Chapter 7 - Rate of

Return Analysis
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EGR 403 Capital Allocation Theory

Dr. Phillip R. Rosenkrantz
Industrial & Manufacturing Engineering Department
Cal Poly Pomona
 EGR 403 - The Big Picture
• Framework: Accounting & Breakeven Analysis
• “Time-value of money” concepts - Ch. 3, 4
• Analysis methods
– Ch. 5 - Present Worth
– Ch. 6 - Annual Worth
– Ch. 7, 8 - Rate of Return (incremental analysis)
– Ch. 9 - Benefit Cost Ratio & other techniques
• Refining the analysis
– Ch. 10, 11 - Depreciation & Taxes
– Ch. 12 - Replacement Analysis

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 Three Major Methods of
Economic Analysis
• PW - Present Worth
• AW - Annual Worth
• IRR - Internal Rate of Return
If P = A(P/A, i, n)
Then (P/A, i, n) = P/A
Solve for (P/A, i, n) and look up
interest in Compound Interest Tables

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 Internal Rate of Return (IRR)
• 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. Ex: P = $5000, i = 10%, n = 5

Year Principal Prin. Paid Int Paid Payment

1 5000.00 818.99 500.00 1318.99
2 4181.01 900.89 418.10 1318.99
3 3280.13 990.97 328.01 1318.99
4 2289.15 1090.07 228.92 1318.99
5 1199.08 1199.08 119.91 1318.99
6 0.00 0.00
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 Calculating Rate of Return

• The IRR is the interest rate at which the

benefits equal the costs. IRR = i*
PW Benefit - PW Cost = 0
PW Benefit/PW Cost = 1
NPW = 0
EUAB - EUAC = 0
PW Benefit = PW Cost

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 Calculating IRR - Example 7-1
• PWB/PWC = 1
• 2000(P/A, i, 5)/8200 = 1
• (P/A, i, 5) = 8200/2000 =
4.1
• From Table, IRR =
7%
From Compound Interest Tables
Interest rate (P/A,i,5)
6% 4.212
7% 4.100
8% 3.993
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 Calculating IRR - Example 7-2

Sometimes we have more than one factor in our equation.

When that happens we cannot solve for just one factor.

If we use: EUAB - EUAC = 0

100 + 75(A/G, i, 4) - 700(A/P, i, 4) = 0

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Calculating IRR - Example 7-2 (cont’d)
• No direct method for calculating. Use trial and error
and iterate to get answer.
• Try i = 5%:
100 + 75(A/G, 5%, 4) - 700(A/P, 5%, 4) = + 11
+ 11 is too high. The interest rate was too low
• Try i = 8%
100 + 75(A/G, 8%, 4) - 700(A/P, 8%, 4) = - 6
- 6 is too low. The interest rate was too high
• Try i = 7%
100 + 75(A/G, 8%, 4) - 700(A/P, 8%, 4) = 0
Therefore IRR = 7%
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 Calculating IRR - Example 7-3
• Example 7-3 shows a series of cash flows that does not match any
of our known patterns. We must use trial and error.
• Using NPW = 0, suppose we start with i = 10% . NPW = + 10.16,
which is too high.
• Using i = 15%, NPW = - 4.02. IRR is between 10% & 15%
• The iterations may be graphed and the true IRR will be indicated
at the point where the NPW curve = 0.
Yr CF
0 - 100
1 + 20
2 + 20
3 + 30
4 + 40
5 + 40
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Calculating IRR - Example 7-3 (Cont’d)
• We can use linear interpolation to find estimate
the point where the curve crosses 0.
• IRR = i* = 10% + (15%-10%)[10.16/(10.16 +
4.02)] = 13.5%
• This is a linear interpolation of a non-linear
function so the answer is slightly inaccurate,
but good enough for decision making here
(after all, the guesswork in our future cash
flows introduces uncertainty in the analysis).
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Calculating IRR - Example 7-3 (Cont’d)
• To get an exact answer, we can use the IRR function in
EXCEL
• Select the IRR function from the fx icon.
• Block the column on the spreadsheet that has the cash flows for
all years.
• The function returns the IRR.
-100
20
The IRR function in
30
EXCEL allows you to
20
evaluate the return of
40 investments very easily
40
13.47% =IRR(A1:A6)
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Calculating IRR for a Bond - Example 7-4a
Bond Costs and Benefits:
Purchase price = $1000
Dividends = $40 every six months
Sold after one year for $950

