WEBVTT
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Welcome to the course Depreciation Alternate
Investment and Profitability Analysis We are
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continuing with module 2 that is alternative
investment In this lecture I will cover a
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new alternate (in) investment technique that
is called incremental rate of return The incremental
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internal rate of return is an analysis which
computes the fiscal return to an investor
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where there are two or more competing investment
opportunities concerning different amounts
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of investments The analysis is applied to
the difference between the cost of the two
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investments
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In this method the cash flow connected with
the cheapest alternative is subtracted from
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the cash flow associated with the more expensive
alternative to arrive at a differential cash
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flow for different alternatives and then an
internal rate of return analysis is conducted
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on this difference Based on Johnston’s quantitative
analysis on one selects the more expensive
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investment opportunity if only it has an incremental
internal rate of return higher than the acceptable
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minimum acceptable rate of return that is
MARR
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Through examples the above concept is demonstrated
in this lecture However the above method is
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not free from weakness There are qualitative
issues such as whether there is an incremental
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increase in risk associated with the more
expensive investment Therefore the investor
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must be advised to weigh a variety of factors
besides just the incremental internal rate
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of return before making an investment decision
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Now the objective is of the problem which
we are going to see or example we are going
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to see is that given the capital investment
estimated life span of capital investments
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annual operating costs and annual earnings
compare three different investments based
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on incremental rate of return method for the
selection of the best investment
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This is a example number 1 the example number
1 tells that there are three construction
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plan A B and C before a contractor Plan A
involves construction of two floors plan B
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three floors and plan C four floors The details
of the financial layout of these floors are
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given below in the table we will just see
that table The contractor is asked to select
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a plan based on incremental rate of return
if the minimum acceptable rate of return is
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5 percent Presume that estimated life of the
construction work for all the plans is 60
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years And the land on which the building is
to be made as well as its development cost
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does not depreciate
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That is salvage value of the land is 100 percent
now we see the table which gives the details
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of these plans So let us calculate annual
capital recovery of building for plan A this
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will be 300000 into i divided by 1 plus 1
sorry 1 minus 1 plus i minus 60 this comes
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out to be 300000 into 0.052828 which comes
out to be rupees 15848.45 Now annual maintenance
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is 10000 so total annual cost of the building
equal to this plus this is 25848.45 as you
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get this plus this is this Annual receipt
of rent is 60000 so annual profit
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is this 60000 minus this value this comes
out to be 34151.55 Now total investment for
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plan A is A is equal to 51 510000 so rate
of return
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equal to 34151.55 divided by 510000 is equal
to 6.696 percent
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Now if you calculate it for plan B
annual capital recovery for plan B is equal
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to 430000 into i divided by 1 minus 1 plus
i to the power minus 60 this comes out to
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be 430000 into 0.052828 this comes out to
be rupees 22716.12 annual maintenance is rupees
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12000 So total annual cost
cost for plan this plus this is equal to 34716.12
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annual receipt of rent is equal to 85000 annual
profit
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this minus this comes out to be 50283.88 total
investment in plan B is equal to 640000 this
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is given as data in the table
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So rate of return
comes out to be 7.857 percent this is nothing
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but this divided by this into 100 Similarly
we can calculate for plan C
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Plan C now annual capital recovery for plan
C is equal to 590000 into i divided by 1 minus
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1 plus i minus 60 this is 590000 into 0.05282818
comes out to be 31168.63 annual maintenance
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is equal to 14000 total annual cost
is equal to this plus this comes out to be
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45168.63 Now annual receipt of rent is equal
to 100000 so annual profit
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is equal to this minus this is equal 54831.37
total investment in plan C is equal to 800000
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this is the data which is given in the table
so rate of return is equal to 6.854 percent
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Now if you see the results of plan A plan
B and plan C all the plans are offering a
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return greater than 5 percent and my minimum
acceptable rate of return was 5 percent and
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hence all the plans are acceptable As far
as they are crossing they are (bi) they are
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crossing the minimum rate of return or they
are giving more return than they minimum rate
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of return but if I do the incremental rate
of return analysis the picture becomes more
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clear Now if I go for the incremental rate
of return
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then this is plan A plan B plan C annual profit
34151.5 this is 50283.88 this is 54831.37
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total investment is 510000 640000 and 800000
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Rate of return 6.696 percent 7.857 percent
and 6.854 percent
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Now if you see the extra investment above
the next lower investment so you find this
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is the lowest investment Now if I deduct this
from this so the extra investment here is
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130000 if I deduct this from this this becomes
Now extra income in comparison to next lower
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is 16132.33 4547.49 now this minus this is
this this minus this is this Now if I find
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out the return on extra investment
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I find here 12.41 percent and this is 2.842
percent how this is calculated This is a extra
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income 16132.33 16132.33 this divided by this
into hundred becomes this
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Similarly this divided by this is this so
what is my conclusion Now we will observe
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that this percentage is less than 5 percent
which is my minimum return which I require
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So what we see that as in incremental rate
of return the incremental rate of returns
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was maximum return for plan B this is the
maximum return for plan B I am getting and
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hence it should be selected So my selection
will be plan B in this case the extra money
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amounting to 160000 I will not go for plan
C
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Now the I have the extra money with me which
is amounting to 160000 if available should
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be invested in such a place like bank which
will give the MARR equal to or more than 5
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percent rather than investing in plan C So
the extra money is available I will not go
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for plan C because if that extra money will
fetch me only 2.842 percent profit whereas
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if I put that extra money into the bank at
least I will get 5 percent or more than 5
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percent which is MARR So based on this my
selection will be the B so if I put that extra
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money into the bank and so I suppose I get
only 5 percent interest than my profit will
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be 50283.88 plus 0.05 into 160000 which comes
out to be rupees 58283.88 which is more than
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this
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So this will be logical to put this 160000
rupees into some bank and at least earn 5
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percent and if I do so my profit will be maximized
in this case I get this profit 58283 but if
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I put it into the plan C I get only 54831.37
Let us summarize today’s lecture we have
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seen how to use the incremental rate of return
method though the problem which we have taken
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there we find that all the plans are okay
as far as minimum rate of return is concerned
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because all were giving more than 5 percent
But when we go for the incremental rate of
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return then out of three one plan which was
giving incremental rate of return more than
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5 and in this case plan B which was giving
12.41 came out to be the winner
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So where rate of return may confuse in many
cases when we do the incremental rate of return
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it clearly comes out that which plan is a
better plan to invest thank you