Module:6

Rate of Return Analysis

M-TH 4.30PM - 6.00 PM
6.00PM – 7.30PM
Engr. Joseph B. Canapi
LIC. Electrical Engr./SO1-Safety
MS Mgmt. Engg
COVERAGE:
•INTRODUCTION
•RATE OF RETURN CONCEPT/DEFINITION
•METHODS OF FINDING RATE OF RETURN
•INTERNAL RATE OF RETURN CRITERION
•INCREMENTAL ANALYSIS FOR COMPARING MUTUALLY
EXCLUSIVE ALTERNATIVES
 Rate-of-Return Analysis

Introduction:
Along with the NPW and the AE criteria, the third primary measure of investment worth is
rate of return(ROR}. Many engineers and financial managers prefer rate-of-return analysis
to the NPW and the AE method because they find it intuitively more appealing to analyze
investments in terms of percentage rates of return rather than dollars of NPW.
Consider the following statements regarding an investment’s profitability:
❑ This project will bring in a 15% rate of return on the investment.
❑ This project will result in a net surplus of $10,000 in the NPW

Neither statement describes the nature of the investment project in any complete sense.
However, the rate of return is somewhat easier to understand because many of familiarity
with savings-and-loan interest rates, which are in fact rates of return.

Many different terms are used to refer to rate of return, including yield (i.e., the yield to
maturity, commonly used in bond valuation), internal rate of return, and marginal
efficiency of capital.
 Rate-of-Return Analysis
Concept of Return on Investment
Definition 1: based on a typical loan transaction
The rate of return is the interest rate earned on the unpaid balance of an amortized loan
Suppose that a bank lends $10,000 and is repaid $4,021 at the end of each year for three
years. How would you determine the interest rate that the bank charges on this transaction?

solve for i =10% , the bank will earn a return of 10% on its investment of $10,000.
The balances calculation over the life of the loan
as follows:
❑ Thus, the three annual payments repay the
loan itself and additionally provide a return of
10% on the amount still outstanding each year.
❑ when the last payment is made, the
outstanding principal is eventually reduced to
zero.
❑ calculate the NPW of the loan transaction at
its rate of return (10%),

which indicates that the bank can break even

at a 10% rate of interest.
 Rate-of-Return Analysis
Concept of Return on Investment
Definition 2 :The rate of return is the break-even interest rate that equates the present worth
of a project’s cash outflows to the present worth of its cash inflows, or

Multiplying both sides of Eq. shown by we obtain

Multiply both sides of Eq. shown by the capital recovery factor we obtain

Therefore, the of a project may be defined as the rate of interest that equates the
present worth, future worth, and annual equivalent worth of the entire series of cash
flows to zero.
NOTES: By the nature of the NPW function in Eq. as shown, it is possible to have more than
one rate of return for certain types of cash flows.
 Rate-of-Return Analysis

Return on Invested Capital

A project’s return is referred to as the internal rate of return (IRR) or the yield
promised by an investment project over its useful life.

Definition 3: based on return that is internal to the project.

The internal rate of return( IRR) is the interest rate charged on the unrecovered project
balance of the investment such that, when the project terminates, the unrecovered project
balance will be zero.
❑ Suppose a company invests $10,000 in a computer with a three-year useful life and
equivalent annual labor savings of $4,021.
❑ Here, we may view the investing firm as the lender and the project as the borrower

❑ In our project balance calculation, we see that 10%

is earned (or charged) on $10,000 during year 1,
10% is earned on $6,979 during year 2, and 10% is
earned on $3,656 during year 3.
❑ This indicates that the firm earns a 10% rate of
return on funds that remain internally invested in the
project.
 Rate-of-Return Analysis

Methods for Finding the Rate of Return

❑ Simple versus Nonsimple Investments
We can classify an investment project by counting the number of sign changes in its net
cash flow sequence. A change from either iis counted as one sign
change. (We ignore a zero cash flow.)
▪ A simple investment is an investment in which the initial cash flows are negative
and only one sign change occurs in the remaining net cash flow series. If the initial
flows are positive and only one sign change occurs in the subsequent net cash
flows, they are referred to as simple borrowing cash flows.
▪ A non simple investment is an investment in which more than one sign change
occurs in the cash flow series
Notes: Multiple occur only in nonsimple investments.
EXAMPLE:1 Investment Classification

Given: Preceding cash flow sequences.

