Lecture 7

Global Engineering Economics
Chapter 5
Comparison Methods Part II
5-1
Global Engineering Economics, Fourth Edition
Outline
5.1 Introduction
5.2 The Internal Rate of Return
5.3 Internal Rate of Return Comparisons
5.3.1 IRR for Independent Projects
5.3.2 IRR for Mutually Exclusive Projects
5.3.3 Multiple IRRs
5.3.4 External Rate of Return Methods
5.3.5 When to Use the ERR
5-2
5.1 Introduction
• Chapter 4 showed how to structure projects so that

they are either independent or mutually exclusive.
• Chapter 4 also introduced the present worth, annual
worth, and payback methods for evaluating projects.
• Chapter 5 introduces the commonly used but
somewhat more complicated method called the
internal rate of return, or IRR.
5-3
5.2 The Internal Rate of Return
• Internal Rate of Return: the interest rate i*

such that, when all cash flows associated
with a project are discounted at i*, the
present worth of the cash inflows equals the
present worth of the cash outflows.
T (R  D ) Rt and Dt are the receipts

PW  0   t t
and disbursements in
t
t 0 (1  i *) period t, t = 0,1,…,T
5-4
Practice Problem 5-1
• Suppose £100 is invested today and it returns £110

in one year from now.
• The IRR for this investment is the interest rate at
which £100 today is equivalent to £110 one year
from now.
Answer
Solve for i* in: P = F(P/F,i*,1)
100 = 110/(1 + i*)
i * = 0.10 or, 10%.
The IRR is 10%
5-5
5.2 The Internal Rate of Return, cont’d
• The IRR is the interest rate at which the project

“breaks even.”
• It is the interest rate such that
– PW(disbursements) = PW(receipts)
– AW(disbursements) = AW(receipts)
– FW(disbursements) = FW(receipts)
• In all three cases, solve for the unknown i*.
5-6
5.2 The Internal Rate of Return, cont’d
• The “internal” in IRR refers to the fact that the return

is due to the cash flows “internal” to the project being
evaluated.
• The IRR is usually positive.
• A negative IRR means that the project is losing
money.
• The equation for the IRR is solved by:
– Trial and error
5-7
• New windows at Nottawasaga Fabricating

(NF) are expected to save £400 per year in
energy over their 30 year life. The windows
have an initial cost of £8000 and will have a
zero salvage value.
a) Plot the PW of this investment as a function of the
interest rate.
b) Calculate the IRR
5-8
Practice Problem 5-2, cont’d
Answer
PW = - 8000 + 400(P/A, i, 30)
5000
4000
3000
Present Worth
2000
1000
0
0.0% 1.0% 2.0% 3.0% 4.0%
-1000
-2000
Interest Rate
5-9
5.3 Internal Rate of Return Comparisons
• This section demonstrates how to use the

IRR to decide whether a project should be
accepted
– IRR for Independent Projects
– IRR for mutually exclusive projects
– Potential for multiple IRRs
– External Rate of Return ERR
5 - 10
5.3.1 IRR for Independent Projects
• For Independent Projects: Invest in any

project that has an IRR equal or exceeding
the MARR.
• Similar to the evaluation of independent
projects from Chapter 4 where any project
with a PW or AW ≥ 0 is acceptable.
5 - 11
Practice Problem 5-3 (5-2 revisited)
• New windows at Nottawasaga Fabricating (NF) are

expected to save £400 per year in energy over their
30 year life. The windows have an initial cost of
£8000 and will have a zero salvage value.
• With a MARR of 8%, should the investment be
made? Use the IRR method.
Answer
NO - The IRR= 2.84% < MARR = 8%
5 - 12
5.3.2 IRR for Mutually Exclusive Projects
• The analysis gets a bit more complex than for

