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Lecture # 14 investment alternatives ii

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Lecture # 14 investment alternatives ii

  1. 1. Lecture # 14 Investment Alternatives Incremental ROI/IRR Method 1 Dr. A. Alim
  2. 2. 1. Incremental ROI Analysis of Multiple Mutually Exclusive Alternatives The concept of incremental investment Suppose a company has $90,000 to invest in a project. Two mutually exclusive alternatives are proposed; MARR is 16%: Alternative A requires an investment of $50,000 and has a ROI of 35% Alternative B requires an investment of $85,000 and has a ROI of 29% The remaining funds after the selection would naturally be invested at MARR. One would intuitively think that option A is preferred since it has a higher ROI, but this would be incorrect . Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 2 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  3. 3. Since the company can always invest the unused funds at MARR, the overall ROI is: With option A, ROI = (50000(0.35) + 40000(0.16))/90000 = 26.6 % With option B, ROI = (85000(0.29) + 5000(0.16))/90000 = 28.3 % Option B is recommended. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 3 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  4. 4. COMPARISON OF ALTERNATIVES The concept of incremental investment Definition: incremental investment means every additional dollar invested must result in an incremental ROI at least equal to MARR. If investment B is more than investment A, then: Investment B is recommended ONLY IF : (Profit ”B” – Profit “A”) / (Investment “B” – Investment “A”) ≥ MARR i.e. incremental ROI ≥ MARR Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 4© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  5. 5. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved 5 Profit $ Investment $ B A Select B and reject A only if : Incremental ROI =(Profit ”B” – Profit “A”) / (Investment “B” – Investment “A”) ≥ MARR
  6. 6. Profit Or Savings InvestmentMaterial sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 6 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  7. 7. Profit Or Savings Investment Incremental ROI = delta profit / delta investment At the limit of delta investment approaches zero, the incremental ROI is the slope to the curve. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 7© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  8. 8. Profit Or Savings Investment Incremental ROI = delta profit / delta investment At the limit of delta investment approaches zero, the incremental ROI is the slope to the curve. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 8© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  9. 9. Profit Or Savings Investment Line of slope = MARR Recommended investment for Incremental ROI = MARR Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 9© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved All investments here have incremental ROI over “X” less than MARR X
  10. 10. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 10 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Incremental investment analysisIncremental Investment Analysis
  11. 11. ROI (A) is larger than ROI(B) Yet we reject A and accept B Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 11 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Incremental Investment Analysis
  12. 12. COMPARISON OF ALTERNATIVES Incremental Investment Analysis Basic concept: We want the return to be higher than MARR for every dollar invested. Below the tangent point:  ROI > MARR , hence, + ve incremental investment Beyond the tangent point:  ROI < MARR , hence, - ve incremental investment Investments beyond the tangent point are therefore not advised when Compared to alternative investment at the tangent point. Calculate incremental ROI:  ROI =  ( profit or savings) /  ( investment) Accept if  ROI ≥ MARR Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 12© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  13. 13. COMPARISON OF ALTERNATIVES Incremental Investment Analysis When comparing several investments using the ROI method, we apply the incremental analysis and follow this principle: Select the one alternative • That requires the largest investment, and • Indicates that the extra investment over another acceptable alternative is justified, i.e. yielding an incremental ROI ≥ MARR. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 13 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  14. 14. Example 8-6, Page 344 Plant Design and Economics For chem. Engineers, 5th ed, 2003 by Peters et al. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 14 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  15. 15. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 15 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  16. 16. • We now apply incremental ROI analysis among alternatives 1,2, and 3: • First step is to arrange the investments from left to right in ascending order. In this case the order is 1, 2, then 3. • We then determine Inc. ROI between pairs starting from the left and moving right. • Inc. ROI (2-1) = (3,000 – 2,000) / (16,000 – 10,000) = 16.7 % which is > MARR. Therefore: Reject alternative 1 • Inc. ROI (3-2) = (3,200 – 3,000) / (20,000 – 16,000) = 5 % which is < MARR. Therefore: Reject alternative 3 Conclusion: Accept alternative 2 Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 16 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  17. 17. Modified example 8-3, page 331 • 3 investments. Need to evaluate profitability of each. • Use ROI, PBP, NPV, and DCFRR. • Assume straight line depreciation. • Tax rate is 35% • MARR is 15% • Use MARR as interest rate for time value of money. • Ignore land value. Incremental ROI analysis Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 17 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved Plant Design and Economics For chem. Engineers, 5th ed, 2003 by Peters et al.