Find: Classify the investments shown into either
simple and nonsimple investments.
 Rate-of-Return Analysis

Methods for Finding the Rate of Return

Present-worth profiles:
EXAMPLE:1 Investment Classification

SOLUTION:
▪ Project A represents many common simple
investments. This situation reveals the NPW profile
shown in Figure 7.1(a). The curve crosses the i-axis
only once.
▪ Project B represents a nonsimple investment. The
NPW profile for this investment has the shape shown
in Figure 7.1(b). The i-axis is crossed at 10%, 30%,
and 50%.
▪ Project C represents neither a simple nor a nonsimple
investment, even though only one sign change occurs
in the cash flow sequence. Since the first cash flow is
positive, this is a simple borrowing cash flow, not an
investment flow.
 Rate-of-Return Analysis
❑ Predicting Multiple i*’s
▪ Net Cash Flow Rule of Signs
The number of real i*’s that are greater than -100% for a project with N periods is never
greater than the number of sign changes in the sequence of the 𝐴𝑛 ’s .
A zero cash flow is ignored.
▪ Three sign changes occur in the cash flow
sequence, so three or fewer real positive i*’s exist.
▪ The rule predicts only the maximum number of
possible i*’s
▪ Many projects have multiple sign changes in their
cash flow sequence, but still possess a unique real
i*’s in the( -100%,∞) range.

▪ Accumulated Cash Flow Sign Test

Let 𝐴𝑛 represent the net cash flow in period n and 𝑆𝑛 represent the accumulated cash flow
(the accounting sum) up to period n,
▪ The sequence of accumulated cash flows(𝑆0 ,
𝑆1, 𝑆2,…., 𝑆𝑛 ) to determine the number of sign
changes.
▪ If the series 𝑆𝑛 starts negatively and changes
sign only once, then a unique positive i* exists.
 Rate-of-Return Analysis
EXAMPLE .2 Predicting the Number of i *’s
Predict the number of real positive rates of return for each of the following cash flow
series:

SOLUTION:
Find: The upper limit on number of i *’s ▪ Only project D begins negatively and
for each series. passes the test; therefore, we may
predict a unique value, rather than 2, 1,
or 0 as predicted by the cash flow rule of
signs. (i1 * = -75.16% and i 2 * = 37.05%)
▪ Project B, with no sign change in the
cumulative cash flow series, has no rate
of return.
▪ For cash flows B, C, and D, apply the ▪ Project C fails the test, and we cannot
more discriminating cumulative cash flow eliminate the possibility of multiple i *’s
test to specify a smaller number of ▪ (i1 * = 10% and i 2 * = 20%)
possible values of i*
 Rate-of-Return Analysis
❑ Computational Methods
▪ Direct Solution Method
For the special case of a project with only a two-flow transaction (an investment followed
by a single future payment) or a project with a service life of two years of return,
EXAMPLE:3 Finding by Direct Solution: Two Flows and Two Periods

FW(i *)= -2000 (F/P, i * ,4)+ 3,500=0,

1.75 = (1 + i * )exp 4
i * = 15.02%

Project 2: NPW expression for this project as

Compute the rate of return for each project

SOLUTION: PW(i *)= -2000 + 1300/(1+ i *)+ 1500/(1+ i *)=0
Given: Cash flows for two projects. Let X=1/(1+ i *)
Find: for each project.
PW(X)= -2000 + 1300X+ 1500𝑋 2 =0 Q.E
Project 1: Solving for i * in PW(i *)=0 is identical
Replacing X values
to solving FW(i *)=0 because FW equals PW
times a constant 0.8= 1/(1+ i *) i *= 25%
-1.667= 1/(1+ i *) i *= -160%
Since an interest rate less than -100% has no
economic significance, hence the project’s i *= 25%
 Rate-of-Return Analysis
❑ Computational Methods
▪ Trial-and-Error Method
Use the “guessed” interest rate to compute the present worth of net cash flows and observe
whether it is positive, negative, or zero. The goal is for the value of i * that makes PW(i *)= 0
Whenever we reach the point where PW(i *) is bounded by one negative and one positive
value, we use linear interpolation to approximate i * .
EXAMPLE:4 Finding by Trial and Error
The Imperial Chemical Company is considering purchasing a chemical analysis machine
worth $13,000. Although the purchase of this machine will not produce any ncrease in
sales revenues, it will result in a reduction of labor costs. In order to operate the machine
properly, it must be calibrated each year. The machine has an expected life of six years,
after which it will have no salvage value. The following table summarizes the annual
savings in labor cost and the annual maintenance cost in calibration over six years:

Find the rate of return for this project.

