Ce22 - 10 - Pem 4 PDF

CE22: Project Evaluation 4 
Rate of Return Criterion
MA. BRIDA LEA DIOLA

CE 22: Engineering Economics
UP Institute of Civil Engineering
2nd sem AY 19-20
2
Objectives:
 To evaluate the economic merit of a project

using different methods
 Internal Rate of Return (IRR) Method
 To decide whether a project is worthwhile
© M.D. Diola 2020. All Rights Reserved.

3
Discussion Topics
 Review: Economic Equivalence
 Rate of Return (ROR)
 Initial Project Screening – Payback Period
 Methods of Evaluation of a Single Project
 Present Worth (PW) Method
 Future Worth (FW) Method
 Annual Worth (AW) Method
 Capitalized Worth (CW) Method
 Benefit-Cost ratio
 Rate of Return Criterion

4
Rate of Return Analysis
Rate of Return - Rate/interest earned on your invested capital, or

commonly known as internal rate of return (IRR)
A Simple Example: The interest earned on your savings account is the

rate of return on your deposits.

5
ROR Definition 1:
Interest Earned on Loan Balance
• Rate of return (ROR) is defined as the interest
rate earned on the unpaid (outstanding)
balance of an installment loan.
ROR is applied on the unrecovered balance not
the initial amount of loan or investment
• Example: A bank lends $10,000 and receives

annual repayment of $4,021 over 3 years.
• The bank is said to earn a return of 10% on its
loan of $10,000.
6
Loan Balance Calculation:

A = $10,000 (A/P, 10%, 3) = $4,021
Unpaid Return on Unpaid
balance unpaid balance
at beg. balance Payment at the end
Year of year (10%) received of year
0 -$10,000 -$10,000
1 -$10,000 -$1,000 +$4,021 -$6,979
2 -$6,979 -$698 +$4,021 -$3,656
3 -$3,656 -$366 +$4,021 0
A return of 10% on the amount These 3 annual payments repay the loan
still outstanding at the beginning itself and provide a return of 10% on the
of each year amount still outstanding each year.
7
LOAN BALANCE GRAPH

8
ROR Definition 2:
Break-Even Interest Rate
• Rate of return (ROR) is the break-even interest rate,
i*, which equates the present worth of a project’s cash
outflows to the present worth of its cash inflows.
• Mathematical Relation:
PW (i * ):PW (i * )cash inflows = PW (i * )cash outflows
• Example:
PW(10%):10,000 =$4,021(P / A,10%,3)

9
ROR Definition 2 (Modified)
 Rate of return is the rate of interest i (−100% to∞),

that equates the PW, FW, AW of the entire series of
cash flows of a project to zero.
• Mathematical Relation:
 PW(i*) = AW(i*) = FW(i*) = 0

10
IRR Definition 3:
Return on Invested Capital – Internal Rate of Return
• The internal rate of return (IRR) is the interest rate
earned on the unrecovered project balance of the
investment such that, when the project
terminates, the unrecovered project balance will
be zero.
• Example: A company invests $10,000 in a

computer system which results in equivalent
annual labor savings of $4,021 over 3 years. The
company is said to earn a return of 10% on its
investment of $10,000.
11
Additional Notes
 The last definition for ROR is for the concept of rate
of return based on the return on invested capital in
terms of a project investment.
 A project’s return is referred to as the internal rate

of return (IRR) promised by an investment project
over its useful life.
 Here, we can view the investing firm as the lender

and the project as the borrower.

12
➢ Firm earns a 10% rate of returns on funds that remain internally

invested in the project.
➢ Since it is a return internal to the project it is called Internal rate of
Return
➢ Computer project brings in enough cash to pay for itself in three
years and to provide the firm a return of 10% on invested capital

13
Why ROR measure is commonly used?
❑ This project will bring in a 15% rate of return

on investment.
❑ This project will result in a net surplus of

$10,000 in Net Present Worth (NPW).
Compare the two statements above. From the

POV of CEOs and managers, which statement is
easier to understand?
14
Methods for Finding the Rate of Return
 To facilitate the process of finding the rate of

return for an investment project, we will first
classify the types of investment cash flows.
 We classify an investment by counting the
number of sign changes in its net cash-flow
sequence. A change from either “-” to “+” or
“+” to “-” is counted as one sign change. (Ignore
the zero cash flows!)

