Part 2 - Chapter 7 - Rate of Return Analysis

Chapter 7
Rate of Return Analysis

❑ Rate of Return
❑ Methods for Finding ROR
❑ Internal Rate of Return

(IRR) Criterion
❑ Incremental Analysis
❑ Mutually Exclusive
Alternatives
Rate of Return
Definition
A relative percentage method which

measures the annual rate of return as a
percentage of investment over the life of a
project.
Example: Meaning of Rate
of Return
In 1982, an investment of 100 shares cost
$1,650. That investment would have
been worth $12,283,904 on January 31,
2014.
What is the rate of return on that

investment?
Solution: $12,283,904
0
32
$1,650
Given: P = $1,650
F = $12,283,904
N = 32
Find i:
F = P (1 + i ) N
$12,283,904 = $1,650 (1 + i )32

i = 32.13% Rate of Return
Suppose that you invested that amount ($1,650) in a
savings account at 6% per year. Then, you could have
only $10,648 on January, 2014.
What is the meaning of this 6% interest here?
This is your opportunity cost if putting money in

savings account was the best you can do at that time!
So, in 1982, as long as you earn more than 6%
interest in another investment, you will take that
investment.
Therefore, that 6% is viewed as a minimum

acceptance rate of return (or required rate of return).
So, you can apply the following decision rule, to see

if the proposed investment is a good one.
ROR (32.13%) > MARR(6%)

Return on Investment
Definition 1: Rate of return (ROR) is defined as the

interest rate earned on the unpaid balance of an
installment loan.
Example: A bank lends $10,000 and receives annual

payment of $4,021 over 3 years. The bank is said to
earn a return of 10% on its loan of $10,000.
Loan Balance Calculation:
A = $10,000 (A/P, 10%, 3)

= $4,021
Unpaid Return on Unpaid
balance unpaid balance
at beg. balance Payment at the end
Year of year (10%) received of year
0 -$10,000 -$10,000
1 -$10,000 -$1,000 +$4,021 -$6,979
2 -$6,979 -$698 +$4,021 -$3,656
3 -$3,656 -$366 +$4,021 0
A return of 10% on the amount still outstanding at the

beginning of each year
Rate of Return:
Definition 2: Rate of return (ROR) is the break-even

interest rate, i*, which equates the present worth of a
project’s cash outflows to the present worth of its cash
inflows.
Mathematical Relation:
PW (i * ) = PW (i * )cash inflows − PW (i * )cash outflows

=0
Methods for Finding Rate of Return
◼ Types of Investment (cash flow) Classification
❑ Simple Investment
❑ Non-simple Investment
◼ Once we identified the type of investment cash flow,

there are several ways available to determine its rate
of return.
◼ Computational Methods
❑ Direct Solution Method
❑ Trial-and-Error Method
❑ Computer Solution Method
Investment Classification
Simple Investment Non-simple Investment
◼ Definition: Initial cash ◼ Definition: Initial cash
flows are negative, flows are negative,
and only one sign but more than one
change occurs in the sign changes in the
net cash flows series. remaining cash flow
series.
◼ Example: -$100, 250,
◼ Example: -$100, 300,
$300 (-, +, +)
-$120 (-, +, -)
◼ ROR: A unique ROR
◼ ROR: A possibility of
◼ If the initial flows are positive and
one sign change occurs referred to multiple RORs
simple-borrowing.
11
Period Project Project Project
(N) A B C
0 -$1,000 -$1,000 +$1,000
1 -500 3,900 -450
2 800 -5,030 -450
3 1,500 2,145 -450
4 2,000
Project A is a simple investment.

Project B is a non-simple investment.
Project C is a simple borrowing.
Computational Methods
Direct Direct Trial & Computer
Solution Solution Error Solution
Method Method
Log Quadratic
n Project A Project B Project C Project D
0 -$1,000 -$2,000 -$75,000 -$10,000
1 0 1,300 24,400 20,000
2 0 1,500 27,340 20,000
3 0 55,760 25,000
4 1,500
Example 7.2 Direct Solution Methods
Project A Project B
$1,300 $1,500
$1,000 = $1,500( P / F , i ,4) PW (i ) = −$2,000 + + =0
(1 + i ) (1 + i ) 2
$1,000 = $1,500(1 + i ) −4 1
Let x = , then
0.6667 = (1 + i ) −4 1+ i
PW (i ) = −2,000 + 1,300 x + 1,500 x 2
ln 0.6667
= ln(1 + i ) Solve for x:
−4
x = 0.8 or -1.667
0.101365 = ln(1 + i )
Solving for i yields
e 0.101365
= 1+ i
1 1
0.8 = → i = 25%, − 1667
. = → i = −160%
i = e 0.101365 − 1 1+ i 1+ i
= 10.67% Since − 100%  i  , the project's i * = 25%.
Trial and Error Method – Project C
◼ Step 1: Guess an interest ◼ Step 4: If you bracket the

rate, say, i = 15% solution, you use a linear
◼ Step 2: Compute PW(i) interpolation to approximate
at the guessed i value. the solution
PW (15%) = $3,553 3,553

