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Econ 4

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10 views26 pages

Econ 4

Uploaded by

Krizia Jean Abbu
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Lecture 4

Rates of Return
Summary of comparison methods we know so far:

Present worth

Future worth

Annual worth
Still to come:
Rate of return

Cost/benefit

Payback period
What is your interest rate?
The MARR
This is your Minimum Acceptable Rate of Return

If you’re in business at all, it’s because you think you


can make more money from your investment than the
bank can.

So, your MARR must be at least as great as the bank


rate.
The MARR
If all the initial investment in the business is yours,
your MARR is whatever you think it should be.

If you’ve borrowed some of the money from the bank,


your MARR must be enough to pay the interest on the
loan.
If your business is owned by its shareholders…

your rate of return must be high enough to keep them happy.


The Internal Rate of Return

One way of comparing projects is to calculate their


rates of return.

If the project’s rate of return is less than your MARR,


don’t do it.

If you have several projects, the one with the highest


rate of return might be the best…
The Internal Rate of Return

If your project requires a single present investment,


P, and yields a single future payout, F, in N years
time, then its rate of return is the solution to:

P = F(P/F, i, N)
The Internal Rate of Return

This can be re-stated as:

PW = P - F(P/F, i, N) = 0

More generally, the internal rate of return, or IRR,


is the interest rate which makes the total present
worth of the project cashflows equal to zero.
Example:
We build a bicycle factory at an initial cost
of $800 000. We hire workers at $100 000 a
year, payable at year’s end. In the first five
years of the project, our year-end sales are:

End of Year Sales ($ 000)


1 80
2 200
3 500
4 1000
5 1200

What is the rate of return for the project?


A good way of solving these problems is to
build a spreadsheet.

We work out the value of:

PW = - 800 - 20(P/F,i,1) + 100(P/F,i,2)

+ 400(P/F,i,3) + 900(P/F,i,4) + 1100(P/F,i,5)

For different values of i and plot a graph.


i -800 -20(P/F,i,1) 100(P/F,i,2) 400(P/F,i,3) 900(P/F,i,4) 1100(P/F,i,5) PW
0.00 -800 -20 100 400 900 1100 1680
0.05 -800 -19 91 346 740 862 1220
0.10 -800 -18 83 301 615 683 863
0.15 -800 -17 76 263 515 547 583
0.20 -800 -17 69 231 434 442 360
0.25 -800 -16 64 205 369 360 182
0.30 -800 -15 59 182 315 296 37
0.35 -800 -15 55 163 271 245 -81
0.40 -800 -14 51 146 234 205 -179
0.45 -800 -14 48 131 204 172 -260
This gives us a rate of return of about 32%, which
is pretty good.

So this is a good way of comparing investments,


apart from a couple of possible traps…
Trap 1

Suppose we have a million dollars, and we


can either build bicycles or unicycles.

The rate of return per unicycle is 50%, and the


rate of return per bicycle is 32%.

Solution: build unicycles.


Trap 1
Suppose we have a million dollars.

We can spend $600 000 on a gold mine, and get back


$900 000 in a year.

Or we can spend the whole million on a silver mine


and get back $1 400 000 in a year.

There are no other investment opportunities available


except putting money in the bank at 5% interest.
Trap 1
Gold Mine:

After a year we have $900 000 + $420 000 = $1 320 000

Rate of return on investment = 50%

Silver mine:

After a year we have $1 400 000.

Rate of return on investment = 40%


We can avoid this trap by considering the incremental
rate of return:

Consider three places we can put the $400,000 left over


from buying the gold mine:

Old sock under mattress: End up with $400,000, rate of return = 0%

Bank: End up with $420,000, rate of return = 20,000/400,000 = 5%

Cancel gold mine investment, use the $400,000 to upgrade to silver mine:

End up with additional $100,000*, rate of return = 100 000/400 000 = 25%

* $1,400,000 - $(900,000+400,000)

This is more than the MARR (5%), so we should do it.


General rule for evading Trap 1:

Arrange the possible projects from cheapest to most costly.

Choose the first one with a rate of return > MARR.

Then consider the incremental return from upgrading to the


next project. If this is greater than the MARR, choose that
next project.

Go on comparing the best candidate to the next most


costly until you run out of projects.
Trap 2
Example:

I have a small research company. A government agency


offers me a contract: I get $20 000 start-up funds now.
If all goes well, I put in $180 000 of my own money in three
year’s time to develop a prototype. If the prototype
works, I get $200 000 in five years time.

What is my rate of return if all goes well?

Solve:

PW ($000) = 20 – 180(P/F,i,3) + 200(P/F,i,5) = 0


We calculate a graphical solution using a spreadsheet.
But it has two solutions, IRR = 16% and IRR = 80%.
Which is right?
The second solution, IRR =80%, assumes that I can
invest my start-up payment at 80% interest. But there
is no reason to think that this is possible.

To escape this trap, I have to assume that surplus


funds can only be invested at a realistic interest
rate, known as the auxiliary rate of return or explicit
rate of return. (Often taken as equal to the MARR.)

There are two ways of doing this, an exact way and


an approximate way. The rate of return for the project
that I calculate is called the external rate of return (exact
or approximate).
External Rate of Return (Exact)
Bring cash inflows forward at the auxiliary rate of return:

So after three years the initial $20 000 becomes


20 000 (F/P, 0.1, 3) = 26, 620

So the amount of my own cash I have to put in is

180 000 – 26 620 = 153 380

So my rate of return on this investment is ie, where

153 380(F/P, ie, 2) = 200 000

So ie = 14.2%
External Rate of Return (Approx)
Bring cash inflows to project’s end at the auxiliary rate of
return, bring cash outflows to project’s end at the (unknown)
approximate external rate of return, equate the future worth
to zero and solve for iea

20(F/P, 0.1, 5) – 180(F/P, iea, 2) + 200 = 0

(F/P, iea, 2) = 232/180

iea = 13.5%
The exact ERR is difficult to calculate if the cashflows
are complicated. Both the exact and the approximate
ERR’s are single-valued – we never get multiple
solutions.

Rate of return methods give the same ordering of


projects as PW, FW, and AW methods, but make it
easy to compare the profitability of projects of
different size.
Sunk Costs
Problem 1:

Quarmby Electronics makes mobile phones. 100 000 batteries will


be needed in the coming year. They can be produced in-house by
two workers. The salaries of these two workers will be $50 000
each, and the cost of raw materials is $1.00 per battery.

Alternatively, the batteries can be purchased from an external


supplier at a unit cost of $1.90 per battery.

Which option should they choose?


Sunk Costs
Problem 2:

Quarmby Electronics makes mobile phones. They have just


invested $500 000 in a battery-making machine. This machine
requires two workers to operate, and can produce 100 000 batteries
per year. The salaries of these two workers will be $50 000 each.
Raw materials for the batteries cost $1.00 per battery. The machine
has no salvage value.

Alternatively, the batteries can be purchased from an external


supplier at a unit cost of $1.90 per battery.

Which option should they choose?

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