3 Present, Annual, and Future Value, Rate of Return and Brbak - Even Analysis

,
CHAPTER 4
MUTUALLY EXCLUSIVE AND NON.MUTUALLY

EXCLUSIVE
PROJECT ANALYSIS
For economic anarysis purposes, income-producing

and service-produc-
ing alternatives must be broken into two sub-classifications
(l ) c-ontpariso, of mutuaily excrusive alrcrnatives,
which are:
which means making an
analysis oJ several alternatives
from which only one can be selected, such
as selectittg the best way to provide service
or to improt,e an existing opera-
tion or the best way to develop a new process, prodict,
mining op"iorio, o,
ctil/gas reserve; (2) comparison of non-mutuaily
excrusivz ahernatives
v'hich nleens analyzing severar arternatives
from which more than otle can
be selected depending on or budget restrictions,
_capital such as rankirtg
researclt' development exrloratio, projects to determine the best pro-
-a11
jects to fund with available dollars. Analysis of mutually exclusive alterna_
tives will be presented first in this chaiter with
non-mutually excrusive
alternative analysis discussed in the ratter pages
of the ;il;;. It will be
shown that valid discounted cash flow criteria
iuch as rate of return, ner pre-
sent value and benefilcost ratio are applied
in very different ways in proper
analysis of mutually exclusive und nor-rnutuaily
exclusive arternative
investments.
4'l Analysis of Mutuaily Excrusive rncome-producing

Alternatives
Using Rate of Return, Net Value and Ratios
In any industry, classic illustration of mutually exclusive
alternative anal_
ysis often involves evaluation of whether it
is economically desirable to
improve, expand or deverop investment projects.
whenever ylu must make
an economic choice between several alternative investment
choices, and
selecting one of the choices excludes in the foreseeable
future being able to
164
chapter 4: Mutuaily Excrubive and Ncn-Mutualy Excrusive project
Anarysis 155
in'est in the other choices, ),ou are invorved with

mutually excrusive alter_
native anaiysis. In Chapter 3 we have already
illustrated iow incremental
analysis of differences betwecn alternati.,,e w,a's
of providing tlie same ser_
vice was the key to rate of return, net present r.true
or raiio anarysis of
:iervi.e prr:.iucing alternati'es. It u,ill be illustrated in
the ibllowing exam_
pies that increntental runhsis is flrc kcl. to correct
analysis of mutuaily
e-tclusive inconte -producitrg arternatit.es v,ith ail
dirrru,r.ira cash fr,.tw
ctnalysis techniEtes. The rvorJs incremental,
difference and marginal are
u,sed interchangeably by persons involved in
evaluaiion work when ref-er_
ring to changes in costs or revenues that are incurred in going
from one
alternative to another or from one level of operation
to another.
EXAMPLE 4-1 Mutuaily Exclusive lncome-producing

Alternatives
consider the anarysis of two different ways, "A'r and ,,8,,,
of improv-
i.lq :n existing process. As shown on ths foilowing time diagrams,
"A" involves a small costing $50,000 with iavings and sal_
vage as iliustrated. 9.!ange
"8" involves a much larger cnange costing
$500,000 which includes the "A" chanEes with savings
and salvage
as shown. Assume $S00,000 is availible to invest "and
that other
opportunities exist to invest any or all of it at a 1s%
RoR. which, if
either, of the mutuaily excrusive arternatives ,,A,,
and ,,8,, shourd we
select as our economic choice? use RoR anarysis,
then verify your
economic concrusions with Npv, NAV NFV and irVB
anarysis.
solution; HoR Anarysis, vatues in Thousands of Doilars

C = CoSt, | = Savings, L = Salvage Value
A) C=50 l=50 l=50

0 1...........5 L=50
PW Eq. 0 = -50 + S0(p/A;,5) + 50(p/F1,5)
By trial and error, i = RORA 1AA"/o > i"=157o, So
= satisfactory
B) c =l9Q l=250
0 1...........s L=500
PW Eq. 0 = -500 + 250(p/A;,5) + 500(p/F;,5)
By trial and error, i = RORB = 5Oo/o > i"=1S7o, so satisfactory
166 Economic Evaluation and lnvestment Decision Methods
The RoR resurts can arso be obtained by dividing annuar

savings
by initial cost and multiplying by 100, since initial cost-equals
satvagJ.
Many people think in terms of the project with the raigest
rate of
return on total investment as aiways being economicatlyiest,
but in
fact, the largest rate of return prolect is not atways tf;e
best eco-
nomic choice. ln this case, although ,,A,, has a totai investment
iaie
of return of 100%, which is twice is large as the,,B,,rate of return,
the investments differ in magnitude by a factor of ten. A smaller
RoR on a bigger investment often is economicaily better than
ger ROR on a smalrer investment. rncremental analysis a big-
must be
made to determine if the extra, (or incrementar) ga50,000
that will
be invested in "B" over the required "A" investment, wili be generat-
ing more or less profit (or savings), than the
$4S0,000 would earn if
invested elsewhere at the minimum rate of return ol 1s%.
The incre-
mental analysis is made for the bigger project ,,8', minus
the smaller
project "A" so that incremental ibst'is ioitowed by incremental
income giving:
B_A) C=450 l=200 l=200

0 1...........5 L=450
PW Eq. 0 = -450 + 200(p/A;,5) + 450(p/F;,5)
; = RORB- A= 44.4"/"
It should be clear from an economic viewpoint that if

$500,000 is
available to invest, we would be better off with all of it invested
ject "8". our incrementar anarysis has broken project ,,B,, in
pro_
into two
components, one of which is like project ,,A," and the other
is like the
incremental project. Selecting proleit ,,8', effectively is
equivalent to
having $50,000 of the capital invested in project ,,A;
earning a 1oo"/"
RoR and $450,000 incrementar investment earning a 44.4./"
RoR.
s-u1ely_selecting "8" is better than selecting ,,A', which
wourd give a
100% ROR on the 950,000 capital invested in ,,A,, and
require invest_
ing the remaining $450,000 elsewhere at the 15% minimum
ROR.
lncreme.ntal analysis is required to come to this correct
conclusion
and notice that it requires rejecting atternative ,,A,, with the
largest
ROR of 100% on total investment.
chapter 4: r"4utuarry Excrusive and Ncn-r\4ri,:aily Excrusrve pr-o.iect Anary"ris
Evaluation of mutually exciusive multiple investment alternatives

(the situation where only one alternative may be selected
from more
than one investment choice) oy rate of return analysrs requires
both
tctal investment and incremenial investment r-atu of return analysis.
T'he rate of reiurn analysis cancept for muttaity
exclusive alterna-
fi'ves is baseci on testrng to sce that each satisia-ctori,,
level of invest_
ment meets two requirements as foliows: lr) The iate of return
an
total individual project investment must be greater than or
equat to
the minimum raie of return, "i"; (2) The rate of return on incremental
investment compared to the last satisfactory level of investment
must
be greater than or equal to the minimum ion, ,'i"". The largest
tevel
of investment that satisfies both criteria is the economic
choice.Anal_
ysis of total investment rate of return alone will not
always lead to the
correct economic choice because the project with the largest
total
investment rate of return is not always best. lt is assumed fl-rat
money not invested in a particular project can be invested
elsewhere
at the minimum rate of return, "i*". Therefore, it is often preferable
lo
invest a large amount of money at a moderate rate of ieturn
rather
than a small amount at a large return with the remainder having
to
be invested elsewhere at a specified minimum rare of return. These
evaluation rules and concepts appty to grow,th rate of return
anatysis
as well as regular rate of return analysis, since growth rate of return
is just a special type of regular return.
NetValue Analysis (present, Annual, Future)

of Mutually Exclusive Alternatives ,.A,, and ,iB,'
To illustrate the application of NpV NAV and NFV to evatuate

mutually exclusive investment alternatives these techniques
will now
be applied to evaruate alternatives "A" and "B" for the previously
stated 15orl, minimum RCR.
atC=$50 l=$50 l=$50

0 1...........s L=$50
B) C = $500 I = $250 | = $250

L = $500
1...........5
't 68 Economic Evaluation and lnvestment Decision Methods
B - A) c-= $$q I = $2oo | = $2oo

1...........5 L = $450
3.352 .4922 L
NPV4 = 50(P/At S./",5) + 50(P/F15
"/",5) - S0 = +g1+ZISO
NPV3 = 250(P/At S"/",5) + S00(P/F1
S"/",5) - 500 = +$5g6.60
.14832 .29832
NAV4 = 50 + 50(A/F1
So/o,S) - 50(A/p1S%,S) = +$42.50
NAVg = 250 + 500(A/F1
S"/",5) - SOO(A/PI5%,S) = +$175.00
6.742 2.011
NFV4 = 50(F/At5%,S) + 50 - S0(F/p15%,S) +$286.50
=
NFV3 = 250(F/At S./",5) + 500 - 500(F/p1
S/",5) = +$1,1g0.00
we see that all the net value results are positive which consistenily
indicates that both aiternatives "A" and ,,B,,are satisfactory
since they
generate sufficient revenle to more than pay off the invLstments
at
the minimum RoR of 15"/". To determine which alternative is best
we
must make incremental net value analysis just as we did for RoR
analysis. we can get the incremental net value results either by look-
ing at the differences between the total investment net values for
the
bigger investment minus the smailer, which is "B-A,, in this case,
or by
working with the incremental costs, savings, and salvage.'Exactly
the
same incremental net values are obtained either way.
NPV6-4 = NPVB - NPVA = 586.6 - 142.5= +$444.10
3.352 .4972
or = 2Qg1p I Al S"t",S) + 450(P lF
1 S"/",5) - 4S0 = +$444. 1 0
directly from the incremental data:
NAVB-4 = NAVB - NAV4 = 175.0 42.5= +$132.50
-
NFVB-4 = NFVB - NFV4 = 1,180.0 - 286.5 +$893.50
=
ln each case the incremental net value results are positive, indicat-
ing a satisfactory incremental investment. The reason it is satisfac-
tory can be shown by looking at the net value that would be received
ilo1_ilvesting the $450,000 incremental capital elsewhere at
i = 15"/".
cnapier 4: Mutually Excrusive and Nor,'-Mutuaily Excrusive project Anarysis 169
c = $450 at i.= 15%'

.F ,E^t-tn \ a^^ . ^-
1.........5 = 450(F/P I St",S) = +$904.95
0.4972
IJPV = 9C4.95(P/F15%.5)- 450 = $0
Similarll,, NAV - $0 anij NFV = $0.

fu1oney invested at the minimum RoR, "i*", arways has
a zero net
value. obviously the positive incremental net vatue results for,,B-A,,
are better than the zero net value that would be obtained by iinvesting
the money elsewhere at "i*"
ln summary, the net value analysis concept for evaluating mutuatty
exclusive alternatives is based on two testsi
1t1the net vatie on to,tit
individual project investment must be positive; (2) the incremental
net
value obtained in comparing the totat investment net value
to the net
vaiue of the last smaller satisfactory investment level must
be positive.
The largest level of investment that satisfies both criteria is the
eco-
nomic choice. This is always the alternative with the targest positive
net value. This means, if you have a dozen mutually exclu-sive
alterna-
tives and calculate NpV, or NAV or NFV for each, the economic
choice wili always be the alternative with the lar.gest net value.
when
you select the mutually exclusive investment alternative with
the
largest net value as the economic choice, ycu are not omitting
incre-
mental anaiysrs. Experience shows that incremenial analysis-always
leads to selection of the project with the biggest net value on
total
investment as the economic choice. you can mathematically
convert
between NPV, NAV and NFV and therefore you must get the
same
economic conclusion using any of these techniques
NPV = NAV(P/A;-,n) = NFV(p/Fi",n)
Ratio Analysis of Mutually Exclusive Atternatives ,,A,,and ,,8,,
n) c =l!Q l=$50 l=$50

0 1...........5 L=$50
B) C = $500 I = $250 I = $250

L = $500
1...........5
t
PVR4 = NPVA / PW cost = 142.srso 2.g5 > 0, so satisfactory

=
PVRB = NPVB / PW Cost = 5g6.6/500 1.17 > 0, so satisfactory
=
Project "A" has the bigger total investmenl ratio byt the
smaller
project "8" ratio relates to ten times larger investment
iatue. Getting
smaller dollars of Npv per present worth cost dollar invested
on
larger investment often is a better mutually exclusive investment
choice. Incremental analysis is the optimization analysis that
answers the question concerning which of mutually exclusive
alter_
natives "A" and "8" is the better investment. This ii true with
ratios
the same as was illustrated earlier for RoR and net value
analysis.
B_A) C = $450 I = $200 I = $200

o 1...........5 L = $450
PVRB-4 = NPVB-A / PW lnvestment

= 444/450 = 0.99 > 0 satisfactory
. Accepting the incrementa! "B-A" investment indicates accepting

ject "8" over'4", even though the total investment
pro-
ratio on ,,8,, is less
than "A". As with RoR anatysis, the mutualty exclusive alternative
with
bigger RoR, PVR or Benefit cost Ratio on totar individuar project
investment often is not the better mutualty exclusive investment.
lncre-
mental analysis along with totat individual project investment
analysis
is the key to correct anarysis of mutuaily excrusive choices.
since benefit cost ratio equals pVFi plus one, it should be evident
to the reader that either pVR or Benefii cost Ratio analysis give
the
same conclusions, as long as the correct break-even ,itio.
of zero
for PVR and one for Benefit Cost Ratio are used.
4.2 unequal Life Mutually Exclusive Income-producing Alternatives

and The Handling of Opportunity Costs in Evaluatlons
As discussed in Chapter 3, it is important to recognize that when
using
RoR' NAV or NFV techniques to anaryze unequar life service-producing
alternatives that generate revenue, you must use a common
evaluation life
for all alternatives, normally the life of the longest life alternative.
The only
exception to this rule involves the evaluation of alternatives
that do not have
the opportunity to have revenue allocated to them, such as
remediation
work' Analysis of unequal life income-producing ahernatives
is not a prob-
chapter 4: Mutually Excrusive and Non-Mutuaily Excrusive project Anarysis 171
leni rvith NPV or ratio analvsis because time zero is a common point in
time for calculating Npv or ratios ot either equal or unequal life altema-
tives. If you have unequal lives for different alremati,res, the tirne value of
molle)' consideratiofis are difi-erent in rate oi return. annual value and future
vaiLie calcuiirtiolts and you may chocrse the wrong aile5nslir. as being
best
if lt-ru do not get a coir.lulon evaluation lii'e. This merely meaus that
1-ou
inu51 calculate NFV at tlie same future point in tirne for aij alrematil,es. or
you inust calculate NAV by s;.readilig costs anci revenues over the same
nurnber of years for all alternadves. hr RoR, tret value or ratio anctbsis of
Lm.:quol life income-producirtg altenntit,rs, treat all projects as hat,irig
equ"al lives whk:h are equal to the longest life project with net reyenues
and
cosrs of zero in the later rears of shorter life projects. Note that this is not
the same technique presented in chapter 3 to convert unequal life sen,ice-
producing alternatives that have revenues associated with thim, to equal life
aiternatives using either Method 1,2 or 3. when projects have different
stalting dates, net present value must be calculated at the same point in time
tbr all proiects tbr the results to be comparable.
opportunity cost is the current market cash value assigned to assets
alreadl' owned which will be used in a project instead of being sold. passing
up the opportunit-v to sell the assets in order to keep and use thenr creates an
opportunity cost equal to the foregone market cash salc value. If an asser is
not saleatrle, the oppor-tunity cost effectively is zero.
Actions taken b1 ma,agement to deiay expenditures mav create a nega-
tire opporiunity cost, or actually add value to the property. An exampie
ir.ri'.i'es invcsti*g adtlitio*al capital in a negative profit general business
unit (or an off.shore petroleum platform or mining operation) in order to
delay abandonment or reclamation costs. As long as the net present value of
the altematives calling for additional investment to defer abandonment has
greater value than the net present viilue of abandonment no$,, deferring
abandonment would be preferred from an economic vie.,vpoint.
Finally. in analyzing either equar lif'e or unequal life income-producin_: or
ser'ice-producing alternatives, c.hangirtg, the mirtimtun discount rate Lnay
chartge tlw ec'ottontic choir:e. You cannot use net y,alue or ratio results t:ul-
culaled at a giv,en discount rate such as l2ch to reach valid economic deci-
sions for a dffirent minimum discount rate such as 25To. you m.ust use net
value and ratio results cctlculated using a discount rate representative of the
opportunitl, cost of capital for consistent economic decision making. The
follorving examples illustrate these considerations.
EXAMPLE 4-2 Anatysis of Unequal Life Mutuafly Exclusive

lncome Producing Alternatives and
Opportunity Costs
Analyze whether it is economically desirable to sefthe develop-

ment rights to a new process or property for a $150,000 cash offer at
time zero, or, to keep the rights and develop them using one of two
development scenarios. The project net before-tax cash flows for
each alternative are presented on the following time diagrams. Use
NPV, RoR and PVR analysis techniques to make this economic
decision for a minimum rate of return of 15.0%. Then, consider the
sensitivity of changing the discount rate to 2o.o%. All dollar values
are in thousands.
(A) Develop -200:gl_100j00 150. . . . . . 150

23 10
(B) Develop -300 -400 200 2ao 200.. ...200
(C) Sell 150

10
Solution for i* = 15.07o:
since much confusion exists regarding the applicability of different

criteria to different investment situations, this solution looks at each
of the decision criteria independent of another to show the overall
equivalence of each.
(A) Develop -z!q:35qjll too 150...... 150

3 4........8 I 10
NPV4 = -200 - 350(P/F1S,1) + 100(P/A1S,2XplF15,1)

+'t 50(P/A1 5,5)(p/F1 5,3)
= -32.37 < 0, so, reject A.
chapter 4: Mutuaily Excrusive and Non-Mutuaily Excrusive project
Anarysis 17g
ROR4 = 13.1g% is the compound interest rate that makes

NPV = 0.
18.ig"/o < 15.O"A, so, reject A.
t
PVR4 = -32.87 t[2AO + 350(prF1S,1)] =
-0.064 < 0, so reject A.
All criteria indicate that Alternative ,,A,, is not economically ccnpeti_

ive with rnvesting money elsewher.e at i* 1S.0%. This leaves only
"8" and "C" for further consideration. =
(B) Develop {9100 J00_!00 2oo. . . . . 200

01
NPVB = -300 - 400(P/F15,1) + 200(p/A15,9)(p/F15,1)
= +182.0 > 0, so, B is acceptable.
RORB = 21.62o/" is the compound interest rate that makes

NPV = 0.
21.62"k > 15.0"/", so, B is acceptable.
PVRg = 182.0/ [3OO + 400(piF15.r)] = +0.2809 > 0,

so, B is acceptable
All criteria indicate that Alternative ,'8,, is economically accept-
able compared to investing money elsewhere with equivalent risk
at
i" = 15.07".
(C) Sell 150

-
0
NPV6 = +150.0 > 0, so, C is acceptable.

