Eng Econ Internal and External ROR

Dr.
Nidal Hussein
 Present worth (PW)
 Future worth (FW)
 Annual worth (AW)
 Internal rate of return (IRR)
 External rate of return (ERR)
 Payback period (generally not appropriate as
a primary decision rule)
Internal Rate of Return (IRR)
The IRR is that interest rate at which a project just breaks even.
Example
Suppose $100 is invested today in a project that returns $110 in
one year.
$110
1 year
$100
P = F(P/F,i*,1) or 100 = 110/(1+ i*)
i* = 0.1 = 10%
Internal Rate of Return (IRR), cont’d.
How to calculate the IRR for complex cash flows:
PW(disbursements) = PW(receipts)
FW(disbursements) = FW(receipts)
AW(disbursements) = AW(receipts)
- Solve equation for i* using trial-and-error and linear

interpolation.
The value of i* could be positive or negative. A negative IRR

means that the project is losing money rather than earning it.
Example :
Salman is considering buying a tuxedo. It would cost JD500, but
would save him $160 per year in rental charges over its five-year
life. What is the IRR for this investment.
PW(disbursements) = JD500
PW(receipts) = JD160(P/A,i*,5)
JD500 = JD160(P/A,i*,5) or (P/A,i*,5) = 3.125
Using interest rate tables, trial -and-error, and linear interpolation
i* = 18.14
Internal Rate of Return Comparisons
1- IRR for Independent Projects
- The project is accepted if its IRR > the MARR value
- The project is considered marginally accepted if its

IRR = MARR
Example
Monster Meats can buy a new meat slicer system for $50,000. They
estimate it will save them $11,000 per year in labour and operating
costs. The same system with an automatic loader is $68,000 and will
save approximately $14,000 per year. The life of either system is
thought to be eight years.
Monster Meats has three feasible alternatives:
Alternative First cost Annual Savings
1-DN $0 $0
2-Meat slicer alone $50,000 $11,000
3-Meat slicer with
automatic loader $68,000 $14,000
Monster Meats uses a MARR of 12% for this type of project. Which
alternative is better?
Step1: Consider the Meat slicer alone
-50000+11000(P/A, i*, 8) = 0
solve for i*: i* = 14.5% > MARR
Meat slicer alone is better than the DN alternative
Step2: Consider the Meat slicer with automatic loader

-68000+14000(P/A, i*, 8) = 0
solve for i*: i* = 12.5% > MARR
Step3: Consider the incremental investment

-(68000-50000)+(14000-11000)(P/A, i*, 8) = 0
solve for i*: i* = 7% < MARR
Monster meat should not buy the automatic loader
Multiple IRRs
A project can have more than one IRR
Example
A project pays $1000 today, costs $5000 a year from now, and pays
$6000 in two years. What is its IRR?
Solution:
PW(receipts) = PW(disbursements)
1000 - 5000(P/F, i*,1) + 6000(P/F, i*,2) = 0
$1000 $6000
0 1 2
-$5000
(P/F, i*,N) =1/(1+i*)N
Substitute in the above equation:
(i*-1)(i*-2) = 0
The roots of this equation are: i* = 1 and i* = 2.
This project has two IRR: 100% and 200%
Project Balance:
End of Year at i* = 100% at i* = 200%
0 $1000 $1000
1 1000(1 + 1) - 5000 1000(1 + 2) - 5000
= -$3000 = -$2000
2 -3000(1 + 1) + 6000 -2000(1 + 2) + 6000
=0 =0
External Rate of Return (ERR)
Modified Internal Rate of Return (MIRR)
- It is used to resolve the problem of multiple IRR.
Definition:
External Rate of Return Method (ERR), denoted by i*e ,
is the rate of return on a project where any cash flows that are
not invested in the project are assumed to earn interest at a
predetermined explicit rate (usually the MARR).
Example 5.8 (p. 140):
A project pays $1000 today, costs $5000 a year from now, and
pays $6000 in two years. What is its rate of return? Assume that
the MARR is 25%.
$1000 $6000
0 1 2
-$5000
Solution:
The $1000 is not invested immediately in the project.
Assume that it is invested elsewhere at the MARR for the first
year.
The cumulative cash flow at the end of year 1 is:
1000(F/P,25%,1) - 5000 = -$3750
Example 5.8, cont’d.:
The new cash flow diagram:
$6000
1 2
-$3750
The new cash flow provide a single ERR as follows:

-3750 + 6000(P/F,i*e,1) = 0
i*e = 0.6
ERR = 60%
* A precise ERR is difficult to be estimated. Therefore, an
approximate ERR can be obtained using the following procedure:
1- Take all net receipts forward at the MARR to the time of

the last cash flow.
2- Take all net disbursement forward at an unknown interest
rate, i*ea, also to the time of the last cash flow.
3- Equate the future value of the receipts from step 1 to the
future value of the disbursements from step 2 and solve for i*ea.
4- The value of i*ea is the approximate ERR for the project
An approximate ERR of Example :
1000(F/P,25%,2) + 6000 = 5000 (F/P,i*ea,1)
Solve the equation for i*ea :
i*ea = 0.5125
ERR = 51%
- The approximate ERR will be always between the precise ERR
and the MARR. This implies that, using the approximate ERR
will always lead to the correct decision.
When to Use ERR
- ERR must be used whenever there are multiple IRR.
- If the project is simple investments, it has a unique IRR.
- Simple investments are projects that consist of one or more

periods of outflows at the start, followed only by one or more
periods of inflows.
0 1 2 j j +1 j + 2 N
When to Use ERR
- If the project is not a simple investment, it may have a unique

or multiple IRR.
- If the project has a unique IRR, it is desirable to obtain it and

use it in the analysis.
- If the project has multiple IRR, then the ERR can be used in
the analysis.
Why Choose One Method over the Other?
- Rate of return methods and present worth/annual worth methods give the
same decisions.
- IRR: facilitates comparisons of projects of different sizes.
- IRR: relatively difficult to calculate and multiple IRRs may exist.
- PW/AW: gives explicit measure of profit contributions.
- PW/AW: difficult to compare projects of different sizes.
- Payback period: very easy to calculate.
- Payback period: discriminates against long term projects, ignores time value
of money and expected service life.

Eng Econ Internal and External ROR

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Dr.

- Solve equation for i* using trial-and-error and linear

The value of i* could be positive or negative. A negative IRR

- The project is accepted if its IRR > the MARR value

- The project is considered marginally accepted if its

Step2: Consider the Meat slicer with automatic loader

Step3: Consider the incremental investment

- It is used to resolve the problem of multiple IRR.

The new cash flow provide a single ERR as follows:

1- Take all net receipts forward at the MARR to the time of

- If the project is simple investments, it has a unique IRR.

- Simple investments are projects that consist of one or more

- If the project is not a simple investment, it may have a unique

- If the project has a unique IRR, it is desirable to obtain it and

- IRR: facilitates comparisons of projects of different sizes.

- IRR: relatively difficult to calculate and multiple IRRs may exist.

- PW/AW: gives explicit measure of profit contributions.

- PW/AW: difficult to compare projects of different sizes.

- Payback period: very easy to calculate.

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