Chapter 7 Rate-of-Return Analysis

Concept of Rate of Return

Note: Symbol convention---The symbol i* represents the breakeven interest rate that
makes the NPW of the project equal to zero.. The symbol IRR represents the internal rate
of return of the investment. For a simple (or pure) investment, IRR = i*. For a nonsimple
investment, generally i* is not equal to IRR.

7.1
$14,500 = $267( P / A, i, 72)
i = 0.8148% per month
r = 0.8148% × 12 = 9.7776%
ia = (1 + 0.008148)12 − 1 = 10.23%

7.2
$900 = $30( P / A, 4%,8) + F ( P / F , 4%,8)
0.7307 F = $698.02
F = $955.27

7.3
$10, 649, 600 = $1, 650( F / P, i,36)
6, 454.30 = (1 + i )36
i = 27.6%

7.4
$2.5 = $1.2( P / A, i,10)
i = 46.98%

7.5
$104, 200, 000 = $30, 000( F / P, i,54)
3, 473.33 = (1 + i )54
i = 16.30%

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Investment Classification and Calculation of i*

7.6
(a) Simple investment: Project A (Note: Project C is a simple borrowing)

(b) Non simple investment: Project B and Project D

(c)
• Project A:

PW (i ) = −$18, 000 + $10, 000( P / A, i,3) + $10, 000( P / G, i,3)

=0
i* = 74.23%

• Project B:

PW (i ) = −$20, 000 + $32, 000( P / A, i, 2) − $22, 000( P / F , i,3)

=0
i* = 111.11%

• Project C:

PW (i ) = $34,578 − $18, 000( P / A, i,3)

=0
i = 26.08% → Borrowing rate of return
*

(d) Project D has no rate of return.

7.7 The equivalent annual cash flow for the first cash flow cycle ($400, $800, $500,
$500) will be

AE (i ) = $500 + [ −$100( P / F , i,1) + $300( P, F , i, 2)]( A / P, i, 4)

Then, the present worth of the infinite cash flow series is expressed as

AE (i )
PW (i ) = −$1, 000 +
i
[−$100( P / F , i,1) + $300( P, F , i, 2)]( A / P, i, 4)
= −$1, 000 +
i
=0

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∴ i* = 54.05%

7.8
(a) Classification of investment projects:

• Simple projects: A,B, and E

• Non simple projects: C and D

(b)
$60 $150
−$100 + + =0
1 + i (1 + i ) 2

1
Let X = , then,
(1 + i )

−$100 + $60 X + $150 X 2 = 0

X 1 = 0.6406, X 2 = −1.0406

∴ i* = 56.09%

(c) Find i* by plotting the NPW as a function of interest rate:

Project i*
A 56.09%
B 47.94%
C 8.32%
D 178.8%
E 24.21%

7.9
(a) Classification of investment projects:

• Simple projects: A,B, and D

• Non simple projects: C

(b)
• Project A: i* = 9.63%
• Project B: i* = 27.6%
• Project C: i* = 276.72%
• Project D: i* = 86.69%

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(c) Use the PW plot command provided in Cash Flow Analyzer, or you may use
the Excel’s Chart Wizard

7.10
(a)
−$50, 000 + ($25, 000 − $9, 000)( P / A, i,8) + $10, 000( P / F , i,8) = 0
Solving for i yields i* = 28.45%

(b) With the geometric expense series

−$50, 000 + $25, 000( P / A, i,8) − $9, 000( P / A1 , 7%, i,8)

+$10, 000( P / F , i,8) = 0
Solving for i* yields i* = 21.47%

(c) To maintain i* = 28.45%

PW (i ) = −$50, 000 + $25, 000( P / A1 , g , 28.45%,8)

−$9, 000( P / A1 , 7%, 28.45%,8) + $10, 000( P / A, 28.45%,8)
=0
Solving for g yields
g = 4.806%

7.11
(a) Rate of return calculation:
• Project A: i = 32.10%
*

• Project B: i = 25.53%
*

(b)