HOR6 = *o/o > 15.O/", So, C iS aCCeptable.
PVH6 = - since your denominator is zero > 0, so c is acceptabre.
All criteria indicate that Alternative ,,c,, is also economically accept-

able.
Proper economic analysis of mutually exclusive alternatives

requires incremental analysis to determine the optimum choice.
However, as previously illustrated in Example 4-1, a proper incre-
mental analysis will always lead to selecting the alterqgtive with the
largest individual NPV. Applying this concept here, Aiternative ,,8,,
with a maximum NPV of $182.0 is the economic choice. However,
note that "B" does not have the largest individual ROR or pVR. With
any type of compound interest rate of return or ratio analysis, you
must make a proper incremental analysis when evaluating mutually
exclusive alternatives.
As just shown, of the three alternatives only "8" and "C" are prefer-
able to investing elsewhere at i* = 1s.o/", so incremental analysis is
provided between "B" and "C".
(B-C) Dev - Sell -450 0
The concept of opportunity cost is formally introduced in chapter g,

section 9.3, on an after-tax basis, but notice here that the Alternative
"B-c" incremental analysis automatically converts the sale cash flow
of +$150 to an incremental opportunity cost of -$150. lf an investor
passes up the opportunity to sell for +9150 in order to keep and
develop, an opportunity cost equal to the forgone sale cash flow must
be built into the economic analysis of the alternatives. lncremental
analysis of mutually exclusive alternatives will always properly
account for opportunity cost considerations as in this Develop minus
Sell analysis where the time zero incremental cash flow of -$450
results from a -$150 opportunity cost and a -$300 development cost.
To prove that selecting the largest individual NpV is best consider

first the incremental NPV analysis which can be solved for with two
different approaches:
NPVg-g = -450 - 400(P/F15,1) + 200(P/A15,9)(P/F15,1)

= +32.0 > 0, the incremental investment is satisfactory,
accept B.
or, = NPVB - NPVC = 182.0 - 150.0 = +32.0 > 0, accept B.

chapter 4: Mutua,y Excrusive and Ncn-Mutuary Excrusive project
Anarysis 175
To support the Npv conciusion that Arternative ,,8,,

generates the
most economic varue, an incrernentat anarysis is reqiired
for both
RoR and PVR anarysis. RoRg-6 is the compcurrd interesi
rate that
makes NPV3_6 = 0. t
HORg-g = 15.g8% by calculator > i* = 15.A"/o, so, accept B.
Note that Alternative "c" (selling), with an infinite

incividual RoR is
not the economic choice. By serecting "8", the additionar
capitar
invested i! "8" is generating a oigger rate of return
than if that money
were earning the minimum rate of return. i" 1S.07o.
= That translates
into more value \,vith "8", as was refrected in the Npv
anaiysis.
PVRB-6 = +32.0 /{4SO + a00(p/F15,t)J= +0.04 > 0, so, accept B.
Analysis of changing the Minimum Discount Rate to Za.ao/o:

Frorn the individual economic analyses jrst compreted,
cr"iy A[ter.-
natives B and c have rates of return competitive
wiih investing else_
where at i* = 20.011. since the rargest NpV is arways
the eccnonrjc
choice when evaruating mutuariy exilusive alternatives,
onry NFV will
be iliustrated here for i* = 20%.
NPV4 @ 20"/o = -104.8 < O, so, reject A.
NPV3 @ 20"/" = + 3g.5 > 0, so, B is acceptable compared

to
investing @ i*= ZO.O"/".
NPVg @ 20% = + 150.0 > 0, so, C is the maximum NpV select

C.
.. Tl" maximum project NpV is the Arternative c, which indicates

the investor shourd sell today and invest the g150 in
other opportuni-
ties where it could earn a 2o.o% RoR and maximize
the investor,s
economic value. This same sensitivity to discount rates can
be
expanded to a graphical format, for a range of i* values.
This is often
referred to as an Npv profire and is iilustratbd in
Figure 4-1.
$1,200
br,ooo
o
5 $8oo
G
$6oo \.- .'.

co . :.,.\]
o
o $400
o-
$200
zo)
$o
10%;
($eool
Discount Rate, i*
lntersection points between the projects indicate the "i." values that make the
prgjects a break-even. They also indicate the incremental rates of return between
the respective alternatives. For example, RoRa-c is equal to 1s.gg% as previously
calcula.ted- Since selling is a time zero value, its NpV is unatfected by the discount
rate, with NPV remaining constant at $150 for all disccunr rates.
Figure 4-1 NPV Profile for Example 4-2, Alternatives A, B and C.
A variation of the analysis in Example 4-2 is presented to show

when mutually exclusive projects have different starting dates, you
must calculate NPV for different alternatives at the same point in
time for results to be comparable.
EXAMPLE 4-3 Analysis of Mutually Excrusive Arternatives with

Different Starting Dates With NpV, ROR and pVR.
Re-analyze mutually exclusive alternatives ,,8', and ,,C,, as

described in Example 4-2 using Npv, RoR and pVR analyses for i.
= 15.0"/", assuming the "8" development project starts at the end of
year two, instead of time zero. All values are still in thousands.
(B) Develop -300-400 200.. ...200

0
crrapter 4: Mutually Exciusive and Non-ly'utuallv trxclucive project Analysis 177
150
{C) Sell
1 2 3 4... ...12
Solution for i* = 15.0o/o: +
NPVg = -300(P/Fr S.e) - 400(p/F15,3) + ZAOptA15,9)(p/F15,3)

= +137.6 > 0, so, ,,8', is acceptable.
NPVg = +150 > 0, so, "C" is acceptable and largest NpV.
selecting the maximum Npv project "c" (or selling) is the eco-
nomic choice. This is a different economic decision than was
reached for the project timing described in Example 4-2 where ,,8,,
Deveiop started at time zero with NpV of +192.0.
lncremental Hate of Heturn Analysis

(B-C)Dev-Sell -150 - -300-400 200 .....200
o 1 2T.-:z
PW EQ: 0 = -'150 - 300(PtFi,z) -a00(ptF;,3) + 200(p/A;,9)(p/F;,3)
By calculator, FOR, i = 14.56"io < 15.0% so, reject Develop,

accept Sell
lncremental PVR Analysis
PVRg-g = lncremental NPV / lncremental PW Costs
= (137.6 - 150 ) / {1S0 + 300(p/F1
5,2) + 400(p/F15,3)}
= -12.4 / 639"83 = -0.0194 < 0
so, reject Develop, accept Sell
When properly applied, NpV, ROR, GROR, pVR and B/C Ratio
criteria will lead to the same economic conclusion in the evaluation of
mutually exclusive alternatives. lf projects have different starting
dates, for valid NPV analysis of mutuaily exclusive alternatives, pro-
ject NPV's must be calculated at the same point in time before
proper interpretation of the results can be ma'de.
EXAMPLE 4-4 Mutually Exclusive Proiect Analysis Case Study

An existing production facility must-be shut,down unless an envi-
ronmental capital cost of $1so mittion is incurred now at year 0. This
improvement will enable production to continue ano @herhte esti-
mated profits of $60 million per year for each of the next g years
when salvage value of the facility is projected to be zero. An alterna-
tive under consideration would combine process improvement and
expansion with an environmental cost change for a cost of $200 mil-
lion now at year 0, plus $150 million cost at year 1 to generate esti-
mated project profits of $00 million in year 1 and $120 million profit
per year in each of years 2 through 8. The minimum ROR is 12ol".
Evaluate which of these alternatives is better using ROR, NpV and
PVR analysis. Then, change the minimum ROR lo 2S/o and analyze
the alternatives using the same techniques.
Solution, allvalues in millions of dollars:
61C=150 l=60 I=60 l=60 l=60 l=60

01 2 4 ......8
l=60
B) C=200 C-150 l=120 l=120 l=120 l=120
.8
ROR Analysis
A) PW Eq: 150 = 60(P/Ai,g), i = ROR4 = 36.7"/o > i* = 12o/o
B) PW Eq: 200 = -90(P/Fi,r) + t 20(PlAi,)(P/F;,1)
i = RORB = 28.60/o > i* = 12o/o
Both projects have acceptable economics, but incremental rate of

return analysis is required to determine if the extra incremental
investment in "B" generates sufficient incremental revenues to justify
the additional $50 million cost at time zero and the additional g150
million cost at year one.
chapter 4: Mutua,y Excrusive and Non-Mutualry
Excrusive project Anarysis
179
B-A) C=50 C=150 l=60 l=60 l=60 l=60

0 3 4......8
B -A ) PW Eq: 50 = -'150(p/F;,1) + 60(p/A i,Jyprci1
i = RORB-
A= 2jo/o > i* = 12o/o
So select "8".
Note that once again, the project with biggest

RoR on totar invest-
ment is not the economic choice.
NPV Analysis
4.968
NPV4 = 60(P/At 2y",8)
- 150 = +$148.1
4.564 '0.8929 0.8929
NPVg = 12a(PtAt2.7",)(ptF1zoh,1) _ 90(plf;;. _ZCO
,ry
= +$208.7
lncrementar anarysis verifies the serection

of the project with the
largest total investment NpV which is ,,8,,.
NPVB-4 - NPVB - NPV4 =ZOg.7 - 14g.1= 60.6 > 0, so select,,B,,.
lncrementar anarysis.of mutuaily excrusive

arternatives arways
leads to selection of the investment project
with rargesi rvpv on totar
investment. often this.is not the project
with tre tarjest Rbn or pvR
on total investment. However, incrementar
anarysil gives tne same
economic conclusion with all techniques
of analysis.
"
PVR Analysis
PVRn=r+h=#=o.ee>o
NPVB 208.7
PVR.L'= -
PW Costg 200 + 90(P/F1 =0.74>0
2/o,i)
Which alternative is better, "A" or "8"? "A't is not necessarily pre-

ferred just because it has the largest ratio on total investment. As
with ROR and NPV incremental analysis must be made and Present
Worth Cost "B-A" is taken from incremental "B-A" time $iagram and
does not equal Present Worth Cost B minus Present Worth Cost A
because of the effect of year 1 income on the year 1 total and incre-
mental investment net costs.
NPVg-4 208.7 - 148.1
PVR3-4 =
PW Costg-4 50 + 150(P/F12/"J)
= o'33 > t' with the

;L'*''ff1'ffi;",.::fitent
See the incremental "B-A' time diagram for verification that the
incremental costs are 50 in year 0 and 150 in year 1 .
Benefit cost ratio analysis gives the same conclusions following the
PVR analysis procedure. Remember that benefit cost ratio equals
PVR plus one, and one is the break-even ratio with benefit cost ratio
analysis while zero is the break-even ratio with PVR analysis.
Change i* lo zso/o:
ROR Analysis
A) RORA = 36.7"h > i* = 25"/o
B) RORg =28.6/o>i* =25"/o
Project ROR for each alternative is greater than the new minimum
ROR, indicating acceptable economics for both. lncremental analysis
is the optimization analysis that tells whether "A" or "B" is the better
economic choice.
B-A) RORB -A=21o/o <i* =25o/o, So reject "B"
Since the "B-A" ROR is less than "i* =25o/o", the incremenlal year
0 and year 1 expenditures in alternative "8" over "A" are not justified.
Alternative "A" becomes the correct investment choice. Recognize
the critical importance of minimum ROR to project economics.
Changing "i " from 12o/o 1o 25% switches the economic choice of
investment from alternative "B" to "A". NPV and PVR analysis verify
this conclusion.
chapter 4: Mutuarry Excrusive an.d Non-Mutuaily Excrusive project Anarysis
181
NPV Analysis.for i*
=21o/o
3.329
NPV4 = 6O(P/AZSy",A) - 150 = +$49.24 ,
3.161 0.8000 0.8000
NPVg = 120(PlAZ57.,)(P/F2So/o,1) - 90(p/F25
"7",1) - 2OO
= +$31.46
At i* = 25"/o, alternative "A" gives the largest NpV and is therefore

the correct economic choice. lncremental evaluation confirms this:
NPVg-4 = 31.46 - 49.74= -18.28, so reject,,B,,
. Note that you cannot use the Npv results calculated for a 12o/o
discount rate to achieve valid economic conclusicns for a 2s% dis-
count rate.
PVR Analysis for i* = 27r/o
PVR1 =
NPV4 49.74
PW Cost4 1S0
=.33>0
NPVg 31.46
PVRg =
PWC"ttB=2@='25>o
PVRe-4= pwc"ffi=ffi-
NPVg-4 31.46 49.74
,,8,'
= -.'1 0 < 0, so reject
NPV and incremental RoR and pVR indicate that alternative ,,A,, is
the correct investment choice when the minimum rate of return is2s"/".
Note that NPV and PVR must be recalculated at the appropriate
mini-
mum RoR in order to make correct economic decisions. ln this exam-
ple, NPV and PVR at i* 12/o cannot be used to evaluate
= the alterna-
tives when the minimum rate of return has changedro 25%.
&
4.3 Mutually Exclusive rnvestment Anal.ysis using Growth Rate of

' Return and Future Worth profit Methods
It
was mentioned in the summary of the Example 4.1 Res. analysis that
Grorvth RoR analysis is applied to evaluate mutually excluiive alternatives
in the same way regular RoR analysis is applied. This means calculating
Growth RoR on both total investments and incremental investments to ver-
ify that both are greater than the minimum ROR, ,,i*,,.
Looking at future worth profit for decision purposes is just a variation of
the Growth RoR or Net Future value evaluation techniqu"i. Th, objective
of
all investments from an economic viewpoint is to maximize the profit that can
be accumrilated at any specified future point in time.
from a giien amount of
startirtg capital. Instead of using analysis methods such as RoR, Growth
RoR, NPV NAV NFV or PVR to achieve that investment objective, another
ralid evaluation approach is to directly calculate the futuie worth profit
(future value) that can be generated by investing
a given amount of capital in
difl'erent*'uvays and assuming the prohts can be reinvested at the
minimum
RoR, "i""', when the profits are received. The investment choice that gives
the maximum future worth profit is the same choice we would get using
RoR, Growth RoR, NPV NAV NFV or pvR analyses. The following
ple illustrates the Growth RoR and future worth profit techniques. "ruo,-
EXAMPLE 4-5 Growth RoR and Future worth profit Analysis

Use Growth RoR analysis for a nrinimum rate of return of 15% to
determine which of the following mutually exclusive alternatives, ,,A,,
or "B", is best. Verify the result with future worth profit analysis and
NPV analysis.
All Values in T'housands of Dollars, c = cost, I = lncome, L = salvage
A) C=200 l=80 l=80

0 L=200
B) C=300 l=150 L=140 Declining Gradient

L=0
chapter 4: Mutuary Excrusive and Non-N4utuary
Excrusive project Anarvsis
183
Solution:
Both Growth FroR and Future worth profit anarysis,
Fii'}v, NAV I\JFV and reguiar RoFi anarysi. as weil as
ur.qEn" ttiaiiesiouar cap_
itai nct invested in one.of the projects and
iircomes as they are
leceiygd can be invested ersewhere at the minimum RoR, which is
i =15"/" for this anaiysis. This gives the foilowing orowtn RoR
future worth income (profit) and
.r,.ilrtion.,
Growth Bate of Return Analysis
Alternative "A,,i
A) C =-?e9 l=80 l=80

0.1 L=200
Reinvest "l" and ,,L,at i"
= 1S"h
C=200
C=80 C=80
F = 1,298
.8
where F = B0(F/A
1b"/",g) + 200 = +1,29g
A + Reinvestment of lncome
C=200
F = 1,298
Growth ROR4 pW Eq: 200 1,29g(p/F1,6)
=
Growth ROR4 i = 26.Syo > i" .157o, so
= satisfactory
Alternative "8,':
B) C=-300 l=150 l=140 declininggradient,'L=0

0
- 15"/o
Reinvest lncome ali*
_____9= 1s0 C = 140 declining gradient

O l----- ,- .......8 F=1,677
where F = ['t S0 - 1 O(A/G1 S1l^,g)]F/ nlSy",e)
= 1,627
B + Reinvestment of lncome
C =_t99_
0 F = 1,677
Growth RORg PW Eq: 300 = 1,627(plFi,g)

Growth RORg, i = 24.1o/o > i* = 1]5/o, so satisfactory
lncremental Growth ROR Analysis (.,8-A',)
(B_A) C = 100
F=379
Growth ROR3_4 PW Eq: 100 = 379(p/F;,g)

Growth ROR3-4 = i = 1 8.4/o >i* = 157o, indicating Select,,B,,
Project "B" does not have the largest GroMh RoR on total investment
but incremental analysis indicates that "B" is the economic choice.
Future Worth Profit Analysis

Future worth profit analysis uses the future worth profit calcula-
tions from the Growth ROR analyses. lf $300 thousand is available to
invest, putting.$200 thousand of it into alternative "A" and reinvesting
i
the profits at = 15% will generate a future value of g.l,2gg thou-
sand in I years. lnvesting elsewhere the $100 thousand of our g300
thousand that is not needed if we choose ,,A,,gives:
(B-n; c = 100 3.059

1...........8 F = 100(F/P1S%.8)
= $305.90
Therefore, the total future value g years from now of $200 thou_
sand invested in project "A" and 9100 thousand elsewhere is g'1,2gg
thousand + $30S.9 thousand or g,|,604 thousand. This is not as
great as the future worth of "8" calculated to be g1,677 thousand, so
select "8". This is the same conclusion reached with Growth RoR
analysis. NPV analysis indicates select,,B,, as'follows:
chapter 4: Mutuarry Excrusive and Non-rJutualry Excrusive project
Anarysis 1g5
Npv4 = -200 . sop,/ll:;,g + eoo(#i33rlr, = +$zz4

