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Internal Rate of Return (IRR) Analysis: Lecture No. 24 Contemporary Engineering Economics

Engineering Economics

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DanielRao
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54 views

Internal Rate of Return (IRR) Analysis: Lecture No. 24 Contemporary Engineering Economics

Engineering Economics

Uploaded by

DanielRao
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Internal Rate of Return (IRR)

Analysis
Lecture No. 24
Chapter 7
Contemporary Engineering Economics
Copyright 2006
Contemporary Engineering Economics, 4th
edition, 2007

Example: Meaning of Rate of Return


In October 1,1970, when Wal-Mart Stores, Inc. went public, an
investment of 100 shares cost $1,650. That investment would
have been worth $9,113,600 on September 30, 2006.
What is the rate of return on that investment?
$9,113,600
$9,113,600 = $1,650 (F/P, i, 36); i = 27.04% 0
$1,650
IRR is widely used because it is easy to understand. Consider the
statements below. Which is easier to understand?

This project will bring in a 15% rate of return on investment.


This project will result in a net surplus of $10,000 in NPW.

36

Definition
The internal rate of return (IRR) is a method of calculating rate of
return. The term internal refers to the fact that its calculation does
not incorporate other external factors (e.g., the interest rate or
inflation).
Rate of return (ROR) is the break-even interest rate, i*, which
equates the present worth (PW) of a projects cash outflows to the
present worth of its cash inflows.
Mathematical Relation:
PW (i * ) PW (i* )cash inflows PW (i* )cash outflows
0

In the context of savings and loans, the IRR is also called the
effective interest rate (Chapter 4).

i (%)

From Chapter 5:
Present Worth
Amounts at
Varying Interest
Rates
*Break even interest rate

PW(i) $
32,500

27,743

20

-3,412

23,309

22

-5,924

19,169

24

-8,296

15,296

26

-10,539

10

11,670

28

-12,662

12

8,270

30

-14,673

14

5,077

32

-16,580

15

3,553

34

-18,360

16

2,076

36

-20,110

38

-21,745

$24,400

$27,340

$55,760

outflow

inflow

18

PW(i) $

17.45*

$75,000

i(%)

-751

Methods for Finding the Rate


of Return
Lecture No. 25
Chapter 7
Contemporary Engineering Economics
Copyright 2006
Contemporary Engineering Economics, 4th
edition, 2007

Simple vs Non simple Investment Classification

Simple Investment: The project with only one sign


change in the net cash flow
Nonsimple investment: an investment in which more than
one sign change occurs in the net cash flow series

Period
n
0
1
2
3
4

Net Cash Flow


Project
A
-1,000
-500
800
1,500
2,000

Project
B
-1,000
3,900
-5,030
2,145

Project
C
1,000
-450
-450
-450

Project A: a simple investment


Project B: a nonsimple investment
Project C: a simple borrowing

Methods for Finding the IRR


Direct
Solution

Direct
Solution

Log

Quadratic

Project A

Project B

Trial &
Error
Method

Computer
Solution
Method

Project C

Project D

-$1,000

-$2,000

-$75,000

-$10,000

1,300

24,400

20,000

1,500

27,340

20,000

55,760

25,000

1,500
Contemporary Engineering Economics, 4th
edition, 2007

Trial and Error Method Project C

Project C

-$75,000

24,400

27,340

2. If NPW(i) > 0 (+ve), choose higher i and recalculate NPW. 3


If PW(i) < 0 (-ve), choose lower i and recalculate NPW.

55,760

The

aim is to get one NPW +ve and one NPW -ve **

1. Compute NPW(i) at the MARR given (i), e.g 15%

NPW(15%) = -75,000 + 24400(P/F,15%,1) + 27340(P/F,15%,2) + 55,760(P/F,15%,3)


= $3,553 (+ve), thus increase i to 18%;
NPW(18%) = -75,000 + 24400(P/F,18%,1) + 27340(P/F,18%,2) + 55,760(P/F,18%,3)
= -$749 (-ve) **

3. Use linear interpolation


3,553

i 15% 3%
17.5%( IRR )

3,553 749

3,553
0
-749
15%

4. Compare IRR with MARR


Since IRR 17.5% is bigger than MARR 15%, ACCEPT the project.

