Lecture # 14 investment alternatives ii

Lecture # 14

Investment Alternatives

Incremental ROI/IRR Method

1

Dr. A. Alim

1. Incremental ROI Analysis of Multiple Mutually Exclusive Alternatives

The concept of incremental investment

Suppose a company has $90,000 to invest in a project. Two mutually exclusive alternatives are proposed; MARR is 16%: Alternative A requires an investment of $50,000 and has a ROI of 35% Alternative B requires an investment of $85,000 and has a ROI of 29% The remaining funds after the selection would naturally be invested at MARR. One would intuitively think that option A is preferred since it has a higher ROI, but this would be incorrect .

Material sourced from "Plant Design and Economics for Chem.

Engineers", 5th ed. by Peters et al. and also from " Engineering

Economy", 6th edition,2005, by Blank and Tarquin. 2 © 2003 and 2005 by McGraw-Hill,

New York, N.Y All Rights Reserved

Since the company can always invest the unused funds at MARR, the overall ROI is: With option A, ROI = (50000(0.35) + 40000(0.16))/90000 = 26.6 % With option B, ROI = (85000(0.29) + 5000(0.16))/90000 = 28.3 % Option B is recommended.





COMPARISON OF ALTERNATIVES

The concept of incremental investment Definition: incremental investment means every additional dollar invested must result in an incremental ROI at least equal to MARR.

If investment B is more than investment A, then: Investment B is recommended ONLY IF : (Profit ”B” – Profit “A”) / (Investment “B” – Investment “A”) ≥ MARR i.e. incremental ROI ≥ MARR

Material sourced from "Plant Design and Economics for Chem. Engineers",

5th ed. by Peters et al. and also from " Engineering Economy", 6th

edition,2005, by Blank and Tarquin.

4 © 2003 and 2005 by McGraw-Hill,


Material sourced from "Plant Design

and Economics for Chem.

Engineers", 5th ed. by Peters et al.

and also from " Engineering

Economy", 6th edition,2005, by

Blank and Tarquin.

© 2003 and 2005 by McGraw-Hill,


5

Profit

$

Investment

$

B

A

Select B and reject A only if :

Incremental ROI =(Profit ”B” – Profit “A”) / (Investment “B” – Investment “A”) ≥ MARR

Profit Or

Savings

Investment Material sourced from "Plant Design and Economics for Chem. Engineers",


edition,2005, by Blank and Tarquin. 6



Profit Or

Savings

Investment

Incremental ROI = delta profit / delta investment At the limit of delta investment approaches zero, the incremental ROI is the slope to the curve.





Profit Or

Savings

Investment

Incremental ROI = delta profit / delta investment At the limit of delta investment approaches zero, the incremental ROI is the slope to the curve.

Material sourced from "Plant Design and Economics for

Chem. Engineers", 5th ed. by Peters et al. and also from

" Engineering Economy", 6th edition,2005, by Blank and

Tarquin. 8 © 2003 and 2005 by McGraw-Hill,


Profit Or

Savings

Investment

Line of slope = MARR

Recommended investment for Incremental ROI = MARR

Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed.

by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank

and Tarquin.



All investments here have incremental ROI over “X” less than MARR

X



edition,2005, by Blank and Tarquin.

10 © 2003 and 2005 by McGraw-Hill, New York, N.Y All

Rights Reserved

Incremental investment analysis

Incremental Investment Analysis

ROI (A) is larger than ROI(B) Yet we reject A and accept B

Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by

Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and

Tarquin.



Incremental Investment Analysis

COMPARISON OF ALTERNATIVES Incremental Investment Analysis

Basic concept: We want the return to be higher than MARR for every dollar invested. Below the tangent point: ROI > MARR , hence, + ve incremental investment Beyond the tangent point: ROI < MARR , hence, - ve incremental investment Investments beyond the tangent point are therefore not advised when Compared to alternative investment at the tangent point. Calculate incremental ROI: ROI = ( profit or savings) / ( investment) Accept if ROI ≥ MARR

Material sourced from "Plant Design and Economics for Chem. Engineers", 5th

ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by

Blank and Tarquin.



COMPARISON OF ALTERNATIVES Incremental Investment Analysis

When comparing several investments using the ROI method, we apply the incremental analysis and follow this principle: Select the one alternative • That requires the largest investment, and • Indicates that the extra investment over another acceptable alternative is justified, i.e. yielding an incremental ROI ≥ MARR.






Example 8-6, Page 344 Plant Design and Economics For chem. Engineers, 5th ed, 2003 by Peters et al.








and Tarquin.