independent projects.
• An example will provide insights into the

complexities.
5 - 13
• Consider two mutually exclusive

investments. The first costs £10 today and
returns £20 in one year. The second costs
£1000 and returns £1200 in one year. Your
MARR is 12%.
• Which is your preferred investment?
• P.S.: You cannot take “multiples” of the
investments.
5 - 14
Answer
First project:
Rate of return = 100%
PW = −10 + 20 (P/F,12%,1) = £7.86
Second Project:
Rate of Return = 20%
PW = −1000 + 1200(P/F,12%,1) = £71.42
The IRR for the first project is higher than the second,
but the second has a higher PW…
The preferred project is the second. Why?
5 - 15
5.3.2 IRR for Mutually Exclusive Projects, cont’d
• If the two projects in Practice Problem 5-4 were

independent, we would do both (both have an IRR >
MARR).
• If they are mutually exclusive, it is tempting to pick
the one with the higher IRR, but this is incorrect
because it can overlook projects whose IRR is at
least the MARR, but don’t have the highest IRR.
• It is important that each incremental investment
earn at least the MARR.
5 - 16
Practice Problem 5-5 (5-3 revisited)
• Consider the project with the smallest first

cost: Project 1 (P1) costs £10. It has an IRR
of 100%, so is considered acceptable.
• The second project (P2) requires an
incremental investment of £ 990 and brings
an incremental benefit of £ 1180 at the end
of one year. What is the IRR on the
incremental investment?
5 - 17
Practice Problem 5-5 (5-3 revisited), cont’d
• Solve for i in PW(P2) − PW(P1) = 0:
−10−(−1000)+(20-1200)(P/F,i,1) = 0
990−1180/(1+i) = 0  i = 0.1919 or 19%
• The incremental investment should be taken

IRR>MARR
• Second Investment should be chosen
5 - 18
• The fundamental principle illustrated by the two

examples is that, to use the IRR to compare two or
more mutually exclusive alternatives, we cannot
make the decision on the basis of the IRRs of
individual alternatives alone.
• The IRRs of the incremental investments must be
taken.
• Before undertaking a systematic analysis of mutually
exclusive alternatives with the IRR method, you must
ensure that the alternatives have equal lives.
5 - 19
ALGORITHM
1. Sort the projects from the lowest first cost to the
highest. Start with the least first cost project. Call
this the current best.
2. Challenge the current best with the next most
expensive project. If the challenger is successful,
i.e., if the incremental investment has an IRR 
MARR, then make the challenger the current best.
3. Repeat Step 2 until there are no further challengers.
5 - 20
Figure 5.5 Flowchart for Comparing Mutually
Exclusive Alternatives
5 - 21
• Helpful hints
– What happens if we must do one project, but none of the
projects have an IRR greater than the MARR?
• e.g. several cost-only plans
• follow the algorithm: pairwise comparison answers “is
Challenger better than Current Best?”
5 - 22
• Rimouski Dairy needs to get a filling machine

for their creamer production line. They have
three choices for filling this need. Revenues
from the line are £20 000 per year. Rimouski
uses a MARR of 10%.
5 - 23
1. Purchase a new machine: First cost = £65 000,

service life = 6 years, and salvage value = £10 000.
2. Contract with a packaging supplier for a “free”
machine. Additional packaging costs £15 000 per
year over the next 6 years.
3. Buy a used machine for £30 000 which will have a
£0 salvage value at the end of 6 years. Maintenance
costs are £3000 in the first year, increasing by
£2500 per year thereafter.
5 - 24
• Installation costs for each alternative are £6000.

With a MARR of 10%, which is the preferred
alternative? Use the IRR method.
5 - 25
Answer
Ordered on first costs, the alternatives are:

A. Free machine : First cost £6000
B. Used machine : First cost £36 000
C. New machine : First cost £71 000
The ‘Free Machine’ (A) becomes “current best”.

The Used Machine (B) becomes the ‘challenger’.
What is the IRR on the incremental investment?
5 - 26
Answer
Solve for i* in PW(B – A) = 0
-30 000 + [12 000 - 2500(A/G, i*, 6)](P/A, i*, 6) = 0
i PW(B - A)=0
10% -£1948
9% -£1400
 IRR must be less than 9%
The “challenge” fails. A is still the ‘current best.’
What is the IRR on the incremental investment from A to C?