2.781 4.4t7
NPVg = -800 + [1S0 - 10(A/c1s%,g)Xp/ArSZ.e) = +$248
ordinary compound interest RoR anarysis cannot

be used on this
problem and many similar problems because
of difiiculties eflclr.;r_
tered with the incrementar RoR anarysis. Evaruation
of ordinary com_
pound interest RoR on totar investment shows
that the rates of
return on projects ,'A,'and ,,8,, are satisfactory.
gives the following time diagram:
tncre*entrt ,;;;;
(B.A) C= 100 l-70 l=60.....1=0
1 2........8 L= -200
This time diagram has inbrementar cost foilowed
.
income followed by negative incrementar sarvage
by incrementar
vatue which is the
same as incremental cost. This is the type of
inalysis situation that
generates the duar RCR probrem discussed
rater in this chapter.
Regular RoR anarysis cannot be used in this
situation for reasons
that will be given iater. This is why it is important
to be familiar witn
other techniques of anarysis src-h as Growth
RoR, Fr-,ture worth
Profit, NPV NAV l',jFV or pVR.
4.{ Changing the }Iinirnum Rate of Return with Time

The minimum rate of return (opportunity cost of
capital or hurdle rate)
represents the rate of return that we think
we could get by investing our
rTl(,r'Iey elservhere, both now ancl in
the future f,rr the p"iioa of tlln. coverecl
by the project evaluation life. There is little reason
to expect that our other
,pportunities rvill remain uniformly the same over
a long period of tirne.
while other opportunities for the irwesrmenr of capital
lAcic, we may expect a major project with
,o* -oy i" *"I'=
a proiectid 207c RoR to be dever-
oped starting three years from norv which
could absorb all of our available
capital and raise "i*" t-o-zoEo. For anaryses with
minimum rates oJ return
that change with time, Npv NFV pvR a-nd Future
worth profi:.t anarysis are
recontmended as the best and reail1' the onry
usa.ble analysis methods. Regu_
lar RoR and Growth RoR are not always consistent
o"i.i", if you
"riteria
do not have a single minimum RoR to which you can compare

them. Simi-
larly, you cannot calculate NAV,with different,minimum rate
of return values
at different points in time. For analysis simplification reasorls,
most investors
including major companies assume theii minimum Rofr is uniform
and
equal over project evaluation lives. However, changing the
minimum rate of
return is illustrated in the following example to demonstrate proper
eco-
nomic analysis techniques for this situation.
EXAMPLE 4-6 Effect of changing the Minimum Rate of

Return
With Time
compare the economic potential of mutually exclusive investments
"A" and "8" using NpV and rate of return anaiysis. Assume
the mini-
mum rate of return is 30.0% in years one and two, changing
to
12.a"/o in years three through ten. Then re-evaluate
the investments
using a 12.0% minimum rate of return over the entire ten year project
life and then again using a 30.0% minimum rate of return over
the
entire ten year project life. comparison of these results emphasizes
the importance of the minimum rate of return in investment decision-
making from an economic viewpoint.
A)
C=20 l=10 l=10 l=10 l=10
L=20
3. .10
B)
C=30 l=12 l=12 l=12 l=12
L=30
Solution, All Values in Thousands of Dollars:

Net Present Value, Changing i* From 30olo in years 1 &2
to 12o/" Over Years 3 to 10
NPV4 = -20 + 10(P/A3g,2) + 10(p/A1
2,e)(p/fr1,r1
+ 2O(P/F 12,6)(P/F3g = +22.ZB
,2)
N PVg = -30 + 1 2(P l Agg,2) + 1 2(p t A1
2,g) (p /F gg,2)
+ 30(PiF12,8)(P/FA0,2) = +28.78
These results indicate virtual break-even economics between ,,A,,
and "8" with a very slight one thousand dollar present value advan_
chapter 4: Mutuaily Excrusive and Non-Mutuaily
Exclusive project Anarysis 1g7
tage to "8." However, if we consider the

minimum rate of return to be
uniform and equar over time at either 12.0%
investors usually do, we get different results.
or 30.070, as most
Net Present Value, i* the entireirolect Life

= 1i2o/oover
NPV4 = -20 + 10(p/A1
2,10) + 2O(P/F12JA) = +42.94
l{PVg = -30 + 1Z(plA1Z,td +30(p/F12.tO)
= +42.46
Select B v;ith Largest NpV
Net Present Value, i* 30% Over the Entire project

= Life
NPV4 = -20 + 10(piA3g,1g) + 20(piF3O,1
0) = +12.17
Select A with Largest NpV
l.JPVg = -30 + 12(p/Agg,1g) + 30(piF3O,10) = +9.27.
Assuming uniformry equar discount rates
.
given different economic conclusions
of 12.0% or 30.0% has
than the break-even economic
conclusion reached by changing the discount
rate with time in the ini_
tial analysis. Most companies oL not want
to get involved in the addi-
iional level of confusion invorved with changin-g
ilre oiscount rate with
respect to time. Therefore, even thougn
a Joripanv Lno* they have
other opportuniti". investing .rpit"t at a reraiiv"ry nigr, rare of
return such as 30.0% J?f
for the next'severar years, tottoweo by an
assumed rower rate-such as 12-o"/o, tl"y
simprify the anarysis by
using a 12.0% rate of 'return over the entire
evaluation life. This exam_
ple shows that such a simprifying assumption,
with respect to the
evaluation discount rate, can nivJan effect
on economic investment
decision-making.
Rate of Return Analysis
I,v_Eq.A 0 = -20 + 1l(lfi,r6) + 20(p/F;,16)

By Trial and Error. i = RORA lbO.OV; >
i*'="C0.07o or 12.0o/o,
so satisfactory
lW_Eq B 0 = -30 + 12(pifi,ro) + 30(p/F;,1s)
By Trial and Error, i = RORfi'J 1O.OU >
i*'-50.0% or 12.Ooh,
' so satisfactory
Economic Evaluation and lnvestment Decision Methods
lncremental rate of return analysis is needed now to determine the

optimum qhqice .since both "A' and "8" have satisfactory.total invest
ment rates of return compared with investing money elsewhere at
either i" = 30.07" oI i* = 12.O"/". +
B-A)c19 l=2 l=2 !=2.-.'.-,-.-,-.-.' E t=lo

0 3...........10
PW Eq B-A 0 = -10 + Z(PlAi,1O) + t0(P/F;,19)
By Trial and Error, i= RORB-A =20'0"/o < i* = 30'07o but > 12'0%
The investor cannot tell with rate of return analysis whether the
incremental "B-A" investment is satisfactory or not relative to investing
elsewhere at 30.0% over the next two years and at 12.O% over the fol-
lowing eight years. The fact that rate of return analysis of projects often
breaks down and cannot be used when discount rates that vary with
tirne possibly is one of the main reasons that changing the discount
rate with time is not more commonly applied in industry practice. A
large majority o{ companies emphasize rate of return analysis over the
other techniques of analysis and that cannot be done if discount rates
are changed with time. Notice that for a uniform minimum discount rate
of either Q.A"/o or 30.0% over all ten years, incremental rate of return
analysis gives economic conclusions consistent with NPV analysis
conclusions. Select "B" if i* = 12.0o/", select "A" if i* = 30.0%.
Finally, if firms are utilizing a discount rate based on financial cost

of capital, that number is very likely to be changing over project lives
the same as opportunity cost of capital changes. once again how-
ever, rather than trying to forecast those future changes, most compa-
nies use a financial cost of capital calculated today, aS reflecting the
average financial cost of capital over the project life. We do not advo-
cate the use of financial cost of capital unless unlimited financing is
assumed to exist so that financial cost of capital equals opportunity
cost of capital. Remember that it is always opportunity cost of capital
that is relevant for valid discounted cash flow analysis of investments.
Chapter 4: Mutually Exclusive and Non-Mutr;ally fy11r.;u" prcjeci
Analysis 139
4.5 Differences Between Net varue Anarysis and cost Anarysis

Thcre is a tcndency for pe,lpre to get confused c.ncernin-e
the .iifference
between Present worth (pw), Annual worth (Aw),
or Euture *onr, (FW) cost
aral-vsis of sei'rice-producrng alterniilives an.i Ner pre-sent
Value (Npv), Net
A-rmual \alue (NAv) and Net Furure Value iNFV)
an*l1,sis of income-producing
aitei-;;atives or dirferences betrveen senice-p;,;d,rcing
allernatives. 11ey are simi_
lai'b.rt very difi.'rent because of sigri uoniinirr;n dir.r.rences.
co.sr nm!.ysis is
u'seti ro evaius.le ser,-ice-producittg inve:rmerti.t.
lvhen L.cst., can1. a positive sign
and any revenlies or s,lvag,e a:'e negatiu'e, the net c.ost lpicsen.t, annuar or
l,arues
.futurc, discounted at "i"') is a positi,e nurnber wirh this ,ign rorrr"ntionfor
Lrnau-Zing altemcfiy,e wa\'s of prcv,idbry a serv,ice,
the minimunt cost option is
selected- Net vcilue analysis, horvet,e4 i.s used to
asses.i i*orte-protrucing
projects or incrcmental differences betw,een seruice-producing "hhu
pt-ojects usirtg
corn'entional cctslt flow' anarysis sigti ctstweniitrt t'herc
,rrt, i,i negadte and
t?t'i.turcs are positive, so the altenntit.e yielding nu:xilnrun
net v-altts is selecud.
To uiliize cost e*ralysis in rhe e'aluation of sirvicetroarcing
altematives, you
work with the given or estimated costs for each individual
alteriative way of pro_
viding a service. To utilize net value anaiysis in service evaluations,
you must
work with incremental savings that incremental costs will generate.
Net v'iue
analysis is just a short-cut form of rate of rerurn anelysis.
Foinet or rate of
tetLlm attalyses, )'ou must look at the incremental 'alue
differences betwecn altemative
rt ays of providing a se^,ice. The foliowing
exarnple illustrates these techniques.
EXAMPLE 4-Z A Comparison of present Worth

Cost and
Net present Value Analysis Criteria
Economic anarysis of the optimum thickness of insuration
for a
steam line needs to be made for an investor with a minimum
rate of
return, i. = 12.0"/". Engineering has arrived at the following
estimates
for installed insulation costs and the annual heat loss
resulting
"o.t, in the
for tlre different amounts of insulation. This data is summarized
following table:
lnsulation Cost of Annual
Thickness Heat Loss (Per Year
0"
1"
$o $40,000
$ 60,000 $20,000
2" $ 85,000 $10,000
3" $1 18,000 $ 6,000
Assume the insulation and project life are eight years with zero
salvage, valuq,,and.bgse your analysis resutts on.both present wsrth
cost analysis and net present value analysis. The 0"'option repre-
sents the current situation, so in calculating net presnt value, com-
pare the current situation with the other amounts of insulation.
Solution: Present Worth Cost Analysis
0" lnsulation 40,000(P/A12,g) = g1gg,704

1" lnsulation 20,000(PlA12,g) + 60,000 = g1Sg,g52
2" lnsulation 10,000(PlA12,g) + g5,000 = g134,676* Minimum Cost
3" lnsulation 6,000(PlA12,g) +11g,000 = g147,g0s
" Selecting two inches of insulation will minimize the present worth
cost. This is illustrated in Figure 4-2.
200,000
o 150,000
oo
o
100,000
=
o
a
o
o- 50,000
0
0 lnches 1 lnch 2 lnches 3 lnches
lnches of lnsulation
Figure 4-2 Present Worth Coit Analysis
Chaprer 4: Mutually Exclusive and Non-MutLrally Erclusive project
AnalVSis 191
Net Present Value (lncremental Analysis)

For NPV analysis, carcurate the incrementar savings
for one, two
and three inches of insulation compared to the currenisituation
of no
insulation. ln other r/,;ords, if $00,000 is spent Today for
one inch of
ir:suiation, the investor can s.i.,,/e $20,000 in annuai heat
loss costs
-20,C00 - (-40,C00) = +20,000 savings
=$c
1"--0" 20,000(P/A 12,8) - 60,000 = $3g,352
2"-0" 30,000(P/A12,S) - 85,000 = $64,028 * Maximum NpV
3"-0" 34,000(PiA12,B) - 118,000 = $S0,ggg
* seleciing
two inches of insulation now maximizes the net present
vaiue obtainable from these investment alternatives.
This is illus-
traied in Figure 4-3.
70,000
60,000
o
:(E
50.000
;o 40,000
o
E
o.
30,0c0
i zo,aoo
10,0c0
0
0lnches 1 lnch 2 lnches 3 lnches
lncremental lnches of lnsulation
Figure 4-3 lncremental Net present Value Analysis
lncremental Analysis (lnch by Inch)

lnstead of comparing each alternative with the current scenario
of
zero inches, each additional one-inch of insulation investment
could be
thought of as representing mutuaily excrusivery income producing
(sav-
ings) alternatives. These alternaiives rangs from doing nothing (0,,
option) to spending the money tor 3" of inJulation. whei the
alterna_
192 €conomic Evaluation and lnvestment Decision Methods
tives are compared with the current "do nothing,,scenario, the individ-
ual economics were determined. Next, the inih-by-inch incremental
analysis for each of these mutually excniriv"
Oras;;;:'
1o4' 20,000(P/A1e;A) - 60,000'E $39;B5Z
,, ---
"it"iriiiiv.r'is
b
As discussed in previous examples in chapter 4, the incremental
NPV of $39,352 teils us that 1" is better than doing nothing. There-
fore, the next level of initial capital investment is coripared to
the last
satisfactory level, as follows:
2'-1' 10,000(P/A12,g) - 25,OOO = g24,676
5a,2" add value over the 1,, option.
Note aiso that the NpV2,
- NpV 1,, gives the same result:
$64,028 $gg,os2 = g24,676
-
comparing the next level of investment to the last satisfactory level
gives:
3'-2' 4,000(P/A1 2,g) - 93,000 = -$1g,1 29
select the largest level of investment for which incremental eco-
nomics are satisfactory. This is two inches of insulation as deter-
mined by the earlier incremental NpV analysis.
The inch by inch incremental process would be more essential
had
rate of return analysis been asked for in this problem as investors
can't expect individual total investment rates of return to consistenfly
determine which alternative is best. ln this example, the results
would be the same by relying on individual RoR criieria, but
this is
not always the case.
Alternative Rate of Return

1',-0" 29"/"
2"-0' 31"/"
3',-j', 23%
2',-1" 37% 2" is preferred to 1"
3',-2', -17o 2" is pretened to S"
9o, 2" is the largest level of investment satisfying both the individ-
ual and incremental economic criteria and is the-ec6nomic choice.
criapter 4: Mutuarly Excrusive and Non-Mutuaily Excrusive project
Anarysis 193
4'6 Effect of Evaruation Life on Economic Anarysis Resu.rts
It n'as illustrared in chapter 3 Example 3-24

thatproject Iife has little
eti'ect on analysrs results when you get biyond 10
orrl5 years, depending on
tite p.oiitabiiity ,ri the projects being evaluated. However,
for shorter life
pr.;jects ri irh er.'aluation lives under 10 years,
the evaluation life used can
atiict tiie economic choice significantry. For example, sometimes
the life
o\cr \\lrich u'e choose to evaluate a process improvement
is very *uit*riiy
chosen due ro the uncertainty assocLted with
irojecting savings in certain
prodess analyses. The following illustration
shows how evaluation life can
affect economic results in this relatively short evaluation
life situation.
EXAIIPLE 4-B Effect of Evaruation Life on comparison

of rwo
Alternatives
Evaluate two different levels of improvernent being

considerec for
an existing process. The new equipment costs anc
f,rojected annuar
savings in labor and materials are as fcllcurs:
Equipment projected Annual

.--qg$_ Savings
Level 1 $200,000 $125,000
Level 2 $350,000 $18O,0OO
For a minimum RoR of 2oo/o evaruate Levers 1 and.2

using NpV
analysis assuming zero sarvage varue for (A) a 3 year
evaruati6n rife,
and (B) a 5 year evaruation life. (c) For what evaluation rife
would
there be no economic differences beiween the arternatives?
Sclution, All Vatues in Thousands of Dollars:
A) 3 Year Life
2.106
NPVI = 125(P1AZO"/"5) - ZOO = +$63.25 Select Maximum NpV
2.1 06
NPV2 = 1 9O(P/ AZA%,3)- 3S0 +$29.08.
=
B) 5 Year Life
lncreasing the evaluation life enhances the economics of both
alternatives. However, the economics of bigger initial cost alterna-
tives are always enhanced relatively mo!'e rapidly thantmaller initial
cost alternatives by lengthening evaluation life (or lowering the mini-
mum discount rate). ln this case the economic choice switches to
selecting Level 2 for a 5 year life whereets Level 1 was preferred for a
3 year life.
2.991
NPVI = 125(P|AZO"/",5) -200 = +$173.88
2.991
NPV2 = 180(P/Az O/",s) - 350 = +$188.38 Setect Maximum NPV
C) Break-even Life "n"

When there are no economic differences between the alternatives,
NPVl will equal NPV2. lf we write an equation setting NPVl=NPV2
for an unknown life "n", we can solve for the break-even life "n".
125(P / A21o/o,n) - 200 = 1 80(P/A2g7",n) - 350

or, 150 = 55(p/A2g7",n)
(PlA2g"1",n) = 150/55 =2.727

By interpolation in the P/A1,n factor column of the 20% tables we
get o = 4.34 years. Select Level 2 for an evaluation life greater than
4.34 years. Select Level 1 for an evaluation life less than 4.34 years.
4.7 Investment Analysis When Income or Savings Precedes Costs

\\''hen income or savings precedes cost, ROR analysis leads to the calcula-
tion of "i" values that have rate of reinvestment requirement meaning instead
of rate of return meaning. These results must be used very differently than
ROR results since "rate of reinvestment requirement" results greater than the
minimum ROR are unsatisfactory (instead of satisfactory with regular ROR).
This is illustrated in Examples 4-9 and 4-10.
Chapter 4: Mutually Exclusive and Non-Mutually Exclusive Proiect Analysis 195
EXAMPLE 4-9 Analysis of Mutually Exclusive Alternatives When

lncome Precedes Cost
Consider the foilowing problem. Evaluate the. follorving two mutu-
Grov;thhOR, Future \l/orth
all;v exclusive aliernatives using ROR,
Profit, NPV and PVR. The minimum rate of return i* = 107o.
A) c = $100,000
L = $305,200
1............5
c = $100,000 I = 941,060 I = $41.060
B) --=' L = $0
Rate of Return Analysis

