Lecture # 22

Engineering Economics (MS-291)

Chapter 7
Rate of Return Analysis: One Project

Dr. Muhammad Ullah

Assistant Professor
Department of Management Sciences GIKI
Learning Outcomes
• Understand meaning of ROR
• Calculate ROR for cash flow series
• Understand difficulties of ROR
• Determine multiple ROR values
• Calculate External ROR (EROR)
• Calculate yields for bonds

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Bonds
ROR of Bond Investment
• Bond is a method of raising capital funds by issuing “IOU” with face
value (V), coupon rate (b), no. of payment periods/year (c), interest
(coupon) (I), and time to maturity (n). Amount paid for the bond is P.

General equation for i*:

P = I(P/A, i*, nxc) + V(P/F, i*, nxc)
0 = - P + I(P/A, i*, nxc) + V(P/F, i*, nxc)
Example

• A $10,000 bond with 6% interest payable quarterly is purchased for $8000. If

the bond matures in 5 years.
• What is the ROR (a) per quarter, (b) per year?
a) ROR per quarter
I = 10,000(0.06)/4 = $150 per quarter
ROR equation is: 0 = -8000 + 150(P/A, i*,20) + 10,000(P/F, i*,20)
By trial and error or spreadsheet: i* = 2.8% per quarter
b) ROR per year
Nominal i* per year = 2.8(4) = 11.2% per year
Effective i* per year = (1 + 0.112/4)4 – 1 = 11.7% per year
Quick Check
Allied Materials needs $3 million in debt capital for expanded
composites manufacturing. It is offering small-denomination bonds
at a discount price of $800 for a 4%, $1000 bond that matures in 20
years with a coupon payable semiannually. What nominal and
effective interest rates per year, compounded semiannually, will
Allied Materials pay an investor?
Solution
The income that a purchaser will receive from the bond purchase is the bond
coupon (I)  $20 every 6 months plus the face value in 20 years. The PW-based
equation for calculating the rate of return is
0 = -800 + 20(P/A, i* ,40) + 1000(P/F, i*, 40)
By trial and error or spreadsheet: i* = 2.8435% semiannually
Nominal i* per year = 2.8435(2)
=  5.6870% per year, compounded semiannually
Effective i* per year = (1 + 0.028435)2 – 1
=  5.7678% per year
 Interpolation

1st Trial? Lets try 2%

P = 800 0 = -800 + 20(P/A, 2% ,40) + 1000(P/F, 2%, 40)

F = 20*40 + 1000 = 1,800 0= −800+20 (27.3555) + 1000 (0.4529)

800 = 1800 (P/F, i, 40) 0 < 200.01

(P/F, i, 40) = 0.4444 Lets try 3%

From the table we can see; 0 = −800 + 20(P/A, 3% ,40) + 1000(P/F, 3%, 40)

For 2% the (P/F, i, 40) = 0.4529 0= −800+20 (23.1148) + 1000 (0.3066)

0 > −30.44
Interpolation

2% 200.10 1st Trail?

𝒙 𝟐𝟎𝟎.𝟎𝟏 P = 800
F = 20*40 + 1000 = 1,800
2% IRR 0 230.45 800 = 1800 (P/F, i, 40)
(P/F, i, 40) = 0.4444
3% -30.44 From the table we can see;
For 2% the (P/F, i, 40) = 0.4529

=> Please note that 2.87% is an approximation

 Thank You

Any Questions?
Email: Muhammad.ullah@giki.edu.pk
References
• Engineering Economy 7th Edition by Leland Blank, Anthony Tarquin
[ISBN-10: 0073376302] and accompanying PowerPoint slides

• Videos from Dragon’s Den are copy righted. We are using it only for
educational purposes.

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