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Incremental Analysis of Economic Proposals

This document discusses incremental analysis for evaluating mutually exclusive alternatives. It explains that incremental analysis considers the cash flows between alternatives to determine the overall return on the total available capital. The example shows calculating the incremental cash flows and return for two machine alternatives, and selecting the one with the higher weighted average return. The key steps are: 1) determine incremental cash flows, 2) set up and solve an equation to calculate the incremental return, and 3) select the alternative with the higher return or, if lower, the alternative that uses less of the available capital.

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maha alenezi
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21 views15 pages

Incremental Analysis of Economic Proposals

This document discusses incremental analysis for evaluating mutually exclusive alternatives. It explains that incremental analysis considers the cash flows between alternatives to determine the overall return on the total available capital. The example shows calculating the incremental cash flows and return for two machine alternatives, and selecting the one with the higher weighted average return. The key steps are: 1) determine incremental cash flows, 2) set up and solve an equation to calculate the incremental return, and 3) select the alternative with the higher return or, if lower, the alternative that uses less of the available capital.

Uploaded by

maha alenezi
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

Chapter 8

Incremental Analysis
Types of Economic Proposals

• Mutually Exclusive (ME) Alternatives:


• Only one project can be selected
• All proposals compete against each other

• Independent Projects:
• More than one project can be selected
• Compete against DN (Do Nothing) alternative
For Independent Projects

• More than one project can be selected


• Compete against DN (Do Nothing)
alternative
For ME Projects

• All proposals compete against each other


• Only one project can be selected

Incremental Analysis is applied for


the case when 2 or more Mutually
Exclusive alternatives are evaluated.
Example

A company has $90,000 available for


investment and uses an MARR of 16% per year.
Two alternatives are being evaluated:
Project A needs an investment of $50,000 and
has iA* = 35% per year
Project B needs an investment of $85,000 and
has iB* = 29% per year

Which project should be selected?


Solution

• While A has the higher projected


return, its initial investment is much
less
• What happens to the investment capital
that is left over?
Solution

Project A needs an investment of


$50,000 and has iA* = 35% per year
Project B needs an investment of
$85,000 and has iB* = 29% per year
Calculating the Overall ROR for each
project(weighted average):
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%
Main Points

• 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
Incremental Cash Flow (CF)

Incremental CF = cash flowB ­ cash flowA


(let larger initial investment be 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
Annual cost, $/year -25,000 -19,000
Salvage value, $ 8,000 10,000
Life, years 5 5

Caculate the incremental CF in the (B-A) column


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 (use LCM of lives).
6. If ∆i*B-A < MARR, select A; otherwise, select 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
Life, years 5 5
Initial observations: ME, cost alternatives with equal life estimates
and no multiple ROR values indicated

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


Solution
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

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

0 = −20,000 + 6,000 (P/A, ∆i*, 5) + 2,000 (P/F, ∆i*, 5)


# (1+ Δi *)5 −1 &
0 = −20,000 + 6,000 % ( + 2,000 (1+i*)-5
5
%$ Δi * (1+ Δi*) ('
Summary

• For independent alternatives, compare


each against DN and select all that have
ROR ≥ MARR
• for mutually exclusive alternatives,
must consider incremental cash flows
• Eliminate alternative based on:
incremental ROR ∆i* < MARR
Practice Problems

• 8.2 • 8.15
• 8.7 • 8.40
• 8.8 • 8.41
• 8.12 • 8.43
• 8.13 • 8.44
• 8.14 • 8.45

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