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    Rate of Return Calculations

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    Srushti M
    The document discusses various rate of return calculations used in engineering economy studies, including the Minimum Acceptable Rate of Return (MARR), Internal Rate of Return (IRR), and External Rate of Return (ERR). It provides examples of calculating the IRR of various investment projects and compares them to the MARR to determine which projects should be accepted. It also discusses common misconceptions around IRR calculations and introduces the concept of using the cost of capital to determine the MARR.

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    Rate of Return Calculations

    Uploaded by

    Srushti M
    380 views37 pages
    The document discusses various rate of return calculations used in engineering economy studies, including the Minimum Acceptable Rate of Return (MARR), Internal Rate of Return (IRR), and External Rate of Return (ERR). It provides examples of calculating the IRR of various investment projects and compares them to the MARR to determine which projects should be accepted. It also discusses common misconceptions around IRR calculations and introduces the concept of using the cost of capital to determine the MARR.

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    The document discusses various rate of return calculations used in engineering economy studies, including the Minimum Acceptable Rate of Return (MARR), Internal Rate of Return (IRR), and External Rate of Return (ERR). It provides examples of calculating the IRR of various investment projects and compares them to the MARR to determine which projects should be accepted. It also discusses common misconceptions around IRR calculations and introduces the concept of using the cost of capital to determine the MARR.

    Copyright:

    © All Rights Reserved
    Download as PPT, PDF, TXT or read online from Scribd
    Download as ppt, pdf, or txt
    380 views37 pages

    Rate of Return Calculations

    Uploaded by

    Srushti M
    The document discusses various rate of return calculations used in engineering economy studies, including the Minimum Acceptable Rate of Return (MARR), Internal Rate of Return (IRR), and External Rate of Return (ERR). It provides examples of calculating the IRR of various investment projects and compares them to the MARR to determine which projects should be accepted. It also discusses common misconceptions around IRR calculations and introduces the concept of using the cost of capital to determine the MARR.

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    © All Rights Reserved
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    The key takeaways are about different types of rates of return used in engineering economy studies including Minimum Acceptable Rate of Return (MARR), Internal Rate of Return (IRR), and External Rate of Return (ERR).

    The different types of rates of return discussed are Minimum Acceptable Rate of Return (MARR), Internal Rate of Return (IRR), and External Rate of Return (ERR).

    The Minimum Acceptable Rate of Return (MARR) is the lowest level of return that makes an investment acceptable, as set by an organization. It varies according to the type of project and organization.

    RATE OF RETURN

    CALCULATIONS
    RATE OF RETURN

    • The rate of return is a percentage that indicates the relative yield on


    different uses of capital
    • Three rates of return appear frequently in engineering economy studies like:

     Minimum Acceptable Rate of Return (MARR)


     Internal Rate of Return (IRR)
     External Rate of Return (ERR)
    • The Minimum Acceptable Rate of Return (MARR):

     The rate set by an organization to designate the lowest level of return that
    makes an investment acceptable

    • Ex: 10%, 20% etc.


    • The Internal Rate of Return (IRR):

     The rate on the unrecovered balance of the investment in a situation where


    the terminal balance is zero
    • The External Rate of Return (ERR):

     The rate of return that is possible to obtain for an investment under current
    economic conditions.
    Minimum Acceptable Rate of Return (MARR)

    • Also known as “Minimum Attractive Rate of Return”.

    • It is a lower limit for investment acceptability set by organizations or


    individuals

    • It is a device designated to make the best possible use of a limited resource


    i.e., money.

