Chapter 7&8

Rate of Return of a Single Alternative

Rate of Return Multiple Alternatives

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 Interpretation of ROR
Rate paid on unrecovered balance of borrowed money such
that final payment brings balance to exactly zero
with interest considered

ROR equation can be written in terms of PW, AW, or FW

Use trial and error solution by factor or spreadsheet

ROR Calculation and Project Evaluation
To determine ROR, find the i* value in the relation
PW = 0 or AW = 0 or FW = 0

Alternatively, a relation like the following finds i*

PWoutflow = PWinflow

For evaluation, a project is economically viable if

i* ≥ MARR
 Special Considerations for ROR
May get multiple i* values

Incremental analysis necessary for multiple alternative

evaluations
 Multiple ROR Values

Multiple i* values may exist when there is more than one sign
change in net cash flow (CF) series.
Such CF series are called non-conventional

Two tests for multiple i* values:

Descarte’s rule of signs: total number of real i* values is ≤ the

number of sign changes in net cash flow series.

Norstrom’s criterion: if the cumulative cash flow starts off negatively

and has only one sign change, there is only one positive root.
 Example: Multiple i* Values
Determine the maximum number of i* values for the cash flow shown below
Year Expense Income Net cash flow Cumulative CF
0 −12,000 n/a −12,000 −12,000
1 −5,000 +3,000 −2,000 −14,000
2 −6,000 +9,000 +3,000 −11,000
3 −7,000 +15,000 +8,000 −3,000
4 −8,000 +16,000 +8,000 +5,000
5 −9,000 +8,000 −1,000 +4,000

Solution:
The sign on the net cash flow changes The cumulative cash flow begins
twice, indicating two possible i* values negatively with one sign change
Therefore, there is only one i* value ( i* = 8.7%)
ROR Calculation Using PW, FW or AW Relation
ROR is the unique i* rate at which a PW, FW, or AW relation equals exactly 0

Example: An
investment of $20,000 in new equipment will generate
income of $7000 per year for 3 years, at which time the machine
can be sold for an estimated $8000. If the company’s MARR is 15%
per year, should it buy the machine?

Solution: The ROR equation, based on a PW relation, is:

𝟎 = −𝟐𝟎, 𝟎𝟎𝟎 + 𝟕𝟎𝟎𝟎(𝐏/𝐀, 𝐢 ∗, 𝟑) + 𝟖𝟎𝟎𝟎(𝐏/𝐅, 𝐢 ∗, 𝟑)

Solve for i* by trial and error or spreadsheet: i* = 18.2% per year

Since i* > MARR = 15%, the company should buy the machine
 Why Incremental Analysis is Necessary (1)

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

Example: Assume $90,000 is available for investment and MARR = 16%

per year. If alternative A would earn 35% per year on investment of $50,000, and
B would earn 29% per year on investment of $85,000, the weighted averages are:

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%

Which investment is better, economically?

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 Why Incremental Analysis is Necessary (2)

If selection basis is higher ROR:

Select alternative A (wrong answer)
If selection basis is higher overall ROR:
Select alternative B
Conclusion: Must use an incremental ROR analysis to make a
consistently correct selection

Unlike PW, AW, and FW values, if not analyzed correctly, ROR

values can lead to an incorrect alternative selection. This is called
the ranking inconsistency problem (discussed later)

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 Calculation of Incremental CF
Incremental cash flow = cash flowB − cash flowA
where larger initial investment is Alternative 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
The incremental CF is shown in the (B − A) column

The ROR on the extra $20,000 investment in B determines which alternative to

select (as discussed later)
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 Interpretation of ROR on Extra Investment
Based on concept that any avoidable investment that
does not yield at least the MARR should not be made.

Once a lower-cost alternative has been economically justified, the ROR

on the extra investment (i.e., additional amount of money associated with a
higher first-cost alternative) must also yield a ROR ≥ MARR (because the
extra investment is avoidable by selecting the economically-justified lower-cost
alternative).
This incremental ROR is identified as ∆i*

For independent projects, select all that have ROR ≥ MARR

(no incremental analysis is necessary)

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 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. The
LCM of lives must be used in the relation

(6) If ∆i*B-A < MARR, select A; otherwise, select B

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 Example: Incremental ROR Evaluation

Either of the cost alternatives shown below can be used in a

chemical refining process. If the company’s MARR is 15% per year,
determine which should be selected on the basis of ROR analysis?

A B
First cost ,$ −40,000 −60,000
Annual cost, $/year −25,000 −19,000
Salvage value, $ 8,000 10,000
Life, years 5 5

Initial observations: ME, cost alternatives with equal life estimates

and no multiple ROR values indicated

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 Example: ROR Evaluation of Two Alternatives
Solution, using procedure:
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
Order by first cost and find incremental cash flow B − A

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

0 = −20,000 + 6000(P/A, ∆i ∗, 5) + 2000(P/F, ∆i ∗, 5)
Solve for ∆i* and compare to MARR
∆i*B-A = 17.2% > MARR of 15%
ROR on $20,000 extra investment is acceptable: Select B
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 ROR Analysis – Multiple Alternatives
Six-Step Procedure for Mutually Exclusive Alternatives
(1) Order alternatives from smallest to largest initial investment
(2) For revenue alts, calculate i* (vs. DN) and eliminate all with i* < MARR; remaining
alternative with lowest cost is defender. For cost alternatives, go to step (3)
(3) Determine incremental CF between defender and next lowest-cost alternative
(known as the challenger). Set up ROR relation
(4) Calculate ∆i* on incremental CF between two alternatives from step (3)
(5) If ∆i* ≥ MARR, eliminate defender and challenger becomes new defender
against next alternative on list
(6) Repeat steps (3) through (5) until only one alternative remains. Select it.

For Independent Projects

Compare each alternative vs. DN and select all with ROR ≥ MARR

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 Example: ROR for Multiple Alternatives
The five mutually exclusive alternatives shown below are under consideration
for improving visitor safety and access to additional areas of a national park. If
all alternatives are considered to last indefinitely, determine which should be
selected on the basis of a rate of return analysis using an interest rate of 10%.
A B C D E
First cost, $ millions −20 −40 −35 −90 −70
Annual M&O cost, $ millions −2 −1.5 −1.9 −1.1 −1.3

Solution: Rank on the basis of initial cost: A,C,B,E,D; calculate CC values

C vs. A: 0 = −15 + 0.1/0.1 ∆i* = 6.7% (eliminate C)
B vs. A: 0 = −20 + 0.5/0.1 ∆i* = 25% (eliminate A)
E vs. B: 0 = −30 + 0.2/0.1 ∆i* = 6.7% (eliminate E)
D vs. B: 0 = −50 + 0.4/0.1 ∆i* = 8% (eliminate D)
Select alternative B
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 Summary of Important Points
Must consider incremental cash flows for mutually exclusive alternatives

Incremental cash flow = cash flowB − cash flowA

where alternative with larger initial investment is Alternative B

Eliminate B if incremental ROR ∆i* < MARR; otherwise, eliminate A

For multiple mutually exclusive alternatives, compare two at a time and

eliminate alternatives until only one remains

For independent alternatives, compare each against DN and select all that
have ROR ≥ MARR

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