  18. 18. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 18© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  19. 19. Inv. 1 Inv. 2 Inv. 3 Total inv. $ 110,000 180,000 225,000 NPAT, $/y 24,300 27,607 32,562 ROI (MARR) 22.1(15) 15.3(15) 14.5(15) Accept? YES YES NO Incremental ROI (2-1) = (27,607 – 24,300) / (180,000 -110,000) = 4.7 % Which is less than MARR. Therefore reject 2 and accept 1. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 19© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  20. 20. 2. Incremental DCFRR (IRR) Analysis of Multiple Mutually Exclusive Alternatives  Given N mutually exclusive alternatives, using the incremental DCFRR method  Select the one alternative that  Requires the largest investment, and at the same time  Indicates that the extra investment over another acceptable investment is justified.  This means incremental IRR must be equal to or higher than MARR. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 20© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  21. 21. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 21 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  22. 22. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 22 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved IRR (B–A) is the incremental IRR or DCFRR
  23. 23. Which project to accept, A or B? • Depends on the value of MARR ! • Accept B and reject A if: IRR (B-A) ≥ MARR • Accept A and reject B if: IRR (B-A) < MARR Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 23© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  24. 24. 24© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  25. 25. MARR Reject both A and B 25© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  26. 26. MARR Reject B, accept A 26© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  27. 27. MARR Reject B, accept A Since IRR (B-A) < MARR 27© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  28. 28. MARR Reject A, accept B Since IRR (B-A) > MARR 28© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  29. 29. Ranking Rules – Selection Process Among Mutually Exclusive Alternatives 1. Order the alternatives from smallest to largest initial investment. For revenue projects the DN alternative is the first on the left (no investment!) 2. Compute the cash flows for each alternative (DN has zero cash flows) 3. Ensure project lives are equal, apply LCM if needed. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 29© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  30. 30. 4. Compute the DCFRR value for all alternatives in the considered set.  If any alternative has an DCFRR < MARR drop it from further consideration  The candidate set will be those alternatives with computed DCFRR values > MARR.  Call this the FEASIBLE set Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 30© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  31. 31.  The first alternative is called the DEFENDER  The second (next higher investment cost) alternative is called the CHALLENGER  Compute the incremental cash flow as (Challenger – Defender) Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 31© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  32. 32. 5. Compute DCFRR Challenger – Defender  If DCFRR Challenger – Defender ≥ MARR drop the defender and the challenger wins the current round.  If DCFRR Challenger – Defender < MARR, drop the challenger and the defender moves on to the next comparison round Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 32© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  33. 33.  At each round, a winner is determined  Either the current Defender or the current Challenger  The winner of a given round moves to the next round and becomes the current DEFENDER and is compared to the next challenger Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 33© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  34. 34. 6. This process continues until there are no more challengers remaining.  The alternative that remains after all alternatives have been evaluated is the final winner. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 34© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  35. 35. Costs Only (Service) Problems – DCFRR Approach Remember  Cost problems do not have computed DCFRR’s since there are more cost amounts that revenue amounts (salvage values may exist)  Thus there are no feasible DCFRR’s for each alternative, but they do exist for the delta between two alternatives. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 8-35 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  36. 36. Costs Only Problems - Rules  Rank the alternatives according to their investment requirements (low to high)  For the first round compare:  (Challenger – Defender) Cash Flow  Compute DCFRR Challenger – Defender  If DCFRR Challenger – Defender ≥ MARR, Challenger wins; else Defender wins Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 8-36 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  37. 37. Costs Only Problems -continued  The current winner now becomes the defender for the next round.  Compare the current defender to the next challenger and DCFRR Challenger – Defender  The winner becomes the current champion and moves to the next round as the defender  Repeat until all alternatives have been compared. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 8-37 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  38. 38. Equal or unequal service lives?  Remember what we did when using PW comparison?  Projects can be compared only if they have equal service lives.  For projects with unequal service lives, we should use the LCM concept.  Alternatively we could use the AW approach to find the breakeven IRR. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 8-38 © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  39. 39. Example from: Engineering Economy, Sullivan, et. al., 12th edition, 2003, P 212 - Equal service lives 39© 2003 by Prentice Hall All rights Reserved.