5 - 27
Answer
Solve for i* in PW(C – A) = 0
−65 000 + 10 000(P/F, i*, 6) + 15 000(P/A, i*, 6) = 0
i PW(C - A)=0
10% £5974.2
9% £8251.2
5 - 28
Answer
 IRR must be greater than 11%
Since IRR > MARR, the challenger (new machine)

replaces the current best.
As there are no further challengers, the current best is

the new machine. Therefore, the new machine should
be chosen.
5 - 29
5.3.3 Multiple IRRs
• The problem with implementing the IRR

method is that there may be more than one
internal rate of return.
5 - 30
• Suppose that a project pays £2500 today,

costs £12,500 one year from now and pays
£15,000 in two years. What is the IRR?
5 - 31
Answer
Solve for i* in:
2500 – 12 500(P/F,i*,1) + 15 000(P/F, i*, 2) = 0
5 6
1  0
1  i * (1  i*) 2
i * 2 3i * 2  0
(i * 1)(i * 2)  0
i* = 100% or 200%. Which is correct?
5 - 32
Answer
1000
800
600
Present Worth ($)
400
200
0
0.00
100% 200%
-200
Interest Rate
5 - 33
5.3.3 Multiple IRRs
• The multiple internal rate of return method may be

stated more generally.
• Consider a project that has cash flows over T
periods.
• Setting the present worth of the net cash flows over
the entire life of the project equal to zero to find the
IRRs generates.
• A0 + A1 (1 + i)-1 + A2 (1 + i)-2 + … + AT (1 + i)-T = 0
• There may be multiple solutions or IRRs to the
equation.
5 - 34
5.3.3 Multiple IRRs, cont’d
• Positive project balances are invested

elsewhere, probably at MARR but not at
100% or 200%.
5 - 35
5.3.4 External Rate of Return Methods
• To resolve the multiple IRR difficulty, we need to

consider what return is earned by money
associated with a project that is not invested in
the project.
• The usual assumption is that the funds are
invested elsewhere and earn an explicit rate of
return (usually the MARR – a “conservative”
assumption).
5 - 36
5.3.4 External Rate of Return Methods, cont’d
• The external rate of return (ERR), denoted

by i*e , is the rate of return on a project where
any “excess” cash from a project is assumed
to earn interest at a pre-determined explicit
rate — usually the MARR.
5 - 37
• A project pays £1000 today, costs £5000 a

year from now, and pays £6000 in two years.
What is the rate of return? Assume the
MARR = 25%.
5 - 38
Answer
The first £1000 is not invested immediately in the

project. It is assumed invested outside the project for
one year at the MARR. The cumulative cash flow for
year one is:
1000(F/P, 25%, 1) – 5000 = 1250 – 5000 = –£3750
With this calculation, the cash flow diagram from Figure

5.7(a) is transformed to that of Figure 5.7(b).
5 - 39
Figure 5.7 Multiple IRR Solved
5 - 40
Answer
These cash flows provide a single (precise) ERR, as

follows:
−3750 + 6000(P/F,i*e, 1) = 0
(P/F,i*e, 1) − 3750/6000 = 0.625
1/(1 + i*e ) = 0.625
1 + i*e = 1.6
ERR = 0.60 or 60%
5 - 41
5.3.4 External Rate of Return Methods, cont’d
• Computing an exact ERR is difficult: The ERR

affects project balances, which affect the ERR.
• To get an approximate ERR:
1. Take all net receipts forward at the MARR to the time of the
last cash flow.
2. Take all net disbursements forward at the unknown rate iea*
(approximate ERR) to the time of the last cash flow.
3. Set FW(receipts) = FW(disbursements) and solve for iea*.
4. The value for iea* is the approximate ERR for the project.
5 - 42
• Consider Practice Problem 5-7 again: A

project has cash flows of £2500 now, –
£12,500 in one year and £15,000 in two
years. If the MARR is 25%, find the
approximate ERR.
5 - 43
Answer
Taking net receipts forward at the MARR and equating
to net disbursements taken forward at the unknown
rate () gives:
2500(F/P,25%,2) + 15 000 = 12 500(F/P, i*ea,1)
(F/P, i*ea,1) = 1.5125
(1+ i*ea) = 1.5125
The approximate ERR is 51.25%.
5 - 44
• Consider Practice Problem 5-8 again.

