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Rate of Return

Analysis
Suppose that a bank lends $10,000 and it is repaid
$4021 at the end of each year for 3 years.
How can be the interest rate determined that the
bank charges on this transaction?
P = A (P/A, i, 3)
$10,000 = $4021 (P/A, i, 3)
i = 10%
The bank will earn 10% return on its investment of
$10,000.
The bank calculates the loan balances over the life of loan
as follows.

Year Unpaid balance Return on Payment Unpaid


at unpaid balance Received balance at
Beginning year (10%) End of year
0 - $10,000 $0 $0 - $10,000
1 - $10,000 - $1,000 $4021 - $ 6979
2 - $ 6979 -$ 698 $4021 - $3656
3 - $3656 - $366 $4021 0

Here, the three annual payments repay the loan itself an


additionally provide a return of 10% on the amount still
outstanding each year.
If we calculate the PW of the loan transaction
at its rate of return (10%). We see,

PW (10%) = -$10,000 + $4021 (P/A, 10%, 3) = 0

It indicates that,
The bank can break even at a 10% rate of
interest.
Rate of return becomes the rate of interest
that equates the present value of future cash
repayments to the amount of loan.
Investment Balance Diagram

11,000
4021
project balance

7677
Un recovered

4021
10,000

4021
6979

4021
3656
years
0 1 2 3
Rate of Return is the break even interest rate (i*) which
equates the present worth of Projects cash outflows
to the present worth of its cash inflows.
PW (i*) =0
PWcash inflow PWcash outflow = 0

Rate of Return (i*) of a project may be defined as the


rate of interest that equates the present worth, future
worth, and annual equivalent worth of the entire
series of cash flow to zero.
PW (i*) =0
FW (i*) =0
AW (i*) =0
PW inflow

i*
0 i

PW outflow
What is IRR?
The discounted rate that equates the present
value of a projects expected cash inflows to
the present value of the projects costs
What is IRR?
The discount rate
which sets the
NPV of all cash
flows equal to 0.
Helps to
determine the
YIELD on an
investment.
How do we calculate IRR?
NPV = Net Present Value of the project
Initial Investment
Ct=Cash flow at time t
IRR = Internal Rate of Return
Calculating IRR
Set the NPV = 0
Plug in your Cash Flows & Initial
Investment
Solve for IRR!
This is the same equation used for NPV,
except you know your interest rate, i.
So now what?
Once youve calculated IRR
If IRR is greater than the cost of capital, then youve
got a GOOD project on your hands (go for it!).
If IRR is less than the cost of capital, then youve got
a BAD project on your hands (dont undertake the
project).
If the IRR and cost of capital are equal, then you
should use another method to evaluate the project!
Basically, the higher the IRR, the better the project
Simple vs. non Simple investment

A simple investment is one in which initial cash flow


is negative.
Only two sign changes occurs in the net cash flow
series.
A non simple investment is one in which more than
two sign change occurs in the cash flow series.
Example

Investment Cash flow sign at period


Type
0 1 2 3 4 5
Simple - + + + + +
Simple - - + + 0 +
Non Simple - + - + + -
Non simple - + + - 0 -
Method of finding i*
Direct Solution Method
Trial and error method
Computer Solution method
Direct Solution Method

For the very special case of a project


with only a two-flow transaction (an
investment followed by a single future
payment) or service life of 2 years of
return, we can apply direct
mathematical solution for determining
the rate of return.
Numerical
Consider two investment projects with the following cash
flow transactions. Compute the rate of return for each project.

Period Project 1 Project 2


(n)
0 - $1,000 -$2,000
1 $0 $1,300
2 $0 $ 1,500
3 $0

4 $1500
Solution

PROJECT 1
FW (i*) =0
FWinflow FWoutflow =0
$1500 - $1,000(F/P,i*,4) = 0
1.5 = (1+i*)4
Solving for i*,
i* =
4
1.5 1
i* = 0.1067 = 10.67%
PROJECT 2
PW (i*) =0
-$2000 + $1300 + $1500 = 0
(1+i*) (1+i*)2

Let, 1/ (1+i*) =X

-$2000 + $1300X + $1500X2 = 0

Above equation represents quadratic equation.


Solving for X, we get 0.8 or -1.667

Putting the value of X ,


i* = 25% and -160%
Since -160% has no economic significance, we
choose i*=25%
Trial and error method
The general procedure of using a PW-
based equation is:
Draw a cash flow diagram
Set up the rate of return equation.
Select values of rate of return by trial
and error until the equation is balanced.
DECISION RULE
To choose the alternative, the calculated rate of return
must be compared with MAAR.