  40. 40. 40© 2003 by Prentice Hall All rights Reserved.
  41. 41. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. © 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved41 The incremental IRR method resulted in alternative E being selected. Let’s try the PW method to check this conclusion: YEAR A B C D E F 0 -900 -1500 -2500 -4000 -5000 -7000 1 150 276 400 925 1125 1425 2 150 276 400 925 1125 1425 3 150 276 400 925 1125 1425 4 150 276 400 925 1125 1425 5 150 276 400 925 1125 1425 6 150 276 400 925 1125 1425 7 150 276 400 925 1125 1425 8 150 276 400 925 1125 1425 9 150 276 400 925 1125 1425 10 150 276 400 925 1125 1425 PW $21.69 $195.90 ($42.17) $1,683.72 $1,912.64 $1,756.01 Justified ? YES YES NO YES YES YES WINNER !
  42. 42. • 10 year project • New equipment is required • Two vendors • MARR = 15% • Which vendor should be selected? • Cost or Service Problem • Lowest Common Multiplier (LCM) = 10 years Example 8.3 Blank (7th ed.), p. 208 Example 8.3 Blank (6th ed.), p. 284 Unequal service lives Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 42© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  43. 43. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 43© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  44. 44. Incremental Cash Flow Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 44© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  45. 45. PW analysis • We could stop because the PW(15%) has signaled that A is the winner! • Lowest PW cost • Proceed with a IRR analysis BUT…. • IRR must be performed on the incremental investment Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 45© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  46. 46. IRR (B-A) is less than the MARR of 15%. Therefore Reject B and go with A IRR (B-A) = 12.65 % Inc. Cash Flow $ 0 -5,000 1 1,900 2 1,900 3 1,900 4 1,900 5 -9,100 6 1,900 7 1,900 8 1,900 9 1,900 10 3,900 IRR 12.65% Inc. Cash Flow Results Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 46© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  47. 47. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 47© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  48. 48. This is the breakeven rate of return Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 48© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  49. 49. Determining incremental DCFRR by using the AW method • Approach is particularly useful for comparing projects of unequal service lives. • Determine AWA and AWB from one cycle only. • For projects A and B, express AWA and AWB as a function of interest rate, then set (AWB – AWA = 0) • The interest rate satisfying (AWB – AWA = 0) is the breakeven incremental IRR Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 49© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  50. 50. Determining incremental DCFRR by using the AW method Example: Re-do example 8.3 Determine the incremental IRR using the AW method: •10 year project (merger) •New equipment is required •Two vendors •MARR = 15% •Which vendor should be selected •Cost or Service Problem Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 50© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  51. 51. Determining incremental DCFRR by using the AW method AWA = -8,000 (A/P, i*, 10) – 3,500 AWB = -13,000(A/P, i*, 5) + 2,000 (A/F, i*, 5) – 1,600 Set AWB - AWA = 0 Solve for breakeven i* (inc. IRR) = 12.65 (using EXCEL Solver) This is the incremental IRR; being less than MARR We then choose project A Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 51© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  52. 52. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 52© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  53. 53. Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 53© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  54. 54. Home Work # 6 Thursday, March 6, 2014 Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 54© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  55. 55. CHEE 5369 / 6369 Homework # 6 The following problem from Peters et al., fifth edition, 2003: Problem 8.16 page 356 The following solved examples from Blank and Tarquin, 7th edition, 2012: Example 5.1 Page 132 Example 6.1 Page 151 Example 8.4 page 211 Example 8.6 page 215 Example 8.7 page 216 Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 55© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved
  56. 56. 8-16 Material sourced from "Plant Design and Economics for Chem. Engineers", 5th ed. by Peters et al. and also from " Engineering Economy", 6th edition,2005, by Blank and Tarquin. 56© 2003 and 2005 by McGraw-Hill, New York, N.Y All Rights Reserved

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