 Rate-of-Return Analysis
▪ Trial-and-Error Method Increase interest rate of 35%,
PW(35%) = - $13,000 + $3,700(P/F, 35%, 1)
EXAMPLE:4 Finding by Trial and Error
+ $4,700(P/F, 35%, 2)
SOLUTION: +$6,700(P/A,35%,4)(P/F,35%,2)
= -$339
Cash flow diagram for a simple investment
We have bracketed the solution:
PW(i) will be zero at i somewhere between
25% and 35%. Using straight-line
interpolation, we approximate
i* ≅ 25% + (35%- 25%)[ 3,095-0/ 3,095-(-339)]
= 25% +10% (0.9013)
= 34.01%
Check the precise value of i*
PW(34%) = - $13,000 + $3,700(P/F, 34%, 1)
+ $4,700(P/F, 34%, 2)
+$6,700(P/A,34%,4)(P/F,34%,2)
start with a guessed interest rate of 25%.
= -$50.58
PW(25%) = - $13,000 + $3,700(P/F, 25%, 1) Recompute i* at a lower interest rate, say,
+ $4,700(P/F, 25%, 2) 33%
+$6,700(P/A,25%,4)(P/F,25%,2) PW(33%) = - $13,000 + $3,700(P/F, 33%, 1)
= $3,095 + $4,700(P/F, 33%, 2)
+$6,700(P/A,33%,4)(P/F,33%,2)
= $248.56
 Rate-of-Return Analysis
▪ Trial-and-Error Method ▪ Computer solution method-EXCEL
(Graphical Method)
EXAMPLE:4 Finding by Trial and Error
Another round of linear interpolation, we approximate

i* ≅ 33% + (34%- 33%)[ 248.56-0/ 248.56-(-50.58)]

= 33% 1% (0.8309)
= 33.83%
Check the precise value of i*

PW(33.83%) = - $13,000 + $3,700(P/F, 33.83%, 1)

+ $4,700(P/F,33.83%,2)+$6,700(P/A,33.83%,4)
(P/F,33.83%,2)
= -$0.49
 Rate-of-Return Analysis

❑ Net-Investment Test: Pure versus Mixed Investments

▪ Net investment test: A process to determine whether or not a firm borrows money from
a project during the investment period
- Passing this test indicates that i* is an internal rate of return and is therefore a
suitable measure of project profitability.
- Failing to pass the test indicates project borrowing, a situation that requires further
analysis with the use of an external interest rate.
To develop a consistent accept–reject decision rule with the NPW, classify a project into
either a pure or a mixed investment:

▪ Pure investment: An investment in which a firm never borrows money from the project.
- when the project balances computed at the project’s i* values PB(i∗)𝑛 , are
either less than or equal to zero throughout the life of the investment, with
the first cash flow being negative (𝐴𝑜 <0).
▪ Mixed investment: An investment in which a firm borrows money from the project
during the investment period
- If any of the project balances calculated at the project’s i* is positive
 Rate-of-Return Analysis
EXAMPLE:5 Pure versus Mixed Investments
Consider the following four investment projects with known i* values:

Determine which projects are pure investments.

(If multiple rates of return exist, use the largest value of greater than zero.)

SOLUTION:
Project A:
PB (33.64%)0 =-1,000
PB (33.64%)1 =-1,000(1 +.3364)+ (-1000)= -$2,336.40

PB (33.64%)2 =-2,336.40(1 +.3364)+ 2,000= -$1,122.36

PB (33.64%)3 =-1,122.36(1 +.3364)+ 1,500= 0

( -,-,-,0); passes the net-investment test (pure investment)

 Rate-of-Return Analysis
EXAMPLE:5 Pure versus Mixed Investments
SOLUTION:
Project B:
PB (21.95%)0 =-1,000
PB (21.95%)1 =-1,000(1 +.2195)+ 1,600 = $380.50
PB (21.95%)2 =380.50(1 +.2195)-300 = $164.02
PB (21.95%)3 =164.02(1 +.2195)-200 = 0
( -,+,+,0); fails the net-investment test (mixed investment)

