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Incremental Analysis

Based on concept that any avoidable investment that does. not yield at least the MARR should not be made. Involves determining the ROR on the extra investment. required for the higher first-cost alternative. If the rate of return on the extra investment is less than the.

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Incremental Analysis

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  1. Based on concept that any avoidable investment that does not yield at least the MARR should not be made Involves determining the ROR on theextra investment required for thehigher first-costalternative If the rate of return on the extra investment is less than the MARR, select the lower cost alternative, and vice versa Incremental Analysis

  2. The first step in an incremental analysis is to determine the extra investment amount and its associated cash flow. The next example illustrates the procedure. Example: Either of the service alternatives shown below can be used in a certain process. Tabulate the incremental cash flow involved. B A B-A First cost ,$ -40,000 -60,000 -20,000 Annual cost, $/yr -25,000 -19,000 +6000 Salvage value,$ 8,000 10,000 +2000 The incremental CF is shown in the (B-A) column Incremental Investment Amount (The ROR on this column determines which alternative to select)

  3. Find ROR on incremental investment and compare to MARR. If i<MARR, select lower first-cost alternative, and vice versa Example: Either of the service alternatives shown below can be used in a certain process. If the company’s Marr is 15% per year, Determine which should be selected on the basis of ROR B A First cost ,$ -40,000 -60,000 Annual cost, $/yr -25,000 -19,000 Salvage value,$ 8,000 10,000 Life,yrs 5 5 Alternative Selection by ROR

  4. Solution: B B-A A First cost ,$ -40,000 -60,000 -20,000 Annual cost, $/yr -25,000 -19,000 +6000 Salvage value,$ 8,000 10,000 +2000 Life,yrs 5 5 First find incremental cash flow Next, find ROR on incremental CF and compare to MARR: 0 = -20,000 + 6000(P/A,i,5) + 2000(P/F,i,5) i = 17.2% > MARR of 15% $20,000 investment is attractive: Select Alt B

  5. Two types: independent and mutually exclusive For independent, compare alts against DN and select all that have ROR > MARR For mutually exclusive, first rank alternatives according to increasing initial investment cost(add DN for revenue alternatives) Multiple Alternatives Next, compare first two alts incrementally Then, eliminate one and compare survivor w/ next alt Finally, continue comparing alts until only 1 remains

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