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11ComparisonMethods2-2013.pdf-Incremental Analysis • This evaluates theshowing page 37-41 out of 44

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Incremental Analysis
This evaluates the difference, or the “increment” between
two or more mutually exclusive alternatives
This approach is required to correctly apply IRR (or B/C
ratio) measures to mutually exclusive alternatives.
The steps in incremental analysis are:
1. Order alternatives in increasing order of FCs to insure that the
increments have cash flow patterns corresponding to
investments
2. Calculate the economic value of the “do nothing“ alternative or
the least-expensive if do-nothing is not available
3. One by one evaluate each alternative (challenger) against the
best alternative (defender) found so far.
The IRRs >= MARR and the B/C >= 1 represent investments
that should be made.


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Incremental Analysis - the Concept
Key principle - MARR is always the default
investment
Goal is to make as much money as possible
Example where MARR = 8% and all lives are 10 y:


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Incremental Investment
Which investment is preferred, MARR = 70%?
$1 first cost today and 2$ return in one year
$1000 first cost today and $1900 return in one year
First project: -1 + 2 (P/F,i,1) = 0
(P/F,i,1) = 0.5
i= 100%
Second project : -1000 + 1900 (P/F,i,1) =0
(P/F,i,1) = 0.5263
i= 90%
Incremental investment: -(1000-1) + (1900-2) (P/F,i,1) = 0
i=89.9%
IRR (incremental investment) > MARR
second project
should be chosen


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PW, AW and IRR
PW, AW, AC and B/C have the same reinvestment
assumptions (we can invest at MARR anytime) and
i*
is
used as the investment rate – this is DO NOTHING
option
MARR is also the reinvestment assumption when IRR is
used, but note that IRR is not the reinvestment rate
IRR uses the same interest rate as other approaches.
In
PW, AW, AC and B/C
i*
appears as the interest rate.
But, for IRR calculations
i*
is used as the standard for
comparison!
For loans, a good IRR<
i*
and for an investment IRR>
i*
They all use the same assumption, and when applied
correctly, they make the same recommendations


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More on Comparison Methods
Constrained Project Selections
i.e. ranking of projects, project selection under constrained
budgets
ranking by IRR is the best method if the implied
assumption is repeated lives
ranking by PW or AW only acceptable for projects with the
same life
and similar cash flow structures
Don’t use this method, stick to IRR if repeated life assumption is
valid
Comparing alternatives (assuming projects can be
repeated)
Easiest way is to use PW (over a common time horizon) if
lives are different, use EAW or EAC
Can also examine IRR of increments
some questions will have to be done with incremental analysis


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