PW Plot

$50,000.00
$40,000.00
$30,000.00
PW ($)

$20,000.00 A
$10,000.00 B
$0.00
($10,000.00) 0 5 10 15 20 25 30 35 40 45 50
($20,000.00)
Interest Rate (%)

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7.12
(a) Cash flow sign rules:
Projects Number of Sign Changes Possible Number of i*
A 1 0, 1
B 1 0, 1
C 1 0, 1
D 1 0, 1
E 2 0, 1, 2
F 1 0, 1

(b) Use the PW plot command provided in Cash Flow Analyzer, or you may use
the Excel’s Chart Wizard

(c)
• Project A: i* = 228.42%
• Project B: i* = 500%
• Project C: i* = 23.27%
• Project D: i* = 70.99%
• Project E: i* = 265.41%
• Project F: i* = 258.91%

7.13
(a) IRR = 69.81%

94, 000 144, 000 72, 000

PW (i ) = −120, 000 + + + =0
(1 + i) (1 + i) 2 (1 + i )3
i* = 69.81%

(b) Use the PW plot command provided in Cash Flow Analyzer, or you may use
the Excel’s Chart Wizard

(c) Since IRR(69.81%) > MARR (15%), accept the project!

Mixed Investments
7.14
(a)
• Project 1: i* = 20%
• Project 2: i* = 18%
• Project 3: i*1 = 32.45%, i*2 = −92.45%

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(b) Investment classification:

• Project 1: simple and pure investment, IRR = 20%
• Project 2: simple and pure investment, IRR = 18%
• Project 3: non simple and mixed investment, IRR = RIC = 31.07%

PB(31.07%,12%)0 = −$1, 000

PB(31.07%,12%)1 = −$1, 000(1 + 0.3107) + $1, 400 = $89.30
PB(31.07%,12%) 2 = $89.30(1 + 0.3107) − 100 = $0

(c) If MARR = 12%, all the projects are acceptable.

7.15
(a)
$100 $24
−$100 + + =0
1 + i (1 + i ) 2

1
Let X = , then,
(1 + i )

−$100 + $100 X + $24 X 2 = 0

X 1 = 0.8333, X 2 = −5
∴ i* = 20%

(b)
• Simple projects: A,B, and D
• Non simple projects: C and E

(c) Apply the cash flow sign rule:

Projects Number of Possible Number of Actual i*

Sign Changes i*
A 1 0, 1 20%
B 1 0, 1 28.58%
C 2 0, 1, 2 14.63%,210.27%
D 1 0, 1 15.24%
E 2 0, 1, 2 12.63%,41.42%
(d)
• Project B: IRRB = 28.59%
• Project C: IRRC = −15.57%

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• Project D: IRRD = 15.24%

• Project E: IRRE = 11.24%

Note that, since projects C and E are mixed investments, we need to find the RIC
for both C and E by using external interest rate of 10%

(e) Apply the net investment test: Project = pure investment, Project D = pure
borrowing

Project Balances
n
Project C ( i = 14.63% )
*
Project D ( i* = 12.63% )
0 -$5.0 $200
1 $4.3 $325
2 $34.89 -$134
3 0 -$651
4 -$533
5 0
7.16
(a)
• Project 1: i* = 612.695%
• Project 2: i*1 = 14.64%, i*2 = 210.28%
• Project 3: i* = 100%

(b) Apply the net investment test:

• Project 1:

PB(612.695%)0 = −$1, 600

PB(612.695%)1 = −$1, 600(1 + 6.12695) + $10, 000 = −$1, 403.2
PB(612.695%) 2 = −$1, 403.2(1 + 6.12695) + $10, 000 = 0
(-,-,0), a pure investment

• Project 2:

PB(14.64%)0 = −$5, 000

PB(14.64%)1 = −$5, 000(1 + 0.1464) + $10, 000 = $4, 268
PB(14.64%) 2 = $4, 268(1 + 0.1464) + $30, 000 = $34,892.80
PB(14.64%)3 = $34,892.8(1 + 0.1464) − $40, 000 = 0
(-,+,0), a mixed investment

