5000 is not economically justified by the lower annual cost
and higher salvage estimates.
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 =IRR(D4:D14)

=NPV($B$1,D5:D14)+D4
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 Bank of America uses a MARR of 30% on alternatives for its own
business that are considered risky, that is, the response of the public
to the service has not been well established by test marketing. Two
alternative software systems and the marketing/delivery plans have
been jointly developed by software engineers and the marketing
department. They are for new online banking and loan services to
passenger cruise ships and military vessels at sea internationally.
For each system, start-up, annual net income, and salvage value (i.e.,
sell-out value to another financial corporation) estimates are
summarized below.
(a) Perform the incremental ROR analysis by computer.
(b) Develop the PW vs. i graphs for each alternative and the
increment. Which alternative, if either, should be selected.?

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Present Worth vs. Interest Rate, MARR =30%

Interest rate, i%
=NPV($C3,$B$4:$B$11)+$B$3

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 Figure 84b (previous slide) provides the opportunity to see why the
ROR method can result in selecting the wrong alternative when only
i* values are used to select between two alternatives.
This is sometimes called the ranking inconsistency problem of the
ROR method. The inconsistency occurs when the MARR is set less
than the breakeven rate between two revenue alternatives.
Since the MARR is established based on conditions of the economy
and market, MARR is established external to any particular
alternative evaluation. In the previous graph, the breakeven rate is
29.41% and the MARR is 30%.
If the MARR were established lower than breakeven, say at 26%, the
incremental ROR analysis results in correctly selecting B, because i*
= 29.41%, which exceeds 26%. When only the i* values were used,
system A would be wrongly chosen, because its i* = 39.31%.
This error occurs because the rate of return method assumes
reinvestment at the alternatives ROR value (39.31%), while PW and
AW analyses use the MARR as the reinvestment rate.
The conclusion: If the ROR method is used to evaluate two or
more alternatives, use the incremental cash flows and i* to make
the decision between alternatives.

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