Question

Two mutually exclusive alternatives are being considered. Both have lives of 5 years. Alternative A has a first cost of $2500 and annual benefits of $746. Alternative B costs $6000 and has annual benefits of

$1664. The minimum attractive rate of return is 8%.

(a) What is the incremental rate of return between the two alternatives?

(b) Which alternative should be selected?

Please explain your response a step by step.

Answer 1

Answer: A. ROR is the rate at which our NPV becomes 0.

Present value = cash flow/(1+ discount rate) ^(no of years)

Use different discount rate values so that sum of all present values becomes 0, Trial and error method to calculate ROR

You can also use the IRR formula in the excel to directly calculate the ROR value.

Below is the calculation, I have used excel to calculate ROR of the given cash flow

Year	A	B	Difference (B-A)
0	-2500	-6000	-3500
1	746	1664	918
2	746	1664	918
3	746	1664	918
4	746	1664	918
5	746	1664	918
ROR	15%	12%	9.8%

Answer B. The increment rate of return of (B-A) 10% > 8% MARR , therefore higher cost alternative must be selected. which is B.

B project will give us more benefit.