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• Project 3:

PB(100%)0 = −$1, 000

PB(100%)1 = −$1, 000(1 + 1) + $4, 000 = $2, 000
PB(100%) 2 = $2, 000(1 + 1) − $4, 000 = 0
(-,+,0), a mixed investment

(c)
• Project 1: IRR1 = 612.695%, PW (12%) = $15,300
• Project 2: IRR2 = RIC = −2.04%, PW (12%) = −$623 < 0
• Project 3: IRR3 = RIC = −57.14%, PW (12%) = −$617 < 0

(d) Only project 1 is acceptable.

7.17
(a) Simple investments: A and B (simple as well as pure)

(b) Mixed investments: C

(c) Project A: IRRA = 23.24% , Project B: IRRB = 21.11% , Project C:

IRRC = 12.24% at an external rate of 12%

(d) All three projects are acceptable.

7.18
(a) There are two sign changes in cash flow, indicating multiple i* s.

i*1 = 20%, i*2 = 40%

Apply the net investment test:

PB(20%)0 = −$100
PB(20%)1 = −$100(1.2) + $260 = $140
PB(20%) 2 = $140(1.2) − $168 = 0
∴ (-,+,0), a mixed investment

(b) At an external interest rate of 12%, RIC = IRR = 10% < 12%.

(c) The project is not acceptable.

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7.19
(a) i*1 = 15.99%, i*2 = 0%

(b) Since all projects pass the net investment test, all projects are pure
investments.

(c) All projects are acceptable at MARR = 10%.

7.20
(a) Project A: i*1 = 10%, i*2 = 100% , Project B: i*1 = 350.33%, i*2 = −80.83%

(b) Pure investment: C, mixed investments: A,B, D and E

(c) Project A: IRRA = 13.57% , Project B: IRRB = 342.16% , Project C:

IRRC = 18% , Project D: IRRD = 31.07% , Project E: IRRE = 19.66%

(d) All projects are acceptable at MARR = 12%.

7.21
(a) Use the PW plot command provided in Cash Flow Analyzer.
From the plot, we get i*1 = 14.64%, i*2 = 210.27%

(b) Apply the net investment test:

PB(14.64%)0 = −$5, 000

PB(14.64%)1 = −$5, 000(1 + 0.1464) + $10, 000 = $4, 268
PB(14.64%) 2 = $4, 268(1 + 0.1464) + $30, 000 = $34,892.80
PB(14.64%)3 = $34,892.8(1 + 0.1464) − $40, 000 = 0
(-,+,+,0): The project is a mixed investment.

(c) Since RIC = IRR = 33.92% > 18%, the project is acceptable.

7.22
(a) IRR for the incremental investment:

n Net Cash Flow

Project A Project B B-A
0 -$300 -$800 -$500
1 0 $1,150 $1,150
2 $690 $40 -$650

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i*B − A = 0% or 30%

Since this is a mixed incremental investment, we need to find the RIC using an
external interest rate of 15%.

RICB-A = IRRB-A = 16.95% >15%

∴ Project B is preferred

(b) Use the PW plot command provided in Cash Flow Analyzer.

7.23
(a) Apply the net investment test using i* = 10%

PB(10%)0 = −$100, 000

PB(10%)1 = −$100, 000(1.1) + $310, 000 = $200, 000
PB(10%)2 = $200, 000(1.1) − $220, 000 = 0
∴ (-,+,0), a mixed investment

(b) RIC = IRR = 6.29% <8%. So the project is not acceptable.

7.24 (c)

IRR Analysis
7.25 The present worth of the project cash flow is

PW (i ) = −$10 M + $1.8M ( P / A, i,8) + $1M ( P / F , i,8) = 0

∴ Since IRR = 10.18% > MARR, accept the project

7.26 The present worth of the project cash flow is

PW (i ) = −$5, 000 + $4,840( P / F , i, 2) + $1, 331( P / F , i, 3) = 0

∴ Since IRR = 10% = MARR, the project breaks even.

