Example IRR on Incremental Investment Two Alternatives

Reconsider the two mutually exclusive projects in Example 17.3.5.

n

B1

B2

B2-B1

O

-$3,OOO

-$12,OOO

-$9,OOO

1

1,35O

4,2OO

2,85O

2

1,8OO

6,225

4,425

3

1,5OO

6 33O

4,83O

IRR

25%

17.43%

Since B1 is the lower cost investment project, we compute the incremental cash flow for B2-B1. Then we compute the IRR on this increment of investment by solving

-$9000 + $2850(P/F, i,1) + $4425(P/F, i,2) + $4830(P/F, i, 3) = 0

We obtain i£2-B1 = 15%. Since IRRB2-B1 > MARR, we select B2, which is consistent with the NPW analysis.

Comments. Why did we choose to look at the increment B2-B1 instead of B1-B2? We want the increment to have investment during at least some part of the time span so that we can calculate an IRR. Subtracting the lower initial investment project from the higher guarantees that the first increment will be investment flow. Ignoring the investment ranking, we might end up with an increment which involves borrowing cash flow and has no internal rate of return. This is the case for B1-B2. (iB1 B2 is also 15%, not -15%.) If we erroneously compare this i with MARR, we might have accepted project B1 over B2.

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