BES 125 ENGINEERING ECONOMICS

WEEK 8: Lecture 8: ROR Multiple Alternatives

October 26-30, 2020

Prof. Jessica Maria Paz S. Casimiro, CE,EnP, DiSDS

Homework No. 5 included inside.

Introduction
Two or more alternatives can be evaluated using a rate of
return (ROR) comparison based on the methods explained in
Lecture 7. The ROR evaluation, when correctly performed,
will result in the same selection as the PW or AW analyses, but
the computational procedure is considerably different for ROR
evaluations. The ROR analysis evaluates the increments
between two alternatives in pairwise comparison. This will be
demonstrated in the examples.
Objectives of this Lecture:
1. State why the ROR method of comparing
alternatives requires an incremental cash flow
analysis;
2. Calculate incremental cash flow series for two
alternatives;
3. Interpret the meaning of the incremental ROR
determined from the incremental cash flow series;
4. Based on a PW relation, select the better of two
alternatives using incremental ROR analysis of a
breakeven ROR value.
 Recap from Previous Lecture:
Decision Rules: One alternative
1. If the PW equivalent is greater than zero (PW>0), when
evaluated at i=MARR, the project is economically feasible.
2. It the FW equivalent is greater than zero (FW>0)
evaluated at i=MARR, the project is economically feasible.
3. If AW equivalent is greater than zero (AW>0), when
evaluated at i=MARR, then the project is economically
justified.
4. Mutually exclusive project – only one is selected
5. Independent projects – all are selected is i* ≥ MARR if
budget is unlimited.
ROR Concepts for Multiple Alternatives
1. Under some circumstances, project ROR values do not
provide the same ranking of alternatives as do PW and AW
analyses. This situation does not occur if we conduct an
incremental ROR analysis.
2. When independent projects are evaluated, no incremental
analysis is necessary between projects. Each project is
evaluated separately from others, and more than one can be
selected.
3. Equal-service requirement must be complied with
when evaluating alternatives using ROR analysis.
Therefore, the LCM of lives for each pairwise comparison
must be used.
Types of cash flows alternatives:
 Revenue alternatives – both positive and negative cash flows are
shown; X Y
Z
0 1 2 3 4 5 6 period

A= P/period

 Cost alternatives – only negative cash flow estimates are shown

0 1 2 3 4 5 6 period
Guidelines in IRR Calculation
1. Each increment of capital must justify itself by producing a
sufficient rate of return (greater than or equal to MARR)
on that increment.
The one with the larger initial investment will be regarded as
alternative B. Thus,
Incremental Cash flow = cash flowB- cash flowA
2. Compare a higher investment alternative against a lower
investment alternative only when the latter is acceptable.
3. Select the alternative that requires the largest investment of
capital, as long as the incremental investment is justified by
benefits that earn at least the MARR.
Example 1:
The company has $90,000 available for investment, and that two alternatives are being
evaluated. Alternative A requires an investment of $50,000 and has an internal rate of return
(IRR) iA* of 35% per year. Alternative B requires $85,000 and has an iB* of 29% per year.
Which alternative is economically feasible based on ROR analysis? Assume company’s
MARR is 16% per year.
1. Interpretation: Both alternatives A and B have IRR higher than the MARR, then,
they shall be considered as feasible alternatives. However, the alternatives require
different capital investments and has different i* (IRR). When using ROR, we invest
the remaining portion at the company’s MARR.
2. Representation: No cash flow can be drawn for this problem.
2. Calculation:
50,000 0.35 :40,000(0.16)
RORA = = 26.6%
90,000
85,000 0.29 :5,000(0.16)
RORB= = 28.3%
90,000
3. Analysis: Although alternative A has higher i*, initial investment lower than alternative
B. It does not necessarily mean that alternative A is a better alternative that alternative B. If
the ROR of the selected alternative is less than MARR, we will reject it. The Do Nothing
alternative will prevail.
4. Conclusion:
Alternative B has a higher overall internal rate of return than alternative A, thus it is
more economically feasible and should be selected.
Example 2: Calculate incremental
cash flow
A tool and die company 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 $7,000 per year, while the used machine is expected to require
$8,200 per year. Each machine is expected to have a 25-year life with a 5% salvage
value. Which should be selected if MARR is 15% per year?
Interpretation:
The incremental costs are next slide. For simplification, we use the convention that
between two alternatives, the one with the larger initial investment will be
regarded as alternative B.
The incremental cash flow in year 0 reflects the extra investment or cost required
if alternative B is selected. If the equivalent worth of the savings is greater than the
equivalent worth of the extra investment at the MARR, then the extra investment
should be made. On the other hand, if the extra investment is not justified by the
savings, we select the lower-investment proposal.
In this problem, the i* cannot be possibly computed because the cash flow is given
as cost alternative. We use the incremental cash flow Δi*.
 Example 2
Interpretation: Tabulated Cash flow