0
◼ Step 3: If PW(i) > 0, then -749
increase i. If PW(i)< 0,
then decrease i. 15% i 18%
 3,553 
i = 15% + 3%  
PW(18%) = -$749  3,553 + 749 
= 17 .45 %
Basic Decision Rule:
If ROR > MARR, Accept
This rule does not work for a situation where

an investment has multiple rates of return
Comparing Mutually Exclusive
Alternatives Based on IRR
Issue: Can we rank the mutually exclusive
projects by the magnitude of its IRR?
n A1 A2
0 -$1,000 -$5,000
1 $2,000 $7,000
IRR 100% > 40%
PW (10%) $818 < $1,364

Who Got More Pay Raise?
Bill Hillary
10% 5%
Can’t Compare without Knowing Their
Base Salaries
Bill Hillary
Base Salary $50,000 $200,000
Pay Raise (%) 10% 5%
Pay Raise ($) $5,000 $10,000
For the same reason, we can’t compare mutually exclusive projects based on
the magnitude of its IRR. We need to know the size of investment and its timing
of when to occur.
Incremental Investment
Incremental
Investment
n Project A1 Project A2 (A2 – A1)
0 -$1,000 -$5,000 -$4,000

1 $2,000 $7,000 $5,000
ROR 100% 40% 25%

PW(10%) $818 $1,364 $546
➢ Assuming a MARR of 10%, you can always earn that rate from
other investment source, i.e., $4,400 at the end of one year for $4,000
investment.
➢ By investing the additional $4,000 in A2, you would make

additional $5,000, which is equivalent to earning at the rate of 25%.
Therefore, the incremental investment in A2 is justified.
Incremental Analysis (Procedure)
Step 1: Compute the cash flow for the difference
between the projects (A,B) by subtracting
the cash flow of the lower investment
cost project (A) from that of the higher
investment cost project (B).
Step 2: Compute the IRR on this incremental
investment (IRRB-A ).
Step 3: Accept the investment B if and only if
IRR B-A > MARR
NOTE: Make sure that both IRRA and IRRB are greater than MARR.
Example 7.7 - Incremental Rate of Return
n B1 B2 B2 - B1
0 -$3,000 -$12,000 -$9,000

1 1,350 4,200 2,850
2 1,800 6,225 4,425
3 1,500 6,330 4,830
IRR 25% 17.43% 15%
Given MARR = 10%, which project is a better choice?

Since IRRB2-B1=15% > 10%, and also IRRB2 > 10%, select B2.
IRR on Increment Investment:
Three Alternatives
Step 1: Examine the IRR for each
n D1 D2 D3
project to eliminate any project
that fails to meet the MARR.
0 -$2,000 -$1,000 -$3,000
Step 2: Compare D1 and D2 in pairs.
1 1,500 800 1,500 IRRD1-D2=27.61% > 15%,
so select D1. D1 becomes the
2 1,000 500 2,000 current best.
3 800 500 1,000 Step 3: Compare D1 and D3.

IRRD3-D1= 8.8% < 15%,
so select D1 again.
IRR 34.37% 40.76% 24.81%
Here, we conclude that D1 is the best
Alternative.
Problem 1
solutions
Problem 1
Problem 2 $15,000
$9,229
Problem 3
Problem 2
Problem 3
Problem 4
Problem 5
Problem 4
Problem 5
Problem 6
Problem 6

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Chapter 7

Rate of Return Analysis

❑ Methods for Finding ROR

❑ Internal Rate of Return

A relative percentage method which

What is the rate of return on that

$12,283,904 = $1,650 (1 + i )32

What is the meaning of this 6% interest here?

This is your opportunity cost if putting money in

Therefore, that 6% is viewed as a minimum

So, you can apply the following decision rule, to see

ROR (32.13%) > MARR(6%)

Definition 1: Rate of return (ROR) is defined as the

Example: A bank lends $10,000 and receives annual

A = $10,000 (A/P, 10%, 3)

A return of 10% on the amount still outstanding at the

Definition 2: Rate of return (ROR) is the break-even

PW (i * ) = PW (i * )cash inflows − PW (i * )cash outflows

◼ Once we identified the type of investment cash flow,

Project A is a simple investment.

n Project A Project B Project C Project D

0 -$1,000 -$2,000 -$75,000 -$10,000

1 0 1,300 24,400 20,000

2 0 1,500 27,340 20,000

◼ Step 1: Guess an interest ◼ Step 4: If you bracket the

PW (15%) = $3,553 3,553

If ROR > MARR, Accept

This rule does not work for a situation where

IRR 100% > 40%

PW (10%) $818 < $1,364

Base Salary $50,000 $200,000

Pay Raise (%) 10% 5%

Pay Raise ($) $5,000 $10,000

0 -$1,000 -$5,000 -$4,000

ROR 100% 40% 25%

➢ By investing the additional $4,000 in A2, you would make

IRR B-A > MARR

0 -$3,000 -$12,000 -$9,000

Given MARR = 10%, which project is a better choice?

3 800 500 1,000 Step 3: Compare D1 and D3.

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