Internal rate of return: multiple alternatives, Other Engineering

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Internal Rate of Return: Multiple Alternatives

To compare multiple alternatives using the IRR as measure of economic worth we must use the incremental approach. It is erroneous to use the ranking approach to compare multiple alternatives using the IRR (or MIRR) as the economic worth. This is based on the economic analysis principle # 6: Continue to invest as long as each additional increment of investment yields a return that is greater than the investor's TVOM (MARR).

Recall the incremental approach (White et al.). In summary

1. Rank the feasible alternatives in increasing order of the initial investment.

2. Calculate the IRR of the alternative with the minimum investment (same as incremental versus do nothing). If alternative has an IRR > MARR then select it as the new defender, and proceed to step 3. If IRR < MARR then select the next alternative with the second minimum investment, and repeat step 2.

3. Select alternative with the next investment level (in ascending order) as the new challenger. Calculate the incremental cash flow of Challenger - cash flow of defender. Calculate the IRR of the incremental cash flow. If IRR > = MARR then select the new challenger as the defender, and repeat step 3 until no alternative can be selected as defender.

4. The preferred alternative is the current (last) defender.

Example

a) Calculate the IRR independently for each of the feasible alternatives of example.

b) Compare the feasible alternatives using the incremental approach.

Note that if we would use the ranking approach we would erroneously select alternative 2 as the preferred alternative (largest IRR). However, using the incremental approach the preferred alternative is 6, which is the same conclusion obtained with the PW, AW, and FW method.


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