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Incremental IRR

The document discusses the importance of incremental analysis for evaluating competing projects, highlighting the need to compare internal rates of return (IRR) and investment costs. It provides examples of project comparisons, including a tool and die company considering different drill press options, and emphasizes the use of minimum attractive rate of return (MARR) in decision-making. Additionally, it outlines a procedure for conducting incremental analysis and presents various scenarios for investment decisions.

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4 views10 pages

Incremental IRR

The document discusses the importance of incremental analysis for evaluating competing projects, highlighting the need to compare internal rates of return (IRR) and investment costs. It provides examples of project comparisons, including a tool and die company considering different drill press options, and emphasizes the use of minimum attractive rate of return (MARR) in decision-making. Additionally, it outlines a procedure for conducting incremental analysis and presents various scenarios for investment decisions.

Uploaded by

sidchat12
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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INCREMENTAL IRR

Why Must Incremental Analysis be Used for


Competing Projects?

• Assume that an MARR of 16% per year is required, and $85000 is


available to invest:

• Project A requires $50000 upfront to obtain an IRR of 35% per


year.

• Project B requires an $85000 first cost and returns an IRR of 29%


per year.

• What could we do with the un-invested money from Project A?


($35000)
Why Must Incremental Analysis be Used for
Competing Projects?

• It would be reasonable to invest the remaining $35000 at the


MARR:

• Overall IRRA = 50 000(0.35) + 35 000(0.16)

85000

= 27.2% per year

• Project B returns an IRR of 29% per year on ALL the money


available to invest.
Comparing Mutually Exclusive
Alternatives Based on IRR
• Issue: Can we rank the mutually exclusive projects by the
magnitude of its IRR?
n A1 A2
0 -$1,000 -$5,000

1 $2,000 $7,000

IRR 100% > 40%

PW (10%) $818 < $1,364


Incremental Analysis (Procedure)
Step 1: Compute the cash flow for the difference
between the projects (A,B) by subtracting
the cash flow of the lower investment
cost project (A) from that of the higher
investment cost project (B).
Step 2: Compute the IRR on this incremental
investment (IRRB-A ).
Step 3: Accept the investment B if and only if

IRR B-A > MARR

NOTE: Make sure that both IRRA and IRRB are greater than MARR.
A tool and die company in Pittsburgh is considering the purchase of a
drill press with fuzzy-logic software to improve accuracy and reduce
tool wear. The company has the opportunity to buy a slightly used
machine for $15,000 or a new one for $21 ,000. Because the new
machine is a more sophisticated model, its operating cost is expected
to be $7000 per year, while the used machine is expected to require
$8200 per year. Each machine is expected to have a 25-year life with
a 5% salvage value. Tabulate the incremental cash flow and identify
the best alternative, by taking MARR = 15%.
You are considering two projects for investment, and you can only
invest in one:

Year A B
0 -10 -20
1 15 28

You have $30 in capital and any funds you do not invest in these
projects may be invested elsewhere at the MARR of 6%. Which
should you choose?
In 2000, Bell Atlantic and GTE merged to form a giant telecommunications
corporation named Verizon Communications. As expected, some equipment
incompatibilities had to be rectified, especially for long distance and
international wireless and video services. One item had two suppliers - a
U.S. firm (A) and an Asian firm (B). Estimates for vendors A and B are
given for each unit. Determine which vendor should be selected if the
MARR is 15% per year.
Caterpillar Corporation wants to build a spare parts storage facility in the
Phoenix, Arizona, vicinity. A plant engineer has identified four different
location options. Initial cost of earthwork and prefab building, and annual
net cash flow estimates are given. The annual net cash flow series vary due
to differences in maintenance, labor costs, transportation charges, etc. If the
MARR is 10%, use incremental ROR analysis to select the one
economically best location.

C = 9.63% A = 10.49% B = 17.28% D = 8.55%


ABC Corporation is considering two types of manufacturing
systems to produce its
shaft couplings over six years: (1) a cellular manufacturing system
(CMS) and (2) a
flexible manufacturing system (FMS). The average number of
pieces to be produced
with either system would be 544,000 per year. The operating cost,
initial investment,
and salvage value for each alternative are estimated as follows:

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