Chap 7-5 - IncrementalAnalysis Lecture No 7-5 Chapter 7...

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Incremental Analysis Lecture No. 7-5 Chapter 7 Contemporary Engineering Economics Copyright © 2006
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Comparing Mutually Exclusive  Alternatives Based on IRR Issue : Can we rank the mutually exclusive projects by the magnitude of its IRR? n A1 A2 0 1 IRR -$1,000 -$5,000 $2,000 $7,000 100% > 40% $818 < $1,364 PW (10%)
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Who Got More Pay Raise? Bill Hillary 10% 5%
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Can’t Compare without Knowing  Their Base Salaries Bill Hillary Base Salary $50,000 $200,000 Pay Raise (%) 10% 5% Pay Raise ($) $5,000 $10,000 For the same reason, we can’t compare mutually exclusive projects based on the magnitude of its IRR. We need to know the size of investment and its timing of when to occur .
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Incremental Investment Assuming a MARR of 10%, you can always earn that rate from other investment source, i.e., $4,400 at the end of one year for $4,000 investment. By investing the additional $4,000 in A2, you would make additional $5,000, which is equivalent to earning at the rate of 25%. Therefore, the incremental investment in A2 is justified. n Project A1 Project A2 Incremental Investment (A2 – A1) 0 1 -$1,000 $2,000 -$5,000 $7,000 -$4,000 $5,000 ROR PW(10%) 100% $818 40% $1,364 25% $546
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Incremental Analysis (Procedure) Step 1 : Compute the cash flow for the difference between the projects (A,B) by subtracting the cash flow of the lower investment cost project (A) from that of the higher investment cost project (B).
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