Question

In an incremental rate of return analysis, which of the following investment criteria apply (select the best answer):

		If the incremental IRR is greater than or equal to the MARR, retain the higher-cost alternative
		If the incremental IRR is less than the MARR, retain the lower-cost alternative
		If the incremental IRR is greater than or equal to the MARR, retain the lower-cost alternative
		If the incremental IRR is less than the MARR, retain the higher cost alternative
		Both (a) and (b)
		Both (c) and (d)

Answer 1

Answer - B) If the incremental IRR is less than MARR, retain the lower-cost alternative

In case of mutually exclusive projects we can use incremental IRR to decide which project is to be select. Under this we have to calculate the IRR of incremental cash flow. Incremental cash flow is the difference between cash flows of highest cost project and lowest cost project.

ICF = Cash flows of highest cost alternative - Cash flows of lowest cost alternative

For the incremental cash flow we have to calculate IRR
Let A is highest cost alternative and B is lowest cost alternative, then calculate ICF of A - B

Then calculate the incremental IRR of A - B

The rule is

If incremental IRR is greater than MARR - Select the highest cost alternative

If incremental IRR is equal  than MARR - Select any (either highest or lowest cost alternative)

If incremental IRR is less than MARR - Select the LOWEST  cost alternative

If we take the above example

If IRR of A - B > MARR - Select A (highest cost Alternative)

If IRR of A - B = MARR - Select A or B

If IRR of A - B < MARR - Select B (lowest cost Alternative)

Note - To use this incremental cash flows approach, both the alternatives must have individual IRR, which must be more than the MARR.