University of Sharjah

Dept. of Civil and Env. Engg.

Engineering Economics

Rate of Return Analysis

Dr. Mohsin Siddique

Assistant Professor
[email protected]
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Ext: 2943
Date:
Outcome of Today’s Lecture
! After completing this lecture…
! The students should be able to:
! Evaluate project cash flows with the internal rate of
return measure
! Plot a project’s present worth against the interest rate
! Use an incremental rate of return analysis to evaluate
competing alternatives

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Techniques for Cash Flow Analysis
! Present Worth Analysis
! Annual Cash Flow Analysis
! Rate of Return Analysis
! Incremental Analysis
! Other Techniques:
! Future Worth Analysis
! Benefit-Cost Ratio Analysis
! Payback Period Analysis

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Rate of Return Analysis
! Internal Rate of Return
! Calculating Rate of Return
! Rate of Return Analysis
! Incremental Cash Flow Analysis

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Internal Rate of Return (IRR) Lender’s Viewpoint

! The interest rate on the balance of a loan such that the

unpaid loan balance equals zero when the final payment is
made
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Internal Rate of Return (IRR)
! Simple Definition:
! Given a cash flow stream, rate of return (a.k.a. IRR) is the
interest rate i* at which the benefits are equivalent to the
costs:

! NPW=0
! PW of benefits - PW of costs = 0
! PW of benefits = PW of costs
! PW of benefits / PW of costs = 1
! EUAB -EUAC = 0

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Internal Rate of Return (IRR)
! Suppose you have the following cash flow stream. You invest $700,
and then receive $100, $175, $250, and $325 at the end of years 1, 2,
3 and 4 respectively. What is the IRR for your investment?

! 700 = 100/(1+i) + 175/(1+i)2+ 250/(1+i)3+ 325/(1+i)4

! Solving for i >>> It turns out that i* = 6.09 %

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Calculating Internal Rate of Return
! Ways to find the IRR:
! 1. Compound Interest Tables (you
may need to use interpolation)
! 2. Trial-and-error
! 3. Numerically (Excel’s IRR function,
MATLAB, or other root finding
methods)
! 4. Graphically
! If you have a CFS with an investment
(-P) followed by benefits (non negative)
from the investment:
! The graph of NPW versus i will have
the same general form.
! It will decrease at a decreasing rate
and have a value 0 at some unique
value i*.
! Where the graph has a value 0
defines the IRR.

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Example 1: Solution Using Interest Tables
! Given the following CFD, find i*

! PWB/PWC = 1

! 1252(P/A,i,5)/5000 = 1

! (P/A,i,5) = 5000/1252 = 3.993

! From Compound Interest

Tables:

i=8%

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Example 2: Solution Using Interest Tables
! An investment resulted in the following
cash flow. Compute the rate of return.

Solve the equation by trial and error

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Example 3: Graphical Solution
! Given the following CFS, find i*

! PW of costs = PW of benefits
! 100=20/(1+i)+30/(1+i)2+20/(1+i)3+
40/(1+i)4+40/(1+i)5
! NPW=-100+20/(1+i)+30/(1+i)2+
20/(1+i)3+40/(1+i)4+40/(1+i)5
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Problem: 7-1
$125

$10
$20
$30
$40
$50
$60

! $125 = $10 (P/A, i%, 6) + $10 (P/G, i%, 6)

! LHS=RHS
at 12%, RHS= $10 (4.111) + $10 (8.930) = $130.4
at 15%, RHS= $10 (3.784) + $10 (7.937) = $117.2

! i* = 12% + (3%) ((130.4 – 125).(130.4-117.2)) = 13.23%

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Problem 7-8

PWC=$400
PWB = [$200 (P/A, i%, 4) - $50 (P/G,
i%, 4)] (P/F, i%, 1)

PWC=PWB

! Try i = 7%
! PWB=[$200 (3.387) - $50 (4.795)] (0.9346) = 409.03
! Try i = 8%
! PWB=[$200 (3.312) - $50 (4.650)] (0.9259) = $398.08

! i* = 7% + (1%) [($409.03 - $400)/($409.03 - $398.04)]

! = 7.82%
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Problem 7-10

PWC=$500 + $100 (P/F, i%, 1)

PWB= $300 (P/A, i%, 2) (P/F, i%, 1) + $400 (P/F, i%, 4) + $500 (P/F, i%, 5)

PWC-PWB=0

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Problem 7-10
! Try i = 30%
! PWC=$500 + $100 (0.7692)= $576.92
! PWB=$300 (1.361) (0.7692) + $400 (0.6501) + $500 (0.2693)=
$588.75
! PWC-PWB = 11.83
! Try i = 35%
! PWC=$500 + $100 (0.7407)= $574.07
! PWB=$300 (1.289) (0.7407) + $400 (0.3011) + $500 (0.2230) =
$518.37
! PWC-PWB= 55.70

! Rate of Return, i* = 30% + (5%) [11.83/55.70)= 31.06%

! Exact Answer: 30.81%

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Rate of Return (RoR) Analysis
! Example statements about a project:
! The net present worth of the project is $32,000
! The equivalent uniform annual benefit is $2,800
! The project will produce a 23% rate of return

! The third statement is perhaps most widely understood.