18%

Explanation: The company only ask for minimum return of 15% from this project. However the
return from this project is 17.5%, thus accept the project

IRR Measure For Independent Project


Decision Rule for Revenue Project Evaluation:
Accept the project as long as its IRR is BIGGER than MARR.
17.5% > 15% MARR, thus accept the project (refer slide 8)

IRR Measure For Service Project


Decision Rule for Service Project Evaluation:
* Cannot calculate the IRR for service project (single project
valuation)

Consider this mutually exclusive example:


Issue: Can we rank the mutually exclusive projects by the
magnitude of its IRR?
N
0

A
B__
-$1,000 -$5,000

IRR

100% > 40%

Both NPW +ve


IRR > MARR10%
1
$2,000 $7,000
Using NPW ranking, choose B NPW(10%) $818 < $1,364
Using IRR ranking, choose A
Contradictory results
We cannot compare the above mutually exclusive projects based on
the magnitude of its IRR as it is affected by the size of investment
and the timing of cash flows when they occur

Mutually Exclusive Revenue & Service


Projects
Use incremental cash flow analysis approach to evaluate
the project
Steps for Incremental Analysis Procedure
1.Refer to cash flow at year 0 (initial investment)
2.Determine the cash flow for which project is BIGGER

3.Take project with BIGGER cash flows minus projects with


SMALLER cash flows

Incremental IRR e.g. calculations


Revenue project
A
0

Service project

Incre. CF

-10000 -30000

-10000 -30000

15000

20000

-15000

20000

20000

-25000 -20000

-10000 -30000 -20000

15000

30000

20000

20000

30000

20000

-8000

C
Refer
slide 15

Incre. CF

-10000 -30000 -20000

-15000

-25000 -12000 -20000

-8000 -10000

Mutually Exclusive Revenue Projects


Decision Rule for Revenue Project Evaluation:
It MUST fulfill the following criteria
1. The IRR for each projects (e.g. A and B) under consideration
must be BIGGER than MARR (NPW +ve)
2. Conduct the cash flow analysis procedures (slide11) and
calculate the incremental IRR (slide 14)
2. Analysis:
IF the calculated IRR for the incremental cash flow (IRR B- A)
is BIGGER than MARR, ACCEPT B
IF the calculated IRR for the incremental cash flow (IRR B- A)
is SMALLER than MARR, ACCEPT A

Incremental IRR
Step
1

Check: IRR for each project


is BIGGER than MARR 10%

0
1

-$1,000
$2,000

-$5,000
$7,000

ROR
PW(10%)

100%
$818

40%
$1,364

Step
3

N
A
B__
N
A
B__
-$1,000 -$5,000
0
$2,000 $7,000
1
40%
IRR 100%
NPW(10%) $818 $1,364

Inc. NCF (B A)
-$4,000
$5,000
25%
$546

Step
2

Calculate the
incremental net cash
flows (check slide 11)

Calculate the IRR on the incremental cash flows.

Analysis (slide 13): By investing the additional $4,000 in B,


you would make additional $5,000, equivalent to 25% return
which is BIGGER than MARR of 10%, thus the incremental
investment in B is justified. ACCEPT B

Step
4

Incremental IRR :
3 Alternatives (MARR 15%)
1: Examine the IRR for each project. Eliminate
any project that fails to meet the MARR
ALL IRR > MARR 15%

-$2,000

1,500

800

1,500

1,000

500

2,000

800

500

1,000

IRR

-$1,000 -$3,000

34.37%

40.76% 24.81%

2: Rank the project by looking at the value at n = 0 from SMALLER (1) TO


BIGGEST (3). Ranking
B(1), A(2) and C(3)

3: Calculate the incremental cash flows for the first pair


by comparing the BIGGER project (A) minus the
SMALLER project (B). Then calculate the
incremental IRR
IRRA-B =27.61% > 15% MARR,
so select A, reject B
4: Calculate the incremental cash flows for the second
pair by comparing the BIGGER project (C) minus the
SMALLER project (A). Then calculate the
incremental IRR
IRRC-A =8.8% < 15% MARR,
so select A, reject C
5: We conclude that A is the best alternative.