    • Rates vary widely according to the type of organization and they vary within
    the organization.
    • The rate of return required for cost reduction proposals may be lower than
    that required for research and development projects in which there is less
    certainty about prospective cash flows

    • A MARR value that include effect of inflation is referred to as the market


    interest rate. Use of this rate will require that all cash flows be in actual
    rupees.
    • How much above the cost of capital to set the Minimum Attractive Rate of
    Return depends on an organization’s circumstances and aspirations

    • A small company strapped for cash and burdened by a low credit rating will
    have a higher cost of capital

    • A Larger, established companies tend to view rate as a realistic expectation


    of how much their capital can earn when it is invested

    • The purpose of establishing a Minimum Attractive Rate of


    Return higher than the cost of capital is to ration capital
    Calculation of INTERNAL RATE OF RETURN (i*)

     The internal rate of return is calculated by equating the annual, present or


    future worth of cash flows to zero and solving for the interest rate that
    allows the equity

     The internal rate of return is the rate of interest earned by an alternative


    investment on the unrecovered balance of an interest
    Procedure for finding an IRR(i*)

    • Start with an intuitive value of i and check whether the present worth
    function is positive

    • If so, increase the value of i until PW(i) becomes negative

    • Then, the rate of return is determined by interpolation method in the range


    of values of i for which the sign of the present worth function changes from
    positive to negative
    EX 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
    Solution

    • Initial investment = Rs. 1,00,000


    • Annual equal revenue = Rs. 30,000
    • Life = 5 years

    The present worth function for the business is

    PW(i) = –1,00,000 + 30,000(P/A, i, 5)


    • When i = 10%

    PW(10%) = –1,00,000 + 30,000(P/A, 10%, 5)


    = –1,00,000 + 30,000(3.7908)
    = Rs. 13,724

    • When i = 15%

    PW(15%) = –1,00,000 + 30,000(P/A, 15%, 5)


    = –1,00,000 + 30,000(3.3522)
    = Rs. 566
    • When i = 18%

    PW(18%) = –1,00,000 + 30,000(P/A, 18%, 5)


    = –1,00,000 + 30,000(3.1272)
    = Rs. – 6,184

    = 15% + 0.252%

    = 15.252%

    Therefore, the rate of return for the new business is 15.252%.


    EX 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 Rs. 20,00,000. The annual net
    profit is Rs. 3,50,000. Find the rate of return for the new business
    • Solution

    • Life of the product line (n) = 10 years


    • Initial outlay = Rs. 20,00,000
    • Annual net profit = Rs. 3,50,000
    • Scrap value after 10 years = 0

    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
    EX 3 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%.
    Solution

    • Calculation of IRR for alternative A1

    • Initial outlay = Rs. 1,50,000


    • Annual profit = Rs. 45,570
    • Life = 5 years
    For alternative A1

    PW(i) = –1,50,000 + 45,570(P/A, i, 5)

    When i = 10%
    • PW(10%) = –1,50,000 + 45,570(P/A, 10%, 5)
    = –1,50,000 + 45,570(3.7908)
    = Rs. 22,746.76

    When i = 12%
    • PW(12%) = –1,50,000 + 45,570(P/A, 12%, 5)
    = –1,50,000 + 45,570(3.6048)
    = Rs. 14,270.74
    When i = 15%

    • PW(15%) = –1,50,000 + 45,570(P/A, 15%, 5)


    = –1,50,000 + 45,570(3.3522)
    = Rs. 2,759.75

    When i = 18%,

    • PW(18%) = –1,50,000 + 45,570(P/A, 18%, 5)


    = –1,50,000 + 45,570(3.1272)
    = Rs. –7,493.50

    Therefore, the rate of return of the alternative A1 is


    • IRR for alternative A2

    • Initial outlay = Rs. 2,10,000


    • Annual profit = Rs. 58,260
    • Life of alternative A2 = 5 years

    PW(i) = –2,10,000 + 58,260 (P/A, i, 5)


    • When i = 12%,

    • PW(12%) = –2,10,000 + 58,260(P/A, 12%, 5)


    = –2,10,000 + 58,260(3.6048)
    = Rs. 15.65
    • When i = 13%,

    • PW(13%) = –2,10,000 + 58,260(P/A, 13%, 5)


