Incremental cash flow is calculated as (cash flowB? cash flowA), where B represents the alternative with the larger initial investment. If the two cash flows were switched wherein B represents the one with the smaller initial investment, which alterna­tive should be selected if the incremental rate of return is 20% and the MARR is 15%? Explain.

Question

What will be an ideal response?

Answer 1

By switching the position of the two cash flows, the interpretation changes completely. The situation would be similar to receiving a loan in the amount of the difference between the two alternatives if the lower cost alternative is selected. The rate of return would represent the interest paid on the loan. Since it is higher than what the company would consider attractive (i.e., 15% or less), the loan should not be accepted. Therefore, select the alternative with the higher initial investment, that is, A.