Engineering Economic

Hamad Manzoor
 Chapter 7
Rate of Return Analysis
Chan S. Park
 Rate of Return Analysis

❑ Rate of Return

❑ Methods for Finding ROR

❑ Internal Rate of Return (IRR)

Criterion

❑ Incremental Analysis

❑ Mutually Exclusive
Alternatives
 Rate of Return

Definition

A relative percentage method which

measures the annual rate of return as a
percentage of investment over the life of a
project.
 Example: Meaning of Rate
of Return
In 1970, when Wal-Mart Stores, Inc. went
public, an investment of 100 shares cost
$1,650. That investment would have
been worth $12,283,904 on January 31,
2002.

What is the rate of return on that

investment?
Solution: $12,283,904

0
32
$1,650
Given: P = $1,650
F = $12,283,904
N = 32
Find i:

$12,283,904 = $1,650 (1 + i )32

i = 32.13% Rate of Return
Suppose that you invested that amount ($1,650) in a
savings account at 6% per year. Then, you could have
only $10,648 on January, 2002.

What is the meaning of this 6% interest here?

This is your opportunity cost if putting money in

savings account was the best you can do at that time!
So, in 1970, as long as you earn more than 6%
interest in another investment, you will take that
investment.

Therefore, that 6% is viewed as a minimum

attractive rate of return (or required rate of return).

So, you can apply the following decision rule, to see

if the proposed investment is a good one.

ROR (32.13%) > MARR(6%)

 Return on Investment

Definition 1: Rate of return (ROR) is defined as the

interest rate earned on the unpaid balance of an
installment loan.

Example: A bank lends $10,000 and receives annual

payment of $4,021 over 3 years. The bank is said to
earn a return of 10% on its loan of $10,000.
 Loan Balance Calculation:

A = $10,000 (A/P, 10%, 3)

= $4,021
Unpaid Return on Unpaid
balance unpaid balance
at beg. balance Payment at the end
Year of year (10%) received of year

0 -$10,000 -$10,000
1 -$10,000 -$1,000 +$4,021 -$6,979
2 -$6,979 -$698 +$4,021 -$3,656
3 -$3,656 -$366 +$4,021 0

A return of 10% on the amount still outstanding at the

beginning of each year
 Rate of Return:

Definition 2: Rate of return (ROR) is the break-even

interest rate, i*, which equates the present worth of a
project’s cash outflows to the present worth of its cash
inflows.

Mathematical Relation:
 Return on Invested Capital
Definition 3: Return on invested capital is defined as the
interest rate earned on the unrecovered project balance of
an investment project. It is commonly known as internal
rate of return (IRR).

Example: A company invests $10,000 in a computer and

results in equivalent annual labor savings of $4,021 over
3 years. The company is said to earn a return of 10% on
its investment of $10,000.
 Project Balance Calculation:
0 1 2 3
Beginning
-$10,000 -$6,979 -$3,656
project balance

Return on
-$1,000 -$697 -$365
invested capital

Payment
-$10,000 +$4,021 +$4,021 +$4,021
received

Ending project
-$10,000 -$6,979 -$3,656 0
balance
The firm earns a 10% rate of return on funds that remain internally
invested in the project. Since the return is internal to the project, we
call it internal rate of return.
 Methods for Finding Rate of Return
• Types of Investment (cash flow) Classification
• Simple Investment
• Non-simple Investment

• Once we identified the type of investment cash flow, there

are several ways available to determine its rate of return.

• Computational Methods
• Direct Solution Method
• Trial-and-Error Method
• Computer Solution Method
 Investment Classification
Simple Investment Non-simple Investment
• Definition: Initial cash • Definition: Initial cash
flows are negative, and flows are negative, but
only one sign change more than one sign
occurs in the net cash changes in the remaining
flows series. cash flow series.
• Example: -$100, 250, • Example: -$100, 300,
$300 (-, +, +) -$120 (-, +, -)
• ROR: A unique ROR • ROR: A possibility of
• If the initial flows are positive and one
sign change occurs referred to multiple RORs
simple-borrowing.

15
Period Project Project Project
(N) A B C
0 -$1,000 -$1,000 +$1,000
1 -500 3,900 -450
2 800 -5,030 -450
3 1,500 2,145 -450

4 2,000

Project A is a simple investment.

Project B is a non-simple investment.
Project C is a simple borrowing.
 Computational Methods
Direct Direct Trial & Computer
Solution Solution Error Solution
Method Method
Log Quadratic

n Project A Project B Project C Project D

0 -$1,000 -$2,000 -$75,000 -$10,000

1 0 1,300 24,400 20,000

2 0 1,500 27,340 20,000

3 0 55,760 25,000

4 1,500
Example 7.2 Direct Solution Methods

Project A Project B
 Trial and Error Method – Project C

• Step 1: Guess an interest • Step 4: If you bracket the

rate, say, i = 15% solution, you use a linear
• Step 2: Compute PW(i) interpolation to approximate
at the guessed i value. the solution

PW (15%) = $3,553 3,553

• Step 3: If PW(i) > 0, then 0
increase i. If PW(i)< 0,
-749
then decrease i.