A) PW Eq: 0 = -100,000 + 305,200(P/F;,5), i = ROF1A =25"/"
B) PW Eq: 0 = -100,000 + 41,060(P/A1,5), i = RORB = 30"/o
Since the initial costs of projects "A" and "8" are equal, many
people conclude there are no incremental differences in the orojects,
so, "8" is the choice, since "8" has the larger ROR on total invest-
ment. This is incorrect! Looking at "A-8" so incremental cost is fol-
lowed by incremental revenue we get the following: (remember nega-
iive incremental income is equivalent to cost)
A_B) C=$0 c = 941,060 c = $41,060

L = $305,200
0 1............5
A-B) PW Eq: 0 = -41,060(P1A1,5) + 305,200(P/F;,5)
ROR4-3, i = ZO.O"k > 10.0% so, accept "A"
Even though project "8" has the largest ROR on total investment,
project "A" is the economic choice from incremental analysis. Differ-
ences in the distribuiion of revenues to be realized cause incremental
differences in the projects that must be analyzed.
The year one through five incremental costs of $41,060 per year are
referred to as "opportunity costs" by many people since they result from
the following rationale. Selecting project "A" causes the investor to forgo
realizing the project "B" revenues each year. Revenues or savings fore-
gone are lost opportunities or "opportunity costs", so selecting "A"
causes opportunity costs of $41,060 in each of years one through five.
I'
lf you look at "B-A", you get incremental income followed by incre-

mental cost so the following rationale-applies:,.,. ;i. ;;
B-A) C=0 l-$41,060 l=$41,060 +

0 1............5 c = 9305,200
B-A) PW Eq: 0 = 41,060(P/A1,S) - 305,200(P/F;,5)

i = 20.A/" > 10.0% so, reject ,'B,'
(This B-A "i" value does not have rate or return meaning. lnstead, it
represents the rate at which funds must be reinvested to cover the
year five future cost of 9005,200. See the foltowing discussion)
The incremental numbers and trial and error "i" value obtained,
are the same for "A-B". However, note that on the "B-A" time dia-
gram incremental income is followed by cost. tt is physicaily impos-
sible to calculate rate of return when income is fottowed by cost.
You must have money invested (cost) foilowed by revenue or sav-
ings to calculate rate of return. when income is foilowed by cost you
calculate an "i" value that has "rate of reinvestment requiretnent,'
meaning. The "B-A" incremental "i" value of 20"/" means the investor
would be required to reinvest the year one through five incremental
incomes al20"h to accrue enough money to cover the year five cost
of $305,200. lf the minimum ROR of 1Oo/o @presents investment
and reinvestment opportunities thought to exist over the project life,
as it should, then a reinvestment requirement of 2a% is unsatisfac-
tory compared to reinvestment opportunities of 107", so reject ,,8,,
and select "A". This is the same conclusion that the "A-8,, ROR
analysis gave.
Summarizing several important considerations about the RoR anal-
ysis for this problem, for the incremental RoR analysis of alternatives
"A" and "8" we discussed the need to subtract alternative ,,B,,from
alternative "A" so that we had incremental costs followed by incremen-
tal revenues. Then we discussed what happens if you incorrectly sub-
tract alternative "A" from "B" as follows:
B_A) C=$0 | = 941,060 1=941 060

c = g3o5,2oo
Anarysis 1S7
lncrementar "B-A" incomes of $41,060 each year precede

the
$305,200 incrementar "B-A" cost at the end ot'yeaitive.
income precedes cost, the "i" that we carcurate when
is the interest rate
tnat must be obtained through the reinvestmeet
of the income each
period, for the finar value ot ine cumuiative
incomes and compound
irrterest to equal the cost at that time. A required
reinvestment rate
greater than the minimum RoR is unsatisfactory,
whereas an RoB
gi-eater than the minimum RoR is sairsfactory.
rigure 4-i shows lhe
cumulative cash position diagram for this situaion.
Note that the
cumulative cash position in this example is positive
project life. whenever the cumularive cash position
durin! the entire
is jositive, no
investment is invorved and the interest rate ,,i,,
means the rate at
rvhich money must be reinvested and not the rate
investment.
of return on
sbo,ooo
"B-A" 264,492
CUMULATIVE
CASH 200,000
POSITION
tor i = 20"k
100,000
345
Figure 4-4 cumurative cash position for rncome preceding
cost
Given that the minimum RoR is 10%, do we accept arternative

"A" or "B" for the exampre just discussed?
As previously mentioned,
if investment preceded income, we wourd accept ariernative ,,A,,
because an increm entar 20"/" RoR is better than
investing else-
where at a 10% ROR. However, if "B-A, incremental income pre-

cedes cost, we would be rejecting projec! ,,B',, becausE the "B-A"
rate of reinvestment required al2o"/" exceeds the other opportuni-
ties we have to invest capital.which is assumed to be @o/o. ,
Future Worth Protit Anatysis from 9100,000 tnitial lnvestment

A) FW Profit = $305,200
6.1 05
B) FW Profit = $41,060(F/A10%,5) = 9250,671
Select Project "A" to maximize future profit.
Since the $100,000 initial investment is the same for both ,,A,,and
"8", maximum future profit (value) on total investment is desired.
GroMh Rate of Return Analysis

A) Growth ROR4 is equal to the regular ROR4, = 2ilyo
B) Growth ROR3, PW Eq: 0 = -100,000 + 2SO,6Z1(p/F;,5)

GROR3 =i=20.2/o
since the same $100,000 inilial investment is involved with both
"A" and "8", we want the alternative with the largest Growth ROR,
"A". lncremental analysis gives the same conclusion.
A-B) GROR PW Eq: O = 54,529(P/F;.5)

GROR4-g = i = o/o > 10.0% SO,' SeleCt "A" OVer "8"
Net Present Value (NPV) Analysis

0.6209
NPV4 = 305,200(P/F:o"7",$ - 100,000 = +$89,500 <- Select,,A,,
With Max. NPV
3.791
NPVg = 41,060(P/A16./.,5) - 1 00,000 = +$SS,70O
NPV4-g = 89,500 55,700 = +$33,800 Therefore, Select "A",

-
consistent with selecting the project with the larlest NpV.
C,rap1s|.4: Mutually Exciusive and Non-lvlutuaiiy Exclusive prolect Analysis '199
Present Value Ratio (PVR) Anatysis

PVR4 = 89,500 / 100,000 = .895 > 0, acceptable
PVFtg = 55,700 / 100,000 = .557 > 0, acceppble
3.1 699
PVR4-3 = (89,500 *
55,700)14i,060(PlA1 A"h,4)
= 33,800i130,155 = C.26 > 0, so select "A".
When each of these evaluation methods is properly applied you con-

sistently come to the same economic conclusion. you only need to uti-
lize one method to make a proper evaluation. Here, as in other examples
throughout this text, multiple criteria solutions are presented to illustrate
the consistent results obtained with any of the evaluation methods.
Proper incremental analysis is the key to the evaluation of mutuaily
exclusive alternatives where only one alternative may be selected.
EXAMPLE 4-10 Rate of Return, Net present Vatue and

Rate of Reinvestrnent in Analyses
When lncome Precedes Cost
Your cornpany has been asked to consider a proposal to accept a
payment of $12 million today and $25 million at the end of one year
from now in order to handie cirsposar of a waste product from a facil-
ity for each of the next 10 years, (enci of years one through ten). your
esiimated costs for disposal of this material include a time zero capi-
tal investment of $5 million with end of year one through ten operat-
ing costs of $4 million per year. The minimum rate of return is '15.0%.
Use ROR and NPV analysis to determine if the company should
accept this opportunity?
lncome:12.0 25.0
Costs: -5.0 -4.O -4.A. ...-4.O
Year 0 1
Net CF: 7.0 21.0
NPV @ 15.0o/o: 7 o - 4.0(P/A15,9)(P/F15,.1)

! ?](PiFrs,r)
>
= $8.66 0, acbeptable
This analysis has income preceding costs, so the

meaning of the
calculated "i" value that makes Npv eq-ual zero
is rate of reinvestment
req ui rement, not rate'of i.eturn. Therefoie,
a req'uired,rnua-strl.i: r"i"
that is less than our minimum rate of ret
inu"ri* nt o p'p oiii, n ti e s) s acce ptanr Ji'x' ;[Et]
i i
#?;?y:i ili?'l*f
"
ment greater than i* = 15.0% wourd be an unacceptabre project.
PW EQ: 0 = 7.0 + 21(ptFi,1) - 4.0(p/Ai,9)(p/F1,1)
Rate of Reinvestment = i 5.06% < 15.0"/o, acceptable.
=
q,
=
810
oq
o
1o
zo 'llk 15k 2Ao/o ZS/, ZO/o g1o/o A}a/a 43% S07o
(s)
(10)
Discount Rate
Figure 4-5 Npv'vs i. with Rate of Reinvestment
Meaning
As illustrated in Figure 4-s, when NpV increases with
spondingly higher discount rate it is generally
a corre_
the result of income
preceding costs and the presence of rate
of reinvestment meaning
associated with each i* varue. This situation
courd be thought of in
two different ways; First, rarger discount rates
arways diminish the
present vafue of future cash flows more
rapidty than imailer discount
rates. second, as other opportunities for ine
Lse or iipitut increase,
the money received up front at time zero and year
one can generate
more future value creating more profit relative
to the estimated down
stream cosfs.
once again note that the "i" carcurated when investment precedes
income has compretery different meaning than
when income pre-
oedes investment. Difficurty arises if these two
types of projects are
mixed in incremental analysis because the interest ,,i,,has
two differ-
chapter 4: Mutualry Excrusive and Non-filutuaily Excrusive project
Anarysis
ent meanings in the same equation. Techniques for analyzing

this
type of investment project situation are presented in the foll6wing
section. lt will be shown that the cumulative cash position
diagram is
a useful tool in the evaluation of this type of prublem.
4.8 Alternating Investment, Income, Investrnent:

The Dual Rate of Return Situation
In the last section, examples 4-9 and 4-10 illustrated situations

where income
preceded costs. Discttssion then focused on how the
meaning of the calculated
"i" r'a]ue was not rate of return, but the rate at which the rev"enues (or positive
cash l1orv.t tlust be reinvested to ilssure sufficient revenues
exist to cover future
costs. When this occurs, thc resulting rates of reinvestntt:nt
that are less than the
investor's minimum rate of retum are considered economically
satisfactory.
Extending this concept, when a time dia,qram contairs cash
flows with an
initial investment, foilowed by income and then more investment(s),
the
related present w'orth equation will yield muitipie ..i', values.
Thcse ,.i,,
will airval's contain a combination of meariing related to both rare of
'alues
retJill on the iriitill irtveslntcnt as weli as rilte of reinvestment
requirement
relarod to ectrnomicallv corering rl:e cost(s) in the tuture years.
These,,i,,
vaiucs are olren rei'erred to as "Duai Rates of Return,,and generally
speak_
ir.ls. iire nor signilicant in assessing the econornic potential
o1a project. This
is due to the fact that despite the label, "Dual Rate of Return,,,
neither solu_
tio, has pure "rate of return" meaning. Instead, as mentioned previously, the
results contain a combination of rate of return and rate of reinvestment
meaning, which may be good part of the time, but unsatisfactory
part of the
time. This forces investors to consider other criteria such as Npv
or a modi-
fied forr, of rate of return ilrustrated in the foilowine examples.
Cash flows containing in'estment-income-investment timing
may occur
in a variety of investment situations. One such case involves the incremental
analysis of mutualll, exclusive alternatives that have different project
lives.
This is often defined as an acceleration probrem and is
to oil and
gas as well as mining investments. In depleting a finite, "o,rr*on
resource, the deci-
sion to accelerate the production rate through immediate capital
expendi-
ture(s) will shorten the life of the project. The incremental
analysis of these
alternatives creates the crassic in'estment-incorire-investment
siiuation.
Alternating investment, income, investment analysis situations occur in a

variety of situations. The most cornmon, which is illustrated in the next example,
occurs from looking at incremental differences between uneqdal life alterna-
tives where the bigger investment alternative has bigger period;revenues.and
sltorter project life. This is the classical acceleration problem nientioned pre-
viously cofirmon to mineral and petroleum development type projects where a
given mineral or petroleum reserve can be depleted more rapidly by making a
bigger initial investment. This evaluation situation also commonly occurs
with acceleration type investments in many different types of general industry
situations. Other examples of cost, income, cost include (1) An investment
in a building or project that generates income for several years after which
the building or project must be razed or restored to different condition;
(2) Mining projects that generate income followed by significant reclamation
costs; (3) Forest planting investments followed by clear-cutting which gener-
ates income but must be followed by forest replanting costs where envi-
ronmental laws or company policy require it; (4) Offshore platform develop-
ment fbr petroleum production that must be followed by significant platform
ree lltmation costs.
EXAMPLE 4-11 Analysis of Mutually Exclusive Unequal Life

Acceleration Type Projects
lnvestments "A" and "B" are mutually exclusive ways of developing a
project. Which is best if the investor desires a minimum rate of return of
20%? Make a valid ROR analysis using either Growth ROR or one of
two present worth cost modifications known as the "Escrow Approach"
or "Year by Year Approach." Verify those conclusions with NPV.
Solution, All Values in Thousands of Dollars:
I = Revenue, L - Salvage Value, C = Cost
A) C = 182 l= 100 l= 100 l= 100

0 1 2
B) C=250 l= 184 l= 184
Get equal life alternatives by assuming the lile of "B' is 3 years

with net revenue and cost of zero at year 3.
chapter 4: Mutually Exclusive and Non-Murually Exclusive prolect Anaiysis
203
Rate of Return Analysis, (ROR)

By trial and error the RORA = 3Oo/o and RORB 3Oo/o both of which
=
exceed the 20% minimum rate of return requirel for the inr,,estment
of
capiial. The investments and project live.s are ufiequal so it is difficult
to teii intuitively if "A" or "B'' is best for i' = ZO"/o. projects with equal
toial investment rates of return are not necessariiy economicaily
equivalent. lncrernental analysis gives:
B_A) C=68 l=84 l=84 C = 100
ROR PW Eq: 68 + 100(P/Fi,3) = B4(p/A;,2)

or, in NPV format: B4(P/Ai,2) - 100(p/F;,3)
- 6g = 0
i = 0"/" : 84(2.000) - 100(1.0000) -68 = 0
i = 10"/": 84(1.736) - 100(0.7513) - 08 = +2.69
i = 15"/": 84(1 .626) - 100(0.6575) 08 i.2.89
- =
i = 20"/": 84(1.528) - 100(0.5787) OS +2.48
- =
i = 307" : 84(1 .361) - 100(0.4552) 68 = +0.80
-
i = 40"/": 84(1 .224) - 100(0.3044) 6S
- = -1 .62
i=0% and i=33"3% are duar rates of return by triar and error.
+
50%
--t--F+-_]%
100%
rL
++
--f-
-r
rt
+
-T
Figure 4-6 NPV vs Discount Rate For Cost, lncome, Cost
100
Cumulative
Cash 50
Position in
Thousands for
i=0% 0.0
i= 33.3%
-50
-68
-1 00
Figurc 4-7 Cumulative Cash position Diagram and

The Meaning of Dual "i" Values
A graph of NPV versus the discount rate "i" as illustrated in Figure 4-6
emphasizes the parabolic variation in NpV with the discount rate
changes for this cost, income, cost situation. This is very different from
the declining exponential variation for NpV versus "i" when cost is fol-
lowed by income as illustrated earlier in chapter 3, Example 3-21. How-
ever, the term "dual rates of return" is really a misnomer because neither
"i" value means rate of return. Both "i" values have a combination rate of
return, rate of reinvestment meaning as the Figure 4-7 cumulative cash
position diagram shows. Note that a oo/o rate of return is bad compared
i
to = 20/o percent whereas a reinvestment rate o'f 0/o is good com-
pared lo 20/" reinvestment opportunities. Similarly, a 3o"/o rate of return
is good but a 33% rate of reinvestment requirement is bad. Both dual
ROR values are good part of tne time and bad part of the time.
Looking at Figure 4-7, whenever you are in a negative cumulative
cash position, the meaning of "i" is rate of return. On the other hand,
whenever you are in a positive cumulative cash position, the mean-
ing of "i" is rate of reinvestment requirement. Using the cumulative
cash position diagram, it becomes evident that the dual ,,i,, values
have different meaning at different points in time. Therefore, an
analysis method other than regular rate of return should be utilized. lf
ihapter 4: Mutuaily Excrusive and Non-Mutuaily Excrusive project
Anarysis
the investment decision must be based on a compound

interest rate
of return measure, severar modifications qan oe'rnaJe
to eriminate
the cost-income-cost sequence in the
wili be introduced and incrude Growth RoR,
tro*...*n i;;." ilffi;;
upe iscrow Approach
and the Year-by-year Approach. The rast two ippror"nus
times referred to as "present worth cost Modiiications.,,
are some_
r.rpv .*uv
aiso be utilized if an alternative to RoR analysis is
acclptable. The
net varue techniques are varid arternative anarysis
tecrrniques inai
avoid the "dual ROR,'problem.
Net Present Vatue Anatysis, (NpV)

For i* = 20"/o,lime zero is a common time for
all projects.
2.1 06
NPV4 = 100(P/AZO%,3)
- 182= +$28.6
1.528
NPVB = 184(?lAZA"k,Z) -.ZSO +$31..1 +_ Select ,,8,,,
= Largest NpV
Growth Rate of Return Anatysis
There is no need to carcurate Growth RoR for the ,,A,,
total investments. we arready know that ,,A,, and ,,B,, dnd ,,g,
are satisfac_
tory from totar investment RoR anarysis, so we
onty neeo to
Growth RoR anarysis to the incrementar investments. "il[
the Growtn RoR reinvestment step eriminates tne Note that
art"rnliin"g*
investment, income, investment siiuation and gets
us back to
incrementar investment foilowed by incrementar
revenue, the RoR
analysis situation.
B-ur.;c = $68 l=$84 l=$84 C = $1oo