A-B

-$2,000

-$1,000

-$1,000

1,500

800

700

1,000

500

500

800

500

300

34.37%

40.76%

24.81%

IRR

C-A

-$2,000

-$3,000

-$1,000

1,500

1,500

1,000

2,000

1,000

800

1,000

200

34.37%

40.76%

24.81%

IRR

Mutually Exclusive - Service Project


Use incremental analysis approach (to calculate cost savings)
at MARR 15%
Items
Investment (year zero)

CMS Option

FMS Option

$4,500,000

$12,500,000

$1,169,600

$707,200

832,320

598,400

3,150,000

1,950,000

Annual tooling cost

470,000

300,000

Annual inventory cost

141,000

31,500

Annual income taxes

1,650,000

1,917,000

$7,412,920

$5,504,100

$500,000

$1,000,000

6 years

6 years

Annual O&M costs:


Annual labor cost
Annual material cost
Annual overhead cost

Total annual costs


Net salvage value (year 6)
Life span

Incremental Cash Flow


(FMS CMS)

CMS Option

FMS Option

Refer year zero. FMS value $12,500,000 is BIGGER than


CMSs value of -$4,500,000.
Thus
FMS CMS (because
we want the value at n=0 is ve)

Incremental Net Cash Flow


(FMS-CMS)

-$4,500,000

-$12,500,000

-$8,000,000

-7,412,920

-5,504,100

1,908,820

-7,412,920

-5,504,100

1,908,820

-7,412,920

-5,504,100

1,908,820

-7,412,920

-5,504,100

1,908,820

-7,412,920

-5,504,100

1,908,820

-7,412,920

-5,504,100

Engineering Economics,$2,408,820
4
(including
+ $500,000 Contemporary
+ $1,000,000
edition, 2007
Salvage value)
th

Solution:
NPW(15%)FMS-CMS = -8,000,000 +1,908,820(P/A,15%,6) +2,408,829(P/F,15%,6)
= -ve, since the value is ve, reduce the i e.g. 12%
NPW(12%)FMS-CMS = -8,000,000 +1,908,820(P/A,12%,6) +2,408,829(P/F,12%,6)
= +ve, since now we have the +ve, we can interpolate to
calculate the IRR
Interpolation : IRRFMS-CMS = 12.43%

IRRFMS-CMS is 12.43% which is smaller than MARR 15%, thus reject


FMS and accept CMS

Mutually Exclusive : Service Project


Decision Rule for Service Project Evaluation
Remember: The IRR for each projects cannot be calculated
IF the calculated IRR for the incremental cash flow (IRR B- A)
is BIGGER than MARR, ACCEPT B
IF the calculated IRR for the incremental cash flow (IRR B- A)
is SMALLER than MARR, ACCEPT A

Summary

Rate of return (ROR) is the interest rate earned on


unrecovered project balances such that an investments cash
receipts make the terminal project balance equal to zero.
Rate of return is an intuitively familiar and understandable
measure of project profitability that many managers prefer to
NPW or other equivalence measures.
Mathematically we can determine the rate of return for a
given project cash flow series by locating an interest rate that
equates the net present worth of its cash flows to zero. This
break-even interest rate is denoted by the symbol i*.

Contemporary Engineering Economics, 4th


edition, 2007

To apply the rate of return analysis correctly, we need to


classify an investment into either a simple or a nonsimple
investment.
A simple investment is defined as one in which the initial
cash flows are negative and only one sign change occurs in
the net cash flow, whereas a nonsimple investment is one for
which more than one sign change occurs in the net cash flow
series.
Multiple i*s occur only in nonsimple investments. However,
not all nonsimple investments will have multiple i*s either.

Contemporary Engineering Economics, 4th


edition, 2007

For a pure investment, the solving rate of return (i*) is the


rate of return internal to the project; so the decision rule is:
If IRR > MARR, accept the project.
If IRR = MARR, remain indifferent.
If IRR < MARR, reject the project.
IRR analysis yields results consistent with NPW and other
equivalence methods.
For a mixed investment, we need to calculate the true IRR, or
known as the return on invested capital. However, if your
objective is simply to make an accept or reject decision, it is
recommended that either the NPW or AE analysis be used to
make an accept/reject decision.
To compare mutually exclusive alternatives by the IRR
analysis, the incremental analysis must be adopted.

Contemporary Engineering Economics, 4th


edition, 2007

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