Chapter 8 - Incremental Rate of Return Analysis Click here for Streaming Audio To Accompany Presentation (optional) Click here for Streaming Audio To Accompany Presentation (optional) EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz Industrial & Manufacturing Engineering Department Cal Poly Pomona

EGR Cal Poly Pomona - SA112 EGR The Big Picture 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) –Ch. 9 - Benefit Cost Ratio & other techniques Refining the analysis –Ch. 10, 11 - Depreciation & Taxes –Ch Replacement Analysis

EGR Cal Poly Pomona - SA113 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.

EGR Cal Poly Pomona - SA114 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  ROR  MARR select the contender. –If  ROR  MARR  keep the present selection.

EGR Cal Poly Pomona - SA115 Incremental Rate of Return Analysis Example PWB = A (P/A, 6%, 20) = A (11.47) MARR = 6% (given) All projects are initially acceptable because IRR  MARR

EGR Cal Poly Pomona - SA116 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

EGR Cal Poly Pomona - SA117 Graphical Solutions PWB vs. PWC at MARR Above the 45 degree line projects are acceptable (NPW>0)

EGR Cal Poly Pomona - SA118 Graphical Solution Projects B, A, C and E shown. Incremental analysis looks at adjacent points on the Benefit- Cost Graph

EGR Cal Poly Pomona - SA119 Graphical Incremental Analysis If line between two alternatives is > 45 degrees, accept higher cost alternative. Alternative A wins.

EGR Cal Poly Pomona - SA1110 Graphical Incremental Analysis Graphical solution has a logical connection to NPW Incremental analysis seeks out the alternative with highest NPW. Alternative A maximizes NPW.

EGR Cal Poly Pomona - SA1111 Choosing an Analysis Method DependsMoreFor comparisonROR DependsLessRequired for calculation AW DependsLessRequired for calculation PW ExplanationComputations*MARRMethod Do what the Organization requires. Occasionally augment with alternate methods where the method adds beneficial information. *Not an issue when using a spreadsheet.