VII.

The external rate of return (ERR)

Before starting the content, we have to know why we need ERR.
For example, MARR =20% and IRR=42.2%, with the high rate of return but company still
hestitate to reinvest on this project because:
- This rate exceeds the required rate, the higher return on an investment, the greater the
inherent risk associated with it, so the company can find another option with similar or
higher returns while potentially mitigating risks. Or the company want to allocate its
capital to other areas such as development, expansion, returning capital to shareholders
so ERR appeared to remedy these weaknesses.
Basically, ERR is relatively similar to IRR
- The external rate of return is the minimun rate of return that an investor expects to
receive from an investment project (MARR). It also mean that the present value of cash
inflows equals the present value of cash outflows.
But
- The ERR takes into account the interest rate which includes reinvestment the money you
earn from a project or the money you borrow from bank or others.
- If the ERR is equal to project’s IRR, then ERR and IRR produce identical results.

The ERR procedure

- All net cash outflows are discounted to time zero (the present) at ∈% per compounding
period. -> This means the expenses you spend on a project now

- All net cash inflows are compounded to period N at ∈% -> This means the money you
receive after project life in the future
- Solve for the ERR, the interest rate (i’%) that establishes equivalence between the above
two quantities. -> we take the outflows in present time equal to inflows in future and the
discount rate which make two value equivalence is ERR.

We have expense in period k, we find its present value for each period with MARR (external
rate) then we convert this into equivalent value in future at time N with interest rate which is
unknown. And this is the future revenue using the external rate or we can use another way is
convert futute value into the present value also.
 We can see the same idea in this graph, we have different cash flow at different time. We
have the expense in time 0 and the revenue in time N and we try to find the interest rate
which makes the future value equal to present value.

So if i’% > ∈% -> acceptable

ERR advantages

- It can usually be solved for directly, without needing to resort to trial and error.
- It is not subject to the possibility of multiple rates of return.

1. In project evaluation, what does a positive ERR indicate?

a) The project is financially viable

b) The project is not financially viable
c) The project has high risk
d) The project is overated

Explaination: The project is acceptable when (minimum

acceptable rate of return), which means the payback or profitable project.

2. Which of the following statements best describes the ERR?

a) ERR is a measure of the project’s return on investment after taxes

b) ERR reflects the rate of return that equates the present value of cash
outflows to the present value of cash inflows
c) ERR represents the cost of borrowing for a project
 d) ERR measures the profitability of a project relative to its competitors

Explaination: The ERR is the interest rate that makes the present value of a project’s cash
inflows equal to the present value of its cash outflows. It represents the rate of return required for
the project to break even in present value terms

3. What distinguishes the ERR from other financial metrics like the internal rate of return
(IRR)?

a) ERR considers only internal factors affecting project profitability

b) IRR considers only external factors affecting project profitability
c) ERR accounts for the impact of external factors on project profitability
d) IRR accounts for the timing of cash flows

Explanation: ERR helps in decision- making by considering the impact of external factors such
as inflation, interest rates, and taxes, on project profitability.

4. What is the fomulate of ERR?

a)

b)

c)