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7.27
(a) Since IRR = 10% and PW(10%) = 0, we have,

PW (10%) = −$2, 000 + $800( P / F ,10%,1) + $900( P / F ,10%, 2)

+ X ( P / F ,10%,3) = 0

∴ X = $704

(b) Since IRR > 8%, the project is acceptable.

7.28
z Let X be the annual rent per apartment unit. Then net cash flow table is:

Capital
N Revenue Maintenance Manager Net Cash Flow
Investment
0 -12,500,000 -12,500,000

1 50 X -250,000 -80,000 50X - 330,000

2 50 X -300,000 -80,000 50X - 380,000

3 50 X -350,000 -80,000 50X - 430,000

4 50 X -400,000 -80,000 50X - 480,000

5 14,000,000 50 X -450,000 -80,000 50X - 13,470,000

PW (15%) = −12,500, 000 + (50 X − 330, 000)( P / A,15%,5)

−50, 000( P / G ,15%,5) + 12,940, 000( P / F ,15%,5)
=0
X * = $41,373 or $3,448 per month

7.29
z Let X be the annual savings in labor, then.

PW (10%) = −$25, 000 + ( X − $3, 000)( P / A,10%, 6)

+ $5, 000( P / F ,10%, 6) = 0

z X = $8,092.15

7.30
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z Net cash flow table:

n Land Building Equipment Revenue Expenses Net Cash Flow

0 ($1.50) ($3) ($4.50)
1 ($4) ($4.00)
2 $3.50 ($1.40) $2.10
3 $3.68 ($1.47) $2.21
4 $3.86 ($1.54) $2.32
5 $4.05 ($1.62) $2.43
6 $4.25 ($1.70) $2.55
7 $4.47 ($1.79) $2.68
8 $4.69 ($1.88) $2.81
9 $4.92 ($1.97) $2.95
10 $5.17 ($2.07) $3.10
11 $5.43 ($2.17) $3.26
12 $5.43 ($2.17) $3.26
13 $5.43 ($2.17) $3.26
14 $2 $1.40 $0.50 $5.43 ($2.17) $7.16

z Rate of return calculation:

PW (i ) = −$4.5 − $4( P / F , i,1) + $2.1( P / F , i, 2) + "

+ $7.16( P / F , i,14) = 0

∴ i* = 24.85%

z Since this is a simple investment, IRR = 24.85%. At MARR = 15%, the

project is economically attractive.

7.31
(a)
PW (i ) = −$20 − $8( P / F , i,1) + $17( P / F , i, 2) + $19( P / F , i,3)
+ $18( P / F , i, 4) + $10( P / F , i,5) + $3( P / F , i, 6)
=0
This is a simple investment. Therefore, IRR = i* = 60.52% .

∴ Since IRR > MARR (18%), the product is worth marketing.

(b) IRR = 67.03%

(c) IRR = 48.07%

Comparing Alternatives
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7.32
(a) Project A: IRR = 11.71%
Project B: IRR = 19.15%

(b) Only project B is acceptable

(c) Since project A is not acceptable, select project B.

7.33 Option 1:Buy a certificate,

Option 2: Purchase a bond, and assume that MARR = 9%

Net Cash Flow

n Option 1 Option 2 Option 1 – Option 2
0 -$10,000 -$10,000 0
1 0 1,000 -1,000
2 0 1,000 -1,000
3 0 1,000 -1,000
4 0 1,000 -1,000
5 16,105 11,000 5,105

The rate of return on incremental investment is

i*1− 2 = 10% > 9%

∴ Option 1 is a better choice.

7.34 Determine the cash flow on incremental investment:

Net Cash Flow

n Project A Project B B-A
0 -$2,000 -$3,000 -$1,000
1 1,400 2,400 1,000
2 1,640 2,000 360

i* B − A = 28.11% > 15%

∴ Select project B.