Cash flow Incremental Cash

Year
Used Press (A) New Press (B) flow (New-Used)
0 $ -15,000 $ -21,000 $ -6,000
1-25 - 8,200 -7,000 +1,200
25 750 1,050 +300

Representation: Cash flow line diagram

1050
750

0 1 2 3 4 5 6 23 24 25 0 1 2 3 4 5 6 23 24 25

A=7,000 A=8,200
15,000
21,000
New Press Used Press
Calculation of ROR: Based on Least PW
(See calculations in Excel workbook.)
Defender: USED Press Challenger: NEW PRESS
Used Press New Press Incremental
Year Cash Flow Cash flow Cash Flow
0 -15000 -21,000 -6,000
1 -8200 -7000 1,200
2 -8200 -7000 1,200
3 -8200 -7000 1,200
4 -8200 -7000 1,200
5 -8200 -7000 1,200
6 -8200 -7000 1,200
7 -8200 -7000 1,200
8 -8200 -7000 1,200
9 -8200 -7000 1,200
10 -7450 -5950 1,500
Internal Rate of Return 15.41%

Since Δi* ≥ MARR, the challenger B is selected. Buying a new

press is economically feasible.
 Multiple Alternatives
Given: MARR is 15%, which income-generating projects can
be economically pursued?
Traffic Management Schemes:
A B C D
i* 22.6% 11.5% 28.7% 14%

Answer:
• Since only Schemes A and C have i* > MARR, they are economically
feasible. Schemes B and D have i* < MARR, therefore, they are eliminated
from the analysis.
• If Schemes A and C are independent projects, then they should both be
implemented, assuming there is not budget limitation.
• If they are mutually exclusive, then we perform incremental analysis on
Scheme A versus Scheme C to determine the more economically feasible
project.
 Guidelines:
 These three elements – incremental cash flow series, LCM,
and multiple roots – are the primary reason that the ROR
method is often applied incorrectly in engineering economy
analyses of multiple alternatives.
 It is always possible, and generally advisable, to use PW or AW
analysis at an established MARR in lieu of the ROR method when
multiple rates are indicated (see Example 2)
 Alternatives with i* less than the MARR is eliminated from
further selection. If all alternative have i* < MARR, the Do
Nothing alternative is adopted, i.e., maintain the status quo.
 If the cash flows are given as Revenue alternative, IRR function in
Excel can be applied to calculate i* (see example on page 179).
 For independent projects, if i* ≥ MARR, then accept the project,
assuming there is no budget limitation.
Example 3: IRR between Two alternatives
Example 8.3/pp 208.
As Ford Motor Company retools an old truck assembly plant in Michigan
to produce a fuel efficient economy model, the Ford Focus. Ford and its
suppliers are seeking additional sources for light, long-life transmissions.
Automatic transmission components manufacturers use highly finished dies
for precision forming of internal gears and other moving parts. Two United
States vendors make the required dies. Use the per unit estimates below
and a MARR of 12% per year to select the more economical vendor bid.
A B
Initial Cost, $ -8,000 -13,000
Annual Cost, $/year -3,500 -1,600
Salvage value, $ 0 2,000
Life, years 10 5

(See calculations in Excel workbook).

