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CH 5 ROR

The document discusses the Rate of Return Method in Engineering Economics, explaining how to calculate the rate of return for various cash flow patterns to determine the best investment alternative. It includes examples of different investment scenarios, illustrating the calculation of present worth and the selection of alternatives based on their rates of return. The analysis emphasizes the importance of comparing the calculated rates against a minimum attractive rate of return to make informed investment decisions.

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Abdulrahman Mohammed
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16 views16 pages

CH 5 ROR

The document discusses the Rate of Return Method in Engineering Economics, explaining how to calculate the rate of return for various cash flow patterns to determine the best investment alternative. It includes examples of different investment scenarios, illustrating the calculation of present worth and the selection of alternatives based on their rates of return. The analysis emphasizes the importance of comparing the calculated rates against a minimum attractive rate of return to make informed investment decisions.

Uploaded by

Abdulrahman Mohammed
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Engineering Economics

Ch. 5

Rate of Return Method

‫ عبد اللطيف سيد أحمد‬/‫د‬


1
Rate of Return Analysis
• The rate of return of a cash flow pattern is the interest rate at
which the present worth of that cash flow pattern reduces to
zero. In this method of comparison, the rate of return for each
alternative is computed. Then the alternative which has the
highest rate of return is selected as the best alternative.
• In this type of analysis, the expenditures are always assigned
with a negative sign and the revenues/inflows are assigned
with a positive sign.
• A generalized cash flow diagram to demonstrate the rate of
return method of comparison is presented in the fig.

2
Rate of Return Analysis
• A generalized cash flow diagram to demonstrate the rate of
return method of comparison is presented in the fig.

In the above cash flow diagram,


P represents an initial investment,
Rj the net revenue at the end of the jth year,
and S the salvage value at the end of the nth year.

PW(i)= –P + R1/(1 + i)1 + R2/(1 + i)2 + ...+ Rj/(1 + i)j + ... + Rn/(1 + i)n + S/(1 + i)n

3
Rate of Return Analysis
The previous function is to be evaluated for different
values of i until the present worth function reduces to
zero

4
EXAMPLE:1

• A person is planning a new business. The initial


outlay and cash flow pattern for the new business
are as listed below. The expected life of the business
is five years. Find the rate of return for the new
business.

5
Initial investment = LE 100,000
Annual equal revenue = LE 30,000 Life = 5 years

PW(i) = –100,000 + 30,000(P/A, i, 5)

When i = 10%, PW
PW(10%) = –100,000 + 30,000(P/A, 10%, 5)
13,724
= –100,000 + 30,000(3.7908) = LE13,724.
When i = 15%,
PW(15%) = –100,000 + 30,000(P/A, 15%, 5)
566
= –100,000 + 30,000(3.3522) = LE566. i

When i = 18%, 10% 15% 18%

PW(18%) = –100,000 + 30,000(P/A, 18%, 5)


= –100,000 + 30,000(3.1272) = LE– 6,184 -6184

i = 15% + ( (566)/(6184+566))*(3%) = 15% + 0.252%


= 15.252%
EXAMPLE 2
• A company is trying to diversify its business in a
new product line. The life of the project is 10 years
with no salvage value at the end of its life. The initial
outlay of the project is LE 2,000,000. The annual net
profit is LE350,000.

• Find the rate of return for the new business.

7
• Life of the product line (n) = 10 years
• Initial outlay = LE 2000,000
• Annual net profit = LE 350,000
• Scrap value after 10 years = 0

8
• The formula for the net present worth function of the situation is

• PW(i) = –20,00,000 + 3,50,000(P/A, i, 10)

• When i = 10%,

• PW(10%) = –20,00,000 + 3,50,000(P/A, 10%, 10)

• = –20,00,000 + 3,50,000(6.1446) = Rs. 1,50,610.

• When i = 12%,

• PW(12%) = –20,00,000 + 3,50,000(P/A, 12%, 10)

• = –20,00,000 + 3,50,000 (5.6502) = Rs. –22,430.

9
EXAMPLE:3
• An initial investment of $500 is being considered. The
revenues from this investment are

• $300 at the end of the first year,

• $300 at the end of the second,

• and $200 at the end of the third.

• If the desired return on investment is 15%, is the


project acceptable?
10
• $500 = $300(PF, i, n=1) + 300(PF, i, n=2) + $200(PF, i, n=3)

• Now solve for i using trial and error method

• Try 10%: $500 = ? $272 + $247 + $156 = $669 (not equal)

• Try 20%: $500 = ? $250 + $208 + $116 = $574 (not equal)

• Try 30%: $500 = ? $231 + $178 + $91 = $500 (equal)

•  i(ROR) = 30%

• The desired return on investment is 15%, the project


returns 30%, so it should be implemented

11
EXAMPLE 4
• A firm has identified three mutually exclusive
investment proposals whose details are given below.
The life of all the three alternatives is estimated to be
five years with negligible salvage value. The
minimum attractive rate of return for the firm is 12%.

Find the best alternative based on the


rate of return method of comparison. 12
Calculation of rate of return for alternative A1
Initial outlay = Rs. 1,50,000 Annual profit = Rs. 45,570 Life = 5 years

The formula for the net present worth of alternative A1 is given as


PW(i) = –1,50,000 + 45,570(P/A, i, 5)
When i = 10%,
PW(10%) = –150,000 + 45,570(P/A, 10%, 5)= -150,000 + 45,570(3.7908) =LE 22,746.76

When i = 12%,
PW(12%) = –1,50,000 + 45,570(P/A, 12%, 5)= –150,000 + 45,570(3.6048)= LE 14,270.74

When i = 15%,
PW(15%) = –1,50,000 + 45,570(P/A, 15%, 5)= –150,000 + 45,570(3.3522)= LE 2,759.75

When i = 18%,
PW(18%) = –1,50,000 + 45,570(P/A, 18%, 5)= –150,000 + 45,570(3.1272) = LE –7,493.50
Therefore, the rate of return of the alternative A1 is
Calculation of rate of return for alternative A2
Initial outlay = LE 210,000 Annual profit = LE 58,260 Life of alternative A2 = 5 years

The formula for the net present worth of this alternative is


PW(i) = –2,10,000 + 58,260(P/A, i, 5)

When i = 12%,
PW(12%) = –210,000 + 58,260(P/A, 12%, 5)
= –210,000 + 58,260(3.6048) = LE15.65

When i = 13%,
PW(13%) = –2,10,000 + 58,260(P/A, 13%, 5)
= –210,000 + 58,260 (3.5172) = LE –5,087.93
Therefore, the rate of return of alternative A2 is
Calculation of rate of return for alternative A3
Initial outlay = Rs. 2,55,000 Annual profit = Rs. 69,000 Life of alternative A3 = 5 years

The formula for the net present worth of this alternative A3 is


PW(i) = –2,55,000 + 69,000(P/A, i, 5)
When i = 11%,
PW(11%) = – 255,000 + 69,000(P/A, 11%, 5)
= – 255,000 + 69,000 (3.6959) = LE 17.1
When i = 12%,
PW(12%) = – 2,55,000 + 69,000(P/A, 12%, 5)
= – 255,000 + 69,000 (3.6048)= LE– 6,268.80
From the above data, it is clear that the rate of return for
alternative A3 is less than the minimum attractive rate of return
of 12%. So, it should not be considered for comparison. The
remaining two alternatives are qualified for consideration.
Among the alternatives A1 and A2, the rate of return of

alternative A1 is greater than that of alternative A2. Hence,


alternative A1 should be selected.
16

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