7.35

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(a) IRR on the incremental investment:

Net Cash Flow

n Project A1 Project A2 A2 – A1
0 -10,000 -12,000 -$2,000
1 5,000 6,100 1,100
2 5,000 6,100 1,100
3 5,000 6,100 1,100

i* A 2− A1 = 29.92%

(b) Since it is a simple incremental investment, IRR A2-A1 = 29.92% > 10% .
Therefore, select project A2.

7.36
(a) IRR on the incremental investment:

Net Cash Flow

n
A1 A2 A2 – A1
0 -$15,000 -$20,000 -$5,000
1 7,500 8,000 500
2 7,500 15,000 7,500
3 7,500 5,000 -2,500

Since the incremental cash flow series portrays a nonsimple investment, we

need to find the RIC at 10%, which is RIC A 2− A1 = 7.36% < 10% . So, select A1.

(b) We can verify the same result by applying the NPW criterion.

PW (10%) A1 = −15, 000 + $7,500( P / A,10%,3)

= $3, 651
PW (10%) A 2 = −20, 000 + $8, 000( P / F ,10%,1) + $15, 000( P / F ,10%2)
+$5, 000( P / F ,10%,3)
= $3, 426

∴ Select project A1.

7.37 Incremental cash flows ( Model A – Model B):

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n A–B
0 -$2,376
1 0
2 0
3 0
4 2,500

IRR A− B = 1.28%

∴ If MARR < 1.28%, Model A is a preferred.

7.38 IRR for Model A: 6.01%, IRR for Model B: 7.25%

∴ The best decision is “do-nothing.”

7.39
(a) The least common multiple project lives = 6 years → Analysis period 6 years

Net Cash Flow

n
Project A Project B B–A
0 -$100 -$200 -100
1 60 120 60
2 50 150-200 -100
3 50-100 120 170
4 60 150-200 -110
5 50 120 70
6 50 150 100

Since the incremental cash flow series indicates a nonsimple investment, but it
is a pure incremental investment.

IRRB − A = 15.98% > 15%

∴ So, select project B.

(b) Incremental analysis between C and D:

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Net Cash Flow

n
Project C Project D C–D
0 -$4,000 -$2,000 -$2,000
1 2,410 1,400 1,010
2 2,930 1,720 1,210

∴ IRR C − D = 7.03% , Project D is preferred

(c) Incremental analysis between E and F:

Net Cash Flow

n
Project E Project F F –E
0 -$2,000 -$3,000 -$1,000
1 3,700 2,500 -1,200
2 1,640 1,500 -140

∴No IRR, Project E dominates project F. Select E.

7.40 Let A0 = current practice, A1 = just-in-time system, A2 = stock-less supply

system.

z Comparison between A0 and A1:

n A0 A1 A1 – A0
0 0 -$2,500,000 -$2,500,000
1-8 -5,000,000 -2,900,000 2,100,000

i* A1− A0 = IRR A1− A 0 = 83.34% > 10%

∴ A1 is a better choice.

z Comparison between A1 and A2:

n A2 A1 A2 – A1
0 -$5,000,000 -$2,500,000 -$2,500,000
1-8 -1,400,000 -2,900,000 1,500,000

i* A 2− A1 = IRR A 2− A1 = 58.49% > 10%

∴ A2 is a better choice. That means that the stockless supply system is the final
choice.

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7.41
(a)
• Project A vs. Project B

Net Cash Flow

n
Project A Project B B–A
0 -$1,000 -$1,000 0
1 900 600 -$300
2 500 500 0
3 100 500 400
4 50 100 50

∴ i* B − A = IRR B − A = 21.27% > 12% , select B.

• Project B vs. Project C

Net Cash Flow

n
Project B Project C C–B
0 -$1,000 -$2,000 -$1,000
1 600 900 300
2 500 900 400
3 500 900 400
4 100 900 800

∴ i*C − B = IRR C − B = 26.32% > 12% , select C.