15% i 18%
PW(18%) = -$749
 Basic Decision Rule:

If ROR > MARR, Accept

This rule does not work for a situation where

an investment has multiple rates of return
 Comparing Mutually Exclusive
Alternatives Based on IRR
Issue: Can we rank the mutually exclusive
projects by the magnitude of its IRR?

n A1 A2
0 -$1,000 -$5,000

1 $2,000 $7,000

IRR 100% > 40%

PW (10%) $818 < $1,364

Who Got More Pay Raise?

Bill Hillary

10% 5%
Can’t Compare without Knowing Their Base Salaries

Bill Hillary

Base Salary $50,000 $200,000

Pay Raise (%) 10% 5%

Pay Raise ($) $5,000 $10,000

For the same reason, we can’t compare mutually exclusive projects based on
the magnitude of its IRR. We need to know the size of investment and its timing
of when to occur.
 Incremental Investment
Incremental
Investment
n Project A1 Project A2 (A2 – A1)

0 -$1,000 -$5,000 -$4,000

1 $2,000 $7,000 $5,000

ROR 100% 40% 25%

PW(10%) $818 $1,364 $546

Assuming a MARR of 10%, you can always earn that rate from other
investment source, i.e., $4,400 at the end of one year for $4,000
investment.

By investing the additional $4,000 in A2, you would make additional

$5,000, which is equivalent to earning at the rate of 25%. Therefore,
the incremental investment in A2 is justified.
 Incremental Analysis (Procedure)
Step 1: Compute the cash flow for the difference
between the projects (A,B) by subtracting the
cash flow of the lower investment cost project (A)
from that of the higher investment cost project (B).
Step 2: Compute the IRR on this incremental
investment (IRR ).
Step 3: Accept the investmentB-AB if and only if

IRR B-A > MARR

NOTE: Make sure that both IRRA and IRRB are greater than MARR.
 Example 7.7 - Incremental Rate of Return

n B1 B2 B2 - B1

0 -$3,000 -$12,000 -$9,000

1 1,350 4,200 2,850
2 1,800 6,225 4,425
3 1,500 6,330 4,830
IRR 25% 17.43% 15%

Given MARR = 10%, which project is a better choice?

Since IRRB2-B1=15% > 10%, and also IRRB2 > 10%, select B2.
 IRR on Increment Investment:
Three Alternatives
Step 1: Examine the IRR for each
n D1 D2 D3
project to eliminate any project
that fails to meet the MARR.
0 -$2,000 -$1,000 -$3,000
Step 2: Compare D1 and D2 in pairs.
1 1,500 800 1,500 IRRD1-D2=27.61% > 15%,
so select D1. D1 becomes the
2 1,000 500 2,000 current best.

3 800 500 1,000 Step 3: Compare D1 and D3.

IRRD3-D1= 8.8% < 15%,
so select D1 again.
IRR 34.37% 40.76% 24.81%
Here, we conclude that D1 is the best
Alternative.
Example 7.9 Incremental Analysis for Cost-Only Projects

Items CMS Option FMS Option

Investment $ 4,500,000 $ 12,500,000
Total annual operating costs $ 7,412,920 $ 5,504,100

Net salvage value $ 500,000 $ 1,000,000

The firm’s MARR is 15%. Which alternative would be a better choice, based
on the IRR criterion?
Discussion: Since we can assume that both manufacturing systems would
provide the same level of revenues over the analysis period, we can compare
these alternatives based on cost only. (these systems are service projects).
Although we can not compute the IRR for each option without knowing the
revenue figures, we can still calculate the IRR on incremental cash flows.
Since the FMS option requires a higher initial investment than that of the
CMS, the incremental cash flow is the difference (FMS – CMS)
 Example 7.9 Incremental Analysis for Cost-Only Projects
(cost are itemized)
Items CMS Option FMS Option
Annual O&M costs:
Annual labor cost $1,169,600 $707,200
Annual material cost 832,320 598,400
Annual overhead cost 3,150,000 1,950,000
Annual tooling cost 470,000 300,000
Annual inventory cost 141,000 31,500
Annual income taxes 1,650,000 1,917,000
Total annual operating costs $7,412,920 $5,504,100
Investment $4,500,000 $12,500,000
Net salvage value $500,000 $1,000,000
Example 7.9 Incremental Cash Flow (FMS – CMS)

Incremental
n CMS Option FMS Option (FMS-CMS)
0 -$4,500,000 -$12,500,000 -$8,000,000
1 -7,412,920 -5,504,100 1,908,820
2 -7,412,920 -5,504,100 1,908,820
3 -7,412,920 -5,504,100 1,908,820
4 -7,412,920 -5,504,100 1,908,820
5 -7,412,920 -5,504,100 1,908,820
6 -7,412,920 -5,504,100
Salvage + $500,000 + $1,000,000 $2,408,820
Solution:
• Although the FMS would provide an incremental annual savings of $1,908,820 in
operating costs, the savings do not justify the incremental investment of $8,000,000.

COMMENTS:

• Note that the CMS option was marginally preferred to the FMS option.

• However, there are dangers in relying solely on the easily quantified savings in input
factors – such as labor, energy, and materials – from FMS and in not considering gains
from improved manufacturing performance that are more difficult and subjective to
quantify.

• Factors such as improved product quality, increased manufacturing flexibility (rapid

response to customer demand), reduced inventory levels, and increased capacity for
product innovation are frequently ignored in financial analysis because we have
inadequate means for quantifying benefits.

• If these intangible benefits were considered, as they ought to be, however, the FMS
option could come out better than the CMS option.