 Increment (B- Using PW Method
Year A B
A)
1. The alternatives are
0 -8,000 -13,000 -5,000
-3500 -1600 1,900
correctly ordered with the
1
2 -3500 -1600 1,900 higher first-cost alternative
3 -3500 -1600 1,900 in column 2.
4 -3500 -1600 1,900
5 -3500 -12600 -9,100 2. The cash flow and the
6 -3500 -1600 1,900 incremental cash flow for
7 -3500 -1600 1,900
LCM 10 is computed and
8 -3500 -1600 1,900
9 -3500 -1600 1,900 tabulated.
10 -3500 400 3,900 3. There are 3 sign changes
-43,000 -38,000 5,000
in the incremental cash flow
Incremental Cash Flow Diagram series, indicating as many as
2,000
3 roots. There are also 3
A=1900
sign changes in the
cumulative incremental
0 1 2 3 4 5 6 7 8 9 10 year series (5th column)
indicating that more than
5000 one positive root may exist.
11,000
4. There are 3 sign changes in the incremental cash flow series, indicating as many
as three roots.

5. The rate of return based equation based on the PW incremental cash flow is:
𝑃 𝑃 P
0 = −5000 + 1900 𝐴
, , 10 − 11,000(𝐹 , , 5) + 2000(A , , 10)
Increment Cumulative Excel
Year A B Value
(B-A) Increment Function
0 -8,000 -13,000 -5,000 -5000 IRR 12.649%
1 -3500 -1600 1,900 -3,100 NPV -₱0.03
2 -3500 -1600 1,900 -1,200
3 -3500 -1600 1,900 700
4 -3500 -1600 1,900 2,600
5 -3500 -12600 -9,100 -6,500
6 -3500 -1600 1,900 -4,600
7 -3500 -1600 1,900 -2,700
8 -3500 -1600 1,900 -800
9 -3500 -1600 1,900 1,100
10 -3500 400 3,900 5,000
-43,000 -38,000 5,000

6. Since the IRR (12.649%) on the extra investment is greater than MARR of
12% , the higher cost vendor B is selected.
Using AW-based incremental ROR method.
Example 4: Compare the alternatives of vendors A and B for Ford in
example 3 using an AW-based incremental ROR method and the same
MARR of 12% per year.
Increment
A B
Year (B-A)
0 -8,000 -13,000 -5,000
1 -3500 -1600 1,900
2 -3500 -1600 1,900
3 -3500 -1600 1,900
4 -3500 -1600 1,900
5 -3500 -12600 -9,100
6 -3500 -1600 1,900
7 -3500 -1600 1,900
8 -3500 -1600 1,900
9 -3500 -1600 1,900
10 -3500 400 3,900
 Incremental Cash Flow Diagram 2000

A=1900

0 1 2 3 4 5 6 7 8 9 10 year

5000
11,000
The AW relation :
𝑃 A A
0= −5000(𝐴/𝑃, , 10) + 1900 − 11,000 𝐹
, ,5 P
, , 10 + 2000(F , , 10)

The procedure for finding by Excel is the same as in PW.

= 12.649%

Comment: It is very important to remember that when an incremental ROR

analysis using an AW-based equation is made on the incremental cash flows, the
LCM must be used.
 Example 5: Multiple Alternative Comparison
8.30/page 223
Given: Planning Period (Study Period) = 3 years
MARR = 15% per year
Find: The copier which should be acquired based on Rate of Return analysis.
Calculation: Use the IRR function in Excel to determine i* for each alternative.

Year iGen-1 iGen-2 iGen-3 iGen-4

0 -500,000 -600,000 -650,000 -750,000
1 100,000 160,000 205,000 310,000
2 100,000 160,000 205,000 310,000
3 170,000 245,000 300,000 430,000
IRR (i*) -12.60% -2.74% 4.25% 17.77%

Only iGen-4 is selected because the rest have i* <MARR.

