Module 19

Application of Money-
Time Relationships
(IRR, ERR, and Payback Methods)
Objectives:
To evaluate the feasibility of a proposal using

• Internal Rate of Return (IRR) Method

• External Rate of Return (ERR) Method

• Payback Method
INTERNAL RATE OF RETURN (IRR)

• The IRR Method is the most widely used rate-of-

return method for performing engineering economic
analyses. It is sometimes called by several other
names, such as the investor’s method, discounted
cash-flow method, and profitability index.
• This method solves for the interest rate that equates
the equivalent worth of outflows.
• Using PW formulation:
INTERNAL RATE OF RETURN (IRR)

N N

 R ( P / F , i'%,k )   E ( P / F , i'%,k )
k 0
k
k 0
k

Where:
Rk = net revenues or savings for the kth year
Ek = net expenditures, including investment cost for the kth year
N = project life
INTERNAL RATE OF RETURN (IRR)

• Once i’ % is calculated, it is compared with the

MARR to assess whether the alternative in
question is acceptable. If i’ % ≥ MARR, the
alternative is acceptable, otherwise, it is not.
EXAMPLE 19.1
• AMT Inc., is considering the purchase of a digital
camera for the maintenance of design specifications
by feeding digital pictures directly into an engineering
workstation where computer-aided design files can be
superimposed over the digital pictures. Differences
between the two images can be noted, and
corrections, as appropriate, can be made by design
engineers.
EXAMPLE 19.1
• The capital investment requirement is $345,000 and
the estimated market value of the system over the six-
year study period is $115,000. Annual revenues are
attributable to the new camera system will be
$120,000 whereas additional annual expenses would
be $22,000. You have been asked by management to
determine the IRR of this project and to make a
recommendation plan. The corporation’s MARR Is 20%
per year.
 $115,000

$120,000 $120,000 $120,000 $120,000 $120,000 $120,000

0 1 2 3 4 5 6

$22,000 $22,000 $22,000 $22,000 $22,000 $22,000

MARR=20%

$345,000
 $115,000

$120,000 $120,000 $120,000 $120,000 $120,000 $120,000

0 1 2 3 4 5 6

$22,000 $22,000 $22,000 $22,000 $22,000 $22,000

MARR=20%

$345,000

(1 + 𝑖)6 −1 (1 + 𝑖)6 −1 −6
$345,000 + 𝑆22,000 = 𝑆120,000 + $115,000(1 + 𝑖)
𝑖(1 + 𝑖)6 𝑖(1 + 𝑖)6
 $115,000

$120,000 $120,000 $120,000 $120,000 $120,000 $120,000

0 1 2 3 4 5 6

$22,000 $22,000 $22,000 $22,000 $22,000 $22,000

MARR=20%

$345,000

(1 + 𝑖)6 −1 (1 + 𝑖)6 −1 −6
$345,000 + 𝑆22,000 = 𝑆120,000 + $115,000(1 + 𝑖)
𝑖(1 + 𝑖)6 𝑖(1 + 𝑖)6

𝑖 = 𝐼𝑅𝑅 = 22.03% > MARR (Acceptable)

EXAMPLE 19.2
• Using the same setup with Example 18.1, the
investment cost is $25,000 and the equipment will
have a market value of $5,000 at the end of its
expected life of five years. Increased profit of $8,000 is
attributable. Evaluate the IRR of the project if the
company is using a MARR of 20%.
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

$20,000
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

$20,000

(1 + 𝑖)5 −1 −5
$20,000 = 𝑆8,000 + $5,000(1 + 𝑖)
𝑖(1 + 𝑖)5
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

$20,000

(1 + 𝑖)5 −1 −5
$20,000 = 𝑆8,000 + $5,000(1 + 𝑖)
𝑖(1 + 𝑖)5

𝑖 = 𝐼𝑅𝑅 = 32.02% > MARR (Acceptable)

 EXTERNAL RATE OF RETURN (ERR)

