Rate of Return Analysis

Chapter 7
Internal Rate of Return

u Defined as 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.
u Revisiting Plan 3 from chapter 3, we can say we are investing $5,000 on a new machine
with a 5-year useful life an equivalent uniform annual benefit of $1252, we can ask
“what rate of return” are we receiving from the investment.
Plan 3
3 – Plan 3 – Constant payment – Five equal end of year payments of $1,252 each. (Will be
explained in example 4.3)
Year Amount owed Interest owed Total owed end Principal Total end of
at beginning of for that year of year (b+c) Payment year payment
year

1 $5,000 400 5,400 $1,252 – 400 $1252

= 852
2 5000-852 = 331 4479 921 1252
4148
3 4148–921 = 258 3,485 994 1252
3,227
4 3,227– 178 2,411 1,074 1252
994=2,233
5 2,233- 93 1,252 1,159 1252
1074=1,159

Total interest earned = $1,260

Total repayment after 5 years = $6,260
Plan 3 Cash Flows

Year Cash Flow

0 -$5000
1 $1252
2 $1252
3 $1252
4 $1252
5 $1252
Plan 3

u The cash flows tells us that we have five payments of $1252 that are equivalent to a
present sum of $5,000 when the interest rate is 8%.
u In terms of Rate of Return, each payment of $1252 represents an 8% return on the
unrecovered investment plus a partial return of the investment.
u The internal rate of return is now defined as the interest rate earned on the
unrecovered investment such that the payment schedule makes the unrecovered
investment equal to zero at the end of the life of the investment.
Plan 3

Unrecovered 8% Return on Investment Unrecovered

Year Cash Flow investment at unrecovered repayment at end investment at end
beginning of year investment of year of year

0 -5000
1 1252 5000 400 852 4148
2 1252 4148 331 921 3227
3 1252 3227 258 994 2233
4 1252 2233 178 1074 1159
5 1252 1159 93 1150 0
$1260 $5000
Internal rate of return

u There are two definitions of IRR, one stated in terms of a loan and the other in terms
of the investment.
u The concept described is that the IRR is the interest rate at which the benefits are
equivalent to the costs or the present worth (PW) is zero.
Calculating rate of return

u To calculate the rate of return we must convert the various consequences of the investment into a cash
flow. Then solve the cash flow for the unknown value of the IRR.
u Five forms of the cash flow equation are:
PW of benefits – PW of costs = 0

PW of benefits/PW of costs = 1

NPW = 0

EUAB – EUAC = 0

PW of costs = PW of benefits
Example 7.1

u An engineer invests $5,000 at the end of every year for a 40-year career. If he wants to
have $1M in savings by the time he retires, what interest rate must he earn?
u Use the Future Worth version of NPW = 0 or NFW = 0

Net FW = 0 = -5000(F/A, i%, 40) + 1,000,000

(F/A, i%, 40) = 1,000,000/5000 = $200
Looking at the compound interest tables then the closest value will be 7% since
(F/A, 7%, 40) = 199.636
Example 1

u An $8200 investment returned $2000 per year over a 5-year useful life. What was the
rate of return on the investment?

PW of benefits / PW of costs = 1

2000(P/A, i%, 5)/8200 = 1

(P/A, i%, 5) = 8200/2000
(P/A, i%, 5) = 4.1
Example 1

u Find the compound interest tables for the value of i where (P/A, i%, 5) = 4.1
u If the exact value is not found, use the values on either side of the desired value and
interpolate to find the IRR.
u In this case no interpolation is needed because the IRR is at 7%.
i (P/A, i%, 5)
6% 4.212
7% 4.100
8% 3.993
Example 7.2

u An investment resulted in the following cash flow. Compute the rate of return:

Year Cash flow

0 -$700
1 100
2 175
3 250
4 325
Example 7.2

u Formula used:

EUAB – EUAC = 0
100 + 75(A/G, i%, 4) – 700(A/P, i%, 4) = 0

We now use a trial and error system:

With i = 5%
100 + 75(1.439) – 700(0.2820) = 0
100 + 108 – 197 = 11
Example 7.2

u Increase i to 8%:

100 + 75(A/G, 8%, 4) – 700(A/P, 8%, 4) = 0

100 + 75(1.404) – 700(0.3019) = 0
100 + 105 – 211 = -6

u Decrease to 7%:
100 + 75(A/G, 7%, 4) – 700(A/P, 7%, 4) = 0
100 + 75(1.416) – 700(.2952) = 0
100 + 106 – 206 = 0
Then, the IRR = 7%
Example 2

u Calculate the rate of return on the investment on the following cash flow:

Year Cash Flow

0 -$100
1 20
2 30
3 20
4 40
5 40
Example 2

u Use NPW = 0 by trial and error start with i = 10%

NPW = -100 + 20(P/F, 10%, 1) + 30(P/F, 10%,2) + 20(P/F, 10%, 3) + 40(P/F, 10%,4)
+ 40(P/F, 10%, 5)

NPW = -100 + 20(0.9091) + 30(0.8264) + 20(0.7513) + 40(0.6830) + 40(0.6209)

= -100 + 18.18 + 24.79 + 15.03 + 27.32 + 24.84
0 = 10.16
Example 2

u Increase to 15%:
NPW = -100 + 20(P/F, 15%, 1) + 30(P/F, 15%,2) + 20(P/F, 15%, 3) + 40(P/F, 15%,4)
+ 40(P/F, 15%, 5)
= -100 + 20(0.8696) + 30(0.7561) + 20(0.6575) + 40(0.5718) + 40(0.4972)
= -4.02

u Interpolate to find the IRR, where y = 0 and:

u 𝑋1 = 15, 𝑋2= 10
u 𝑌1 = −4.02, 𝑌2 = 10.16
u IRR = 13.57%
Example 7.3 - HW

u A firm borrows $300,000 to be repaid with 5 annual payments of $45,000 and a final
balloon payment of $170,000. What interest rate is the firm paying o this loan?

Use the PW equation:

PW = PW of benefits – PW of costs
Example 7.4

u HW
Example 7.5

u A new corporate bond was initially sold by a stockbroker to an investor for $1000. The
issuing corporation promised to pay the bondholder $40 interest on the $1,000 face
value of the bond every six months, and to repay the $1,000 at the end of 10 years.
After one year the bond was sold by the original buyer for $950.
u What rate of return did the original buyer receive on his investment?
Example 7.5

u Initial cost - $1,000

u Payment of benefits – every 6 months (semesters, twice per year)
u Original owner sold bond after one year for $950
u Use the formula to calculate the effective interest rate (annual):
2
IRR = (1 + 𝑖) −1
Use:
PW costs = PW of benefits
1000 = 40(P/A, i%, 2) + 950(P/F, i%, 2)
Try 1.5%
1000 = 40(1.956) + 950(0.9707)
1000 = 1000.41
Example 7.5

u If the IRR is close to 1.5% then the annual interest rate would be 3%.
1.5 X 2 = 3%
u Calculate the actual annual interest rate:
2
IRR = (1 + 𝑖) −1
2
= (1 + 0.015) −1 = 3.02%
Incremental Analysis

u As a method of analysis, the Internal rate of return is calculated from the cah flows.
u This calculated rate of return is compared with a preselected minimum rate of return
or MARR, which is the same value of i used for PW and EUAW calculations.
u When there are two alternatives, the analysis is performed by computing the
“incremental rate of return” (∆IRR) on the difference between alternatives. What is
analyzed is the increments of investment, and the cash flow for the difference
between alternatives is computed by taking the highest initial-cost alternative minus
the lower initial-cost alternative.
u If the ∆IRR is the same or greater than the MARR, choose the highest cost alternative.
If the ∆IRR is less than the MARR, choose the lower cost alternative.
Example 7.11

u You may select one of two mutually exclusive alternatives for investment. Doing
nothing is allowed. If the money is not invested in any of these alternatives, it can be
invested in a savings account at the MARR of 6%. The alternatives are:

Year Alternative 1 Alternative 2

0 -$1000 -$2000
1 $1,500 $2800
Example 7.11

u Using incremental analysis and NPW = 0

Year Alternative 1 Alternative 2 ∆ alt 2 – alt 1

0 -$1000 -$2000 -$1000
1 $1500 $2800 $1300
Example 7.11

u 0 = PW benefits – PW costs

0 = 1300(P/F, i%, 1) – 1000

1000/1300 = (P/F, i%, 1)
(P/F, i%, 1) = 0.7692
Therefore, i = 30%
Comparing the ∆IRR of 30% to an MRR = 6%, then consider alternative 2 over alternative 1
or the “do nothing approach”.
Example 7.12

u Calculate the same scenario but now with Alternative 1 – Alternative 2:

Year Alt 1 – Alt 2 ∆

0 -1000 – (-2000) = $1000
1 1500 – 2800 = -$1300
Example 7.12

u NPW = 0
0 = 1000 – 1300(P/F, i%, 1)
1300(P/F, i%, 1) = 1000
(P/F, i%, 1) = 1000/1300 = 0.7692
u The answer for the ∆IRR remains the same at 30%.
u Now, what does this 30% represent?
u Instead of an investment, this is a loan.
u If we borrow $1,000 today and will pay $1300 at year 1, we are paying 30% interest on
the loan.
u Comparing to the MARR = 6%, this is not an attractive alternative.
Example 7.13

u A firm is considering which two devices to install to reduce costs. Both have a useful
life of 5 years and no salvage value. Device A costs $10,000 and can be expected to
result in annual savings of $3,000. Device B costs $13,500 and will provide savings of
$3,000 the first year with annual increases of $500. For an MARR of 7%, which device
should be purchased?
Example 7.13

Year Device A Device B Device B – Device A

0 -$10,000 -$13,500 -$3500
1 3000 3000 0
2 3000 3500 500
3 3000 4000 1000
4 3000 4500 1500
5 3000 5000 2000
Example 7.13

u Using NPW = 0
0 = -3500 + 500(P/G, i%, 5)
3500 = 500(P/G, i%, 5)
3500/500 = (P/G, i%, 5)
(P/G, i%, 5) = 7
u Using the compound interest tables we find that:
(P/G, 9%, 5) = 7.111
(P/G, 10%, 5) = 6.862
Example 7.13

u Interpolate with the following variables:

u X = 7, Y = i%
u 𝑋1 = 7.111, 𝑌1 = 9%
u 𝑋2 = 6.862, 𝑌2 = 10%

Y = i = 9.45%
Analysis period

u Just as PW analysis and annual cash flow analysis the time period must be considered.
u The alternatives may have the same useful life or same time periods, or common
multiple may be needed, assuming identical replacement.
Example 7.14

u Two machines are being considered for purchase. If the MARR is 10%, which machine
should be bought?

Type of cash flow Machine X Machine Y

Initial cost $200 $700
Uniform annual benefits 95 120
End of useful life or salvage 50 150
value
Useful life 6 12
Example 7.14
Year Machine X Machine Y Difference Y - X
0 -200 -700 -500
1 95 120 25
2 95 120 25
3 95 120 25
4 95 120 25
5 95 120 25
6 95 120 25
50 150
-200
7 95 120 25
8 95 120 25
9 95 120 25
10 95 120 25
11 95 120 25
12 95 120 25
50 150 100
Example 7.14

u NPW = 0

0 = -500 + 25(P/A, i%, 12) + 150(P/F, i%, 6) + 100(P/F, i%, 12)

u Observing the cash flows, they add to $550 which is a little bit more than the $500
original increment of additional cost, therefore the interest rate can’t be too high.
u At i = 1%
0 = -500 + 25(11.255) + 150(0.942) + 100(0.887) = 11
u At i = 1 ½%
0 = -500 + 25(10.908) + 150(0.914) + 100(0.836) = -6
Example 7.14

u By analysis, we can assume that the ∆IRR will be between 1.3% and 1.4%.
u It is far lower than the MARR of 10%, therefore the increment of costs for obtaining
Machine Y over Machine X is undesirable. Machine X is the most favorable alternative.