When the best alternative (economically suitable) is to be selected from two or more mutually exclusive alternatives on the basis of rate of return analysis, the incremental investment analysis is used. In incremental rate of return method, the alternative with larger investment is selected, provided the incremental (extra) investment over the lower investment alternative produces a rate of return that is greater than or equal to MARR. In other words if the additional benefits i.e. increased productivity, increased income, reduced operating expenditure etc. achieved at the expense of extra investment (associated with larger investment alternative) are more than that could have been obtained from the investment of same amount at MARR elsewhere by the organization, then this additional capital should be invested.
In incremental rate of return method, the economically acceptable lower investment alternative is considered as the base alternative against which the higher investment alternative is compared. The cash flow of higher investment alternative is considered equal to the cash flow of lower investment alternative plus the incremental cash flow i.e. difference in cash flow between the higher investment and lower investment alternatives.
When using rate of return method for comparing two or more mutually exclusive alternatives, the analysis must be done correctly, otherwise it may lead to incorrect ranking of the alternatives. However this problem is avoided in incremental investment rate of return analysis. In this technique, the individual rate of return values on total cash flow of the mutually exclusive alternatives are not compared against each other rather the rate of return (or IRR) of the mutually exclusive alternatives or the rate of return of the incremental investment is compared against MARR.
The procedures for comparison of mutually exclusive cost alternatives and that of mutually exclusive investment alternatives using incremental investment rate of return analysis are mentioned below. The details about cost and investment alternatives are already stated in Lecture-1 of Module 2.
Steps for comparison of cost alternatives:
i) First arrange the mutually exclusive cost alternatives on the basis of increasing initial capital investment. The lowest capital investment alternative is considered as the base alternative (B).
ii) The incremental cash flow is calculated between the base alternative (B) and the next higher capital investment alternative (H) over the useful life.
iii) Then the rate of return ‘ir (H-B)’ of this incremental investment is calculated (procedure as stated earlier) by equating the net equivalent worth (present worth or annual worth or future worth) to zero.
iv) If the calculated ‘ ir (H-B)’ is greater than or equal to MARR, then alternative ‘B’ is removed from further analysis. Alternative ‘H’ now becomes the new base alternative and is compared against the next higher capital investment alternative. If ‘ir (H-B)’ is less than MARR, then alternative ‘H’ is removed from further analysis and alternative ‘B’ remains as the base alternative and is compared against the next higher investment alternative (alternative with investment higher than ‘H’).
v) Steps ii) to iv) are repeated till only one alternative is left i.e. the best alternative which justifies the incremental investment associated with.