Chapter 11 Fall Spring 2010 White

Chapter 11 Fall Spring 2010 White - CHAPTER 11 CHAPTER...

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CHAPTER 11 CHAPTER 11 Incremental Rate of Return Incremental Rate of Return (IROR) on Required (IROR) on Required Investments Investments
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HW HW CHAPTER 11 CHAPTER 11 Due Due A.3, A.8, A.10, B.5, C4
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Rate of Return Compared Cost and Income directly I.e. setting a given alternative’s NPW equation equal to zero Incremental Rate of Return (IROR) Looks at the amount saved on additional return that occurs from each additional dollar invested above the required minimum investment “For every additional $ I spend on the higher cost alternative, I am earning the equivalent of X% return.
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Important Information Important Information Key Words MUTUALLY EXCLUSIVE Are differential costs justified by differential benefits? Means you MUST do an incremental analysis Assumptions The assumption is made that all funds are available for the most expensive alternative
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Uses Uses Selecting Between alternatives Find the most cost beneficial alternative for all existing funds It is not always enough to know the total cost of an alternative (i.e. what was found from NPW, NAW, NFW at a given interest rate) – the question may be what is the best way to allocate all available funds Needed when there is no income from an alternative (i.e. calculating the ROR is infinitely negative
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**Drawing Conclusions** **Drawing Conclusions** IF MARR is Less than the IROR, Select the HIGHER INITIAL COST alternative MARR < IROR HIGHER INITIAL COST If MARR is Greater than the IROR, Select the LOWER INITIAL COST alternative MARR > IROR LOWER INITIAL COST
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11.1 11.1 Example 11.1 GIVEN : 200 1 4 200 0 2 3 Cheap tires for $200 that will last 2 years What methods do we know to select between these alternatives? NPW, NAW, NFW, ROR, IROR 325 1 4 0 2 3 Not so cheap tires for $325 that will last 4 years A B
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11.1 11.1 200 1 4 200 0 2 3 Cheap tires for $200 that will last 2 years 325 1 4 0 2 3 Not so cheap tires for $325 that will last 4 years NPW, NAW, NFW, Must be given an i and these methods only tell you which alternative is best for the given i ROR There is no return on this investment IROR Allow you to determine the best way to spend your money A B
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11.1 11.1 200 1 4 200 0 2 3 Cheap tires for $200 that will last 2 years 325 1 4 0 2 3 Not so cheap tires for $325 that will last 4 years NPW A = -200 – 200(P/F, i, 2) NPW B = -325 NPW B-A = -125 + 200(P/F, i, 2) =0 125/200 = (P/F, i, 2) .625 = (P/F, i, 2) Calculate the IROR A B
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11.1 11.1 .625 = (P/F, i, 2) i = 25% P/F = .64 i = 30% P/F = .59172 INTERPOLATE i = IROR = 26.5% WHAT THIS MEANS Spending the extra $125 on the more expensive tires, B, results in the equivalent of a 26.5% return on the additional $ spent above the minimum $200 investment Unless you can make 26.5% or greater on your money somewhere else, it is best to purchase the more expensive tires.
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11.1 11.1 If MARR < 26.5% Alt B is best If MARR > 26.5% Alt A is best If MARR = 26.5% Either is fine Which alternative would you select if MARR = 30%
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Chapter 11 Fall Spring 2010 White - CHAPTER 11 CHAPTER...

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