15
Classification of investments
Simple (Conventional) Nonsimple (Nonconventional)
investment investment
 Definition: An investment with  Definition: An investment in which
only one sign change in the net more than one sign change occurs
cash flow series. in the net cash flow series.
3 sign changes
3 sign changes
Simple Borrowing – 1st cash flows is/are positive followed by negative cash flows
(borrowing instead of investing)
16
Classification of investments
Simple Investment – the computed interest rate is unique and is the true IRR
Nonsimple Investment – multiple interest rates can be computed. Problem in
identifying the true IRR
17
Example: Investment Classification
Net Cash Flow

EOY Project A Project B Project C
0 -1,000 -1,000 1,000
1 -500 3,900 -450
2 800 -5,030 -450
3 1,500 2,145 -450
4 2,000
Project A: a simple investment

Project B: a nonsimple investment
Project C: a simple borrowing
18
How to compute for interest rates/IRR?

 Using Excel’s Financial Command (will only give one solution or interest rate)
 Direct Solution Method (use Shift-solve function of calculators!)
 Trial-and-Error Method (will only give one solution or interest rate)
Excel command to find the rate of return:

=IRR(cell range, guess value)
e.g., =IRR(C0:C7, 10%)
The answer will be closest to the guess value. For nonsimple investment
with multiple solutions, try changing the guess value to arrive with different
solution/answe

19
Example
 Calculate the interest rate/s for the following Projects.
 First, classify the type of investment (simple or nonsimple)
Direct Direct Trial & Computer
Solution Solution Error Solution
Log Quadratic
Method Method
n Project A Project B Project C Project D
0 -$1,000 -$1,000 -$75,000 -$10,000

1 0 2,300 24,400 20,000
2 0 -1,320 27,340 20,000
3 0 55,760 25,000
4 1,500
20
Direct Solution Method

(use shift-solve function of calculators)
• Project A (Simple)
$1,000 = $1,500(P / F , i ,4) • Project B (Nonsimple)
$1,000 = $1,500(1 + i)−4 PW(i) = -$1,000 +
$2,300 $1,320
- 2
=0
(1+ i) (1+ i)
0.6667 = (1 + i)−4 1
Let x = , then
ln0.6667 1+ i
= ln(1 + i) PW(i) = -1,000 +2,300x -1,320x 2 = 0
−4
Solve for x :
0.101365 = ln(1 + i)
x = 10 /11 or 10/12
e 0.101365
=1+i Solving for i yields
i = e 0.101365 − 1 10 /11 =
1
® i = 10%, 10/12 =
1
® i = 20%
1+ i 1+ i
= 10.67% Since the project's i * =10%or20%
© M.D. Diola 2020. All Rights Reserved. Multiple Rates of Return Problem!
21
Trial and Error Method

– Project C
 Step 1: Guess an interest rate, say, i = 15%
 Step 2: Compute PW(i) at the guessed i

value.
PW (15%) = $3,553 $3,553
0
 Step 3: If PW(i) > 0, then increase i. If
-$749
PW(i) < 0, then decrease i.
PW(18%) = -$749 15% i 18%
• Step 4: If you bracket the solution, you  3,553 

i = 15% + 3%  
use a linear interpolation to approximate  3,553 + 749 
the solution = 17.45%
Note: This method works only properly
This method utilizes interest tables. If you have
for finding i* for simple investments
calculators, just use shift-solve!
22
Internal Rate of Return (IRR)

 is a number i∗ resulting to a zero Present Worth
(PW) of a project
 IRR is defined without reference to the external
financial world (external interest rate). It is
determined entirely by the cash flow stream
 Equation for IRR is a polynomial equation in x of
degree n. Has at least one root, may have as many
as n roots, but some or all roots may be complex
numbers

23
The IRR is not positive unless
 Both receipts and expenses are present in the

cash flow pattern
 The sum of receipts exceeds the sum of all cash
outflows

24
Additional Notes
 In calculating the IRR of a project, set-up an equation for computing
Equivalent Worth (usually PW), with i as unknown, and equate that to
zero.
 The resulting equation is a polynomial equation.
For easier computation, you may let x = 1/(1+i)
 Since it is a polynomial, it will help if we can identify first the number of

possible roots – see Descartes’ rule of signs and Norstrom’s test
 Be careful when using shift-solve function in calculators! Only one

answer per shift-solve – the value depends on the guess value
 You may use the “Equation” function in calculators to be sure in the

answers (number of roots)
25
Descartes’ Rule of Signs

 If a polynomial with real coefficients has m sign changes, then
the number of positive roots will be
r = m − 2k • But this rule is applicable
to the roots, x.
where r is the number of positive roots, • Since, x = 1/(1+i), a
k is a positive integer or zero positive root x, does not
ensure a positive value
(k = 0, 1, 2, 3, . . . ). for i.
• There may be as many
positive values of i∗ (root
of ROR equation) as there
are sign changes in the
cash flow.

