Question

1. A firm is considering three mutually exclusive alternatives as part of a production improvement program. The alternatives are as follows:

A                         B                            C

Installed Cost ($)                                   10,000                 15,000                 20,000

Uniform Annual benefit ($)                    1,625            1,625                  2000

Useful life (Years)                                 20                 20                       20         

For each alternative, the salvage value is zero. The MARR is 6%. Which alternative should be selected based on the INCREMENTAL ANALYSIS method?

Answer 1

The first cost of A is lowest therefore consider A as defender and and B as its challenger. The incremental cash flow must be calculated by subtracting cash flow of A from B.

Year	A	B	∆(B-A)
0	-10,000	-15,000	-5,000
1-20	1,625	1,625	0

As we can see the annual benefit the incremental cash flow between B and A is zero. Therefore, reject B and accept A.

Now, compare alternative A and C.

Year	A	C	∆(C-A)
0	- 10,000	- 20,000	- 10,000
1-20	1,625	2,000	375

The net present worth of the incremental cash flow can be expressed as

Assume rate = 6%

At a rate of 6% the incremental cash flow is -$5,698.78. Therefore, the incremental rate of return would be less than 6%. Hence, reject alternative C and accept alternative A.

Accept alternative A.