Rate Of Return Analysis (ROR)

Rate of Return (ROR)

ROR is defined as the interest rate paid on the unpaid balance of a loan such that the payment schedule makes the unpaid loan balance equal to zero when the final payment is made.

Calculating ROR
There are 5 forms of the cash flow equation as follows :

1. PW of benefits PW of cost = 0
2.

3. 4. 5.

PW benefit PW cost = 1 Net Present Worth = 0 EUAB EUAC = 0 PW of benefits = PW of cost

Calculating ROR(2)

Example : Given the cash flow below Year Cash Flow 0 - $ 100 20 1 + 20 2 + 30 1 3 + 20 4 + 40 100 5 + 40 Calculate ROR on the investment.

40 40 30 20
2 3 4 5

Calculating ROR(3)

Using NPW = 0, try i =10% NPW = -100 + 20(P/F,10%,1) + 30(P/F,10%,2) + 20 (P/F,10%,3) + 40(P/F,10%,4) + 40(P/F,10%,5) = - 100 + 18,18 + 24,79 + 15,03 + 27,32 + 24,84 = + 10,16 too low Try i = 15% NPW = -100 + 20(P/F,15%,1) + 30(P/F,15%,2) + 20 (P/F,15%,3) + 40(P/F,15%,4) + 40(P/F,15%,5) = - 100 + 17,39 + 22,68 + 13,15 + 22,87 + 19,89 = - 4,02

Calculate ROR(4)
12 7

NPW

2 -30% -8 5% i 10% 15%

Calculate ROR(5)

From the graphic, calculate i where NPW = 0 i = 10 % + (15% - 10%)(10,16 / (10,16 + 4,02)) = 13,5 % Thus, ROR = 13,5 %

12 7

NPW

2 -30% -8 5% i 10% 15%

Analyze ROR

Analyze ROR using internal rate of return and MARR(Minimum Attractive Rate of Return) as comparison in making decision. When there are two alternatives, ROR analysis is performed by computing the ROR (incremental rate of return), on the difference between higher initial-cost alternative with lower initial-cost alternative if ROR MARR, choose the higher cost alternative dan if ROR < MARR choose the lower cost alternative.

Analyze ROR(2)

When theres two alternatives, compare interest rates used in the economic analysis, use i as comparison.
if i MARR, then choose the higher interest rate alternative and if i > MARR choose the lower interest rate alternative.

Analyze ROR(3)
Example : There are 2 alternatives with following cashflow : Year alternative 1 alternative 2 0 - $ 10 - $ 20 1 + $ 15 + $ 28 if MARR = 6%, which alternative is chosen ?

Alternative 2 has higher initial investment, Thus : Year Alt. 1 Alt. 2 Alt. 2 Alt. 1 0 - $10 -$20 -$20 (-$10) = -$10 1 + 15 +28 +28 (+15) = + 13

Analyze ROR(4)

Pwof cost = Pwof benefits 10 = 13(P/F,i,1) (P/F,i,1) = 10 / 13 = 0,7692 Because i > MARR then choose the higher initial cost -alternative 2.

Analysis Period

In discussing Present Worth Analysis and Annual Cash Flow analysis, an important consideration is the analysis period. Example : There are two machines with following cashflow : Machine X Machine Y Initial Cost $ 200 $ 700 Uniform Annual Benefit 95 120 Salvage Value 50 150 Useful life, in years 6 12 with MARR=10%, which investment is chosen ?

Analysis Period (2)

The solution is based on a twelve-year analysis period and a Replacement Machine identical to the present Machine X. Cashflow for both alternatives as follows :
Year Machine X 0 - $ 200 1 + 95 2 + 95 3 + 95 4 + 95 5 + 95 Machine Y Machine Y Machine X - $ 700 - $ 500 + 120 + 25 + 120 + 25 + 120 + 25 + 120 + 25 + 120 + 25

Analysis Period(3)
Year Machine X + 95 6 + 50 -200 7 + 95 8 + 95 9 + 95 10 + 95 11 + 95 12 + 95 + 50 Machine Y Machine (Y X ) + 120 + 25

- 150
+ 120 + 120 + 120 + 120 + 120 + 120 + 150 + 25 + 25 + 25 + 25 + 25 + 25 + 100

Machine X
A = 95 ; n = 12

10

11

12

200

Machine Y

200

A = 120 ; n = 12

10

11

12

700

Analysis Period(4)
PW of benefits = PW of cost 500 = 25(P/A,i,12) + 150(P/F,i,6) + 100(P/F,i,12) From the above equation, we get i = 1,3 %, < MARR thus alternative X is chosen.

Difficulties Solving For An Interest Rate

Cash Flow Rule of Signs

There may be as many positive values of I as there sign changes in the cash flow. Sign Changes, is where successive nonzero values in the cash flow have different signs (that is, change from + to -, or vice versa.

Cash Flow Rule of Signs(2)

Number of sign changes, m 0 1 2 3

Number of positive values of i 0 0 or 1 0,1, or 2 0,1,2, or 3

A situation with no positive value of i or multiple positive values represents a situation that may be attractice, unattractive, or confusing.

External Interest Rate

Solving a cash flow for an unknown interest rate means that money in any required external investment is assumed to earn the same interest rate as money invested in the internal rate.

External Interest Rate(2)

example : Given following cashflow : Year Cashflow (million) 0 + $ 19 1 + 10 2 - 50 3 - 50 4 + 20 5 + 60

+ 60

+ $ 19

+ 20
+ 10
1 2 3 4

- 50

if $19 million will be invested externally for 2 years, and the +10 million for 1 year, Calculate the ROR.

External Interest Rate(3)

Compound amount at the end of Year 2 = 19(F/P,6%,2) + 10(F/P,6%,1) = +32 If the value is returned to initial project, then here is the casflow for several interest rates:

Year

0 1 2 3 4 5

Aliran kas + $ 19 + 10 - 18 - 50 + 20 + 60

0% 0 0 -18 - 50 + 20 + 60

8% 10% 0 0 0 0 -15,4 -14,9 -39,7 -37,6 +14,7 +13,7 +40,8 +37,3

External Interest Rate(4)

NPW for each i : 0% +$12 8% +$0,4 10% -$1,5

From above values, we can determine i where NPW = 0 : i = 8% + 2%(0,4/(1,5+0,4)) = 8,4% Thus, at the external interest rate of 6%, the ROR is

8,4%.