Chapter 8 Incremental Analysis

graphs can be used to solve multiple alternative and continuous-function alternatives as easily
as two alternative problems.

The i m p o r t a n t steps i n incremental rate of r e t u r n analysis are:

1. Check to see that all the alternatives in the problem are identified.
2.

(Optional) Compute the mte of return for each alternative. If one or more
alternatives has ROR 2 MARR, reject any alternatives with ROR < MARR.

3. Arrange the remaining alternat~vesIn ascending order of Investment.

4.

Make a two-alterative analysis of the first two alternatives.

5. Take the preferred alternative from Step 4, and the next alternative from the list
in Step 3. Proceed with another two-alteratwe comparison.
6. Continue until all alternatives have been examined and the best of the multiple

alternatives has been identified.

Decision Criteria for Increments oflnvestment:
if ARORZ MARR, retain the higher-cost alternative.
if AROR < MARR, retain the lower-cost alternative.
Reject the other alternative used in the analysis.

Decision Criteria for Increments of Borrowing:

If, AROR _< MARR, the increment is acceptable.

If, AROR > MARR, the increment is not acceptable
Benefit-cost graphs, being a plot of the P W of benefits vs. the PW of cost, can also be
used in present worth analysis to graphically show the NPW for each alternative.

Problems
Unless otherwise noted, all Cb. 8 problems should be solved by rate of return
analysis.

8-1 A fm is considering moving its manufacturing plant from Chicago to a new location. The
Industrial Engineering Depamnent was asked to identify the various alternatives together with the

1
3

Plant location

Denver
Dallas
San Antonio
Los Angeles
Cleveland
Atlanta

First cost

Uniform annual benefir

$300 thousand
550
450
750
150
200

52 thousand
137
117
167
18
49

The annual benefits are expected to be constant over the eight-year analysis period. If the f m uses
10% annual interest in its economic analysis, where should the manufacturing plant be located?
(Answer: Dallas)

8 2 In a particular situation, four mutually exclusive alternatives are being considered. Each of the
alternatives costs $ 1300 and has no end-of-useful-life salvage value.

Alternorive

Annual benefit

$100 at end of f m t year; increasing

$30 per year thereafter
$10 at end of fust year; increasing $50
per year thereafter
Annual end of year benefit = $260
S450 at end of first year; declining $50
per year thereafter

B
C

Useful life,
in years

Calculated rare of
return

10

10.0%

10
10

8.8%
15.0%

LO

18.1%

8 3 A more detailed examination of the situation in Problem 8-2 reveals that there are two additional
mutually exclusive alternatives to be considered. Both cost more than the $1300 for the four original
Alternative

Cost

Annual end-OF
years benefit

. Useful lfe,
years

in

Calculated
rate ofrehrrn

If tbe MARR remains at 8%, which one of the six alternatives should be selected? Neither Alt. E
nor F h a s any end-of-useful-life salvage value. (Answer: Alt. F)

84 The owner o f a downtown parking lot has employed a civil engineering consulting f

m to advise

r
3 18

Chapter 8 Incremental Analvsis

him whether or not it is economically feasible to consmct an office building on the site. Bill Samuels,
a newly hired civil engineer, has been assigned to make the analysis. He has assembled the following
data:
Total investment*

Alternative

Sell parking lot

Keep parking lot
Build I-story building
Build 2-story building
Build 3-story building
Build 4-story building
Build 5-story building

Total net annual

revenue from property

0
200,000
400,000
555,000
750,000
875,000
1,000,000

'Includes the value of the land.

The analysis period is to be 15 years. For all alternatives, the propeny has an estimated resale
(salvage) value at the end of 15 years equal to the present total investment. If the MARR is lo%, what
recommendation should Bill make?
\

8-5 An oil company plans to purchase a piece of vacant land on the comer of two busy streets for
S70.000. The company has four different types of businesses that it installs on properties of this type.
Plan
A

B
C
D

Cost of
rmprovements*
S 75,000
Conventional gas station with service
facilities for lubrication, oil changes, etc.
230,000
Automatic carwash facility with gasoline
pump island in front
30,000
Discount gas station (no service bays)
130,000
Gas station with low-cost quick-carwash
facility

*Cost of improvements docs not include the 570,000 cost of land.

In each case, the estimated useful life of the improvements is 15 years. The salvage value for each is
estimated to be the S70,000 cost of the land. The net annual income, after paying all operating
expenses, is projected as follows:
Plan

Net annual income

A
B
C
D

S23,300
44,300
10,000
27,500

If the oil company expects a 10% rate of return on its invesrments, which plan (if any) should be
selected?

$1 5,000
1,625
20

$20,000
1,890
20

A
Installed cost
Uniform annual benefit
Useful life, in y e m

$10,000
1,625
10

For each alternative, the salvage value at the end-of-useful-life is zero. At the end of ten years, Alt.
A could be replaced by another A with identical cost and benefits. The MARR is 6%. If the analysis
period is twenty years, which alternative should be selected?

