Rate of Return

Analysis
Internal Rate of Return
Calculating Rate of Return
Rate of Return Analysis
 Internal Rate of Return
Lender’s Viewpoint
The interest rate on the balance of a loan such that
the unpaid loan balance equals zero when the
final payment is made.

Year Cash flow 1. We know that the PW of five

payments of $1252 are equivalent
0 -5000
to $5000 when interest rate is 8%.
1 +1252
2. At the end of 5 years, the
2 +1252
payments exactly repaid the
3 +1252 $5000 debt with interest rate 8%.
We say the lender received 8%
4 +1252
rate of return.
5 +1252
 Internal Rate of Return
Investor’s Viewpoint
The interest rate earned on the unrecovered
investment such that the unrecovered
investment equals zero at the end of the life of
the investment.
Year Cash flow
1. Investment $5000 in a machine
0 -5000 with life time 5 years and an EUAC
of $1252, what is the interest rate
1 +1252
we receive on this investment?
2 +1252
2. The cash flow stream is with 8%
3 +1252 rate of return.
4 +1252
5 +1252
 Calculating
Rate of Return
 The IRR is the interest rate at which the
benefits equal the costs.
 PW benefit – PW Cost = 0
 PW Benefit/PW Cost = 1
 NPW = 0
 EUAB – EUAC = 0
 PW Benefit = PW Cost
Internal Rate of Return (IRR)

Suppose you have the following cash flow stream. You

invest $700, and then receive $100, $175, $250, and $325
at the end of years 1, 2, 3 and 4 respectively. What is the IRR
for your investment?
$325
$250
$100 $175

0 1 2 3 4
time

$700

700 = 100/(1+i) + 175/(1+i)2 + 250/(1+i)3 + 325/(1+i)4. 

It turns out that i = 6.9 %.

How to calculate IRR?

 Calculating Rate of Return
$325
$250
$175
$100
Ways to find the IRR
• Compound Interest Tables 2 3 4 time
0 1
•  Interest Tables and Interpolation
•  Graphically (see the graph of f(c)) $700
•  Numerically (Excel’s IRR, or other root finding methods).

NPW = -700 + 100/(1+i) + 175/(1+i)2 + 250/(1+i)3 + 325/(1+i)4. 

If you have a CFS with an investment
NPW
(-P) followed by benefits (non negative)
from the investment. The graph of NPW 50
40
versus i will have the same general form. 30
It will decrease at a decreasing rate and 20
NPW
have a value 0 at some unique value i*. 10
0
Where the graph has a value 0 defines the IRR.

4.60%
6.40%
8.20%

11.80%
13.60%
1.00%
2.80%

10.00%

15.40%
17.20%
19.00%
-10
-20
i in %
 Example 1
$1252 $1252 $1252 $1252 $1252

0 1 2 3 4 5
time

$5000

From Compound Interest Tables

PWB/PWC = 1 Interest rate (P/A,i,5)

1252(P/A,i,5)/5000 = 1 7% 4.100
8% 3.993
(P/A,i,5) = 5000/1252 = 3.993 9% 3.890

i=8%
Example 2 :Graphic solution

PW of costs = PW of benefits

100=20/(1+i)+30/(1+i)2+20/(1+i)3+40/(1+i)4+40/(1+i)5

NPW=-100+20/(1+i)+30/(1+i)2+20/(1+i)3+40/(1+i)4+40/(1+i)5

i=13.5%
 Practice 1

An $8200 investment returned $2000 per year

over a 5-year useful life. What was the rate of
return on the investment?
 Practice 2
An investment resulted in the following cash
flow. Compute the rate of return

Year Cash Flow

0 -$700
1 +100
2 +175
3 +250
4 +325
 Practice 3
Calculate the rate of return on the investment
on the following cash flow

Year Cash Flow

0 -$100
1 +20
2 +30
3 +20
4 +40
5 +40
Rate of Return Analysis
Example statements about a project: 
1. The net present worth of the project is $32,000. 
2. The equivalent uniform annual benefit is $2,800.
3. The project will produce a 23% rate of return

The third statement is perhaps most widely understood.

 Rate of return analysis is probably the most frequently

used analysis technique in industry.
 Its major advantage is that it provides a figure of merit that
is readily understood.
Rate of Return Analysis
 Most frequently used measure of merit in industry
 More accurately called Internal Rate of Return (IRR)
 Calculating ROR
 Where two mutually exclusive alternatives will provide
the same benefit, ROR is performed using an
incremental rate of return –ROR- on the difference
between the alternatives

Two-alternative Decision
situation
ΔROR≥MARR Choose higher-cost
alternative
ΔROR≤MARR Choose lower-cost
alternative
 Rate of Return Analysis
Motivating Example.
Banks 1 and 2 offer you the following Deals 1 and 2
respectively:

Deal 1.
Invest $2,000 today. At the end of years 1, 2, and 3 get $100,
$100, and $500 in interest; at the end of year 4, get $2,200
in principal and interest.
Deal 2:
Invest $2,000 today. At the end of years 1, 2, and 3 get $100,
$100, and $100 in interest; at the end of year 4, get $2,000 in
principal only.

Question. Which deal is the best?

Rate of Return Analysis
Deal 1:
Find out the implicit interest rate you would be receiving;
that is, solve for

2000 = 100/(1+i)1 + 100/(1+i)2 + 500/(1+i)3 + 2200/(1+i)4

IRR: i = 10.7844 %.

This is the interest rate for the PV of your payments to be $2,000.

Deal 2:
We find i for which

2000 = 100/(1+i)1 + 100/(1+i)2 + 100/(1+i)3 + 2000/(1+i)4

IRR: i = 3.8194%.

Which deal would you prefer?

Rate of Return Analysis
 Incremental cash flows for ROR analysis.
 The procedure
 Order the alternatives by initial investment or cost,
starting with smaller one
 Develop the cash flow and incremental cash flow, use
LCM if necessary
 Draw incremental cash flow diagram
 Set up PW and determine ΔROR
 Select the economically better alternatives
 Practice 4
Bank of America uses MARR of 30% on alternatives for its
own business that are considered risky. Two alternative
system software has been developed. Perform the
incremental ROR analysis.

System A System B
Initial -12,000 -18,000
investment
Estimated net 5,000 7,000
income
Salvage value 2,500 3,000
Estimated 8 8
competitive life,
years
 Practice 5
Two vendor had submitted proposal for the replacement of
a new flash drum. They are summarize in the table below.
By performing ROR analysis, determine which vendor
should be selected if the MARR is 15% per year.

A B
Initial cost, $ -8,000 -13,000
Annual cost, $ -3,500 -1,600
Salvage value, $ 0 2,000
Life, years 10 5