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    Chapter 7&8: Rate of Return of A Single Alternative Rate of Return Multiple Alternatives

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    Chapter 7&8: Rate of Return of A Single Alternative Rate of Return Multiple Alternatives

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    Chapter 7&8: Rate of Return of A Single Alternative Rate of Return Multiple Alternatives

    Uploaded by

    Blessing Fajemirokun

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    © All Rights Reserved
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    Chapter 7&8

    Rate of Return of a Single Alternative


    Rate of Return Multiple Alternatives

    ©McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.
    Interpretation of ROR
    Rate paid on unrecovered balance of borrowed money such
    that final payment brings balance to exactly zero
    with interest considered

    ROR equation can be written in terms of PW, AW, or FW

    Use trial and error solution by factor or spreadsheet


    ROR Calculation and Project Evaluation
    To determine ROR, find the i* value in the relation
    PW = 0 or AW = 0 or FW = 0

    Alternatively, a relation like the following finds i*


    PWoutflow = PWinflow

    For evaluation, a project is economically viable if


    i* ≥ MARR
    Special Considerations for ROR
    May get multiple i* values

    Incremental analysis necessary for multiple alternative


    evaluations
    Multiple ROR Values

    Multiple i* values may exist when there is more than one sign
    change in net cash flow (CF) series.
    Such CF series are called non-conventional

    Two tests for multiple i* values:

    Descarte’s rule of signs: total number of real i* values is ≤ the


    number of sign changes in net cash flow series.

    Norstrom’s criterion: if the cumulative cash flow starts off negatively


    and has only one sign change, there is only one positive root.
    Example: Multiple i* Values
    Determine the maximum number of i* values for the cash flow shown below
    Year Expense Income Net cash flow Cumulative CF
    0 −12,000 n/a −12,000 −12,000
    1 −5,000 +3,000 −2,000 −14,000
    2 −6,000 +9,000 +3,000 −11,000
    3 −7,000 +15,000 +8,000 −3,000
    4 −8,000 +16,000 +8,000 +5,000
    5 −9,000 +8,000 −1,000 +4,000

    Solution:
    The sign on the net cash flow changes The cumulative cash flow begins
    twice, indicating two possible i* values negatively with one sign change
    Therefore, there is only one i* value ( i* = 8.7%)
    ROR Calculation Using PW, FW or AW Relation
    ROR is the unique i* rate at which a PW, FW, or AW relation equals exactly 0

    Example: An
    investment of $20,000 in new equipment will generate
    income of $7000 per year for 3 years, at which time the machine
    can be sold for an estimated $8000. If the company’s MARR is 15%
    per year, should it buy the machine?

    Solution: The ROR equation, based on a PW relation, is:


    𝟎 = −𝟐𝟎, 𝟎𝟎𝟎 + 𝟕𝟎𝟎𝟎(𝐏/𝐀, 𝐢 ∗, 𝟑) + 𝟖𝟎𝟎𝟎(𝐏/𝐅, 𝐢 ∗, 𝟑)

    Solve for i* by trial and error or spreadsheet: i* = 18.2% per year


    Since i* > MARR = 15%, the company should buy the machine
    Why Incremental Analysis is Necessary (1)

    Selecting the alternative with highest ROR may not yield highest return
    on available capital
    Must consider weighted average of total capital available
    Capital not invested in a project is assumed to earn at MARR

    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:

    Overall 𝐑𝐎𝐑𝐀 = [𝟓𝟎, 𝟎𝟎𝟎(𝟎. 𝟑𝟓) + 𝟒𝟎, 𝟎𝟎𝟎(𝟎. 𝟏𝟔)]/𝟗𝟎, 𝟎𝟎𝟎 = 𝟐𝟔. 𝟔%
    Overall 𝐑𝐎𝐑𝐁 = [𝟖𝟓, 𝟎𝟎𝟎(𝟎. 𝟐𝟗) + 𝟓, 𝟎𝟎𝟎(𝟎. 𝟏𝟔)]/𝟗𝟎, 𝟎𝟎𝟎 = 𝟐𝟖. 𝟑%

    Which investment is better, economically?

    ©McGraw-Hill Education.
    Why Incremental Analysis is Necessary (2)

    If selection basis is higher ROR:


    Select alternative A (wrong answer)
    If selection basis is higher overall ROR:
    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)

    ©McGraw-Hill Education.
    Calculation of Incremental CF
    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
    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)
    ©McGraw-Hill Education.
    Interpretation of ROR on Extra Investment
    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)

    ©McGraw-Hill Education.
    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

    ©McGraw-Hill Education.
    Example: Incremental ROR Evaluation

    Either of the cost alternatives shown below can be used in a


    chemical refining process. If the company’s MARR is 15% per year,
    determine which should be selected on the basis of ROR analysis?

    A B
    First cost ,$ −40,000 −60,000
    Annual cost, $/year −25,000 −19,000
    Salvage value, $ 8,000 10,000
    Life, years 5 5

    Initial observations: ME, cost alternatives with equal life estimates


    and no multiple ROR values indicated

    ©McGraw-Hill Education.
    Example: ROR Evaluation of Two 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
    Order by first cost and find incremental cash flow B − A

    Write ROR equation (in terms of PW, AW, or FW) on incremental CF


    0 = −20,000 + 6000(P/A, ∆i ∗, 5) + 2000(P/F, ∆i ∗, 5)
    Solve for ∆i* and compare to MARR
    ∆i*B-A = 17.2% > MARR of 15%
    ROR on $20,000 extra investment is acceptable: Select B
    ©McGraw-Hill Education.
    ROR Analysis – Multiple Alternatives
    Six-Step Procedure for Mutually Exclusive Alternatives
    (1) Order alternatives from smallest to largest initial investment
    (2) For revenue alts, calculate i* (vs. DN) 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

    ©McGraw-Hill Education.
    Example: ROR for Multiple Alternatives
    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

    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
    ©McGraw-Hill Education.
    Summary of Important Points
    Must consider incremental cash flows for mutually exclusive alternatives

    Incremental cash flow = cash flowB − cash flowA


    where alternative with larger initial investment is Alternative B

    Eliminate B if incremental ROR ∆i* < MARR; otherwise, eliminate A

    For multiple mutually exclusive alternatives, compare two at a time and


    eliminate alternatives until only one remains

    For independent alternatives, compare each against DN and select all that
    have ROR ≥ MARR

    ©McGraw-Hill Education.

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