If IRR > MARR , accept the project


IRR = MARR, remains indifferent
IRR < MARR, reject the project
Numerical
A piece of new equipment has been purposed by
Engineers to increase the productivity of a certain
manual welding operation. The investment cost is
$25000 and equipment will have a salvage value of
$5000 at the end of its expected life of five years.
Increased productivity attribution to the equipment will
amount to $8000 per year after extra operating cost have
been subtracted from the value of additional production.
Evaluate the IRR of purpose equipment. Is the
investment a good one? Recall the MARR is 20% per
year.
Solution:
Numerical
Agdist Corporation distributes agricultural equipment.
The board of directors is considering a proposal to
establish a facility to manufacture an electronically
controlled intelligent crop sprayer invented by a
professor at a local university. This crop sprayer
project would require an investment of $10 million in
assets and would produce an annual after tax net
benefit of $1.8million over a service life of 8 years.
When the project terminates, the corporation would
earn $1 million from the assets. Compute the Internal
rate of return generated by this project, if the
corporation MARR is 10%. Should the corporation
accept this project? Show the investment balance
diagram also.
Step 1 Cash Flow Diagram

$1

$ 1.8 $ 1.8 $ 1.8 $ 1.8 $ 1.8 $ 1.8 $ 1.8 $ 1.8

0 1 2 3 4 5 6 7 8

All amounts in million


$ 10
Step 2 Setting up rate of return equation

PW (i*) = 0
PW inflow PW outflow = 0
1.8 (P/A, i*%, 8) + 1 (P/F, i*%, 8) -10 = 0
Lets select interest rate = 8%
PW (8%) = 1.8 (P/A, 8%, 8) + 1 (P/F, 8%, 8) 10 = $ 0.88
Since PW is positive, the value of i is raised,
Lets suppose interest rate =12%
PW (12%) = 1.8 (P/A, 12%, 8) 1 (P/F, 12%, 8) 10 = - $ 0.65

The value of i* lies between 8% and 12%.


By linear interpolation,
i* = 10.30%

PW (10.30%) = 1.8 (P/A, 10.30%, 8) 1 (P/F, 10.30%, 8) 10 = - $ 0.045


The value of i* lies between 8% and 10.30%.
By linear interpolation,
i* = 10.18%
PW (10.18%) = 1.8 (P/A, 10.18, 8) +1(P/A, 10.18, 8) 10 = $ 0.0007

IRR (i*) = 10.18 > MARR (10%)

The project is marginally acceptable


11.018
Un recovered project balance

1.8 10.156
9.207

1.8
8.161

1.8
9.218
$ 10

8.356 7.008

1.8
7.407 5.738

1.8
6.361 4.339

1.8
5.208
2.8

1.8
3.938
2.539

2.8
0 1 2 3 4 5 6 7 8
Years

Fig: Investment Balance Diagram


DRAWBACKS OF IRR
The recovered funds are re-invested at i*% rather
than MARR, which leads to the concept of
External rate of return (ERR).
It needs trial and error approach for the
calculation.
If the algebraic sum of the cash flow changes in
the middle of the project more that two times, we
might obtain multiple IRR.
When choosing between the mutually exclusive
alternatives, IRR method can be misleading and
does not compare the scale of investment.
EXTERNAL RATE OF RETURN/
MODIFIED IRR
The drawback of the IRR method (reinvestment
assumption) may not be valid in the engineering economy.
For example, if a firms MARR is 20% per year and the
IRR for a project is 42.4%, it may not be possible for the
firm to reinvest net cash proceeds from the project at
much more than 20%.
This situation, coupled with the computational demands
and possible multiple interest rates associated with the
IRR method, has given rise to other rate of return methods
that can remedy this weakness which is referred as
External rate of Return or Modified IRR.
The External Rate of Return (i) is the
unique rate of return for a project that
assumes that net positive cash flows, which
represent money not immediately needed by
the project, are reinvested at the
reinvestment rate %.
The reinvestment rate depends upon the
market rate available for investments.
Steps of ERR Calculation

All cash outflows are discounted to period


zero (present) at % per compounding
period.
All cash inflows are Compounded to period
N at %
ERR is the interest rate that equivalence
between the two equation.
N

i Rk (F/P, %, N-k)
k o

Rk

0 k N
Ek

k o
Ek (P/F, %, k)
Ek (P/F, %, k) (F/P, i, N) = Rk (F/P, %, N-k)
Where,
Rk = receipts in period k
Ek = expenditures in period k
N = project life or number of study period
% = external reinvestment rate per period.
Accept /Reject Decision Rule

If ERR > MARR, accept the project


ERR = MARR, remain indifferent
ERR < MARR, reject the project
Numerical
Consider the following cash flow of the project
RS 6000

0 1 2 3 4 5 6

RS 1000 RS 1000
RS 5000

Calculate the ERR of the project if MARR = 20% and


reinvestment rate % =15%. Is the project accepted?
Solution
Discounting all the cash outflows to the time zero at
15%.
1,000 + 5,000 (P/F, 15%, 1)
= 1,000 + 5,000 (1+0.15)-1 = 5,347.82
Compounding all the cash inflows to the year 6 at 15%
5,000 (F/A, 15%, 5)
= 5,000 {(1.15)5 -1 / 0.15} = 33,711.90
Establishing the equivalence between the two
equation
5,347.82 (F/P, i, 6) = 33,711.90
5,347.82 (1+i) 6 = 33,711.90
(1+i) 6 = 6.303
i = 1.359 -1 = 35.91% is the ERR of the project.
Here ERR (35.91%) > MARR (20%), the project is accepted.