    = –2,10,000 + 58,260 (3.5172)
    = Rs. –5,087.93
    • IRR for alternative A3

    • Initial outlay = Rs. 2,55,000


    • Annual profit = Rs. 69,000
    • Life of alternative A3 = 5 years

    Present worth of this alternative A3 is

    PW(i) = –2,55,000 + 69,000(P/A, i, 5)

    When i = 11%
    ,
    PW(11%) = – 2,55,000 + 69,000(P/A, 11%, 5)
    = –2,55,000 + 69,000 (3.6959)
    = Rs. 17.1

    When i = 12%
    PW(12%) = – 2,55,000 + 69,000(P/A, 12%, 5)
    = –2,55,000 + 69,000 (3.6048)
    = Rs. – 6,268.80
    The IRR for A3 is

    = 11%

    The rates of return for the three alternatives are

    •The rate of return for alternative A3 is less than the minimum attractive rate
    of return of 12%. So, it should not beconsidered for comparison.
    •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


    EX4 For the cash flow diagram shown in Fig. 7.8, compute the rate of return. The
    amounts are in rupees.
    • Solution

    • A1 = Rs. 150, G = Rs. 150

    • The annual equivalent of the cash flows of the uniform gradient series is

    • A = A1 + G(A/G, i, n)
    = 150 + 150(A/G, i, 5)

    • present worth PW = –1,275 + [150 + 150(A/G, i, 5)] (P/A, i, 5)


    • PW(10%) = –1,275 + [150 + 150(A/G, 10%, 5)] (P/A, 10%, 5)
    • = –1,275 + [150 + 150(1.8101)] (3.7908)
    • = Rs. 322.88

    • PW(15%)= Rs. 94.11

    • PW(18%) = Rs. –21.24

    • Therefore,
    • IRR MISCONCEPTIONS

    • It includes the following:


    • (i) Ranking alternatives by individual IRR values:
    • (ii) More than one possible Rate of return ( Non simple investment)
    • (iii) Explicit investment Rate
    • (iv) Historical external rate
    • (v) Project balance method
    • (vi) Reinvestment question
    • (vii) Alternatives with unequal lives
    (i) Ranking alternatives by individual IRR values:

    - Results or IRR calculations and other (PW,FW,AW) methods can conflict when the
    alternatives are of mutually exclusive type

    (II) More than one possible Rate of Return (Non simple investment) :

    when the cash flow or cumulative cash flow of a project switches from negative to
    positive (or the reverse) more than once ( a non simple investment) the project may
    have more than one root of the present worth equation PW(i) =0.

    in this case, true IRR value is to be determined


    (III) Explicit Investment Rate:

    • An explicit investment rate is applied to a limited portion of the cash flow that will
    disturb the total cash flow pattern as little as possible while eliminating one of the sign
    reversals.

    • An explicit reinvestment rate is a designated interest percentage appropriate for a


    specific application.

    • The explicit reinvestment rate may be the minimum attractive rate of return employed
    by the organization or a rate suggested by the Present worth profile.
    (IV) Historical External Rate of return method:

    • The occurrence of multiple i* roots with the non simple investment return can be
    avoided by using the historical External Rate of Return (HERR) method where the
    main appeal is its pragmatic assumption that receipts are actually reinvested at a
    generally available interest rate. This rate is typically taken to be the MARR

    • Drawback: It does base the reinvestment on project cash flow balances; it is based
    solely on project receipts.
    • COST OF CAPITAL CONCEPTS

    • The cost of capital is derived from the composition of capital pool


    • The term pool is appropriately suggestive of capital from many sources, pooled for
    funding purposes

    • A weighted cost of capital: The proportion of capital from different sources


    obtained at different costs to a firm
    This weighted cost sets the lower bound for MARR

    • The actual rate of return expected from new investments is normally


    greater than the cost of capital. How much greater depends on the risk
    involved.
    • The weighted cost of capital Kw
    Kw = P1K1 +P2K2 + . . . . . . . +PnKn

    • Where n  types of financing sources in proportions P of total capital, each


    source with its own cost K

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