01 23
Reinvesting incremental year 1 and 2 incomes
ati" =20"k:
C=$84 C=$84
F = +$221.8
2.200 1.200
where F = 84(F / A2g"/",2)ff /p
2O%,1) = +$221 .B
B-A + Reinvesting incremental income:

B:A) C=$68 l-== +$121.8
F
3 +,:
PW Eq: 68 = 121.8(PlFi,g), i = Growth RORB-4=21.4/o > 2O/"
Select "B"
ROR Using the Escrow Approach

Another modification for ROR analysis that many individuals and
companies use to eliminate the alternating investment, income, invest-
ment situation is a present worth modification of the final cost. By dis-
counting the final cost at the minimum ROR, you convert the problem
to a regular cost followed by income type of evaluation. Working with
the incremental "B-A" diagram, discount the final year 3 cost of 9100
thousand at i* = 20%, giviig the following modified iime diagram:
0.5787-
l=$84
01
Modified PW Eq: 0 = -125.87 + 84(PlA1,2)
i = 21.6/o > 2Oo/o, Select "B"
NPV
Figure 4-8 NPV vs. Discount Rate For Modified PW Cost Analysis
chapter 4: Mutually Excrusive and Non-Mutuailv Excrusive project Anarysis
Explanation of the Escrow Approach

This present worth cost modified RoR analysis really involves adding
an outside investment earning at the minimum discouni rate to the initial
cost, income, cosi project. By seiecting the nra$nitude of the outside
investment so it wiil generate income in the later years equai to
costs fol-
iowing income in the initiai prolect, cost following income is eliminated.
B-A) C=$68 l=$84 l=$84 6 = 9100

+ 3
An Outside
lnvestment C = $57.g7 | = 9100
at i = 29"1o
23
0.5787
where "C" at time 0 = 57.87= 100(P/F;.=
20"/o3)
c = $125.87 l=$84 l=$84 _
= Total
Modifiect Present Worth Equation:
0=-125.BZ +84(p/Ai,2) i = 21.6"/" PW Cost Modified ROR
ROR Using the Year-by-year Modification
it is not necessary to present worth costs following income all the
way to time 0 to eliminate costs following income. lt iJonly necessary
to bring costs following revenue back one year at a time until they are
offset by income, as the following illustrates.
B_A) C=$68 l=$84 l=$84 c = 9100

+ 2 3
An Outside
lnvestment C = $83.3 I = 9100
at i* = 20"/o 23
0.8333
whereCatyear2= 1 OO(P lF
2g"/", t ) = $83.3e
C=$68 l=$84 I = $0.7

= Total
0 3
Modified PW Eq.: 0 = -68 + 84(PlFi.1) +.0.7(PlFi.2)
i = 24.4/o PW Cost Modified HOR
Adding an outside investment of 83.9 at year 2 to the uB-A" project

does not .weight,the PW',Modified RoR,as. lsw^as.adding,the invest-
ment of 57.87 at time zero. However, note that the zq.4y" modified
RoR result relates to very different unamortized invesment values
each year than the time zero 21.6% pw Modified RoR relates to.
Both results are economically equivalent even though different in
magnitude. The modification that eliminates cost following revenue
and modifies the analysis as little as possible is felt by many people
to be the most desirable modification to use, so the latter year 2
modification often finds use in industry practice.
All of the analysis methods utilized for this example, other than
regular ROR, have selected alternative "B" consistenfly. Any of these
techniques can and should be used in place of regular rate or return
analysis when the investment, income, investment type of analysis is
encountered. The combination rate of return, rate of reinvestment
meaning associated with cost, income, cost dual rates of return is
what makes the dual RoR results useless for valid economic deci-
sir:ns. The existence of dual rates is algebraically caused by the sign
changes in cost, income, cost equations. This can be illustrated for
incremental "B-A" analysis in this example.
B-n; c :igq l=$84 l=$84 C = $100
PW Eq: 0 = -68 + 84(PlFi,1) + 84(p/F

i,2) - 100(p/F;,3)
Mathematically:
0 = -68 + Bailt(+i)) + 8a(1/(1+i))2 - 100(1/(1+i))3
Substirute X = (1/(1+i)):
0 = -68 + 84X +84X2 - 100X3
This is a "third order polynomial equation" as a function of X. Alge-

braic rules indicate that polynomial equations may have as many
Anarysis
positive roots as sign changes, two in this

case. sorving for X: X = 1,
and_X = 314 gives i = O7o and i
= g3.A%. These are tf,e same dual
ROR results obtained earlier by trial and erroi..
t
EXAMPLE 4-12 Recramation costs can cause the

Duar RoR
problem
. An investment project requires the initiar investment of g70,000

to generate a projected stream of positive g40,oo0 per year
cash
flows in^each of years one througi'r tive. However, a reclamation
cost of $140,000 is expected to be required at year 6 (the year
6
reclamation cost could relate to restoration of srrface
land to origi_
nal contours for an open pit mining operation, recramation
offshore platform for an offshore pitroreum production project,
of an
or
reciamation costs for land cleanup from chemical
contanrination,
to name several possibilities). The minimum RoR is 2c7". Analyze
iire econornic potential of this project using both Npv and
RoR
analysis.
Solution, All Values in Thousands of Doltars:
C =7O l=40 l=40 l=40 l=40 l=40 C=140
when cost foilows revenue, correct RoR anarysis requires use of

one of the modified noR analysis techniques intioduced
in Example
4-11 (Escrow Approach, year-by-year Approach, or Growth
Rate
of Return). ln this exampre, the sum of ine posiiive cash frows is
$200 while the negative cash frows totar $21d. crea;ry,;ome of the
early cash flows will be utilized to pay off the initiii investment,
providing a return on that investment, while the remaining
positive
cash flows will have to be reinvesied at an interest rate if
enough
cash is to be generated to cover the future obrigation. This iilus-
trates the rate of return and rate of reinvestment-meaning
associ_
ated with all dual "i" values.
ROR Analysis Using an NPV Type of Equation

PW Eq: 40(P/A;,5)- 140(P/Fi,6) - 70 = 0
i = O"/" 40(5.000) - 140(1 .0000) - 70 = -10.0 +.
i = 5"/" 40(4.329) -140Q.7462) - 70 = -1 .3
i = 8"/" 40(3.993) - 140(0.6302) - 70 = +1.5
i = 15/" 40(3.352) -140(0.4323) - 70 = +3.0
i = 20o/" 40(2.991) -140(0.3349)- 70= +2.7
i = 25"/" 40(2.689) -140(0.2621) - 70 = +0.9
i=30% 40(2.436) - 140(0.2072) - 70 = -1 .6
Note that due to the "parabolic variation" of the NpV type equa-
tion results versus "i", by interpolation, Npv = 0 fgr the dual rates of
return of 6.40oh and 26.780/, Each of these rates makes the cumu-
lative cash position zero at the end of project-life. Both rates involve
a combination meaning of rate of return on investment in early pro-
ject life and rate of reinvestment rate in the later project years.
These dual rates cannot be used direcily for decision making pur
poses as ROR results. However, the dual rates do provide some
useful information because they bracket the range of minimum rate
of return values for.which project net present value is positive. This
tells the range of 'ri " for which the project is satisfactory. whenever
dual rates exist, it is easiest to rely on NpV analysis for decision
purposes. However, going to Growth RoR analysis or present worth
cost modified RoR analy.sis is equally valid, but generally more
work. NPV calculated at "i^" always leads to correct economic deci-
sion in this situation, whereas the dual rates problem makes RoR
analysis more confusing.
2.991 0.3349
N PV @ i* =2O/" = qA(P I AZOo/o,S)
- ltr;O(P lF 2g/",d - 70 = +$2.754 > 0
The NPV analysis is quick and simple to make and the positive
NPV result tells us the project investment is satisfactory, although the
NPV of +2.754 is only slightly greater than zero compared to the
magnitude of costs that generated it, so project economics effectively
are a break-even with investing elsewhere al2O"/o.
chapter 4: Mutuaily Excrusive and Non-Mutuaily
Excrusive project Anarysis 211
-60
-t
|
Figure 4-g NpV vs Discount Rate for Cost, lncome,

Cost
Now before getting into the detairs of the modified

RoR anarysis,
note that Npv at i = 0."/o is negative for this
exampre, whln has duar
positive rate values of 6.4% ind 26.7g%.
whenever the NpV at i =
0% is negative for an investment, income, investment
situation, due to
the paraboric variation of NpV with changes in ,,i,,,
ouat positive ,,i,,var-
ues exist if any real interest rate solutions exist
for the Npv equation.
lf NPV at i = 97 is positive, duar rate varues
exist with one being neg-
ative and the other positive. This test of NpV at
investor where to rook for the dual rates if
i = 0% tells an
it is deemed desirable to
determine them.
Beforg presenting the modified RoR anarysis
.
in calculating the duar rates at the beginning of
carcurations, note that
this sorution that as ,,i,,
increased from 0% to 15% that NpV i-n"r"rr".
rather than decreases.
This is a unique resurt of cost foilowing revenue
in the cost, income,
cost analysis situation. whenever you firid Npv
increa.ing-*itn increas_
ing interest rates (rather than de'creasing as
it always does for cost,
income analyses) it is the author's expeiience
tnat ihis is caused by
cost following revenue in the analysis.
--r&..
ROR Using the Escrow Approach

To eliminate this investment, income, investment situation, present
worth the finai cost or costs at the minimum RoR to an equivalent
present value, giving the following diagram: t
0.3349
6 = $70 * $1a0(P/FZO*,O) |
0 1............5 6
PW Cost Modified ROR PW Eq: 116.88 = 40(P/Ai,5)
Modified ROR = i = 21.1"/" > 2oo/o, so satisfactory. since this modi-
fied RoR result is based solely on income following cost, it is valid for
economic decision-making purposes as a rate of return result. Dis:
counting the year 6 cost modifies the magnitude of our RoR result but
not its validity for comparison to i* = 20"/o for the economic decision.
Growth ROR
combine reinvestment of revenue at "i*" with the initial project to
eliminate cost following revenue as follows:
lnitial Project
C=$70 l=940 l=940 C=9140
0 1..........5 6
Reinvest Flevenues @ i*=2Oo/o

_ c=940 c=940
0 F=$357.20
1..........5 6
7.442 1.200
where, F = 40(FiA 2O%,5)(F /P 21o/o,1) = $3SZ.Z
Combine lnitial + Reinvestment Revenues

C=$70 - "-
C=9140-
o F=$357'2
Growth ROR PW Eq: 70 = ZlZ.2(PlFi,A)

Growth ROR = i = 20.9"/" > 2oo/o, so satisfactory.
Ana,ysis 213
Both the present worth cost modified RoR analysis and

Growth RoR
ar-ialysis have given the same economic condulion, which is in this
case and in general always consistent with Npv analysis
eccnomic
conclusions. The key, to correct RoR analysis of cost, income,
cost
anaiysis situations is to modity tne analysis to eiinrinate
cost following
revenue before making ihe HoR anaiysis. The present worth
cost ani
Growth RoR nrcciifications ai.e the turc basic approaches
used to elimi_
nate cost following revenues. Hcwever, there are several variatiorrs
in
the v'ray different people apply these modifications. one in particular
is
worth noting.
- ln applying the escrow approach it is not necessary to bring costs
following revenue all the way to year'0. lt realry is only n*""r.rry
to pre_
sent worth costs following revenue year by yea, until those
costs are
offset by project revenue. This gives the foilowing modification
referred to as the "year by year Modification.,,
HOR Using the Year-by-year Modification
. Discount the year 6 cost year by year until offset by project

income.
C=19.90 \ C=63.88\ C-110.66\

\
- \Net +4!!A e)rro..,
Dttr
I=40.00
Net l=20.1 0
20,1. C=23 88
l= 4o.oo t"ro,\"=ro9
\Net c= 76.66
3' 4 56
New Modified Diagram
c=70 l=40 l=40 I = 20.1
PW Eq: 0 = -70 + 4O(p/Ai,2) + 20.1(p/F;,3)
i = l,{odified ROR = 22.75% > i* = ZO"k so satisfactory
This modified RoR result is several percent bigger than the initial
present worth cost modified result. This is oecause the
two modified
RoR results relate to very different initial year 0 investments. The
results are really equivalent and give the same economic
conclusion
when compared to the 20% minimum RoR. Remember that you
can-
not and should not look at the magnitude of RoR results and
think
big is best' A projggt with a big RoR that rerates to a given

invesr
ment an d stream
9f , i
ingome m.ay. not .be,a.s..desi rable qs project.with
a smarrer noR that'r"ritei t, biffiffi;Ji;"r",;; dirrerent
stream of income. b "
EXAMPLE 4-rs A petroteum tnfifi Driiling Accereration probrem
lnvolving Dual Rates of Return
A producing oil field has wells drilled on 160 acre centers.
lt is pro-
posed to infill drill wells on g0 acre centers
to accelerate petroleum
production and give more efficient drainage
of the petroleum reser-
voir. Present and proposed costs and net revenues
are shown on the
following time diagrams with varues in thousands
of doilars:
Present C o
0129456
Accelerate C=
0129456
For a minimum RoR of 12yo, use rate of return
anarysis to deter-
mine if the acceleration drilling program investment
is satisfactory
from an economic viewpoint.
Solution:
The-"present" producing project is crearry satisfactory
since
costs for deveropment.have arready been incurred (so
they are
sunk). For no additionar costs to be lncurred, the ,,present,,
project
revenues are projected to be generated. This relates
to an infinite
percent return on zero dollars invested in
the present project, an
economically satisfactory project. The accererated plolect
total
investment RoR is 2oo%. However, this RoR does
not need to be
calculated because knowing the present project is
satisfactory, we
can go to incremental analysis to determine if incremental
invest_
ment dollars spent on the accererated production infiil
driiling pro_
gram are justified economically by incremental
revenues. The
incremental diagram involves cost, income, cost as follows
because the negative incrementar incomes in years
4, 5 and 6 are
effectively costs as follows:
chapter 4: Mutuary Excrusive and Non-t\,.lutuary
lncremental Rate of Return Analysis

Accelerated C=
*Present o 1 O
2 s ,4 5 6
lf you i,vrite a conventionar present worth eqtration
for the incre_
nrental diagranr values, you get dual rates
as follows:
PIV Eq: 0 = -735 + 850(p/F;,1) + a50{F iFi,2}
+50(ptF;,3)
-
310(p/F;,4)_ 280(p/Fi,5) _ 1S0(p/F;,6)
. rrial and error, duar "i" varues of 12"/, and 2so/o resurt. An investor
that treats either of these resurts as rate
of return co*pareo with the
minirnuin RoR of 12/, wourd concrude
that the incrementar project
economics are satisfactory. This turns
out to be an incorrect conclu-
sion. Both of the duar rates of 17% and
25"/" have rate of reinvest_
rnent meaning as weil as rate of return
rneaning at different pc:nts in
time..Required rates of revenue reinvestment
of 1 Zo/" and 25"k com-
pared with 120,L reinvestment opporiuniiles
mum ROR indicate a very unsatisfactory
inoratei oy trre mini_
incrementar investment
whereas rates of return of izx and 25"/.
compared to the 120n mini-
mum RoR rook satisfactory. The unsatisfactory
rate of reinvestment
meaning is stronger than the rate of return
melning as t!:e foilowing
NPV and Escrow ROR analysis results
show.
Net Present Value Anatysis

NPV= -7OS + 850(p/F1
2"/",1) + 450(p/F1 2y.,2) + S0(p/F1 2%,g)
- 310(P/F1 2/o,4) -12y",5) - 150(p/F1 2/.,6)
2BO(P/F
= -13.6 < 0, so slighfly unsatisfactory.
Escrow Approach ROR Analysis

tulod. Yr 0 Cost =735 + 3i0(p/F1 2"k,4) + ZgO(p/F12o/o,S)
+ 150(P/F12%,6) - $1,166.90
Mod. PW Eq: 0 = -'t ,1 66.9 + 850(p/Fi,1) + 4S0(p /Fi,2) + 50(p/F1,3)
Trial and error:
i = Modified ROR = 11"/o <i" = 12o/o,so unsatisfactory
Note that any investor who treats either of the positive dual rates of
17o/o ond 257" as rate of r€turn comes to,the wrong economic con-
clusion in this analysis. when cost follows revenue, you must modify
the analysis to eliminate cost foilowing revenue oefoi5you can make
ROR analysis.
EXAMPLE 4-14 cost, lncome, cost from lncremental Service

producing Analysis
It is necessary to evaluate whether an asset should be replaced

today for a $20,000 cost or two years from today for a 925,000 cost
with operating costs and salvage values as shown on the diagrams
for a six year evaluation life. Use incremental RoR analysiJfor a
15% minimum RoR to reach the economic decision. Allvalues are in
thousands of dollars on the diagrams.
Replace C:?9__OC:I_-9C=Z OC=3 'OC=4 OC=S OC=6

Now (A) 0 1234 L=4
C=25
Replace C=0 oc=6 oc=g oc=1 oc=Z OC=S OC=4
Later (B) L=9
Solution:
Analyze "A-B" to get incremental cost followed by incremental sav-
ings. However, it is impossible to avoid having incremental costs and
negative incremental salvage (effectively cost) in years 3 through 6,
giving the dual ROR problem.
R = incremental savings which are equivalent to revenue.
A_B)
C=2O R=5 R=31 C=2 C=2 C=2 C=2
L=-5
A modified RoR analysis is needed to eliminate cost following rev-
enue or savings. There is litfle value obtained from calculating the
dual rates of return except to satisfy curiosity, but the dual rates for
this analysis are +22.32/" and -13.03%.
Chapter 4: Mutually Exclusive and Non-Mutually Exclusive project
Analysis
Mod. Cost = 20 + ZtPiA157",4)(p/F15"/o,Z) + 5(p/F1