Breakeven rate of return

- The incremental i* value, Δi*, at which the PW (or AW) value

of the incremental cash flows is exactly zero. Equivalently, the
breakeven ROR is the i value, i*, at which the PW (or AW)
values of two alternatives’ actual cash flows are exactly equal to
each other.
 Incremental ROR Analysis of Multiple
Alternatives
Procedure: (see page 214)
1. Order the alternatives from smallest to largest initial
investment. Record the annual cash flow estimates for each
equal-life alternative.
2. Revenue alternatives only: Calculate i* for the first alternative. In
effect, this makes DN the defender and the first alternative the
challenger. If i*<MARR eliminate the alternative and go to the
next one. Repeat this until i*≥MARR for the first time, and
define that alternative as the defender. The next alternative is
now the challenger. Go to step 3.
Procedure: continued

 (In Excel, calculate the i* for all alternatives first using the
IRR function, and select as the defender the first one for
which i*≥ MARR. Label it the defender and go to Step 3.)
Same as Example 5.
3. Determine the incremental cash flow between the challenger
and defender, using the relation
Incremental cash flow = challenger cash flow – defender cash flow
Set up the ROR relation
4. Calculate for the incremental cash flow series using a
PW- or AW- based equation. (PW is most commonly used).
Incremental ROR Analysis of Multiple
Alternatives
Procedure: (see page 214)
5. If ≥ MARR, the challenger becomes the defender and
the previous defender is eliminated. Conversely, if <
MARR, the challenger is removed, and the defender remains
against the next challenger.
6. Repeat Step 3 to 5 until one alternative remains. It is the
selected one.
Note that only two alternatives (i.e., pairwise) are compared at
any one time.
Example 6: Revenues alternatives
Example 8.6 pp. 215:
Caterpillar Corporation wants to build a spare parts facility in
the Phoenix, Arizona vicinity. A plant engineers has identified 4
different location options. The initial cost of earth-work and
pre-fab building and the annual cash flow estimates are detailed
below. The annual net cash flow series may 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.

Note: When evaluating multiple alternatives by the incremental ROR method, an

alternative should never be compared with one for which the incremental
investment
 Estimates for four alternative building locations
A B C D
Initial Cost -200,000 -275,000 -190,000 -350,000
Annual Cash
+22,000 +35,000 +19,500 +42,000
Flow, $/yr
Life, years 30 30 30 30
Interpretation: All sites have 30-year life and they are revenue alternatives. The procedure
outlined above is applied.
Step 1: The alternatives are ordered by increasing initial cost:
C, A, B, D
Estimates for four alternative building locations
C A B D
Initial Cost -190,000 -200,000 -275,000 -350,000
Annual Cash
+19,500 +22,000 +35,000 +42,000
Flow, $/yr
Life, years 30 30 30 30
 Estimates for four alternative building locations:
MARR 10%
Pairwise comparisons: C A B D
1. C with DN
Initial Cost -190,000 -200,000 -275,000 -350,000
2. DN with A
Annual Cash
3. B with A Flow, $/yr
+19,500 +22,000 +35,000 +42,000
4. D with B Alternatives
C to DN A to DN B to A D to B
compared
Incremental
-190,000 -200,000 -75,000 -75,000
Cost
Incremental
+19,500 +22,000 +13,000 7,000
cash flow
Calculated
9.7436 9.0909 5.7692 10.7143
(P/A, , 30)
% 9.609 10.44 17.18 8.53
Is increment
No Yes Yes No
justified?
Alternative
DN A B B
selected

See the calculations in the accompanying Excel file.

Homework No. 5:
Show Excel calculations using ROR method
No. 1
No. 2
Problem:
A greenway walking trail improve the Star Rating of schools in Zamboanga
City is proposed. Two mutually exclusive alternative locations for the 2-
meter-wide trail have been proposed: one is on flat terrain and is 14
kilometers in length, and the other is in hilly terrain and is 12 kilometers in
length.
Planning and site preparation cost is 20% of the asphalt-paving cost, which
is P150 per square meter. Annual maintenance for the flat terrain trail is
5% of the paving cost, and the annual maintenance for the hilly trail is 8%
of the paving cost.
If the MARR is 1.5% per month, and perpetual life for trail is assumed,
which trail should be recommended? Consider both economic and non-
economic factors in the analysis.
 END
Midterm Exam is Nov 2-7, 2020