8-7 Given the following four mutually exclusive alternatives:

First cost
Uniform annual benefit
Useful life, in years
End-of-useful-life salvage value
Computed rate of return

A
$75
16
10
0
16.8%

$50
12
10
0
20.2%

$50
10
10
0
15.1%

$85
17
10
0
15.1%

If the MARR is 8%, which alternative should be selected? ( A w e r : A )

8-8 Consider the following three mutually exclusive alternatives:

First cost
Uniform annual benefit
Useful life, in years
End-of-useful-life salvage value
Computed rate of return

$200
59.7
5
. 0
15%

$300
77.1
5
0
9%

$600
165.2
5
0
11.7%

For what range of values of MARR is Alt. C the preferred alternative? Put your answer in the
following form: "Alt. C is preferred when
% < MARR <
%."

8-9 Consider four mutually exclusive alternatives that each have an 8-year useful life:
A
6
C
D
First cost
Uniform annual benefit
Salvage value

$1000
122
750

$800
120
500

5600
97
500

$500
122
0

If the minimum attractive rate of return is 8%, which alternative should be selected?

r
320

Chapter 8 Incremental Analysis

8-10 Three mutually exclusive projects are being considered:

First cost
Uniform annual benefit
Salvage value
Useful life, in years

$I000
150
1000
5

$2000
150
2700
6

$3000
0
5600
7

When each project reaches the end of its useful life, it would be sold for its salvage value and there
would be no replacement. If 8% is the desired rate of return, which project should be selected?

8-1 1 Consider three mutually exclusive alternatives:

Buy X

Year

Buy Y

Do nothing

Which alternative should be selected:

a.

if the minimum attractive rate of return equals 6%?

b. ifMARR=9%?
c.

ifMARR- lo%?

d. ifMARR= 14%?
(Answers: a. ,C b. Y; c. Y;d. Do nothing)

8-12 Consider the three alternatives:

Year

Do nothing

0
I
2
3
4
5

-$lo0
+30
+30
+30
+30
+30

-$I50
+43
+43
+43
+43
+43

0
0
0
0
0
0

Which alternative should be selected:

a.

ifMARR

= 6%?

6. ifMARR=8%?

c.

ifMARR= lo%?

Problems

Initial cost
Uniform annual benefits
Salvage value at end of useful life
Useful life, in years

$10,700
2,100
0
8

$5,500
1,800
0
4

321

~t the end of four years, another B may be purchased with the same cost, benefits, and so forth. If
the MARR is 1O0h,which alternative should be selected?
'- 8-14 Consider the following alternatives:

lnitial cost
Uniform annual benefits

$300
41

$600
98

$200
35

Each alternative has a ten-year useful life and no salvage value. If the MARR is 8%. which alternative
should be selected?

8-15 Given the following:

Year

Over what range of values of MARR is Y the preferred alternative?

8-16 Consider four mutually exclusive alternatives:

A

Initial cost
Uniform annual benefit
Useful life, in years
Computed rate of return

$770.00
420.00
2
6.0%

B
$1406.30
420.00
4
7.5%

C
$2563.30
420.00
8
6.4%

0
0
0
0

The analysis period is eight years. At the end of two years, four years, and six years, Alt. A will have
an identical replacement. Alternative B will have a single identical replacement at the end of four
years. Over what range of values of MARR is Alt. B the preferred alternative?

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Problems

323

20 A problem often discussed in the engineering economy literamre is the "oil-well pump
pmhlern":z Pump 1 is a small pump; Pump 2 is a larger pump that costs more, will produce slightly
more oil, and will produce it more rapidly. If the MARR is 2096, which pump should be selected?
Assume any temporary external investment of money earns 10% per year.
Pump I
($000~)
-S 100
+70

Year

0
I

Pump 2
(6000s)
-61 10
+l I5

8-21

Three mutually exclusive alternatives are being studied. If the MARR is 12%. which
alternative should be selected?
Year
0
I
2
3
4

A
-$20,000
+10,000
+5,000
+10,000
+6,000

-$20,000
. +10,000
+10,000
+ 10,000
0

-$20,000
+5,000
+5,000
+5,000
+15.000

8-22 The South End bookstore has an annual profit of $170,000. The owner is considering opening
a second bookstore on the north side of the campus. He'can lease an existing building for five yean
with ao option to continue the lease for a second five year period. If he opens the second bookstore
he expects the existing store will lose some business that will he gained by the new "The North End"
bookstore. It will take $500,000 of store fixtures and inventory to open The North End. He believes
that the two stores will have a combined profit of $260,000 a year after paying all the expenses of both
stores.
The owner's economic analysis is basedon a five year period. He will beable torecover this
$500,000 investment at the end of five years by selling the store fixtures and inventory. The owner will
not open The North End unless he can expect a 15% rate of return. What should he do? Show
computations to justify your decision.

