Rate-of-Return

Analysis
Learning Objectives

● Evaluate project cash flows with the internal rate of return (IRR)
measure.
● Plot a project’s present worth (PW) against the interest rate.
● Use an incremental rate of return analysis to evaluate competing
alternatives.
Rate of Return
There are several ways of defining the concept
of rate of return on investment. We will show
two of them: the first is based on a typical loan
transaction, and the second is based on the
mathematical expression of the present-worth
function.
Definition 1: Rate of Return is the interest
earned on the unpaid balance of amortized
loan.
Definition 2: Rate of return is the break even
interest rate i* at which the net present worth
of a project is zero
PW(i*) = PWcash inflow - PWcash outflow = 0
Return on Invested Capital

Investment projects can be viewed as

analogous to bank loans.
We will now introduce 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), or the yield promised by
an im·cstment project over its useful life.
Definition 3. The internal rate of return is the
interest rate charged to the unrecovered project
balance of the investment such that, when the
project terminates, the unrecovered project
balance is zero.
Methods for Finding Rate of Return

Simple versus Nonsimple

Investments
We can classify an investment
project 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. We ignore a zero
cash flow.)
Simple versus Nonsimple Investments

• A simple (or conventional) investment is

simply when one sign change occurs in the net
cash flow series. If the initial cash flows are
negative, we call them simple-investment cash
flows. If the initial flows are positive, we call
them simple-borrowing cash flows.
• A nonsimple (or nonconventional) investment
is an investment in which more than one sign
change occurs in the cash flow series.
Computational Method
Once we identify the type of an investment
cash flow, there are several ways to
determine its rate of return. We will discuss
some of the most practical methods here.
They are as follows:
• Direct-solution method
• Trial-and-error method
• Excel method
Sample Problem

A cash flow profile with two

interest periods consists of A0 =
+1,200, A1 = —2,700, and A2 =
+1,500. Find the internal rate of
return per interest period
Sample Problem
The Maxwell Manufacturing Company
plans to invest $77,000 in an energy
saving device with the expectation of
receiving benefits for the next 5 years
in the amounts of $38,000, $32,000,
$26,000, $20,000, and $14,000 at the
end of first, second, third, fourth, and
fifth years, respectively. What is the
internal rate of return for investing in
this device?
Internal Rate of Return Criterion

Relationship to the PW Analysis

PW analysis is dependent on the rate of
interest used for the PW computation.
A different rate may change a project
from being considered acceptable to
being considered unacceptable, or it
may change the priority of several
projects.
Evaluating a Single Project
For a simple investment, i* is indeed the IRR of the
investment. Because firms typically wish to do better
than break even recall that at PW = 0, we were
indifferent to the project), a minimum acceptable rate
of return (MARR) is indicated by company policy,
management, or the project decision maker. the
decision rule for a simple project is as follows:

If IRR > MARR, accept the project.

If IRR = MARR, remain indifferent.

If IRR < MARR, reject the project.

Sample Problem
An energy firm is betting on wind power's long-term viability in
Texas and plans to erect what would be one of the biggest wind
farms in the world with 200 wind turbines costing some $1.69
million each. Energy companies investing in wind power are also
expecting governments to toughen rules relating to traditional
energy sources, as part of long-term efforts to reduce global-
warming emissions. But generating power from wind is not
profitable for companies without government tax breaks. The
following financial and technical data have been compiled for
further consideration:
Number of wind turbines to be built: 200 units: Power capacity:
310,000 kW ; Capital investment required: $338,000,000 ; Project
life: 20 years; Salvage value of the wind turbines after 20 years: $0 ;
Annual net cash flows {after all deductions): $41,391,160
According to the data provided, answer the following questions: (a)
What is the projected IRR on this investment? (b) If the company's
MARR is known to be 10%, is the investment justified?
Evaluating Mutually Exclusive Projects

When we have to compare mutually

exclusive investment projects, we
need to apply the incremental analysis
approach
Incremental Analysis

When there are two alternatives, rate of return analysis is

performed by computing the incremental rate of return—
IRR—on the difference between the alternatives.

Since we want to look at increments of investment, the

cash flow for the difference between the alternatives is
computed by taking the higher initial-cost alternative
minus the lower initial-cost alternative. If IRR is the same
or greater than the MARR, choose the higher-cost
alternative. If IRR is less than the MARR, choose the
lower-cost alternative.
Sample Problem
You must select one of two mutually exclusive alternatives.
(Note: Engineering economists often use the term “mutually
exclusive alternatives” to emphasize that selecting one
alternative precludes selecting any other.) The alternatives
are as follows:

Year Alt. 1 Alt. 2

0 −$1000 −$2000

1 +1500 +2800

Any money not invested here may be invested elsewhere at

the MARR of 6%. If you can choose only one alternative
one time, using the internal rate of return (IRR) analysis
method, which one would you select?
Homework # 3.

1. Find the net present value of the following unconventional investment cash flow
profile: A0 = -1,500, A1 = +4,200, A2 = -3,500, and A3 = +1,890. The specified
MARR is 18% per period.

2. Suppose you deposited $1,500 five years ago and another $500 three years ago in
your savings account. If your current account balance shows $3,200, what is the
rate of return on your deposit?

3. You spend $1000 and in return receive two payments of $1100—one at the end of
3 years and the other at the end of 6 years. Calculate the resulting rate of return.