26
Norstrom’s cumulative cash flow sign test
 Let {A0,A1,…,An} be net cash flows and let {C0,C1,…,Cn}

be cumulative cash flows:
t
Ct =  Ai
i =0
 A cash flow {A0,A1,…,An} with cumulative cash flow

{C0,C1,…,Cn} will have a unique non-negative internal
rate of return if the cumulative cash flow changes
signs once and Cn ≠ 0.
Adapted from:
Carl J. Norstrom. A sufficient condition for a unique nonnegative internal rate of return.
Journal of Financial and Quantitative Analysis, 7(3):1835-1839, 1972.

27
Predicting the Number of i*s

 Descartes’ Rule  Norstrom’s Cumulative Cash Flow Test
Period Accumulated Sign

n An Cash Flows Change
0 -$100 -$100 0
1 -$20 -$120 0
2 $50 -$70 0
3 $0 -$70 0
4 $60 -$10 0
5 -$30 -$40 0
6 $100 $60 1
• No. of real i*s is 3

• This implies that the project could • No of sign change in Cumulative cash
have (1 or 3) i*s but NOT more than 3. flows = 1, indicating a unique i*.
• i* = 10.46%
28
Example
A construction company has requested that $500,000 be spent now
during construction on software and hardware to improve the efficiency of
environmental control systems for the construction of a skyscraper. This is
expected to save $10,000 per year for 10 years in energy costs and
$700,000 at the end of 10 years in equipment refurbishment costs. Find
the rate of return
Simple Investment!
Solution:
0 = -500, 000 + 10, 000(P/A, i*%, 10) + 700, 000(P/F, i*%, 10)

i* = 5.16%
29
Example
During the last 3 years, the net cash flows for contract payments have
varied widely, as shown below:
Year 0 1 2 3
Cash Flow -2,000 500 8,100 -6,800
1. Determine the maximum number of i values that may satisfy the

ROR relation.
2. Calculate the corresponding i values.

30
Solution
➢ There are two sign changes, therefore it indicates a maximum of two i

values.
➢ Nonsimple Investment!
𝑃𝑊 = −2,000 + 500 𝑃Τ𝐹 𝑖%, 1 + 8,100 𝑃Τ𝐹 , 𝑖%, 2 − 6,800 𝑃Τ𝐹 , 𝑖%, 3
500 8,100 6,800
𝑃𝑊 = −2,000 + + −
1+𝑖 1+𝑖 2 1+𝑖 3
Solving for i:
i* = 7.47% and 41.35%

31
For the previous problem, there are two break-even interest rates
(nonsimple investment)
150.00
100.00
50.00
0.00
0% 10% 20% 30% 40% 50% 60%
PW (i%)
-50.00
-100.00
-150.00
-200.00
-250.00
Interest Rate
32
Project Evaluation using IRR Method

 Decision Criterion for a Single Project:
 If IRR > MARR, accept the project
 If IRR = MARR, remain indifferent
 If IRR < MARR, reject the project

33
Resolution of Multiple Rates of

Return

34
NPW Plot
At Issue:
If your MARR = 15%, which rate
of return should we use to make
an accept/reject decision—
7.47% or 41.35%?
If 7.47% - reject the project

If 41.35% - accept the project
Answer: NONE! Both rates are

not true IRR!

35
Net Investment Test

 What it is: A process to determine whether or not a firm
borrows money from a project during the investment period.
 i* is the true rate of return and is earned on the money
invested in a project while the money is actually in the
project.
 How to test: A project is said to be a net investment (pure

investment) when the project balances computed at the
project’s i* values, PB(i*)n, are either less than or equal to zero
throughout the life of the investment.

36
Additional Notes
 To understand the nature of multiple i∗s, we need to understand the
investment situation represented by any cash flow.
 The net-investment test will indicate whether the computed i∗ (by setting
PW equation equal to 0) represents the true IRR.
 The investment is net in the sense that the firm does not overdraw on its
return at any point and hence is not indebted to the project. These
investments are called pure investments.
 If any of the project balances computed at project’s i∗ is positive, the project
is a mixed investment. A positive balance indicates that, at some point
during the project’s life, the firm acts as a borrower thus having some
external factors (not solely internal to the project which is the premise for
true internal rate of return).
 [PB(i∗)n > 0] rather than an investor [PB(i∗)n < 0] in the project.