S"/".6) = 26.4g
PW Eq: C = -i6.48 -,.5(p/F1,1) + 3.t(p,,F;,2) E
i = incremental investment mocjified ROR
= 1g.05% > i. _ 1syo
Accept the incremental investment in "A" an,c reject,,B', (repiace
later).
iircremental i{PV anarysis verifies this modified Ron anatysis
conciusion.
0.8696 0.7561 2.855 0.7561
NPV4-B = S(P/F1 S"/o,i + 31(P/F15"/",2)
-2(P/A15o7o,4)p/F115r",Z)
0.4323
- 5(P/F15%,6) -20 = +1.31 > 0, so accept,,A,,,
reject "B"
To compiete oui'discussion of the investment, income, investment
siiuations, it is inrportant to point out and emphasize that if
income
fciiows the second investment, a duat RoR situation may not
exist.
This means that investment, income, investment, income analysis
situations may not give the duat RoR prablem but investment,
income, investment always does. Look'at the project cumulative
cash position diagram for the positive ,'i,, value calculated to test
whether combination rate of return, rate of reinvestment meaning
is
associated with the "i" value at different points in time. Remember,
if
the cumuiative cash position does not go positive at any time,
rate of
reinvestment meaning does not exist aid ihe meaning of ,,i,,
is rate of
return for the entire project evaluation life. The foll6wing example
illustrates this important analysis consideration.
EXAMPLE 4-15 An lnvestment, lncome, lnvestment,
lncome Situation Where Conventional
ROR Anatysis is Vatid
Diagram values in thousands of dollars.
C=100
C=50 l=30 l=30 l=60 l=60 l=60
A development project will require investments of g50,000 at time

zero and $100,000 the end of year 2 as shown on the time diagram,
9f
with incomes of 930,000 at the end of years 1 and 2, and $60,0-00 ai
Eoonomic Evaluation and lnvestment Decision Methods
tggnd of years 3, 4 and 5. For a minimum rate of return of 2070, use

RoR. analysis to, evatuate. the economi'.desirabirity..i
tni. oroject. rs
the "i" value that you calculate meaningful for economic
decision mak_
ing as RoR? Does NpV anarysis verify'your conctusioni--
Solution, All Values in Thousands of Do[ars:

NPV Eq: 30(P/A;,2) + 60(p/A;,3)@/Fi,2) _ 100(p/F;,2) _
50 - 0
Since the NPV at i = O"/o is positive, only one positive ,,i,,
exists that
will make NPV = 0. By trial and error, i 22.46"/" makes
= NpV = g. 1s
this "i" value of 27.46o/o a rate of return result or is ii onl
of a pair of
"dual rates of return" that have combination
rate of-rrirrn, iate of
reinvestment requirement meaning at difierent points
in time? lf a
companion dual rate. of return exisG, it would be'negative.
However,
it is possible to avoid the search for the possinte-iompanion
ouat
Rpn-lv testing to see if rate of reinvestment meaning is associated
wilh 27.46"/" "i" value at any point in rime. Dual rates
have combined rate of return, rate of reinvestment
if return arways
meaning at differ-
ent point in time. lf rate of reinvestment meaning does
not exist at
anv time, then dual rates of return do not exi$ f6r this probtem
and
the 27.46% "i" varue can be treated as RoR for
decision'pirpo,i'"1'"
Project years
Figure 4-10 cumurative cash position Diagram of a
cost,
lncome, Cost, lncome Rate'of Return Analysis
chapter 4: Mutua,y Excrusive anri Non-Mutuariy
Exclusive project Anarysis
219
Evaluation of the cumrrrative cash position

diagram for this project.
at the project "i" varue of 22,46/" does
show thatih; cumurative cash
position never goes above zero at
any ti*" Jriirgiie prolect tife.
Therefore, the "i" of 27.460k means*rate
of Eturn,,over rhe entire
project life and never means rate
of reinvestment. onry ,/.,ien ::e
cumulative cash position goes positive
does ,,i,, nave tne rate of re_
investment meaning.
{.9 Alternating Income, Investment, Income Situations

For the situation when you have alternating
income, in'estment, income
on the time diagram, dual rates of return
occur for the opposite conditions
rlescribed in the previous section for
the inr.,estment, income, investment
situittion. For income, in'esiment, income
situations, duAl ..i,, varues that are
hr;th positive wiii exist if Npv ar i
= O,ra is p<-rsitive, and positive duar ..i,,
.'alues *'ill not exist if Npv at i
= avc is negaiive. Analysis'rules rre similar
to tlrose given in the last sectior. Hon,ever.
note that fbr income, investmerit,
income siruations, a groject is acceptable
for an ;.r;.;;;;;;ii.,un tt. rrgesr
project posrtive dual "i" value because
this is the iegion of positive net
present when <iuar rlics erist, a project i,. acc#tabr"
'arut. ,rniy f-- ,,i,,,;
between the durt rares, because mis is rhe
.l.lX:";3,11t;*l::-..*,"n
r values rhar *rakes Npv positi'e. Figure -t-,11
range of
in Exampre 4_16 illus_
trates those considerations.
EXAMPLE 4-16 lncome, Cost, tncome

and Rate of Return
Analysis
As a variation to.Exampre 4-10, a company
has been asked to
consider a proposal to accept two payments
of $12 million, one at
time zero and the second at the end of year
one, arong with a pay-
ment for $23 miilion at the end of ten years
from now ,,.Ir,en the pro_
ject is to be compreted. These payments
are to provide for the cost to
your company in disposing of waste product
from a processing facir-
ity for each of the next 10 years, (end
of years on" inlorli ten). your
estimated costs for disposar of this materiar
incrude a tinie zero capi_
tal investment of $7 miilion with end of year
on" inrortnien operat-
ing costs of $4 million per year. The minimum
rate of return is 15.0%.
Use ROR and NpV analysis to determine if the
accept this opportunity? should
"ornprny
Solution: All Values in Millions of Doltars

lncoine: 12.0 .-12.O
23.0
Costs: -7.0 -4.O -4.0
Year: 01
Net CF: 5.0 8.0
NPV @ 15.0o/oi 5.0 +€(P/F1S,1)- a.OplA15,gXp/F15,1)

+ 19(P/F15,1g)
= $1.04 > 0, acceptable, but close to break-even
This analysis has inconi.E preceding costs, followed by more

income, which is another dual "i" value situation with 0% and g.6%
being the dual "i" values. ln this analysis, the meaning of the calcu-
lated "i" value is rate of reinvestment requirement in the early years
as inilial positive cash flows pay off the negative cash flows in some
of the early years of the project. tn the later years, the ineaning of "i,,
switches to rate of return as the remaining cosfs are paid off-by the
positive cash flow in year /0. This analysiJrequires a cash flow mod-
ification to eliminate the multiple sign changes in the present worth
equation. The same procedures used in cost-income-cost situations
must be employed here, giving an that an initial investment generat-
ing positive cash flow. such a modification is presented below in the
form of Growth RoR. ln this anarysis, all positive cash flows are
taken forward to the end of the project, while negative cash flows are
discounted to time zero.
Net CF: 5.0 8.0 -4.O. -4.0 19.0

Year: 10
rime Zero Modiried cost: -4 ofiill#x8;Piil ) = -15.61
End or year 10 Future Varue: 561p0i;:0) . 8(3l3ll,nn, . , e = 62.32

PW Eq:0 = -15.61 + 67.37(P/Fi,1g),
GROR = i = 1 5.75% > 15.0"/o, acceptable

Chapter 4: Mutualiy Exclusive and Non-i\,4u+ri::Ii,, f {clusive i.oject
Analysis
The following diagram illustrates that when income-cost-income

exists, the analysis relationship between NpV and i* is inverted
when
compared to cost-income-cost. *
2.0c
1.50
o
E
1.00
c
o
o
E 0.50
o-
zo 0.0c
(0.50)
'47o -27o Oo/o 2% 4% 6% g% 1oo/o 12% 14/o 16%
Discount Rate
Figure +I1 NpV vs i* for lncome_Cost_lncome
As illustrated in Figure 4-11, the parabolic relationship between

NjPV and the discount rate in this income-cost-income
analysis tends
to vary in an inverse fashion to that in a cost-income-ccst situation.
once again, to get varid rate of return resurts, you must modify the
analysis to have dollars invested initially followed by income in
later
years to provide a return on the invested capital.
4.10 Evaluation of Non-Mutually Exclusive Investments

Non-mutually exclusiYe invesiments :Ire investment zrlternatives
from which
more than one choice can be selected deoending on available capital
or budget
resrictions, such as selecting research, developrnent or exploration projects
from
many altematives. The ranking of drilling prospects in the petroleum
industry is
a classic example of non-mutually exclusive alternative
analysis. The objective in
analyzing non-mutually exclusive projects is to maximize the cumulative
prof-
itabiliry that can be generated from the available investment dollars.
To maximize the cumulative profitability that can be generated
by invest-
ing available investment capitar in several non-ntutually exclusive
alterna-
tiv'es, select the combination of pr<tjects tlnt will maximize
cumttlatit,e net
value or cumulative future worth profit. use of any of these methods

requires looking at all the different possible combinations.of projects:to
determine the group of projects that is best for a given budget.
To rank non-mutuallv exclusive projects in the o:rder thafiou will want to
select them to maximize curnulative net value or
future profit for a given
bttdget, ttt'o ranking techniques may be used. They are growth rate of return
and ratio analysis using either PVR or B/C Ratio as calculated earlier The
following examples will show that often this does not involve selecting the
project with the largest individual project net value, and that ranking the
projects in the order of decreasing regular RoR on project investments does
not properly rank non-mutually exclusive alternatives. of the basic evalua-
tion techniques discussed earlier in this text, only Ratio analysis and
Growth RoR consistently rank non-mutually exclusive alternatives in the
order that you want to select them to maximize cumulative profitability.
If a true opportunit.tt cost o1 capital is used as the minimum discount rate,
all proiects with positive NPV will be accepted for investment and there is
no need for ranking mdependent non-mutually exclusive alternatives. Hoyv-
ev'er, inv'estors usually do not have an exactly correct opportttnity cost of
cupital, so under conditions of rationed capital (limited budget dollars), the
ranking of independent or non-mutually exclusive projects is necessary.
EXAMPLE 4-17 Evaluation of Non-Mutually Exclusive

Alttirnatives Compared to Mutually Exclusive
Alternatives With Net present Value
consider the following four investment alternatives which all have a
5 year life and zero salvage value. Assume that i. = 2oo/o before taxes.
Operating Cost
Alternative lnvestment, $ Savings Per Year, $
1 10,000 6,000
2 25,000 10,000
3 35,000 15,000
4 50,000 17,000
A) lf $50,000 is available to invest and alternatives 1 , 2,3 and 4

are mutually exclusive (only one alternative can be chosen), which
alternative should be selected?
chapter 4: Mutualry Excrusive and Nori-rvi.rtuary
Excrusive project Anarysis
B) lf 93s,000 is avairabre to be invested,

and the arternatives are
non-mutuaily excrusive, shouid we
choose aiternaiivli or arternative
1 plus 2? we do not have enough
money to finance arternative 4 so
for financiai reasons (rather thai
economic regsons) it must be reft
cut of this analysis.
Solution:
A) Mutually Exctusive Alternatives
NPV anarysis wiil be presented here
because it is generary the
simplest method to use to evaruate n.,rtrrrrv
*.i*iu"'p)oi".t..
NFVI = 6,000(p/A133r1,r,- 10,000 +$7,e46
=
NPV2 = 10,000(plAZO"7
,S)_ 25,000 = +$4,910
NPV3 = 15,0C0(p /AZO1",S) _ 35,000
= +$9,g65 ,,
NPV4 = 17,000(p /AZO"7 _
,d SO,0C0 = +$g47
Alternative 3 has il-re largest NpV
at i* = 20o/o, sofor mutually
exclusive arternatives, arternitive 3 is
,re triJ.".
B) Non-Mutualty Exclusive Alternatives
".onon.,i.
lf we were to pro.ceed we did in part (A) and pick the rargest

3s
we wourd serect arternative NpV,
3 for this anarysis arso. However, it shourd
be very obvious that if these arternatives
are not mutuaily excrusive,
we can make better use of our g35,000
by selecting rft"r*tives 1 plus
2, rather than 3, since this gives us
$iO,OOO in savings each yearfor
the $35,000 investment, ra-ther tfran tfre
form atternative 3. cumurative r.rpv $15,000 .iring. obtained
compared to NpV3 = $9,965. Therefore,
ro,, J,"rn"rr"i"""r;; is $12,8s6 t
note that tne prolect.witi
biggest NPV is notrYnvorveo in tre
economic choices. onry with mutu_
ally exclusive arternatives is the biggest
NpV projeciur*rvi 0".t.
. Y.h:' a smail group of arternatives is being considered, cumurative
NPV is usuary the easiest approacrr
utirized to determine optimar
value for a rimited bydget, However,
*n"n the number of arternatives
increases, the use of ranking tecnn(ues
such as ratios can herp evaru-
ators rank arternatives in the economic
order of serection to maximize
cumulative NpV.
L
EXAMPLE 4'18 Ranking Non-Mutua[y Exctusive projects

Using
Determine whether-a.manager should spend

$5O,OOO on project 1
or projects 2 and 3 if the projects are non-mutually txclusive
for a
minimum ROR 10%.
ROR = 40%
1) C = $5o,ooo I = 920,000 I = $20,000
L = $so,ooo
ROR = 337.
2) C=$30,000 l=$10,000 .l=$10,000
0 L=$30,000
3) C = $20,000 | =$5,000. : .. .. . . . . I =$S,OOO

L=$20,000
Solution:
Maximize Gumulative NpV
1.736 .8264
NPV1 = 20,000(PlAtO.t",Z) + 50,000(p lFrcy",Z)
- S0,OO0 = +$26,033
3.791 .6209
NPV2 = 10,000(PlAlO.t",S) + 30,000(p lFfin,S)- OO,O0O
= +$26,535
4.868 .5132
NPV3 = 5,000(P/A
10"/",i + 20,000(plFlyo/o,7) _ 20,000 = +$14,605
Maximum Cumulative NpV = NpV2 + NpV3 +$41,140
=
Note that ranking by regurar RoR or Npv does not give
the correct
answer. However, ranking the alternatives by Growth ndR
or pVR does
rank the projects correcfly as is illustrated in ihe following
calculations.
Growth Rate of Return

Use a common evaruation rife of 7 years for each arternative
assuming net revenues and costs of zero in the later years
of shorter
life alternatives "1" and,,2,,.
cnapter 4: Mutuaily Exclusive and Non-Mutually Exclusive project Analysis 225
.t C=$50,000 I=$20,000 l=$20,000

1) L=9S0,000
C = $50,000
Rein-
VESt -01 C=$20,000 C=$20,000
F = +$148,210
2. .. .. .7
1.772 1.611
where, F = 20,000(FlP13"7",6) + 70,000(Flp19"7",5 ) = +$148,210
t+
Rein- v^-
$50,000
VESt F = +$148,210
1 .... .......7
Growth ROR PW Eq: 0 = -50,000 + 148,210(p/Fi,7),
Gi'owthHCR=t=17"t'o
Z\ C=$30,000 l=$'t0,000 l=910,000

0 1...........s L=$30,000
c=930,000
Rein-
C=$10,000 C=$1C,000
VESt -0 1 .....5 P=+$110,170
7
6.1 05 1.21
where, F = [1 0,000(F/A1 0%,5) + 30,000](F/p {0"/",2) = +$1 10,1 70
2+
Rein- ^
v- $30,000
VESt F=+$1 1 0,1 70
1 .... .......7
Growth ROR Eq: C = -30,000 + 110,170(plFi,7),
GrowthROR-i=20.4/"
^\ C=$20,000 l=$5,000 l=$5,000.L=920,000

J) ^
C=$20,000
Rein-
Vest
C=$5,000 C=$5,000
F=$67,430
1...........7
9.487
where, F = 5,000(F/A 1O%,) + 20,000 = $67,430
3+
Rein-
Vest F=$67,430
1 ...........7 v
Growth ROR Eq: 0 = -20,000 + 67,430(plFi,7),
Growth ROR = i= 19.1%
Alternatives 2 and 3 with the largest and next largest Growth RoR
values are the economic choices for the available investment budget
of $50,000. Ratio analysis verifies these choices as follows:
PVR = NPV @ i. / PW Cost @ i* B/C Ratio = PVR + 1
PVRI = 26,033/50,000 = 0.52 B/C Ratiol = 1.52

PVR2 = 26,535/30,000 = 0.88 B/C Ratio2 = 1.88
PVR3 = 14,605120,000 = 0.73 B/C Ratiq = 1.73
Both PVR and B/c Flatio results indicate projects z and 3 are the
economic choices consistent with Growth RoR and cumulative Npv
results. Properly calculated ratios and Growth RoR results will
always rank non-mutually exclusive alternatives in exacily the same
correct order.
It is instructive to note that a higher minimum RoR such as i* = 257o
causes the choice to switch to alternative 1. when you have good rein-
vestment opportunities, the short life high RoR project 1 is economi-
cally more desirable than when reinvestment opportunities are poor.
NPV for i* = 25o1o
1.440 .6400
N PV 1 = 20,000( P I AZS"k,Z) + 50,000( P lF
ZS"1",Z) - S0, 000
= +$10,800
2.689 .3277
N PV2 = 1 0,000(P / A25"y.,5) + 30,000( P /F - gO,0O0
25"/",5)
= +$6,700
3.1 61 .2097
N PV3 = 5,000(P/ AZS"t",i + 20,000(P I F - 20,000 = +$0
2gy",)
Maximum Cumulative NPV = NPVI = +$10,800, so select prolect 1.
chapter 4: Mutually Excrusive and Non-rr4uluaily Excrusive prciect Anarysis
Growth ROB for i* = 25"/o

GroMh ROR calculations for i* = ZSo/o verity that project 1 is best
based on the following results: Growth RORI
=bl.gt", Growth ROR2 =
28.S1L, Gro'.*h BOR3 = 25oh. Aithough the GrowihhOR results
for p?c_
jecis 1 and 2 are equal, with a $50,000 budEet we can
either Cc project
1 vrith a28.6% GroMh RoR cr the combination projects
2 anc 3 which
nave Growth RoR results at 29.6% and Zs"/o respectively. lntuitively
you know tiiat ihe Growth HoR of 28.6% on $30,000 inveited in pro-
jects 2 and the Growth RoR of 2s"k on
920,000 invested in project 3
has to be less desirable than the Growth RoR of 2g.6% on all'gsb,ooo
in project 1, so select project 1 as the economic choice.
PVFI for i* = 25o1o
PVRl = 10,800/50,000 =A.22

