Rate of Return on Incremental Investment

In our previous ranking example, the more costly option requires an incremental investment of $4000 at an incremental return of $5000. If you decide to take the more costly option, certainly you would be interested in knowing that this additional investment can be justified at the MARR. The 10% of MARR value implies that you can always earn that rate from other investment sources — $4400 at the end of 1 year for $4000 investment. However, by investing the additional $4000 in the second option, you would make an additional $5000, which is equivalent to earning at the rate of 25%. Therefore, the incremental investment can be justified.

Now we can generalize the decision rule for comparing mutually exclusive projects. For a pair of mutually exclusive projects (A, B), rate of return analysis is done by computing the internal rate of return on incremental investment (IRRA) between the projects. Since we want to consider increments of investment, we compute the cash flow for the difference between the projects by subtracting the cash flow for the lower investment-cost project (A) from that of the higher investment-cost project (B). Then, the decision rule is select B, if IRRB-A > MARR. Otherwise select A.

Project Management Made Easy

Project Management Made Easy

What you need to know about… Project Management Made Easy! Project management consists of more than just a large building project and can encompass small projects as well. No matter what the size of your project, you need to have some sort of project management. How you manage your project has everything to do with its outcome.

Get My Free Ebook

Post a comment