Engineering Economics
Chapter 5
Comparison Methods Part II
5-1
Outline
5.1 Introduction
5.2 The Internal Rate of Return
5.3 Internal Rate of Return Comparisons
5.3.1 IRR for Independent Projects
5.3.2 IRR for Mutually Exclusive Projects
5.3.3 Multiple IRRs
5.3.4 External Rate of Return Methods
5.3.5 When to Use the ERR
5.4 Rate of Return and Present/Annual Worth Methods
5.4.1 Equivalence of Rate of Return and Present/Annual Worth
Methods
5.4.2 Why Choose One Method Over the Other?
5-2
5.2 The Internal Rate of Return (IRR)
• IRR: interest rate i* such that when all cash
flows of project are discounted at i*, PW of
cash inflows equals PW of the cash outflows.
• IRR can be viewed as the interest rate at
which project “breaks even” between all
cash inflows and cash outflows.
T
( Rt Dt ) Rt and Dt are the receipts
PW 0 and disbursements in
t 0 (1 i*)t
period t, t = 0,1,…,T
Ex: If $100 invested today returns $110 in a year, the IRR is 10%
Mathematically: 100 = 110/(1 + i*) Solve for i
5.2 The Internal Rate of Return (cont’d)
• IRR is the interest rate at which project “breaks even”
• We can solve for this interest (discount) rate by setting:
– PW(disbursements) = PW(receipts) or
– AW(disbursements) = AW(receipts) or
– FW(disbursements) = FW(receipts)
• IRR is usually positive. (otherwise project is losing money)
• The above three equations for the IRR can be solved by:
– Trial and error alone
– Trial and error along with linear interpolation
– built-in IRR function in many spreadsheet programs (i.e. Excel)
5-4
Practice Problem 5.2a
New windows at Nottawasaga Fabricating (NF)
are expected to save $400 per year in energy
over their 30 year life. The windows have an
initial cost of $8,000. and will have a zero
salvage value.
a) Use a spreadsheet to plot the PW of this
investment as a function of the interest rate.
b) Use a spreadsheet to calculate the IRR
5-5
Practice Problem 5.2a (cont’d)
Answer
PW = - 8000 + 400(P/A, i, 30)
5000
4000
Present Worth
3000
2000
1000
0
0.0% 1.0% 2.0% 3.0% 4.0%
-1000
-2000
Interest Rate
5-6
Practice Problem 5-2a (cont’d)
Answer
5-7
Example:
For a project with the following cash flows, what
3000 3000 3000 3000
is its IRR? at t=0, invest 10,000.
at t=1, receive 3,000.
at t=2, receive 3,000. 0 1 2 3 4 5 6
at t=3, receive 3,000. -10000
at t=4, receive 3,000.
PW(investment) = PW(receipts)
10,000 = 3000*(P/A, i*, 4) so (P/A, i*, 4)=10/3 = 3.3333
(1+𝑖)𝑁 −1
(P/A, i, N) =
From the interest tables, we found 𝑖(1+𝑖)𝑁
(P/A, 7%, 4) = 3.3872 (P/A, 8%, 4) = 3.3121
So IRR is between 7% and 8%, by interpolation
We found IRR = 7.28%. Using EXCEL, IRR=7.7138%
5-8
Example:
For a project with the following cash flows, find its IRR?
at t=0, invest 10,000. 4000 4000
3000 3000
at t=1, receive 3,000.
at t=2, receive 4,000.
at t=3, receive 4,000. 0 1 2 3 4 5 6
at t=4, receive 3,000.
-10000
PW(investment) = PW(receipts)
𝟑𝟎𝟎𝟎 𝟒𝟎𝟎𝟎 𝟒𝟎𝟎𝟎 𝟑𝟎𝟎𝟎
10,000 = + + + Let X=(1+i)
(𝟏+𝒊) (𝟏+𝒊)𝟐 (𝟏+𝒊)𝟑 (𝟏+𝒊)𝟒
10,000X4-3000X3-4000X2-4000X = 3000
10X4-3X3-4X2-4X = 3
By trial, we found when (1+i) = 1.14, LHS = 2.6866
when (1+i) = 1.15, LHS = 3.0374
since RHS = 3.0 is between 2.6866 and 3.0374,
we figured that (1+i) is in between 1.14 and 1.15,
i.e., 14% < IRR < 15% Using EXCEL, we get IRR=14.9
5-9
5.3 Internal Rate of Return Comparisons
5.3.1 IRR for Independent Projects
• Independent Projects: Invest in a project if IRR
equals or exceeds the MARR.