! Rate of return analysis is probably the most frequently
used analysis technique in industry.
! Its major advantage is that it provides a figure of merit
that is readily understood.

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Rate of Return (RoR) Analysis

! Rate of return analysis has another advantage: With NPW or

EUAB one must choose an interest rate for using in the
calculations.
! This choice may possibly be difficult or controversial.

! With RoR analysis no (exterior) interest rate is introduced

into the calculations.
! Instead, we compute a RoR from the CFS.

! Warning: Relying only on RoR is not always a good idea.

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Rate of Return (RoR) Analysis
! Example: Which of the following two investment options
would you select?

! Option 1:
! Invest $2,000 today. At the end of years 1, 2, and 3 get $100,
$100, and $500 profit; at the end of year 4, you get $2,200.

! Option 2:
! Invest $2,000 today. At the end of years 1, 2, and 3 get $100,
$100, and $100 profit; at the end of year 4, you get $2,000.

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Rate of Return (RoR) Analysis
! Find out the implicit interest rate you would be receiving; that is,
solve for the interest rate in which the PW of benefits are equal to
your payments $2,000.

! Option 1:
! 2000 = 100/(1+i)1+ 100/(1+i)2+ 500/(1+i)3+ 2200/(1+i)4
! IRR: i= 10.78%

! Option 2:
! 2000 = 100/(1+i)1+ 100/(1+i)2+ 100/(1+i)3+ 2000/(1+i)4
! IRR: i= 3.82%
Which deal would you prefer?
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The Minimum Attractive Rate of Return (MARR)

! The MARR is a minimum return the company will accept

on the money it invests

! The MARR is usually calculated by financial analysts in the

company and provided to those who evaluate projects

! It is the same as the interest rate used for Present Worth

and Annual Worth analysis.

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Incremental Cash Flow Analysis (ΔCFS)
! Suppose you must choose between projects A or B.
! We can rewrite the CFS for B as B = A + (B –A).
! In this representation B has two CFS components:
! 1. the same CFS as A, and
! 2. the incremental component (B –A).

! B is preferred to A when the IRR on the difference (B–A)

exceeds the MARR.
! Thus, to choose one between B and A, IRR analysis is done by
computing the IRR on the incremental investment (B-A)
between the projects.

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Incremental Cash Flow Analysis (ΔCFS)
! Steps to conduct ∆CFS on two CFS’s:
! 1. Number them CFS1and CFS2, with CFS1 having the largest initial
(year 0) cost (in absolute value)
! 2. Compute ∆CFS = CFS1–CFS2 (It’s year 0 entry must be negative)
! 3. Find the IRR for ∆CFS, say ∆IRR
! 4. If ∆IRR ≥ MARR, choose CFS1; if not, choose CFS2

! Example: There are two cash flows: (-20,28) and (-10,15) and MARR
= 6%.
! 1.CFS1= (-20,28), CFS2= (-10,15)
! 2. ∆CFS = CFS1-CFS2=(-10,13)
! 3. ∆IRR = 30%.
! 4. ∆IRR > MARR => we choose CFS1= (-20,28)

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Incremental Cash Flow Analysis (ΔCFS)
! In summary, we compute the CFS for the difference
between the projects by subtracting the cash flow for the
lower investment-cost project (A) from that of the higher
investment-cost project (B).

! Then, the decision rule is as follows:

! IF ∆IRRB-A> MARR, select B
! IF ∆IRRB-A= MARR, select either A or B
! IF ΔIRRB-A< MARR, select A
! Here, B-A is an investment increment.

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Why We Use ∆IRR in IRR analysis?

! Although the rate of return of A is higher than B, B got $8 return

from the $20 investment and A only got $5 return from $10
investment.
! Project B: you put $20 in project B to get a return $8.
! Project A: you put $10 in project A (and $10 in your pocket) to get a
return $5.
! From this example, we know that we can’t evaluate two projects by
comparing the IRRs of the projects. Instead, we use ∆IRR and MARR
to make the decision.
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Problem 7-47

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Problem 7-47
Year A B (B- A)

0 -$2,000 -$2,800 -$800

1- 3 +$800 +$1,100 +$300

Computed ROR 9.7% 8.7% 6.1%

The rate of return on the increment (B - A) exceeds the

Minimum Attractive Rate of Return (MARR), therefore the
higher cost alternative B should be selected.

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Problem 7-51

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Problem 7-51
Year X Y X- Y
0 -$5,000 -$5,000 $0
1 -$3,000 +$2,000 -$5,000
2 +$4,000 +$2,000 +$2,000
3 +$4,000 +$2,000 +$2,000
4 +$4,000 +$2,000 +$2,000
Computed ROR 16.9% 21.9% 9.7%

Since X- Y difference between alternatives is desirable, select

Alternative X.

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Summary
! RoR analysis is often used but not always well understood
by practitioners
! RoR can be computationally difficult manually; a
spreadsheet model helps reduce solution time
! If an exact RoR is not necessary, use the PW or AW
methods
! Use incremental analysis when using IRR

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