Project C:
PB (29.95%)0 =-1,000
PB (29.95%)1 =-1,000(1 +.2995)+ 500 = -$799.50
PB (29.95%)2 =-799.50(1 +.2995)-500 = -$1,538.95
PB (29.95%)3 =-1,538.95(1 +.2995)+2,000 = 0
( -,-,-,0); passes the net-investment test (pure investment)
 Rate-of-Return Analysis
EXAMPLE:5 Pure versus Mixed Investments
SOLUTION:
Project D:
PB (50%)0 =-1,000
PB (50%)1 =-1,000(1 +.50)+ 3,900 = $2,400
PB (50%)2 =2,400(1 +.50) – 5,030 = -$1,430
PB (50%)3 =-1,430(1 +.50) 2,145 = 0

( -,+,-,0); fails the net-investment test (mixed investment)

❑ Decision Rule for Pure Investments

▪ Applied for a single project evaluation
 Rate-of-Return Analysis

EXAMPLE: 6 Investment Decision for a Pure Investment

Merco, Inc., a machinery builder is considering investing $1,250,000 in a complete
structural beam-fabrication system.
▪ Project investment cost: $1,250,000.
▪ Projected annual net savings:$731,500.
▪ Projected after-tax salvage value at the end of year 15: $80,000.
(a) What is the projected IRR on this fabrication investment?
(b) If Merco’s MARR is known to be 18%, is this investment justifiable?
SOLUTION:
(a) Since only one sign change occurs in the net cash
flow series, the fabrication project is a simple
investment.
PW(i *)= -1,250k + 731.5k (P/A, i,15)+80k(P/F,i,15)=0
i *= 58.485%

(b) The IRR figure far exceeds Merco’s MARR,

indicating that the fabrication system project is an
economically attractive one.

IRR > MARR

 Rate-of-Return Analysis
EXAMPLE: 6 Investment Decision for a Pure Investment

▪ Computer solution method-EXCEL

(Graphical Method)

i *= 58.485%
 Rate-of-Return Analysis
❑ Decision Rule for Mixed Investments
▪ For a mixed investment, we must calculate a rate of return on the portion of capital that
remains invested internally. This rate is defined as the true IRR and is commonly
known as the return on invested capital (RIC)
▪ Return on invested capital (RIC): The amount that a company earns on the total
investment it has made in its project
▪ Project balance: The amount of money committed to a project at a specific period
Note: the MARR will be used as an established external interest rate (i.e., the rate
earned by money invested outside of the project).
▪ steps for determining the IRR for a mixed investment:
 Rate-of-Return Analysis
▪ steps for determining the IRR for a mixed investment:

Summary the IRR computation for a mixed investment.

 Rate-of-Return Analysis

EXAMPLE: 7 IRR for a Mixed Investment

Find: (a) Compute the NPW, (b) i *, and

(c) RIC at MARR=15% and determine
whether to accept the project.

SOLUTION:
a) PW(15%) = -$1,000,000 + $2,300,000(P/F,15%,1)
+ $1,320,000(P/F,15%,2)
= $1,890 > 0

b)Since the project has a 2- year life, solve NPW by

Quadratic formula:
-$1,000,000 + $2,300,000/(1+i*)
-$1,320,000/(1 + 𝑖 ∗)2 =0 ;
let X = 1/(1+i*)
-1,000,000+2,300,000X - 1,320,000𝑥 2 =0

Solving for X=10/11 & 10/12 or i*=10% & 20%

NPW plot for a non simple investment

with multiple rates of return
 Rate-of-Return Analysis

EXAMPLE: 7 IRR for a Mixed Investment

(c) As calculated in (b), the project has multiple rates of return. This is obviously not a net investment,

At N=0 there is a net investment to the firm, so the project balance expression becomes
PB (i,15%)0 =-1,000,000 Consider: case 1: i<1.3 then PB (i,15%)1 > 0
Since this indicates a positive balance, the cash released
Since:
from the project would be returned to the firm’s investment
PB (i,15%)1 =-1,000,000(1+i)+2,300,000 pool to grow at the MARR until it is required back in the
=1,300,000-1000,000i project.
= 1,000,000 (1.3-i), PB (i,15%)2 =1,000,000(1.3+i)(1+0.15)-1,320,000
PB (i,15%)𝟏 if this is positive or negative ? =175,000- 1,150,000i=0
Solving for i:
RIC =IRR=0.1522 or 15.22% > 15%
 Rate-of-Return Analysis

EXAMPLE: 7 IRR for a Mixed Investment

Consider: case 2: i>1.3 then PB (i,15%)1 < 0

The firm is still in an investment mode.

