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Incremental Rate of Return Analysis in Capital Allocation

Discover the methodology of incremental analysis for evaluating investment alternatives based on rate of return considerations. Learn how to rank, compare, and select projects efficiently to maximize value generation.

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Incremental Rate of Return Analysis in Capital Allocation

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

  2. EGR 403 - 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. 12 - Replacement Analysis EGR 403 - Cal Poly Pomona - SA11

  3. 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 403 - Cal Poly Pomona - SA11

  4. 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 DROR £ MARR select the contender. • If DROR ³ MARRkeep the present selection. EGR 403 - Cal Poly Pomona - SA11

  5. Incremental Rate of Return Analysis • Example 8 - 7 • PWB = A (P/A, 6%, 20) = A (11.47) • MARR = 6% (given) • All projects are initially acceptable because IRR  MARR EGR 403 - Cal Poly Pomona - SA11

  6. Incremental Analysis1. Rank from lowest cost to highest cost2. Start with two lowest cost alternatives3. Compare increments using MARR criteria4. Repeat until a “winner” is determined EGR 403 - Cal Poly Pomona - SA11

  7. Graphical SolutionsPWB vs. PWC at MARRAbove the 45 degree line projects are acceptable (NPW>0) EGR 403 - Cal Poly Pomona - SA11

  8. Graphical Solution • Projects B, A, C and E shown. • Incremental analysis looks at adjacent points on the Benefit-Cost Graph EGR 403 - Cal Poly Pomona - SA11

  9. Graphical Incremental AnalysisIf line between two alternatives is > 45 degrees, accept higher cost alternative. Alternative A wins. EGR 403 - Cal Poly Pomona - SA11

  10. 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 403 - Cal Poly Pomona - SA11

  11. Method MARR Computations* Explanation PW Required for calculation Less Depends AW Required for calculation Less Depends ROR For comparison More Depends Choosing an Analysis Method *Not an issue when using a spreadsheet. Do what the Organization requires. Occasionally augment with alternate methods where the method adds beneficial information. EGR 403 - Cal Poly Pomona - SA11

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