< 8-23 A paper mill is considering two types of pollution control equipment.
Initial cost
Annual chemical cost
Salvage value
Useful life

1
3

Neunalizarion

Precipitation

$700,000
40,000
175,000
5 years

$500,000
110,000
125,000
5 years

'Oneofthernore [Link] problem is In Pmf. Manin Wohl's "CommonMisunderrtandinas

About the lnrrnal Rate o f ~ e t u r nind ~ e t ~ n c x Value
nt
~conornicAnalysis Methods:" and the asociated discussion by
RofssronW i n h v . Leavenwonh. Steiner. and Beremann. oublished in Evaluatin~
Transoonarion
-Tmm~ortarionPro~oraI~.
,
k c a r c h Record ;3 1. T r a n s p m ~ ~ oResearch
n
g a d , wkhugton. D C

r
324

Chapter 8 Incremental Analysis

The f i wants a 12% rate of return on any avoidable increments of invesbnent. Which equipment
should be purchased?

8-24 A stockbroker has proposed two investments in low-rated corporate bonds paying high interest
rates and selling below their stated value (in other words. junk bonds). Both bonds are rated as equally
risky. Which, if any, of the bonds should you buy if your MARR is 25%?
Stated value

Annual
inreresr
payment

Current market
price, including
buying commissron

%I000
1000

5 94
140

$480
630

Bond

Gen Dev
WR

Bond
maturily3

15 years
15

8-25 Three mutually exclusive alternatives are being considered.

Initial investment
Annual net income
Computed rate of return

$50,000
5,093
8%

$22,000
2,077
7%

$15,000
1,643
9%

Each alternative has a 20-year useful life with no salvage value. If the minimum attractive rate of
return is 7%, which alternative should be selected?

8-26 A f i is considering five alternatives.

Initial cost
Uniform annual
net income
Computed rate of
return

$100.00

$130.00

$200.00

$330.00

26.38

38.78

47.48

9 1.55

10%

15%

6%

12%

Do
nothing

Each alternative has a five-year useful life. The f i ' s minimum attractive rate of return is 8%.
Which alternative should be selected?

'AI rnilfurlty the bondholder recetves the l z t Interest payment plus the bond stated value

Problems

325

Alternatives

5000
Initial Cost
$2000
4000
500
400
A M U Benefit
~
800
1500
Salvage Value
2000
1,400
6
7
Life in Years
5
6%
6%
MARR Required
6%
Find the best alternative using incremental ROR analysis.

3000
1,300
3,000
4

6%

' 8-28
,

,,

Our cat Fred's summer kitty-cottage needs a new roof. He's considering the two
proposals below and feels a I5 year analysis period is in line with his remaining lives. Which
roof should he choose if his MARR = 12%? What is the actual value of the ROR on the
incremental cost? (There is no salvage value for old roofs.)

First Cost
A M U Upkeep
~
Serv~ceL ~ f e

Thatch
$20 00
5 00
3 years

Slate
$40.00
2.00
5 years

8-29

Don Garlits is a landscaper. He is considering the purchase of a new commercial lawn

mower. Two machines are being considered, the Atlas and the Zippy. The table shown below
provides all the necessary information for the two machines. The minimum amactive rate of
return is 8%.
a. Determine the rate of return on the Atlas mower (to the nearest lo/.).
6. Does the rate of return on the Zippy mower exceed the MARR?
c. Use incremental rate of return analysis to decide which machine to purchase.

Atlas

Zippy

Initial cost

$6,700

5 16,900

Annual operation and maintenance

cost

$1,500

$ 1,200

A M U benefit
~~

$4,000

$ 4,500

Salvage value

$1,000

$ 3,500

Useful life

8-30 QZY, Inc. is evaluating new widget machines offered by three companies. The machines
have the following characteristics:

~-

- .-. - ..
F = r ..:...-

;:

:,A

$20,000

1,600
8,000

400
13,000

900
9,000

3,000

6,000

4,500

-,r.t
,

Company C

$25,000

\#.i:.--,u
i(t
.,TCL
;? .-:
% - l-L,

Company B

5 1 5.000

L -1

= 15 %. Using rate of return analysis, from which company, if any, should you
purchase the widget machine?

bCx:&

8-31 The Croc Co. is considering a new milling machine. They have narrowed the choices
down to three alternatives:
Alternative

First cost

Delure

Regular

Economy

S220,OOO

S125,OOO

$75,000

Annual benefit

79,000

43,000

28,000

Maintenance & operating costs

38,000

13,000

8,000

Salvage value
16,000
6,900
3,000
All machines have a life of ten years. Using incremental rate of return analysis, which alternative,
if any, should the company choose? MARR = 15%.

8-32 Wayward A f i i g h t , Inc. has asked you to recommend a new automatic parcel sorter. You
have obtained the following bids:
First cost
Salvage value

SHIP-R

SORT-Of

U-SORT-M

S184.000

$235,000

$180,000

38,300

44,000

14,400

Annual benefit
75,300
89,000
68,000
Yearly maintenance and
operating cost
2 1,000
2 1,000
12,000
Useful life, in years
7
7
7
Using an MARR of 15% and a rate of return analysis, which alternative, if any, should be
selected?

a 8-33

Build a spreadsheet to fmd the EAC of each roof in 8-28. Use the GOAL SEEK tool
of Excel to fmd the IRR of the incremental investment.

5 8-34

Build a spreadsheet to find the EAW of each lawnmower in 8-29. Use the GOAL
SEEK tool of Excel to find the IRR of the incremental investment.