Calculation of Periodic interest rate & IRR:

m = 2 compounding periods/year
1000 = 40(P/A, i, 2) + 950(P/F, i, 2)
By trial and error and interpolation i*  1.5%
IRR Nominal rate = 2 x 0.015 = 0.03 (3%)
IRR Effective rate = (1 + 0.015)2 - 1 = 0.0302 (3.02%)

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 Example 7-4a EXCEL Solution
• Use IRR function to find periodic IRR (i)
• Find nominal using r = i * m
• Use EFFECT function to find effective interest rate

Period Buy/sell Dividend Total

0 -1000 -1000
1 40 40
2 950 40 990
1.52% periodic
3.04% nominal
3.06% effective

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 Rate Of Return (ROR) Analysis

• Most frequently used measure of merit in

industry.
• More accurately called Internal Rate of
Return (IRR).

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 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.
• You cannot simply choose the higher IRR alternative.

Two-alternative Decision
situation
ROR MARR Choose higher-cost
alternative

ROR MARR Choose lower-cost

alternative

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The Minimum Attractive Rate of
Return (MARR)
• The MARR is a minimum return the
company will accept on the money it invests
• The MARR is usually calculated by financial
analysts in the company and provided to
those who evaluate projects
• It is the same as the interest rate used for
Present Worth and Annual Worth analysis.

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ROR on Alternatives With Equivalent Benefits
Example 7-5: Consider the lease vs. buy situation. MARR = 10%
• Leasco: Lease for five years for 3 annual payments of $1000 each
• Saleco: Purchase up front for $2783
• Both alternatives have a $1200/year benefit for 5 years
Cash flow - Cash flow - Cash flow -
Year alternative alternative alternative
A (Leaseco) B (Saleco) B-A

0 -$1,000.00 -$2,783.00 -$1,783.00

1 $200.00 $1,200.00 $1,000.00
2 $200.00 $1,200.00 $1,000.00
3 $1,200.00 $1,200.00 $0.00
4 $1,200.00 $1,200.00 $0.00
5 $1,200.00 $1,200.00 $0.00

IRR/period 48.72% 32.60% 8.01%

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 Example 7-5 (Cont’d)
• Cannot simply pick the highest IRR if alternatives have
different investment costs
• Must examine the incremental cash flows!!
• Subtract the cash flows for the “Lower First Cost”
alternative from the cash flows of the “Higher First Cost”
alternative to obtain the “Incremental Cash Flow” or 
• Compute the IRR on the incremental cash flow. This is
the ROR.
• For this problem the ROR is 8.01% which is
MARR, therefore choose the lower cost alternative.
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 Example 7-5 (Cont’d)
• Q. Why did we do this?
• A. Both alternatives were acceptable compared only to the
MARR. Since either alternative will work, the question is
whether we want to spend the additional $1783 to go from
the lower cost to the higher cost alternative. The benefit for
doing so is the savings of two years of $1000 lease
payments. Essentially we are getting an 8.01% return on
that $1783 investment. The company can get 10% ROR on
its money elsewhere, so reject the increment. That is, spend
$1000 now on Leaseco and invest the other $1783 for a
higher return.

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 Analysis Period
• Just as in PW and AW analysis the analysis period must be
considered:
– Useful life of the alternative equals the analysis period.
– Alternatives have useful lives different from the analysis period.
– The analysis period is infinite, n = 

For an example of that uses a

common multiple of the
alternate service lives, see
Example 7-10. EXCEL would 7-10
be useful here because of the
irregularity of the cash flows.
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