• The ERR Method directly takes into account the interest rate
(ϵ) external to a project at which net cash flows generated by
the project over its life can be reinvested.
• In general, there are three steps in the calculating procedure.
• All net cash outflows are discounted to time zero
(present) at ϵ% per compounding period.
• All net cash inflows are compounded to period N at ϵ %.
• The ERR, which is the interest rate that establishes
equivalence between the two quantities, is determined.
EXTERNAL RATE OF RETURN (ERR)

N N

 E ( P / F , %, k )( F / P, i'%, N )   R ( F / P, %, N  k )
k 0
k
k 0
k

Where:
Rk = excess of receipts over expenses in period k
Ek = excess of expenditures over receipts in period k
N = project life or number of periods for the study
ϵ = external reinvestment rate per period
EXAMPLE 19.3
• Using the same setup with Example 18.1, the
investment cost is $25,000 and the equipment will
have a market value of $5,000 at the end of its
expected life of five years. Increased profit of $8,000 is
attributable. Suppose that ϵ = MARR = 20% per year,
what is the ERR, and is the project acceptable?
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

ϵ =MARR=20%

$20,000
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

ϵ =MARR=20%

𝑃 = $20,000

$20,000
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

ϵ =MARR=20%

(1 + 0.2)5 −1
𝑃 = $20,000 𝐹 = $8000 + $5000
0.2
$20,000
𝐹 = $64,532.80
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

ϵ =MARR=20%

(1 + 0.2)5 −1
𝑃 = $20,000 𝐹 = $8000 + $5000
0.2
$20,000
𝐹 = $64,532.80

𝐹 = 𝑃(1 + 𝑖)𝑛
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

ϵ =MARR=20%

(1 + 0.2)5 −1
𝑃 = $20,000 𝐹 = $8000 + $5000
0.2
$20,000
𝐹 = $64,532.80

𝐹 = 𝑃(1 + 𝑖)𝑛
$64,532.80 = $20,000(1 + 𝑖)5
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

ϵ =MARR=20%

(1 + 0.2)5 −1
𝑃 = $20,000 𝐹 = $8000 + $5000
0.2
$20,000
𝐹 = $64,532.80

𝐹 = 𝑃(1 + 𝑖)𝑛
$64,532.80 = $20,000(1 + 𝑖)5

𝑖 = 𝐸𝑅𝑅 = 26.4% > MARR (Acceptable)

EXAMPLE 19.4
• An equipment needs an investment cost of $10,000.
After a year of purchase, another cost of $5,000 is
expended. A yearly profit of $5,000 is realized until the
end of the six-year study period. When ϵ = 15% and
MARR is 20% per year, determine whether the project
is acceptable.
 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000

0 1 2 3 4 5 6

$5,000
MARR=20% ϵ = 15%

$10,000
 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000

0 1 2 3 4 5 6

$5,000
MARR=20% ϵ = 15%

$10,000
𝑃 = $10,000 + $5,000(1 + 0.15)−1

𝑃 = $14,347.83
 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000

0 1 2 3 4 5 6

$5,000
MARR=20% ϵ = 15%

$10,000
𝑃 = $10,000 + $5,000(1 + 0.15)−1

𝑃 = $14,347.83

(1 + 0.15)6 −1
𝐹 = $5000
0.15

𝐹 = $43,768.69
 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000

0 1 2 3 4 5 6

$5,000
MARR=20% ϵ = 15%

$10,000 𝑃 = $14,347.83 𝐹 = $43,768.69

𝐹 = 𝑃(1 + 𝑖)𝑛
 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000

0 1 2 3 4 5 6

$5,000
MARR=20% ϵ = 15%

$10,000 𝑃 = $14,347.83 𝐹 = $43,768.69

𝐹 = 𝑃(1 + 𝑖)𝑛

$43,768.69 = $14,347.83(1 + 𝑖)6

 $5,000 $5,000 $5,000 $5,000 $5,000 $5,000

0 1 2 3 4 5 6

$5,000
MARR=20% ϵ = 15%

$10,000 𝑃 = $14,347.83 𝐹 = $43,768.69

𝐹 = 𝑃(1 + 𝑖)𝑛

$43,768.69 = $14,347.83(1 + 𝑖)6

𝑖 = 𝐸𝑅𝑅 = 20.4% > MARR (Acceptable)