15 © 2003 and 2005 by McGraw-Hill, New York, N.Y

All Rights Reserved

• We now apply incremental ROI analysis among alternatives 1,2, and 3:

• First step is to arrange the investments from left to right in ascending order. In this case the order is 1, 2, then 3.

• We then determine Inc. ROI between pairs starting from the left and moving right.

• Inc. ROI (2-1) = (3,000 – 2,000) / (16,000 – 10,000) = 16.7 % which is > MARR.

Therefore: Reject alternative 1

• Inc. ROI (3-2) = (3,200 – 3,000) / (20,000 – 16,000) = 5 % which is < MARR.

Therefore: Reject alternative 3

Conclusion: Accept alternative 2



Blank and Tarquin. 16



Modified example 8-3, page 331

• 3 investments. Need to evaluate profitability of each.

• Use ROI, PBP, NPV, and DCFRR.

• Assume straight line depreciation.

• Tax rate is 35%

• MARR is 15%

• Use MARR as interest rate for time value of money.

• Ignore land value.

Incremental ROI analysis






Plant Design and Economics For chem. Engineers, 5th ed, 2003 by Peters et al.



Blank and Tarquin.



Inv. 1 Inv. 2 Inv. 3

Total inv. $ 110,000 180,000 225,000 NPAT, $/y 24,300 27,607 32,562 ROI (MARR) 22.1(15) 15.3(15) 14.5(15) Accept? YES YES NO Incremental ROI (2-1) = (27,607 – 24,300) / (180,000 -110,000) = 4.7 % Which is less than MARR. Therefore reject 2 and accept 1.



Blank and Tarquin. 19 © 2003 and 2005 by McGraw-Hill,


2. Incremental DCFRR (IRR) Analysis of

Multiple Mutually Exclusive Alternatives

Given N mutually exclusive alternatives, using

the incremental DCFRR method

Select the one alternative that

Requires the largest investment, and at the same time

Indicates that the extra investment over another acceptable investment is justified.

This means incremental IRR must be equal to or higher than MARR.



Blank and Tarquin.










and Tarquin. 22



IRR (B–A) is the incremental IRR or DCFRR

Which project to accept, A or B?

• Depends on the value of MARR !

• Accept B and reject A if: IRR (B-A) ≥ MARR

• Accept A and reject B if: IRR (B-A) < MARR



edition,2005, by Blank and Tarquin. 23 © 2003 and 2005 by McGraw-Hill,




MARR

Reject both A and B



MARR

Reject B, accept A



MARR

Reject B, accept A

Since IRR (B-A) < MARR



MARR

Reject A, accept B

Since IRR (B-A) > MARR



Ranking Rules – Selection Process

Among Mutually Exclusive Alternatives

1. Order the alternatives from smallest to largest initial investment. For revenue projects the DN alternative is the first on the left (no investment!)

2. Compute the cash flows for each alternative (DN has zero cash flows)

3. Ensure project lives are equal, apply LCM if needed.

Material sourced from "Plant Design and

Economics for Chem. Engineers", 5th ed.

by Peters et al. and also from "

Engineering Economy", 6th edition,2005,

by Blank and Tarquin.



4. Compute the DCFRR value for all alternatives in the considered set.

If any alternative has an DCFRR < MARR drop it from further consideration

The candidate set will be those alternatives with computed DCFRR values > MARR.

Call this the FEASIBLE set


Economics for Chem. Engineers", 5th ed. by

Peters et al. and also from " Engineering

Economy", 6th edition,2005, by Blank and

Tarquin.



The first alternative is called the DEFENDER

The second (next higher investment cost) alternative is called the CHALLENGER

Compute the incremental cash flow as

(Challenger – Defender)


Economics for Chem. Engineers", 5th ed. by

Peters et al. and also from " Engineering

Economy", 6th edition,2005, by Blank and

Tarquin.



5. Compute DCFRR Challenger – Defender

If DCFRR Challenger – Defender ≥ MARR drop the defender and the challenger wins the current round.

If DCFRR Challenger – Defender < MARR, drop the challenger and the defender moves on to the next comparison round








At each round, a winner is determined

Either the current Defender or the current Challenger

The winner of a given round moves to the next round and becomes the current DEFENDER and is compared to the next challenger








6. This process continues until there are no more challengers remaining.

The alternative that remains after all alternatives have been evaluated is the final winner.








Costs Only (Service) Problems –

DCFRR Approach

Remember

Cost problems do not have computed DCFRR’s since there are more cost amounts that revenue amounts (salvage values may exist)

Thus there are no feasible DCFRR’s for each alternative, but they do exist for the delta between two alternatives.