(b)
$1, 000 = $300( P / A, i, 4)
i = 7.71%

(c) Since BRR (borrowing rate of return) is less than MARR, project D is
acceptable.

(d)
Net Cash Flow
n
Project C Project E C–E
0 -$2,000 -$1,200 -$800
1 900 400 500
2 900 400 500
3 900 400 500
4 900 400 500

∴ i*C − E = IRR C − E = 50.23% > 12% , select C.

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7.42
(a)
i1* = 85.08%, i2* = 48.11%, and i3* = 44.31%

(b)
• Project 1 versus Project 2:

n Project 1 Project 2 2–1

0 -$1,000 -$5,000 -$4,000
1 500 7,500 7,000
2 2,500 600 -1,900

This is a nonsimple incremental investment. So, we need to compute RIC at

15%.
RIC2−1 = 33.69% > 15%

∴ Select Project 2.

• Project 2 versus Project 3:

n Project 2 Project 3 2–3

0 -$5,000 -$2,000 -$3,000
1 7,500 1,500 6,000
2 600 2,000 -1,400

This is another nonsimple incremental investment, so we need to calculate

RIC on the incremental investment.

RIC2−3 = 59.42% > 15%

∴ Again, select Project 2.

7.43
(a) IRRB = 25.99%

(b) PW (15%) A = −$10, 000 + $5,500( P / A,15%,3) = $2,558

(c) Incremental analysis:

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Net Cash Flow

n Project A Project B B–A
0 -$10,000 -$20,000 -$10,000
1 5,500 0 -5,500
2 5,500 0 -5,500
3 5,500 40,000 34,500

∴ Since IRR B − A = 24.24% > 15%, select project B.

7.44 Select Model C. Note that all three projects would be acceptable individually,
as each project’s IRR exceeds the MARR. The incremental IRR of Model (C –
B) is 40%, indicating that Model C is preferred over Model B at MARR = 12%.
Similarly, the incremental IRR of Model (C – A) is 15% which exceeds the
MARR. Therefore, Model C is again preferred.

7.45 All projects would be acceptable because individual ROR exceed the MARR.
Based on the incremental analysis, we observe the following relationships:

IRR A 2− A1 = 10% < 15% (Select A1)

IRR A3− A1 = 18% > 15% (Select A3)
IRR A3− A 2 = 23% > 15% (Select A3)

∴ Therefore, A3 is the best alternative.

7.46 From the incremental rate of return table, we can deduce the following
relationships:

IRR A 2− A1 = 9% < 15% (Select A1)

IRR A3− A 2 = 42.8% > 15% (Select A3)
IRR A 4− A3 = 0% < 15% (Select A3)
IRR A5− A 4 = 20.2% > 15% (Select A5)
IRR A6− A5 = 36.3% > 15% (Select A6)

It is necessary to determine the preference relationship among A1, A3, and A6.

IRR A3− A1 = 16.66% > 15% (Select A3)

IRR A6− A3 = 20.18% > 15% (Select A6)
IRR A6− A1 = 18.24% > 15% (Select A6)

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∴ A6 is the best alternative.

7.47 For each power saw model, we need to determine the incremental cash flows
over the “by-hand” operation that will result over a 20-year service life.

Power Saw
Category Model A Model B Model C
Investment cost $4,000 $6,000 $7,000
Salvage value $400 $600 $700
Annual labor savings $1,296 $1,725 $1,944
Annual power cost $400 $420 $480
Net annual savings $896 $1,305 $1,464

Net Cash Flow

n Model A Model B Model C
0 -$4,000 -$6,000 -$7,000
1 896 1,305 1,464
2 896 1,305 1,464
#
20 400+896 600+1,305 700+1,464
IRR 22.03% 21.35% 20.46%
PW(10%) $3,688 $5,199 $5,568

z Model A versus Model B:

PW (i ) B − A = −$2, 000 + $409( P / A, i, 20) + $200( P / F , i, 20)

=0
IRR B − A = 19.97% > 10%

∴ Select Model B.