37
Recall
 Loan balance graph (POV of bank)
 In the graph, all Project balances are negative and terminates at

year 3 (zero)
 Example of simple investment with unique true IRR

38
Pure vs Mixed Investment
Pure Investment Mixed Investment

 Definition: An investment in which a firm
 Definition: An investment in
borrows money from the project during
which a firm never borrows
the investment period
money from the project.
 How to determine: If a project fails the
 How to Determine: If the project
net investment test, it is a mixed
passes the net investment test, it
investment.
is a pure investment.
 Relationship: If a project is a mixed
 Relationship: A simple
investment, it is a nonsimple investment.
investment is always a pure
(However, we can’t say that a nonsimple
investment.
investment is also a mixed investment.)
 The interest rate is called the
 Some nonsimple investment (with 1
internal rate of return (IRR)
ROR) may still be considered a pure
investment if it passes the test
39
Summary of IRR Method

• For Pure
Investments, use
IRR Method.
• For Mixed
Investments, IRR
Method is not
applicable!
• Use External Rate

of Return (ERR)
Method or use
PW/AW/FW
methods instead!

40
Decision Rule for Pure Investment

Example: Simple Investment → Pure
Decision Criterion for a Investment, IRR Method is applicable!
Single Project:
 If IRR > MARR,
accept the project.
 If IRR = MARR,
remain indifferent.
 If IRR < MARR, reject
the project.

41
• We need to compute project balances of each project at its respective i∗

• If multiple i∗ exist for a project, we may use the largest i∗ greater than 0.
• In fact, you can use any of the i∗s. If one i∗ fails, all i∗s fail the test (Indeed we
know that they will fail!) --> presence multiple i*s indicate mixed investment

42
PROJECT A
EOY Net CF
0 -$1,000
1 -$1,000
2 $2,000
3 $1,500
i* 33.64 %
OBSERVATIONS:
1. Sign changes in net-cash flow

sequence: 1 → simple
investment → automatic pure
investment!
2. Signs of PB: (−,−,−, 0) →
Passes the net-investment test
(pure investment)
3. unique i* = 33.64% = IRR

43
PROJECT B

44
PROJECT C

45
PROJECT D

46

47
• In reality, reinvesting the borrowed (released) money

from project at rate equal to a rate of return (i∗) that
received from project is not always possible
© M.D. Diola 2020. All Rights Reserved. • an external rate (smaller than i∗) is more usual
48
Summary of IRR Method
to calculate the true

rate of return of any
internal portion of an
mixed investment, it
is necessary to
compute project
balances at two
rates of interest:
one on internal
investments when
PB < 0 one on
external investments
when PB > 0

49

50
Decision Rule for Mixed Investments

 External Rate of Return (ERR) Method
 Need for an external interest rate for mixed investments.
We will use the MARR as established external interest
rate—the rate earned by money invested outside of the
project.
 Calculate a rate of return on the portion of capital that
remains invested internally—commonly known as the
return on invested capital (RIC) or true IRR.
 Select the investment if IRR > MARR.
 Alternatively, since IRR Method is not applicable,
recommend to use PW/AW/FW Method instead of ERR
Method
51
Additional self-assessment
 Answer Problem 1 in the CE 22 Problem Set

uploaded in UVLê

Out of the scope of CE 22
Optional Topic
External Rate of Return Method
53
ERR Method
R0 R1 R3 Rn
R2 R4 Rn-1
0 1 2 3 4 5 n-3 n-2 n-1 n

C0 C1 C3 C4 C5
Cn-1 Cn
C2
 Note that we DO NOT consider “net” cash flow at each t

 Since positive and negative cash flows are associated with
different interest rates
 Numerically, both Rt and Ct are positive- we account for the
sign in our equations explicitly
54
Modified IRR Method
R0 R1 R3 Rn
R2 R4 Rn-1
0 1 2 3 4 5 n-3 n-2 n-1 n

C0 C1 C3 C4 C5
Cn-1 Cn
C2
 For Rt, the reinvestment rate is rt for the amount at time t

(i.e., they could be different for each Rt and they are all
known values)
 Typically, rt = MARR for all periods
 For Ct the interest rate is i’ – the unknown RIC
55
Modified IRR Method
R0 R1 R3 Rn
R2 R4 Rn-1
0 1 2 3 4 5 n-3 n-2 n-1 n

C0 C1 C3 C4 C5
Cn-1 Cn
C2
 Now we solve for IRR from the following eqn
n n
 t t
R (
t =0
1 + r ) n −t
=  t
C (1 + i
t =0
' ) n −t
R0 (1 + r0 ) n + R1 (1 + r1 ) n −1 + ... + Rn −1 (1 + rn −1 )1 + Rn =
n −1
C0 (1 + i' ) + C1 (1 + i ' )
n
+ ... + Cn −1 (1 + i ' ) + Cn
1
56
Modified IRR Method
R0 R1 R3 Rn
R2 R4 Rn-1
0 1 2 3 4 5 n-3 n-2 n-1 n