Chem. Engineers", 5th ed. by Peters et al. and also from "

Engineering Economy", 6th edition,2005, by Blank and

Tarquin.

8-35 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights

Reserved

Costs Only Problems - Rules

Rank the alternatives according to their investment requirements (low to high)

For the first round compare:

(Challenger – Defender) Cash Flow

Compute DCFRR Challenger – Defender

If DCFRR Challenger – Defender ≥ MARR,

Challenger wins; else Defender wins




Tarquin.

8-36 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights

Reserved

Costs Only Problems -continued

The current winner now becomes the defender

for the next round.

Compare the current defender to the next

challenger and DCFRR Challenger – Defender

The winner becomes the current champion and

moves to the next round as the defender

Repeat until all alternatives have been

compared.




Tarquin. 8-37 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights

Reserved

Equal or unequal service lives?

Remember what we did when using PW

comparison?

Projects can be compared only if they have

equal service lives.

For projects with unequal service lives, we

should use the LCM concept.

Alternatively we could use the AW approach to

find the breakeven IRR.




Tarquin. 8-38 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights

Reserved

Example from: Engineering Economy, Sullivan, et. al., 12th edition, 2003, P 212 - Equal service lives

39 © 2003 by Prentice Hall All rights Reserved.

40 © 2003 by Prentice Hall All rights Reserved.




Tarquin.

© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights

Reserved 41

The incremental IRR method resulted in alternative E being selected. Let’s try the PW method

to check this conclusion:

YEAR A B C D E F

0 -900 -1500 -2500 -4000 -5000 -7000

1 150 276 400 925 1125 1425

2 150 276 400 925 1125 1425

3 150 276 400 925 1125 1425

4 150 276 400 925 1125 1425

5 150 276 400 925 1125 1425

6 150 276 400 925 1125 1425

7 150 276 400 925 1125 1425

8 150 276 400 925 1125 1425

9 150 276 400 925 1125 1425

10 150 276 400 925 1125 1425

PW $21.69 $195.90 ($42.17) $1,683.72 $1,912.64 $1,756.01

Justified ? YES YES NO YES YES YES

WINNER !

• 10 year project

• New equipment is required

• Two vendors

• MARR = 15%

• Which vendor should be selected?

• Cost or Service Problem

• Lowest Common Multiplier (LCM) = 10 years

Example 8.3 Blank (7th ed.), p. 208 Example 8.3 Blank (6th ed.), p. 284

Unequal service lives





by Blank and Tarquin. 42 © 2003 and 2005 by McGraw-Hill,








Incremental Cash Flow







PW analysis

• We could stop because the PW(15%) has signaled that A is the winner!

• Lowest PW cost

• Proceed with a IRR analysis BUT….

• IRR must be performed on the incremental investment








IRR (B-A) is less

than the MARR of

15%.

Therefore Reject B

and go with A

IRR (B-A) = 12.65 %

Inc. Cash Flow $

0 -5,000

1 1,900

2 1,900

3 1,900

4 1,900

5 -9,100

6 1,900

7 1,900

8 1,900

9 1,900

10 3,900

IRR 12.65%

Inc. Cash Flow Results














This is the breakeven rate of return








Determining incremental DCFRR by using the AW method

• Approach is particularly useful for comparing projects of unequal

service lives.

• Determine AWA and AWB from one cycle only.

• For projects A and B, express AWA and AWB as a function of

interest rate, then set (AWB – AWA = 0)

• The interest rate satisfying (AWB – AWA = 0) is the breakeven

incremental IRR









Example: Re-do example 8.3

Determine the incremental IRR using the AW method:

•10 year project (merger)

•New equipment is required

•Two vendors

•MARR = 15%

•Which vendor should be selected

•Cost or Service Problem









AWA = -8,000 (A/P, i*, 10) – 3,500 AWB = -13,000(A/P, i*, 5) + 2,000 (A/F, i*, 5) – 1,600 Set AWB - AWA = 0 Solve for breakeven i* (inc. IRR) = 12.65 (using EXCEL Solver)

This is the incremental IRR; being less than MARR We then choose project A






















Home Work # 6

Thursday, March 6, 2014







CHEE 5369 / 6369

Homework # 6

The following problem from Peters et al., fifth

edition, 2003:

Problem 8.16 page 356

The following solved examples from Blank and

Tarquin, 7th edition, 2012:

Example 5.1 Page 132

Example 6.1 Page 151

Example 8.4 page 211










8-16







Business

Lecture # 14 investment alternatives ii