Therefore, the balance at the end of year 1 that
remains invested will grow at the rate i for the
next period.

PB (i,15%)2 =1,000,000(1.3+i)(1+ i)-1,320,000

=20,000 + 300,000i-1,000,000𝑖 2 =0
Solving for i:
IRR=0.1 or 0.2 < 1.3

which violates the initial assumption i>1.3 that

Therefore, Case 1 is the only correct situation.
Since it indicates that IRR> MARR, the project
is acceptable, resulting in the same decision
as obtained in (a) by applying the NPW
criterion.
 Rate-of-Return Analysis

❑ Comparing Mutually Exclusive Alternatives Based on IRR

Issue: Can we rank the mutually exclusive projects by the magnitude
of its IRR?

Answer is no
▪ NPW, NFW, and AE are absolute (dollar) measures of investment worth
▪ IRR is a relative (percentage) measure, ignores the scale of the investment
Rate-of-Return Analysis

Who Got More Pay Raise?

 Rate-of-Return Analysis

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.
 Rate-of-Return Analysis

❑ Incremental Investment Analysis

▪ Selecting among alternative projects by IRR analysis, incremental investment must
be used.
▪ In creating an incremental investment, we always subtract the lower cost
investment from the higher cost one.
▪ Decision rule is:

EXAMPLE: 8 IRR on Incremental Investment: Two Alternatives

Both alternatives are revenue projects, which project would be

selected at MARR= 10%
 Rate-of-Return Analysis
EXAMPLE: 8 IRR on Incremental Investment: Two Alternatives
SOLUTION:
NPW profiles for B1 and B2
Given: Incremental cash flow between two
alternatives and MARR=10%
Find: (a) IRR on the increment and (b) which
alternative is preferable
a)From Incremental cash Flow , B2-B1 :
- $9,000 + $2,850 (P/F, i, 1) + $4,425 (P/F,i, 2)
+ $4,830 (P/F, i, 3) = 0
By Trial & Error:
i∗ B2-B1 = IRR B2-B1 = 15%,
This is Simple Investment
b) Since : IRR B2-B1 > MARR Select B2
Note: consistent with the NPW analysis
 Rate-of-Return Analysis

EXAMPLE:9 IRR on Incremental Investment: Three Alternatives

▪ From Incremental cash Flow , D1- D2 :

- $1,000 + $700 (P/F, i, 1) + $500 (P/F,i, 2)
+ $300(P/F, i, 3) = 0
i∗ D1-D2 = IRRD1-D2 = 27.61%,exceeds
MARR hence D1 preferred over D2
▪ Compare D1 and D3 .

Which project would you select on the basis of the

rate of return on incremental investment, assuming
That MARR =15%
SOLUTION:
Find: IRR on incremental investment and which IRRD3-D1= 8.8% < 15%, so select D1 again.
alternative is preferable.
▪ Check IRR of each alternative and eliminate any ▪ Compare D3 and D2.
alternative that fails to meet the MARR=15% IRRD3-D2= 17.2% >15%, so select D3

▪ Compare D1 and D2 .
Here, we conclude that D1 is the best Alternative.
 Rate-of-Return Analysis
EXAMPLE: 10 Incremental Analysis for Cost-Only Projects
Falk Corporation is considering two types of The incremental cash flow is the difference
manufacturing systems to produce its shaft (FMS – CMS)
couplings over six years: (1) a cellular
manufacturing system (CMS) and (2) a flexible
manufacturing system (FMS). The average
number of pieces to be produced with either
system would be 544,000 per year. The operating
cost, initial investment, and salvage value for
each alternative are estimated as follows:

The firm’s MARR is 15%. On the basis of the IRR

criterion, which alternative would be a better
choice?
 Rate-of-Return Analysis
EXAMPLE: 10 Incremental Analysis for Cost-Only Projects
Solution:

▪ Compare FMS and CMS .

- $8,000,000 + $1,908,820 (P/A, i, 5)
+ $2,408,820 (P/F,i,6)
=0

IRRFMS –CMS = 12.43 % < 15%,select CMS

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.
 Rate-of-Return Analysis
EXAMPLE: 10 Incremental Analysis for Cost-Only Projects

IRRFMS –CMS = 12.43 % < 15%,select CMS

Note: consistent with the NPW analysis

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