PVRz = 6,700/30,000 =0.22
PVR3 = 0120,000 = 0.00
since the Growth RoR results for pro.iects 1 and 2 were equal, we
expect the ratios to be equal. once again, as rvith groivth RCil, h,ro
mutually exclusive choices exist for spending $sc,obo on ncn-mutu-
ally exclusive projects 1, 2 and 3. we can either invest in project 1, or
in the combination of projects 2 and 3.
PVRl = 0.22
PVR2a3 = (6,700 + O) / (30,000 + 20,000) = 0.13
Since the same $50,000 would be invested either way, select the
maximum PVR which is project 1. This is consistent with Growth
RoR results and conclusions. with both pvR and Growth RoR
results, the projects were put in the desired selection order but the
budget constraint caused us to analyze several mutually exclusive
choices before making the final investment decision.
The next example has a primary objective of emphasizing the necessiry
of netting togerher all inflows and outflows of money ana wJrking with thl
resultant net cash flow each compounding period in either Growth RoR
or
Ratio calculations.
EXAMPLE 4-19 Ranking Non-Mutually Exclusive Projects Using

, , . PVR ald Growth ROR
i .
Rank the following non-mutually exclusive alternatives
''*' using PVR
157o.
for i* =
"
l=$110 l=$110 l=$110
A) C=$100 C=$2OO OC=$0 OC=$0
0 1 2 ....... . . .8
l=$150 l=$150
B) c = 9100 6=$90 OC=$40 OC=940
01 2 ..........I
Solution: All Values in Dollars
Net Present Value (NPV)
4.487 .8696
NPV4 = 1 10(P/A1s%,8) - 200(P/F1 s"/",i- 100 = +$219.60
4.160 .8696
NPVg = [110(P/A15./",2) - 90](P/F1 S"/",i - 100 = +$219.60
These two projects are identical economically and financially from
an out-of-pocket cost viewpoint. To rank them equally with PVR (or
Growth ROR) you must first net costs and incomes together that are
at the same points in time and work with resultant net costs in the
cienominator of PVR.
Present Value Ratio (PVR)
.8696
PVR4 = 219.6 / [100 + (200 - 1 10)(PiF 15"/o,1)] = +1 .23
.8696
PVR3 = 219.6 / [100 + 90(P/F15%,1)] = +1 .23
lf you incorrectly do not net the project "A" year 1 cost of $200
against the revenue of $1 10 before calculating the ratio denominator,
you calculate
.8696
PVR4 = 219.6 / [100 + 200(P/F1 S%,i] = 0.80 = incorrect PVR4
This ranks project "A" as economically inferior to project "8" which
is not the case.
chapter 4: Mutually Excrusive arrd Non-Mr-rtuaiiy Exciusive projecl Analysis
GroMh Rate of Fleturn

To use Growth RoR as a ranking technique, project net costs must
he discounted at the minimum RoR to a common time zero before
making the Growth RoR calculations for a c*:;non evaluation life.
This makes the cost basis for Growth RoB calculations identical to
the PVR denominator.
A) C=$100 NetC=$90 l=$110 l=9110

0 2..........8
Reinvest
lncome
C=$110 C=$110
F=$1,217.40
@ i" =15"/o 1 2........8
1"i.067
where, F = 1 1O(F/A1 S./",7) = $1,217.40
A+
Reinyest
c=$100 C=$90
lncome F=$1,217.40
@ i*=15"/o 2 .......8
Tb properly rank projects using Growth RoR, bring the net costs
beyond time zero back to time zero by discounting at the minimum RoR,
which is 1So,a for this anarysis. This enables us io calculaie rate of growth
of a single year 0 sum of money which wilt always be identical to the
denominator of a properly calculated pvfr or B/c Ratio. By caiculating
Growth RoR on year 0 single sums of money, it is clear that projects with
the largest Growth RoR are our choices. Those projects must generate
the greatest future value possible from available investment dollars.
Growth RoR pw Eq: 100 . e0(p/P1T"7.: 1) = 1,212.4(p/Fi,s)

GrowthROR=i=27.14"h
since the net costs and incomes on the "8" diagram are identical
to the "A" diagram, Growth RORB = Growth ROR4 =27.14/o
As with PVR analysis, it should be evident that if the year 1 costs
and revenues for project "A" are not netted together, a Growth ROR
is calculated based on year 0 cost of $100 and year 1 cost of $200
and the 23.79% Growth RoR4 result would rank "A" inferior to "8".
This is not a valid result.
230 Economlc Evaluation and lnvestment Decision Methods
Finally, if costs such as major repair; reclamntion or expansion costs occur in

project years after poiitive net income has been realigd
fur one or ntore years,
cnlv the resultant present wofth net cost that is not covered by the present worth
of net income from the early project years goes into the denrytinator of pvR
calculatiorts or as part of the cost basis for Growth RoR carculations.
when investments have different starting dates, whether they are mutu-
ally exclusive or non-mutually exclusive, it is necessary to use a common
evaluation time for NPV or PVR results that lead to valid economic deci-
sions as the following variation of Example 4-18 illustrates.
EXAMPLE 4-19a Analysis of Mutually Exctusive or

Non-M.utually Exclusive Alternatives
With Different Starting Dates
Re-evaluate alternatives A and B in Example 4-19, first as mutually
exclusive alternatives and second as non-mutually exclusive alterna-
tives, considering that investment alternative B starts closer to year 1
than year 0 for i. equal to 't5%.
l=$110 l=$110 l=9110

A) C-$100 C=$200 OC=$0 OC=$0
1 2........8 I
= =I $150 | 9150
B) C = $100 6=$90 gg=940 66 = 940
2 3........9
Solution:
lf you incorrectly calculate Npv and pVR results at the start of
each project, you get the results shown in Example 4-19 which lead
to break-even economic conclusions whether the alternatives are
mutually exclusive alternatives with equal NpV results of g21g.60 or
non-mutually exclusive alternatives with equal pVR results of +1.23.
when projects have different start dates, for valid analysis, you must
calculate NPV and PVR results at a common evaluation date, so we
arbitrarily select year zerc for this analysis.
chapter 4: Mutually Exclusive and Non-lvlutualry Exclusive project Analysis 231
Net Present Value (NPV)

4.487 0.8696
NPVA = 1 10(P/AtS%,8) - 200(PlF tS%,1) - 100 = +$219.60
4.160 0 7561 0.7561
NPV6 = i 10(PiAt 5"r
,)(PlF11orc,Z) - 9O(P/F1 S"/",2)
0.8696
- 1 C0(P/F1 Sozt,,1 ) = +91
gC.gB
lf A and B are mutually exclusive, the maximum Npv (alternative

A) is the economic choice. This is a different economic result than
the break-even economic conclusion reached in Example 4-ig
where the same projects were assumed to have the same starting
dates. Therefore, project start date affects mutually exclusive alterna-
tive analysis conclusions. lf the alternatives are non-mutually exclu-
siie, rank them with PVR as follows.
Present Value Flatio (pVR)

0.8696
Year 0 PVR4 = +219.6/[100+(200- 110)(p/F15,1)] +1.23
=
0.8696 0.756'1
Year 0 PVRg = +190.98/[100(P/F1S,t)+ 90(p/F1S,2)] +1.23
=
l'he alternatives are economically break-even non-mutually exclusive

investments as was concluded for the equal starting date investment alterna-
tives in Example 4-18. Notice rhat since pvR is rhe rario of Npv divided by
present worth net cost not offset by revenue, pvR results calculated at any
year are the same, because discounting or compounding both the numerator
and denominator of PVR (or benefit cost ratio) the same number of years has
no impact on the PVR result. However, the numerator and denominator of
PVR must both be at the same evaluation tirne.
The following example concerns ratio analvsis ranking of non-mutually
exclusive alternatives. It has been shown in numerous earlier examples that
changing the minimum rate of return can and often will change economic
choices, which emphasizes the need to use a minimum rate of retum in all
analysis situations that represents other opportunities thought to exist for the
investment of capital. Straying from this requirement causes inconsistent
and often incorrect economic decision-making. Similarly, with ratio analy-

sis it is necessary to use break-even cutoff rates of zero for PVR and one for
B/C Ratio. You will not get economic decisions that are consistent with
results from other valid techniques if you raise the ratio cutqff rate to say,
0.25 for PVR or 1.25 for B/C Ratio as an alternative to raising the minimum
ROR and leaving the cutoff at zero for PVR and one for B/C Ratio. The fol-
lowing example illustrates considerations related to these points.
EXAMPLE 4-20 Ratio Analysis Considerations Related to Net

Present Value and Rate Of Return
Alternatirres "A" and "B" may be either mutually exclusive or non-
mutually exclusive investments. Discuss the analysis of these alterna-
tives for either situation using NPV, PVR, B/C Ratio, ROR and Growth
ROR for minimum ROR values of 't2o/o, 15% and 20/". Analyze some
of the effects of changing the PVR cutoff value. as an alternative to
changing minimum ROR.
A) C = $100 I = $34.67 I = $34.67

0
B) C = $100 I = $16.67 t= $16.67
Solution:
By Trial and Error, ROR4 = 21.7"/", RORB = 16.0%
Decision Criteria i* = 12o/o i* = 15o/o i* = 20"/o
NPVA .*- +16.20 + 3.70

NPVg +25.00 + 4.80 -18.50
PVR4 + .25 + .16 + .04
PVRg + .25 + .05 .18
B/C Ratio4 + 1.25 + 1.16 + 1.04
B/C Ratiog + 1.25 + 1.05 + .82
Growth ROR4 13.1% 15.6% 20.1%
Growth RORg 13.1% 15.2P/" 18.4"/"
chapter 4: Mutuarry Excrusive and Non-tvrutuary Exclusive project Anarysis
23t
i
For = 12/". alrernatives "A" and "B" are economicaily equivarenr
whether
lhey are mutually exclusive or non-mutually exetusive alter-
natives. Raising "i-" to 1s"h or 20% causes the economi:
cho;ce to
.rrr.
shift to
r.(, favoring A over ,,8,,
r.1vurrilg"A" -b" wrtn
with all tech*iques. Not+
NotS lJpvp.
I is
greater than NPVB fcr both i* = 15% and i' rru "A"
kro,nr,,A,,is
=bay.: knovr is
better than ''8" if we conside'rhe arternatives tc be 6rrifr;alry excir.I-
s;ve. Explicit incremental analysis calcuiations nrust be done tc vei.ify
tilat conclusion with PVR, B/c Ratic, RoR and Growth RoF, but ait
techniques give the same economic conclusion.
lf "A" and "8" are considered to be non-mutually exclusive alterna-

tives, PVR, B/c Ratio, anci Growth RoR, are the valid ranking tech-
niques and all indicate "A" is better than ,,8,, for i* 157o and 2O%.
=
Now iet's analyze the effect of using i* = 1}o:o tc handte tirne value
of money in ratio calcurations, but effictivery in.r"rul ii;,, by raising
the cutoff for acceplable projects from zero to 0.25 with pvR and
from 1.0 to 1.25 with B/c Ratio. This is an evaluation aporoach
sonretimes used in industry practice. Notice ii leads to the conclusion
in this case that "A" and "B" are equivalent,',r,h€ti,lr the-,.are r:-ir_i._;-
aliy exclusive or non-mutually exclusive. Actually raising ,,i*', to 15%
or 20"/" shows clear economic advantage to "A" for the higher ,,i*,' val-
ues with all standard techniques of analysis. Aiso notice that for i*
i2'lo. all merl-rods show the aliernatives are equivalent. This means=
incr"emental RoR analysis ("8-A" to get incremental costs followed by
incremental revenues) will give the incremental ,,B-A" RoR to be
12'/". Treating alternatives "A" and "B" as eco*nomically equivalent is
the conclusion given by ratio calculations at i* = 12/o with increased
cutoff values of 0.25 for pVR or 1.2s for B/c Ratio. This expliciily
means that a 12/" incremental RoR on "B-A" is satisfactorv. This is a
misleading conclusion if other opportunities really, exist to invest dcl-
krs-at an RoR greater than 12%, which raising the cutoff rates on
PVR to 0.25 and B/c Ratio to 1.25 implies. Since this approach
involves inconsistencies in economic conclusions, it seems undesir-
able to use it. However, it can be argued that the differences in
results from increasing the ratio cutoff instead of increasing ,,i*,, are
small and not significant. Regardless, it is important to be aware that
this approach may give economic results and conclusions that are
inconsistent with other standard evaluaticn techniques.
4.ll Summary of Mutually Exclusive and Non-Mutually Exclusive

Alternative Analysis
MutuallyExcIusiveAlternativeA:ralysis...:.:.b.
Rate of Return or Growth Rate of Return. With either regular ROR or
Growth ROR analysis of mutually exclusive alternatives you must evaluate
both total investment ROR and incremental investment ROR, selecting the
largest investment for which both are satisfactory. Use a common evalua-
tion life for Growth ROR analysis of unequal life alternatives, normally the
life of the longest life alternative, assuming net revenues and costs are zero
in the later years of shorter life alternatives.
Net Value Analysis. With NPY NAV or NFV analysis you want the
mutually exclusive alternative with the largest net value because this is the
alternative with the largest investment that has both a positive total invest-
ment net value and a positive incremental net value compared to the last
satisfactory smaller investment. When using NAV or NFV to evaluate
uncqual lit-e altematives vou must Llse a common evaluation life, normally
tht life of the longest lit'e alternative, assuming nel revenues and costs are
zero in the later years of shofier lit-e alternatives as with ROR analysis.
Ratio Analysis. With ratio analysis of mutually exclusive alternatives

using either PVR or BiC Ratio, it is necessary to evaluate both total invest-
ment ratios and incremental investment ratios. Analogous to ROR analysis,
the mutually exclusive alternative with the biggest total investment i'atio
often is not the best economic choice. A bigger investment with a somewhat
smaller ratio often is a better mutually exclusive alternative choice.
Future Worth Profit Analysis. Calculate the FW Profit that can be gener-
ated by each alternative*project if profits and salvage are reinvested at the min-
imum rate of return, "i'''". Select the project that maximizes FW profit for the
investment money available to invest, With this method ),ou must compare the
FW profit for the same investment dollars in all cases. by assuming the budget
money not required in one project will be invested elsewhere at "i*".
Dual-i-Values
Dual-i-values relate to the multiple solutions that occur when cash flows
result in investments generating revenue that are followed by more invest-
ments. All dual-i-values contain a combination of rate of reinvestment and
chapter 4: Mutuallv Exclusive and Non-Mutually Exclusive project Analvsis
235
rate of rerurn meaning. rvhich makes them useless for RoR analysis in
terrns of being used to reliably assess economic profitability. If a compound
interest RoR measure of economic value is desired, three modifications to
the cash flows were described incruding Grc,urth RoR. the Escrow
Approach anij thc Ytar-by'-!'ear Approach. In euc:h present north m,;dificr-
ti0n. cash flou's are adjusted at the minirnum rare of return tit eliminate r\e
exisience of cost-income-cost. Each of the present u'cri'th rnodificatiops
resulis in the same NPV. This n'reans that cven rhough the i:pproaches genrr-
ate nrodifii-:d ROR results of varying rna-tnitudes, the eccr.riirnic conclusions
r.vill always be consistent with NpV.
Non-Mutuall_r, Exclusive Alternatives

Rate of I{eturn or Growth Rate of Return. Regular RCR analysis can-
not be used to consistently rank nou-mutuallv exclusive alternatiyes. Use
cror,',rh RoR and rank the alternatives in ti-re order of decreasing Growth
RoR. This will maximize protrt from avaiiable investmr:nt cirpital. use a
common evaination lif'e r'or Growth ROR anall,sis of unequal life alternir_
iives. normally the life of the longest alternative.
Net value Analysis. with NPV NAV or NFV analvsis of non-murua:11,
exciusire pi'ojects, seiect rhe gloup of projects that will maxirnize cumula-
tive net r-aluc for tlie dollars available to invest. This does not necessarily
involve seiecting rhe project with lar-sest net valnc on inclividual project
investrnent. when using NAV or NFV to evaluate unequal life alternatives
you must use a common evaluation life, normally the life of the longest
life alternative.
Ratio Analysis. Ranking projects in the order of decreasing present value
ratio (PVR) or B/C Ratio is the easiest u,ay of selecting non-mutually exclu-
sive projects to maximize cumulative NpV for available investment dollars.
l'uture.lYorth Profit Anall,sis. carcurate the FW profit that can be gen-

erated by each alternative project if profits and sall,age are reinvested at the
minirnum rate of return, "i'". use a comnon evaluation life equal to the
longest life alternative if unequal life projects are involved. Select the group
of investment projects that will maximize the cumulative FW profit for the
money available to invest, analogous to the way Npv and NFV are applied.
Assume that any odd dollar amounts can be invested elsewhere at '.i*;', the
same as with other techniques of analysis.
Remember, with all of these evaluation methods, the minimum rate of

return, "i*", 1s the rate of return that represents the other opportunities
which are felt to exist for the use of available investment capital. This term
is sometimes called the hurdle rate;..discount rate, opportunityrost of capital
or just cost of capital.
If you use a valid minimum ROR and apply the discounted cash flow
analysis techniques as described in this chapter and summary, you will
reach correct economic decisions for your cost, revenue, and timing of cost
and revenue project data and assumptions. It is always important to recog-
nize that economic analysis calculation results are just a direct reflection of
the input data and analysis assumptions. With any techniques of analysis,
economic evaluation conclusions are only as good and valid as the data and
assumptions on which they are based.
chapter 4: Mutualry Exclusiveand Non-Mutually Excrusive project Analysis
237
PROBLEMS
4-1 If a time zero cost of $300,000 is incurred for equipment replacement,

an existing project '4" is expected to maintqin the generation of
$450,000 before-tax profits each year for year one through year 10.
Two alternatives are being considered for improvement (project ,,8")
and improvement combined with expansion (project,,C;,) with pro_
jected costs and revenues as shown on the time diagrams. All
dollar
values are expressed in thousands of dollars.
A) C=300 J=450 I=450 I=450

