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EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz

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

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EGR 403 Capital Allocation Theory Dr. Phillip R. Rosenkrantz

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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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