Module 2 : Comparison of alternatives

Lecture 9 : Incremental Rate of Return - I

Steps for comparison of investment alternatives:

i) Arrange the mutually exclusive investment alternatives on the basis of increasing initial capital investment.

ii) Then the rate of return (IRR) on total cash flow of the lowest investment alternative is determined (procedure already stated earlier) to find out its acceptability as the base alternative. If the calculated rate of return is greater than or equal to MARR, this is selected as the base alternative. If the calculated rate of return is less than MARR, then this alternative is not considered for further analysis and the acceptability of the next higher investment alternative as base alternative is found out by calculating the rate of return on its total cash flow and comparing against MARR. This process is continued till the base alternative ‘B’ (acceptable alternative for which rate of return greater than or equal to MARR) is obtained. If no alternative is obtained in this manner i.e. rate of return less than MARR, then do-nothing alternative is selected. The do-nothing alternative indicates that all the investment alternatives are rejected. Similar to the comparison of cost alternatives, the incremental cash flow is now calculated between the base alternative (B) and the next higher investment alternative (H) over the useful life.

Steps iii) to v) as mentioned above for the comparison of cost alternatives are then followed to select the best alternative.

The comparison of cost alternatives is illustrated in the following example.  

Example -15  
The development authority of a city has to select a pumping unit from four feasible mutually exclusive alternatives for supply of water to a particular location of the city. The details of cash flow and the useful life of all the alternatives are presented in the following table. The minimum attractive rate of return (MARR) is 20% per year. Select the best alternative using the incremental investment rate of return analysis.

Solution:

The cash flow and useful life of all the alternatives are presented in Table 2.1.