Question

5. Compare the following two alternatives by the IRR method, given MARR of 8%/year. Is the incement in cost form A to B justified? Alt. Construction cost | Benefits Styr | Salvage Service Life (yrs 510,000 145,000 10,000 775,000 155,000 20,000

Answer 1

IRR is the minimum rate of return acceptable from a project. It can be calculated with the use of IRR function/formula of EXCEL/Financial Calculator. The basic function/formula for calculating IRR is given as below:

NPV = 0 = Cash Flow Year 0 + Cash Flow Year 1/(1+IRR)^1 + Cash Flow Year 2/(1+IRR)^2 + Cash Flow Year 3/(1+IRR)^3 + Cash Flow Year 4/(1+IRR)^4 + Cash Flow Year 5/(1+IRR)^5 + Cash Flow Year 6/(1+IRR)^6 + Cash Flow Year 7/(1+IRR)^7 + Cash Flow Year 8/(1+IRR)^8 + Cash Flow Year 9/(1+IRR)^9

IRR is calculated with the use of EXCEL as below:

Year O Cash Flows Alternative A Alternative B -510000 -775000 145000 155000 145000 155000 145000 155000 145000 155000 145000 155000 145000 155000 145000 155000 145000 155000 145000 155000 145000 155000 155000 155000 175000 26.29% 17.04% 9 11 12 IRR 16 17

where

IRR (Alt. A) = IRR(B3:B14) = 26.29%

IRR (Alt. B) = IRR(C3:C15) = 17.04%

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Based on the above calculations, it can be concluded that the increment in cost from A to B is not justified. It is because, even though both the alternatives provide IRR greater than MARR, IRR of alternative A is higher than that of alternative B.