z Model B versus Model C:

PW (i )C − B = −$1, 000 + $159( P / A, i, 20) + $100( P / F , i, 20)

=0
IRR C − B = 15.03% > 10%

∴ Select Model C

Unequal Service Life

7.48 With the least common multiple of 6 project years,

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 21

Net Cash Flow

n Project A Project B B–A
0 -$100 -$200 -$100
1 60 120 60
2 50 150-200 -100
3 50-100 120 170
4 60 150-200 -110
5 50 120 70
6 50 150 100

Since the incremental cash flow series is a nonsimple investment, we may

abandon the IRR analysis, and use the PW decision rule.

PW (15%) B − A = −$100 + $60( P / F ,15%,1)

+ " + $100( P / F ,15%, 6)
= $3.48

Since PW (15%) B − A > 0, or PW (15%) B > PW (15%) A , select project B.

Comments: Even though the incremental flow is a nonsimple, it has a unique rate
of return. As shown in Problem 7.39, this incremental cash flow series will pass the
net investment test, indicating that the incremental cash flow is a pure investment.

IRR B − A = 15.98% > 15%

7.49
(a) Since there is not much information given regarding the future replacement
options and the required service period, we may assume that the required
service period is indefinite and both projects can be repeated at the same cost
in the future.
(b) The analysis period may be chosen as the least common multiple of project
lives, which is 3 years.

n A2 – A1
0 -$5,000
1 0
2 0
3 15,000

IRR A 2− A1 = 44.195%
∴ The MARR must be less than 44.195% for Project A1 to be preferred.

Contemporary Engineering Economics, Fourth Edition, By Chan S. Park. ISBN 0-13-187628-7.

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 22

Short Case Studies

ST 7.1
(a) Analysis period of 40 years:

• Without the “mothballing” cost:

PW (i ) = −$1,500, 000 + $138, 000( P / A1 , 0.05%, i, 40)

=0
i = 8.94%
*

• With the “mothballing” cost of $0.75 billion:

PW (i ) = −$1,500, 000 + $138, 000( P / A1 , 0.05%, i, 40)

= −$750, 000( P / F , i, 40)
i* = 8.77%

For a 40-year analysis period, the drop of IRR with the mothballing cost is
only 1.9%, which is relatively insignificant.

(b) Analysis period of 25 years (unit: thousand $):

• Without the “mothballing” cost:

PW (i ) = −$1,500, 000 + ($207, 000 − $69, 000)( P / A1 , 0.05%, i, 25)

=0
i* = 8.94%

• With the “mothballing” cost of $0.75 billion:

PW (i ) = −$1,500, 000 + ($207, 000 − $69, 000)( P / A1 , 0.05%, i, 25)

−$750, 000( P / F , i, 25)
=0
i* = 6.80%

For a 25-year analysis period, the drop of IRR with the mothballing cost is
about 13.27%, which is relatively significant.

ST 7.2
Contemporary Engineering Economics, Fourth Edition, By Chan S. Park. ISBN 0-13-187628-7.
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 23

(a) Assumptions required:

• There is no information regarding the expected cash flows from the current
operation if B&E Cooling decides to defer the introduction of the absorption
technology for 3 years. Therefore, we need to make an explicit assumption
of the expected cash flows for the first three years if B&E Cooling decides
to defer the decision. Assume that the annual cash flow during this period
would be X.
• Another assumption we have to make is about the analysis period.
Assuming that the firm will be in business for an indefinite period, we also
need to make an explicit assumption regarding the future cooling technology.
Since there is no information about the future cooling technology options,
we may assume that the best cooling technology will be the absorption
technology that will be introduced 3 years from now. Therefore, if B&E
Cooling decides to select Option1, we could assume that, at the end of 8
years, Option 2 (the best cooling technology at that time) will be adopted for
an indefinite period.