• A project pays £1000 today, costs £5000 a
year from now, and pays £6000 in two years.
What is the rate of return? Assume the
MARR = 25%.
5 - 45
Answer
1000(F/P,25%,2) + 6000 = 5000(F/P, i*ea,1)
(F/P, i*ea,1) = (1000(1.5625) + 6000)/5000 =
1.5125
(1+ i*ea) = 1.5125
i*ea = 0.5125 or 51.25%
The approximate ERR is 51.25% vs. 60% for
the precise ERR.
5 - 46
5.3.5 When to Use the ERR
• The ERR method should be used whenever multiple IRRs are

possible.
• Unfortunately, it is sometimes hard to know in advance when
there are multiple IRRs.
• However, most investments will have a cash flow structure
which excludes multiple IRRs.
• Simple investment: an investment characterized by one or
more periods of cash outflows, followed by one or more
periods of cash inflows.
• If a project is a simple investment, it will have at most one
positive IRR
5 - 47
5.3.5 When to Use the ERR, cont’d
• If a project is not a simple investment, there may be

more than one IRR.
• If the sign of successive cash flows changes X times
there may be up to X IRRs.
• A plot of PW (or AW, FW) vs interest rate may show
multiple IRRs if they exist.
5 - 48
Conclusions:
• Use a regular IRR computation for simple
investments or for investments for which you have
ruled out multiple IRRs by plotting the PW (AW or
PW) for many interest rates.
• Use an ERR computation if you have found multiple
IRRs with a plot, or if you are not sure.
5 - 49
Important:
• The use of the approximate ERR for decision
making will produce decisions consistent with the
exact ERR and PW methods. (e.g., invest or don’t
invest)
5 - 50

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Global Engineering Economics

• Chapter 4 showed how to structure projects so that

5.2 The Internal Rate of Return

• Internal Rate of Return: the interest rate i*

T (R  D ) Rt and Dt are the receipts

Practice Problem 5-1

• Suppose £100 is invested today and it returns £110

• The IRR is the interest rate at which the project

• In all three cases, solve for the unknown i*.

• The “internal” in IRR refers to the fact that the return

Practice Problem 5-2

• New windows at Nottawasaga Fabricating

5.3 Internal Rate of Return Comparisons

• This section demonstrates how to use the

5.3.1 IRR for Independent Projects

• For Independent Projects: Invest in any

Practice Problem 5-3 (5-2 revisited)

• New windows at Nottawasaga Fabricating (NF) are

5.3.2 IRR for Mutually Exclusive Projects

• The analysis gets a bit more complex than for

• An example will provide insights into the

Practice Problem 5-4

• Consider two mutually exclusive

• If the two projects in Practice Problem 5-4 were

Practice Problem 5-5 (5-3 revisited)

• Consider the project with the smallest first

• Solve for i in PW(P2) − PW(P1) = 0:

• The incremental investment should be taken

• The fundamental principle illustrated by the two

Practice Problem 5-6

• Rimouski Dairy needs to get a filling machine

1. Purchase a new machine: First cost = £65 000,

• Installation costs for each alternative are £6000.

Ordered on first costs, the alternatives are:

The ‘Free Machine’ (A) becomes “current best”.

 IRR must be less than 9%

The “challenge” fails. A is still the ‘current best.’

What is the IRR on the incremental investment from A to C?

 IRR must be greater than 11%

Since IRR > MARR, the challenger (new machine)

As there are no further challengers, the current best is

5.3.3 Multiple IRRs

• The problem with implementing the IRR

Practice Problem 5-7

• Suppose that a project pays £2500 today,

i* = 100% or 200%. Which is correct?

5.3.3 Multiple IRRs

• The multiple internal rate of return method may be

• Positive project balances are invested

5.3.4 External Rate of Return Methods

• To resolve the multiple IRR difficulty, we need to

• The external rate of return (ERR), denoted

Practice Problem 5-8

• A project pays £1000 today, costs £5000 a

The first £1000 is not invested immediately in the

1000(F/P, 25%, 1) – 5000 = 1250 – 5000 = –£3750

With this calculation, the cash flow diagram from Figure

Practice Problem 5-8