• Similar to the evaluation of independent projects
(Ch 4) where PW or AW ≥ 0 is acceptable
• Recall previous Problem 5-2a where the IRR of
the project was found to be 2.8%. With a MARR
of 8%, should the investment be made?
• NO - The IRR is 2.84% which is < MARR of 8%
5 - 10
5.3.2 IRR for Mutually Exclusive Projects
The analysis gets more complex than previous:
Consider two mutually exclusive investments. The first
costs $10 today and returns $20 in a year. The second
costs $1000 and returns $1200 in one year. MARR is
12%. Which is your preferred investment?
• First project:
– Rate of return = 100%
– PW = −10 + 20 (P/F,12%,1) = $7.86
• Second Project:
– Rate of Return = 20%
– PW = −1000 + 1200(P/F,12%,1) = $71.42
5 - 11
5.3.2 IRR for Mutually Exclusive Projects (cont’d)
• The IRR for the first project is higher than the second,
but the second has a higher PW…second is preferred!
• When mutually exclusive, tempting to pick higher IRR!
Incorrect: does not consider magnitude
• Overlooks projects where IRR > MARR and due to
magnitude of return represents higher PW
• Therefore have to consider incremental investment.
• Does the incremental investment earn at least MARR?
• If so, this is the better investment.
5 - 12
5.3.2 IRR for Mutually Exclusive Projects (cont’d)
• Consider project with smallest first cost: $10. It
has an IRR of 100%, obviously acceptable
• Second project (P2) requires incremental
investment of $990, brings incremental benefit
of $1180. What is IRR on incremental
investment?
• Solve for i in PW(P2) − PW(P1) = 0:
−10−(−1000)+(20-1200)(P/F,i,1) = 0
990−1180/(1+i) = 0 i = 0.1919 or 19%
• Therefore take the incremental investment!
5 - 13
5.3.2 IRR for Mutually Exclusive Projects (cont’d)
Comparing mutually exclusive alternatives
1. Sort the projects from the lowest first cost to the
highest. Call this lowest first cost the current
best.
2. Challenge the current best with the next most
expensive project. If the challenger is
successful, i.e., if the incremental investment has
an IRR MARR, then make the challenger the
current best.
3. Repeat Step 2 until there are no further
challengers.
5 - 14
Figure 5.5 Flowchart for Comparing Mutually Exclusive Alternatives
5 - 15
Example
Consider the following two mutually exclusive
investment alternatives:
End of Year Alternative A Alternative B
0 -250,000 -300,000
1 50,000 55,000
2 55,000 65,000
3 70,000 80,000
4 80,000 95,000
5 90,000 105,000
If MARR is 8%, which alternative should be
selected based upon the IRR approach.
5 - 16
Solution
First, Rank “A” and “B” according to the initial cost, A then B
since 250,000 < 300,000
Second, consider the increment from “do-nothing” to “A”
End of Year Increment to ‘A’
0 -250,000
1 50,000
2 55,000
3 70,000
4 80,000
5 90,000
Calculate the IRR=10.56% (by Excel or solve the polynomial
eq.). The current winner is therefore replaced by “A”.
Third, consider the increment from “A” to “B”.
End of Year Increment from ‘A’ to ‘B’
The IRR for the A to B 0 -50,000
Increment is IRR=2.82% 1 5,000
2 10,000
which < MARR, reject B. 3 10,000
4 15,000
So select A only. 5 15,000 5 - 17
KAHOOT Session
5 - 18
Quiz #6 November 5
For a project with the following cash flows, what is its IRR?
at t=0, invest 10,000.
at t=1, receive 6,000.
at t=2, receive 6,000.
Hint: PW(investment) = PW(receipts)
i (P/A, i, 2)
12% 1.6901
13% 1.6681
14% 1.6467
15% 1.6257
20% 1.5278
5 - 19
Quiz #6 November 5 SOLUTION
For a project with the following cash flows, what is its IRR?
at t=0, invest 10,000.
at t=1, receive 6,000.
at t=2, receive 6,000.
Hint: PW(investment) = PW(receipts)
10,000 = 6000*(P/A, i*, 2) so (P/A, i*, 2)=10/6 = 1.6667
From the interest tables, we found
(P/A, 13%, 2) = 1.6681 (P/A, 14%, 2) = 1.6467
So IRR is between 13% and 14%, by interpolation
We found IRR = 13.07%. Using EXCEL, IRR=13.0662%
5 - 20