(b) Investment decision:

• Present worth analysis: First, we will determine the equivalent present worth
for each option:

PW (i )1 = −$6 + $9( P / A, i,8) + $1( P / F , i,8)

[−$5 + $4( P / A, i,8) + $2( P / F , i,8)]( A / P, i,8)
+
i
×( P / F , i,8)
PW (i ) 2 = X ( P / A, i,3)
[−$5 + $4( P / A, i,8) + $2( P / F , i,8)]( A / P, i,8)
+
i
×( P / F , i,3)
Now we can determine the value X that makes the two options economically
equivalent at an interest rate of 15%. In other words, if we evaluate the two
present worth functions at i = 15% , we have

PW (15%)1 = $41.31
PW (15%)2 = 2.2832 X + $13.28

Letting PW (15%)1 = PW (15%) 2 and solving for X gives

X = $12.28

As long as the current operation continues to generate annual net revenue of

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$12.28 millions for 3 years, Option 2 is a better choice.

• Rate of return analysis: The present worth analysis above indicates that, if
X = $12.28 , the break-even rate of return on incremental investment is
i*1− 2 = 15%

Therefore, the ultimate choice will depend on the level of annual revenues
generated during the first 3 years when the advanced cooling technology is
deferred. Clearly, if

X < $12.28 , then i*1− 2 > 15% , Option 1 is preferred.

ST 7.3
n Current Pump(A) Larger Pump(B) B-A
0 $0 -$1,600,000 -$1,600,000
1 $10,000,000 $20,000,000 $10,000,000
2 $10,000,000 $0 -$10,000,000

IRR = 25%
400%

The incremental cash flows result in multiple rates of return (25% and 400%), so
we may abandon the rate of return analysis. Using the PW analysis,

PW (20%) = −$1.6 M + $10 M ( P / F , 20%,1) − $10 M ( P / F , 20%, 2)

= −$0.21 < 0
Reject the larger pump.

Return on Invested Capital: Using the procedure outlined in Section 7.3.4,

PB(i, 20%)0 = −$1, 600, 000

PB(i, 20%)1 = −$1, 600, 000(1 + i ) + $10, 000, 000
= 8, 400, 000 − 1, 600, 000i

If i < 525%, then PB(i, 20%)1 > 0 .

PB(i, 20%) 2 = (8, 400, 000 − 1, 600, 000i)(1 + 0.20) − $10, 000, 000
= 80, 000 − 1,920, 000i
=0
i = 4.17% < 20%
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If i > 525%, then PB (i, 20%)1 < 0 , no RIC exists. So, the RIC on the incremental
cash flows should be 4.17%, which indicates “Select a smaller pump.”

ST 7.4
(a) Whenever you need to compare a set of mutually exclusive projects based
on the rate of return criterion, you should perform an incremental analysis.
In our example, the incremental cash flows would look like the following:

n B-A
0 -$10,000
1 +23,000
2 -13,200

This is a nonsimple investment with two rates of return.

i* B − A = 10% or 20%

We could abandon the IRR analysis and use either the PW analysis to rank
the projects.

(b) If we plot the present worth as a function of interest rate, we will observe
the following:

• If MARR < 10% select project A.

• If 10% ≤ MARR ≤ 18.1%, select project B.
• If MARR > 18.1%, do nothing.

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Return on Invested Capital: Using the procedure outlined in Section 7.3.4, the
true rate of return can be found as a function of MARR.

Let i = IRR and assume i < 1.3

PB (i, MARR) 0 = −$10, 000

PB (i, MARR)1 = −$10, 000(1 + i ) + $23, 000
= $13, 000 − 10, 000i
PB (i, MARR) 2 = ($13, 000 − 10, 000i)(1 + MARR)
−$13, 200
=0

(Note that, if, i > 1.3, there will be no feasible solution.) Rearranging the terms
in PB(i, MARR) 2 gives an expression of IRR as a function of MARR.

1.32
IRR = 1.3 −
1 + MARR

For example, at MARR = 15%

IRR B − A = 15.3% > 15%

∴ Project B (the higher cost investment) would be justified.

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