0 1
B) C=900 I=550 I=550 I=550
I=750
c) C=1,200 C=800 I=850 I=850
0 I 2.........10
For a minimum rate of return of r5vo and considering the alternatives
to be mutually exclusive, determine whether project ,A,,, ..8,, or ,,C,,
is economically best using RoR, Npv and pvR. Then increase the
minimum RoR to 257o from l5vc over the entire l0 year evaluation
life and re- evaluate the alternatives using any valid analysis.
4-2 A company is analyzing the economics of leasing a parcel of land over

the next 6 years for time zero lease payment of $g0,000. The land
would be used as a product marketing center requiring construction of
a $200,000 building on the land in time zero and it is estimated that it
would generate annual revenues of $290,000 and annual operating
costs of $160,000 at the end of years one through five. The lease con-
tract stipulates that at the end of year six the building must be torn
down and the property restored to its initial conditions and this is esti-
mated to cost $360,000 at the end of year six. Use rate of return analy_
sis to determine if this project is economically viable for a 20To mini-
mum ROR. Verify your results with NpV.
Economic Evaluation and lnvestment Decision Methods
4-3 A double pipe heat exchanger with steam in the shell is to be insulated
to reduce heat loss to surroundings. The thickness of insulation, initial
cost and projected annual cost of heat loss are given in the following
table. If the minimum RoR is 2ovo before taxes, detdrmine the opti-
mum thickness of insulation for an insulation life of six years with a
zero salvage value.
insulation Initial Annual Heat

(Inches) Cost, g
Thickness Loss Cost, g
00 r400
1 1200 800
2 1800 600
3 2500 500
4 3500 400
Base your results on Net Present value Analysis, then verify them
using Present Worth Cost Analysis.
4-4 You have been asked to make rate of return analysis to support or
reject the economic viability of project development that has the esti-
mated potential of generating $450,000 revenue per year and operating
costs of $310,000 per year for each of the next l0 years (assume end_
of-year one through 10 values). A company has agreed to construct
and finance the project for deferred payments of $50,000 per year at
the end-of-year two, three and four with final lump sum purchase cost
of $ 1.450,000 to be made at the end of year five. The year ten salvage
yalue is estimated to be $300,000. Make rate of return
analysis to eval_
uate project economics for rninimum rates of return of (a) 5ro, (b)
15Vo and (c) 507o. Do NPV results support your conclusions?
4-5 To achieve labor cost savings on a manufacturing process, a company

rvill install one of two possible equipment automation changes. New
capital equipment costs and projected savings are as follows:
Equipment Projected Annual

Cost Savings
Change I $150,000 $ 80,000
Change 2 $230,000 $115,000'
chapter 4: Mutuary Excrusive and Non-Muluary
(A) For a six year evaluation life, which

change, if a,y, should be
selected if ix - 40va beforc tax? use Net piesent
vaiue Analysis
aitd assume zero salvags lrlues.
(B) Is rirere a,y evaiuariori lifc orher rhan
,ii y"r^ rhar *,ould swirc:h
the eco.omic evaiuai;on rcsuii f,un..l in (A)?
Ii yes, what is the
b,eak-even rife for r'hich there are no econonlic
ciifferences
hc:tweefl the alternatives?
4-6 R'ank non-mutuaily exclusive alternatives 'A" and ..B,, using pvR
Anall'sis for i* = l5Vo.
= C $200 C = $230
A)
g=U00 I=$110 I=$110 I = $110 I = $110 i = $110
2 J 4... . ..8.
C = $200 C = S180
B) C=$100 I=$i10 I = $20 I = $110 I=$110 I = $1to
4. ...8
4-7 Two muiualry excrusive unequai lir-e investrnent
alternatives, .A,, and
"8".,rust be evaruated to deierminc rhe best econonric
choice for i* =
20vc.T..e in'estrnenis, "c". a,cj incorres,'.I".
and salva-ee values,.,L,,,
are sirou,n on the trrne clial,rams in thc.usands
of dollars.
A) C=100 J=40 I=40 I=40 I=40 I=40

0 I 2 3
L=100
4
B) C=150 I=60 I=60 I=60

L=150
Determine the dual rates of return that resurt

from a direct incre-
mental ROR Analvsis of ,,B_A',.
ii) Evaluate the projects using NpV Analysis.
iii) Evaluate the projects using incremental Growth ROR
Analysis.
iv) Evaluate the projects using pW Cost Modified
ROR Analysis.
v) Is the economic choice affected by reducing
the rninimum RoR to
l07o from207c'!
.
4-8 A friend offers to give you 10 payments of $1000 ar annuar time peri-
ods zero through lo.:excepr year three if you give,him $9000 at year
three as shown on the time diagram. All values are in dollars.
I
I=1000 I=1000 I=1000 C=9000 I=1000 I = i000
4.. 10
Evaluate this income, investment, income opportunity shown on the

time diagram for before-tax minimum rates of retu oi loEo and 20vo.
^
A) Use Net Present Value Analysis.
B) Analyze the project using present worth cost Modified RoR.
4-9 A new process can be developed and operated at Levers ,d,, 6. ,,g,,
with capital costs, sales and operating costs as shown. All values are in
thousands of dollars.
Sales = 75 Sales = 75
Sales =100 Sales = 100

C=150 Op. Costs = 45 Op. Costs = 45
B)
0. 1.... .....5
If i* = 207o, which level of investment should be selected? use Npv
Analysis and verify your resulrs with RoR and pvR Analysis. If the
minimum RoR is reduced to 12vo, what is the economic choice? If the
minimum RoR is r2vo for years one and two and 2ovo for years three,
four and five, what is the economic choice?
4- 10 Improvement and expansion of a production facility are under

consider-
ation. Ai the present time profits are $450,000 per year, and in the future
escalation of operating costs each year is expected to exactly offset esca-
lation of revenue, so profit margins .re projected to remain constant at
$450,000 per year for each of the next years one through 10. Two alter-
natives for improvement and improvement combined with expansion
are
being considered with projected costs and revenues as shown on the
time diagrams following this problem statement, with all dollar values
expressed in thousands of dollars.
Chapler 4: Mutually Exclusive and Non-Mutually Exclusive prolect Analysis
241
A) I=450 I=450 I=450

0 1 2.,......10
t
B) C= 80{-) I=700 I=7C0 I=700
2........10
I=850
c) C=1,300 C=900 I= 1,050 I= 1,050
0 2........10
For a mirrimum rate of return of l5%o. and considering the altematives
to
be rnutualiy e.rclusive, determine whether the present'A,', improvement
"8", or ir,rprrcrvement plus expiinsion projeci "c" is economically best
using RoR. i\iPV and pvR. Then incrcase rhe minimum RoR to 25%
from 15vc over the entire l0 year evaluation lit-e and re-evaluate the
alternatives using both RoR and Npv analysis. Then assume that
the
nrinimurn I?"oR is increased from 15% to 25vo tbr evaluation vears
orie
and two ancl then. stz*ting in year three, the minimum RoR reverrs to
157c again through vear 10.
4-1 I An ethylene plant manager is considering the investment of $32,000,000

today (time zero) to integrate heavy duty industrial single shaft gas tur-
bines to reduce energy costs for a 750,000 metric ton per year liquids
cracker. The time zero investment is expected to generate energy operat-
ing cost savin-qs of $12,000,000 at the end of each of years one thiough
five. An alternative is to consider using aero-derivative turbines (based
on jet engines) that cost $34,000,000 but require an adclitional
$4,000,000 time zero invesrment in design modifications. These rur-
bines are slightly more efficient and generate annual energy savings of
$14,000,000 but also require additional maintenance or $soo,oOO per
year at the end of each of years one through five. If the desired mini-
mum rate of return is 15vo, use rate of return analysis to determine
which of these two alternatives should be the economic choice. verify
your conclusion with NpV analysis.
4-12 IJse ROR analysis to compare project 'A" involving the investment of
$240,000 to generate a,series of equat end-of-year revenues of $50,000
per year for five years plus a salvage value of $240,000 at the end of year
five and project "B" involving the investment of $240,000 to generate a
series of equal end-of-year revenues of $98,500 per year for 5 years with
zero salvage value. The projects are mutually exclusive and the minimum
ROR is l}%o.Yeify your results with NPV Analysis.
4-13 Dctermine the best economic way for a research manager to allocate
$500,000 in the following non- mutually exclusive projects if 1* = 207o'
A) c ,Offi
L=0
B) C =-$1Q0,999
L=0
0
Ll C = $300,000 ,000
L = $100,000
0
Use NPV Analysis and verify the results with Growth ROR Analysis
and PVR Analysis
4-14lf alternatives 'A" and "B" are mutually exclusive projects, use ROR
Analysis to determine which is economically best rf i* = l5Vc.
A) C=$20,000 I=$12,000 .....I=$12,000

L=$20'000
0 l .......r2
B) C=$28,000 I=$14,000 ...'.I=Sl4-000

L=$28'000
0 I .... .i
Verify the ROR Analysis results with NPV and PVR Analysis.
cnapter 4: Mutua'y Excrusive and Non-Mutua,y
Excrusive pr.ojeci Anarvsis
?43
4-15 Three unequai lit'e investment

alternati'es'u,ith costs, profits and
vage values as shown on the time sar_
diagrams are being considered.
C = Sl60.0o(i tr
Al I=Sl-50,000 = I50,000
"$
0 L = $50.000
ts) C = $,120,0(1.1 I = $27.':.i;00. I = $275,000

0
.4 L = $70.000
c) C = 5436,000 I = $500,000 I = $500,000

L = $100,000
Assume $490,{100 is avairabre ro invest

and other opportuniries exist to
irr'est all avaiial',re d,ilars at a 2avc
RoR- use Nl-v'anary.si.
,o a"r"._
n'rine how the 9490,000 shourcr
be spent from an economic viewpoint
if the altematii'es are non-rnutuairy exclusive. Then
use Npv Analysis
to determine r.ihiih of the alic.n;itives. .A,,. .!ll,i
or ,.(J,,, is best if the
iliernarives are inutuary excrusivc-. \'erify
these results r.vith pvR
Analysis.
4-16 For an in'estor with a minimum

rate of return of 20.070: (1) Rank
the fo'owing non-mutually exclusive
alternatives. (2) For a time
zero budget of $500, which of these projects
wourd you setect? con_
sider that year one or later year budgets
wilr cover costs in year o,e
or later years n't co-r'ered by project revenues
in earlier years. (.3)
Deve lop the "cunlulative NI,v,,biog.o.n
for alternative ..D,, and
indicate the poini ott this dia-uranr
that represenfs tle investor,s m..r:i-
nrum capital at risk.
Yr
A) -200 60 100 -200 300 300
B) -300 -90 100 200 300 400
c) -300 2s0 250 250 250
D) -600
-300 100 r50 -350 400 400
4-17 lmprovement to a coal mine haul road is being considered to shorten the
overall.haul distance and reduce ffuck cycle times thereby increasing the total
number of cycles per day. The cost of the improvements is estimated to be
$6,0U),000 at time zero. Currently, the trucks make 16 cyclgs per day from
the mine pit to a port load out facility which translates into 2,000,000 tons of
coal being hauled each year. If the road improvement is made, the number of
cycles is anticipated to increase by 257o to 20 cycles per day which translates
into an additional 500,000 tons of annual production from the mine. Total
mine reserves are estimated to be 14,000,000 tons and the coal is sold at an
average selling price of $32.00 per ton with operating costs of $12.00 per ton.
If the haul road improvement is made, the life of the mine will be shortened
from seven to six years due to the accelerated production schedule. With the
modified haul road, total production in years one through five would be
2,500,000 tons per year with year six production of 1,500,000 tons.
For this acceleration problem, use rate of return analysis to determine
if the investment in the haul road improvement should be made today.
The minimum acceptable rate of retumis l5%o.
4-18 Improvement to a mine haul road is being considered to shorten the over-
all haul distance and reduce truck cycle times, thereby increasing the total
number of cycles per day. The cost of the improvements is estimated to be
$6,000,000 at time zero. Currently, the trucks make 16 cycles per day
from the mine pit to a crushing facility rvhich, given the truck perfor-
nrance, capacities and haul distance, translates into 2,000,000 tons of ore
- being hauled each year. If the road improvement is made. the number of
cycles is anticipated to increase by 257o to 20 cycles per day which trans-
lates into an additional 500,000 tons of annual production tiom the mine.
Total rnine reserves are estimated to be 14,000,000 tons. If the haul road
inrprovement is made, the life of the mine will be shortened from seven to
six yeilrs due to the accelerated production schedule. With the modified
haul road, total production in years one through five would be 2,500,000
tons per year with yezr six production totaling 1,500,000 tons at which
tirre the resenres wor-rld be depleted. For each alternative, the average ore
is 0.09 ounces per ton with a 0.85 recovery rate. The average selling
-erade
price is $350.00 per ounce while the operating costs are S 190.00 per ounce
beginning in year 1. The minimum acceptable rate of return is 15.0Vo.
For this acceleration problem, use rate of retum analysis to determine
if the haul road improvement can be economically justifred. Then verify
your findings with a net present value analysis.
Chapter 4: Mutually Exclusive and Non-l,4uri.rally Exclusive project Analysis
4-19 Two alternatives exist for you to invest $100,000 as shown on the
fol_
lowing time diagrams. consider risk to be identical for each invest-
nrent. Assuming your rninimum discounr rate is L5.\va, determine the
economically better choice using the rate of retu?n, net present value,
present value ratio, grorvth rate of return and future worth profit.
A) -250 11532 .....115.32
B) -250 1,206.7
4-20 A proposed investment has the following projected net cash flow
stream from development ccst and-product sale profits, ancl abandon-
ment costs. use rate of return analysis to determine if this investment
is satisiactory tbr a minirnum discount rate of lz.ovo. All cash flows
are in thousands.
BTCF -1!70 +1,705 +897 +103 _617 _-559 _2g4
4-21 A natural gas distribution company is evaluating the economic desir-

ability of replacing or repairing existing gas mains in a small town. At
the present time, with the existing gas mains, it is estimated that
100,000 Mcf of gas is being lost per year and that this gas could be
sold to colporate customers at $2.00 per Mcf. The cost of replacing
the gas mains is estimated to be $1,000,000 at time zero. Replacement
of the mains ri'ould effectivery eriminate all gas loss for the next 10
vears. The cosr of repairing the gas mains is estimated to be
$400,000
rvhich would reduce annual gas loss to 25,000 Mcf at year one (allo-
cate to the end of the year), with gas loss increasing by a constant gra-
dient of 6,000 Mcf per year in years following year one. Use present
rvorth cost analysis for a l0 year evaluation life and i*
= l5.0vo to
determine from an economic viewpoint if the gas mains should be
replaced, repaired, or left in the present condition. verify your cost
analysis results with incremental NpV.

3 Present, Annual, and Future Value, Rate of Return and Brbak - Even Analysis

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3 Present, Annual, and Future Value, Rate of Return and Brbak - Even Analysis

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MUTUALLY EXCLUSIVE AND NON.MUTUALLY

For economic anarysis purposes, income-producing

4'l Analysis of Mutuaily Excrusive rncome-producing

in'est in the other choices, ),ou are invorved with

EXAMPLE 4-1 Mutuaily Exclusive lncome-producing

solution; HoR Anarysis, vatues in Thousands of Doilars

A) C=50 l=50 l=50

The RoR resurts can arso be obtained by dividing annuar

B_A) C=450 l=200 l=200

PW Eq. 0 = -450 + 200(p/A;,5) + 450(p/F;,5)

It should be clear from an economic viewpoint that if

Evaluation of mutually exciusive multiple investment alternatives

NetValue Analysis (present, Annual, Future)

To illustrate the application of NpV NAV and NFV to evatuate

atC=$50 l=$50 l=$50

B) C = $500 I = $250 | = $250

B - A) c-= $$q I = $2oo | = $2oo

c = $450 at i.= 15%'

Similarll,, NAV - $0 anij NFV = $0.

Ratio Analysis of Mutually Exclusive Atternatives ,,A,,and ,,8,,

n) c =l!Q l=$50 l=$50

B) C = $500 I = $250 I = $250

PVR4 = NPVA / PW cost = 142.srso 2.g5 > 0, so satisfactory

B_A) C = $450 I = $200 I = $200

PVRB-4 = NPVB-A / PW lnvestment

. Accepting the incrementa! "B-A" investment indicates accepting

4.2 unequal Life Mutually Exclusive Income-producing Alternatives

EXAMPLE 4-2 Anatysis of Unequal Life Mutuafly Exclusive

Analyze whether it is economically desirable to sefthe develop-

(A) Develop -200:gl_100j00 150. . . . . . 150

(B) Develop -300 -400 200 2ao 200.. ...200

(C) Sell 150

Solution for i* = 15.07o:

since much confusion exists regarding the applicability of different

(A) Develop -z!q:35qjll too 150...... 150

NPV4 = -200 - 350(P/F1S,1) + 100(P/A1S,2XplF15,1)

ROR4 = 13.1g% is the compound interest rate that makes

All criteria indicate that Alternative ,,A,, is not economically ccnpeti_

(B) Develop {9100 J00_!00 2oo. . . . . 200

RORB = 21.62o/" is the compound interest rate that makes

PVRg = 182.0/ [3OO + 400(piF15.r)] = +0.2809 > 0,

(C) Sell 150

NPV6 = +150.0 > 0, so, C is acceptable.

All criteria indicate that Alternative ,,c,, is also economically accept-

Proper economic analysis of mutually exclusive alternatives

(B-C) Dev - Sell -450 0

The concept of opportunity cost is formally introduced in chapter g,

To prove that selecting the largest individual NpV is best consider

NPVg-g = -450 - 400(P/F15,1) + 200(P/A15,9)(P/F15,1)

or, = NPVB - NPVC = 182.0 - 150.0 = +32.0 > 0, accept B.

To support the Npv conciusion that Arternative ,,8,,

Note that Alternative "c" (selling), with an infinite

PVRB-6 = +32.0 /{4SO + a00(p/F15,t)J= +0.04 > 0, so, accept B.

Analysis of changing the Minimum Discount Rate to Za.ao/o:

NPV4 @ 20"/o = -104.8 < O, so, reject A.

NPV3 @ 20"/" = + 3g.5 > 0, so, B is acceptable compared

NPVg @ 20% = + 150.0 > 0, so, C is the maximum NpV select

.. Tl" maximum project NpV is the Arternative c, which indicates

$6oo \.- .'.

A variation of the analysis in Example 4-2 is presented to show

EXAMPLE 4-3 Analysis of Mutually Excrusive Arternatives with