PAYBACK (PAYOUT) METHOD

• The payback period is a measure of the speed with

which an investment is recovered by the cash inflows
it produces. This measure, in its most common form,
ignores time value of money principles.
• It is often used to supplement information produced
by the five primary methods.
PAYBACK (PAYOUT) METHOD

• Unlike the previous methods that talks about

profitability, the payout method indicates a project’s
liquidity.
• It is the measure of the project’s riskiness, since
liquidity deals with how fast an investment can be
recovered.
• The payback method calculates the number of years
required for cash inflows to just equal outflows.
PAYBACK (PAYOUT) METHOD

• The simple payback period, Ѳ, ignores the time value

of money and all cash flows that occur after Ѳ then:

 (R
k 1
k  Ek )  I  0
PAYBACK (PAYOUT) METHOD

• Sometimes, the discounted payback period, Ѳ’, (Ѳ’ ≤

N), is calculated so that the time value of money is
considered. In this case,


 (R
k 1
k  Ek )( P / F , i%, k )  I  0

• Where i% is MARR. Payback periods of three years or

less are often desired.
PAYBACK (PAYOUT) METHOD

• Using Examples 18.1, 18.2, 19.1, and 19.4,

calculate the simple and discounted
payback periods and decide whether to go
with the investment or not.
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

$20,000
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

Year Cash Flow Balance

$20,000
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

Year Cash Flow Balance

$20,000 0 -$20,000 -$20,000

 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

Year Cash Flow Balance

$20,000 0 -$20,000 -$20,000

1 $8000 -$12,000
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

Year Cash Flow Balance

$20,000 0 -$20,000 -$20,000

1 $8000 -$12,000
2 $8000 -$4000
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

Year Cash Flow Balance

$20,000 0 -$20,000 -$20,000

1 $8000 -$12,000
2 $8000 -$4000
3 $8000 $4,000
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

Year Cash Flow Balance

$20,000 0 -$20,000 -$20,000

1 $8000 -$12,000
2 $8000 -$4000
3 $8000 $4,000

𝑃𝑎𝑦𝑏𝑎𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 3 𝑦𝑒𝑎𝑟𝑠

 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

Year Cash Flow Balance

0 -$20,000 -$20,000
$20,000 1 $8000(1+0.2)-1 -$13,333.33
2 $8000(1+0.2)-2 -$7,777.77
3 $8000(1+0.2)-3 -$3,148.15
4 $8000(1+0.2)-4 -$709.88
5 $13000(1+0.2)-5 $4514.83
 $5,000

$8,000 $8,000 $8,000 $8,000 $8,000

0 1 2 3 4 5

MARR=20%

Year Cash Flow Balance

0 -$20,000 -$20,000
$20,000 1 $8000(1+0.2)-1 -$13,333.33
2 $8000(1+0.2)-2 -$7,777.77
3 $8000(1+0.2)-3 -$3,148.15
4 $8000(1+0.2)-4 -$709.88
5 $13000(1+0.2)-5 $4514.83
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡𝑒𝑑 𝑃𝑎𝑦𝑏𝑎𝑘 𝑃𝑒𝑟𝑖𝑜𝑑 = 5 𝑦𝑒𝑎𝑟𝑠
Assignment:

A printing press machine has a cash equivalent of P250,000.

For the first three years, it will provide P20,000 worth of profit
each year. For the next four years, annual profit will be
P35,000. For the last two years, expenses will exceed revenues
and will have a loss of P10,000 each year.
1. Calculate the acceptability of this investment using IRR
method if MARR is 18% per year.
2. What is ERR if ϵ = 15%?
3. Determine the simple payback and discounted payback
periods for this investment.