C0 C1 C3 C4 C5
Cn-1 Cn
C2
 If we assume positive cash flows were reinvested at the

same unknown rate i’ the previous equation reduces to:
 The unknown i’ would then be the internal rate of return

 Hence the IRR method implicitly assumes reinvestment at
IRR
57
ERR Method
R0 R1 R3 Rn
R2 R4 Rn-1
0 1 2 3 4 5 n-3 n-2 n-1 n

C0 C1 C3 C4 C5
Cn-1 Cn
C2
 When rt are equal to “MARR”

n n
 Rt (1 + MARR)
t =0
n −t
=  Ct (1 + i ' ) n −t
t =0
58
Decision Rule for ERR Method
RIC ≥ MARR, project is acceptable

RIC < MARR, project is NOT acceptable
59
60
Solution
◆ TWO sign changes in the net cash flow series → NON-SIMPLE INVESTMENT
◆ MULTIPLE i* may exist
o DESCARTES’ Rule of Signs – 2 IRR

o NORSTROM’S – inconclusive
61
Solution
Multiple IRR → MIXED INVESTMENT
Resolve multiple IRR issue → DETERMINE ERR
n n
 Rt (1 + MARR)
t =0
n −t
=  Ct (1 + i ' ) n −t
t =0
Set-up equation
4.3M(1.15) + 3M = 1M(1 + i’)2 +2M(1 + i’) + 4.32M
ERR = i’ = ___ >MARR

ACCEPT PROJECT!
62
Practice Problem
 Determine whether the project whose total cash flow
diagram appears below is acceptable using MARR = 15%.
 (this is a mixed investment)
63
mddiola

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CE22: Project Evaluation 4 

Rate of Return Criterion

MA. BRIDA LEA DIOLA

 To evaluate the economic merit of a project

 To decide whether a project is worthwhile

© M.D. Diola 2020. All Rights Reserved.

© M.D. Diola 2020. All Rights Reserved.

Rate of Return Analysis

Rate of Return - Rate/interest earned on your invested capital, or

A Simple Example: The interest earned on your savings account is the

© M.D. Diola 2020. All Rights Reserved.

• Example: A bank lends $10,000 and receives

Loan Balance Calculation:

LOAN BALANCE GRAPH

© M.D. Diola 2020. All Rights Reserved.

PW(10%):10,000 =$4,021(P / A,10%,3)

ROR Definition 2 (Modified)

 Rate of return is the rate of interest i (−100% to∞),

 PW(i*) = AW(i*) = FW(i*) = 0

© M.D. Diola 2020. All Rights Reserved.

• Example: A company invests $10,000 in a

 A project’s return is referred to as the internal rate

 Here, we can view the investing firm as the lender

© M.D. Diola 2020. All Rights Reserved.

➢ Firm earns a 10% rate of returns on funds that remain internally

© M.D. Diola 2020. All Rights Reserved.

Why ROR measure is commonly used?

❑ This project will bring in a 15% rate of return

❑ This project will result in a net surplus of

Compare the two statements above. From the

Methods for Finding the Rate of Return

 To facilitate the process of finding the rate of

© M.D. Diola 2020. All Rights Reserved.

Example: Investment Classification

Net Cash Flow

Project A: a simple investment

How to compute for interest rates/IRR?

Excel command to find the rate of return:

© M.D. Diola 2020. All Rights Reserved.

n Project A Project B Project C Project D

0 -$1,000 -$1,000 -$75,000 -$10,000

Direct Solution Method

Trial and Error Method

 Step 2: Compute PW(i) at the guessed i

• Step 4: If you bracket the solution, you  3,553 

Internal Rate of Return (IRR)

© M.D. Diola 2020. All Rights Reserved.

The IRR is not positive unless

 Both receipts and expenses are present in the

© M.D. Diola 2020. All Rights Reserved.

 The resulting equation is a polynomial equation.

For easier computation, you may let x = 1/(1+i)

 Since it is a polynomial, it will help if we can identify first the number of

 Be careful when using shift-solve function in calculators! Only one

 You may use the “Equation” function in calculators to be sure in the

Descartes’ Rule of Signs

© M.D. Diola 2020. All Rights Reserved.

Norstrom’s cumulative cash flow sign test

 Let {A0,A1,…,An} be net cash flows and let {C0,C1,…,Cn}

 A cash flow {A0,A1,…,An} with cumulative cash flow

© M.D. Diola 2020. All Rights Reserved.

Predicting the Number of i*s

Period Accumulated Sign

 PW(i) = AW(i) = FW(i*) = 0