Dr.

Yaser AlAlawi
Rate of Return
Analysis
Chapter 7
( IRR )

IEN 505 - Advanced Engineering Economy

Single
Alternative

1
 Dr. Yaser AlAlawi
Introduction

• Referred to as ROR or IRR (Internal Rate of Return)

method.
• It is one of the popular measures of investment worth
• DEFINITION:
IRR is either the interest rate paid on the unpaid balance of a

IEN 505 - Advanced Engineering Economy

loan, or the interest rate earned on the unrecovered investment
balance of an investment such that the final payment or receipt
brings the terminal value to exactly equal “0”

• The IRR of found using a PW or AW relation. The rate

determined is called i*.

2
 Dr. Yaser AlAlawi
Unrecovered Investment Balance

• IRR is the interest rate earned/charged on the unrecovered

balance of a loan or investment project
• IRR is not the interest rate earned on the original loan amount
or investment amount (P)

IEN 505 - Advanced Engineering Economy

• The i* value is compared to the MARR:
 If i* > MARR, investment is justified
 If i* = MARR, investment is justified (indifferent decision)
 If i* < MARR, investment is not justified

3
 Dr. Yaser AlAlawi
Example 1

• You borrow $1000 at 10% per year for 4 years.

• You are to make 4 equal end of year payments to pay
off this loan.
• Your payments are: A = $1000(A/P,10%,4) = $315.47

IEN 505 - Advanced Engineering Economy

• Compare the amount of the unrecovered investment
for each of 4 years using:
a. The rate of return on the unrecovered balance
b. The return on the initial $1000

4
 Dr. Yaser AlAlawi
Solution (a)

Interest Prin. Red. Unpaid

Year Beg. Bal. PMT Amount Amount Balance
C1 C2 C3 C4 = i . C2 C5 = C3 - C4 C6 = C2 - C5
0 $1,000 -- -- --- $1,000

1 1,000 315.47 100.00 215.47 784.53

IEN 505 - Advanced Engineering Economy

2 784.53 315.47 78.45 237.02 547.51

3 547.51 315.47 54.75 260.72 286.79

4 286.79 315.47 28.68 286.79 0

After 4 years the total $1000 is recovered

5
 Dr. Yaser AlAlawi
Solution (b)

Interest Prin. Red. UnPaid

Year Beg. Bal. PMT Amount Amount Balance
C1 C2 C3 C4 = i . 1000 C5 = C3 - C2 C6 = C2- C3
0 $1,000 -- -- --- $1,000

1 1,000 315.47 100 215.47 784.53

IEN 505 - Advanced Engineering Economy

2 784.53 315.47 100 215.47 569.06

3 547.51 315.47 100 215.47 3.53.59

4 286.79 315.47 100 215.47 138.12

After 4 years there is still a remaining

unrecovered amount of $138.12
6
 Dr. Yaser AlAlawi
Valid Ranges for usable i* rates
Mathematically, i* rates must be:

*
−100% < i ≤ +∞

1. An i* = – 100% signals total and complete loss of capital

IEN 505 - Advanced Engineering Economy

2. One can have a negative i* value (feasible) but not less
than –100%
3. All values above i* = 0 indicate a positive return on the
investment

7
 Dr. Yaser AlAlawi
Calculation of i*
using PW or AW Relations

• Set up an IRR equation using either PW or AW relations

and equate to zero

IEN 505 - Advanced Engineering Economy

• 0 = - PW of disbursements + PW receipts
= - PWD + PWR
• 0 = - AW of disbursements + AW receipts
= - AWD + AWR

8
 Dr. Yaser AlAlawi
i* by Trial and Error
by Hand Using a PW Relation

1. Draw a cash flow diagram

2. Set up the appropriate PW equivalence equation and
set equal to 0

IEN 505 - Advanced Engineering Economy

3. Select values of i and solve the PW equation
4. Repeat for values of i until “0” is bracketed, i.e., the
equation is balanced
5. May have to interpolate to find the approximate i*
value

9
 $500 $1,500
Example 2

Dr. Yaser AlAlawi

0 1 2 3 4 5

$1,000

NPV = 0
– 1000 + 500 (P/F, i* ,3) + 1500 (P/F, i*, 5) = 0

IEN 505 - Advanced Engineering Economy

1. Guess at a rate and try it;
2. Adjust accordingly; Bracket
3. Interpolate
4. i* approximately 16.9% per year on the unrecovered
investment balances
10
 Solution

IEN 505 - Advanced Engineering Economy Dr. Yaser AlAlawi

11
 Dr. Yaser AlAlawi
Spreadsheet Methods

Excel supports IRR analysis with 2 functions:

• For Uniform A: = RATE (n,A,P,F)
• For Varying cash flows: = IRR (first_cell:last_cell, guess)
• RATE is used when an investment (P) is made followed by
“n” equal, end of period cash flows (A)

IEN 505 - Advanced Engineering Economy

• This is a special case for annuities

12
 Dr. Yaser AlAlawi
The IRR Excel Function

• When cash flows vary from period to period

• Entries: Enter the cash flow values into contiguous cells
(including any $0 amounts)
• Enter the IRR function:
 = IRR (first_cell:last_cell,guess)

IEN 505 - Advanced Engineering Economy

 “guess” is an optional starting value the user feels
is in the “vicinity” of the true i* value
 If omitted, Excel assumes a starting value of 10%

13
 Dr. Yaser AlAlawi
Example 3

Find the IRR for:

P = - $ 500,000
F10 = + $ 700,000
A = + $10,000

IEN 505 - Advanced Engineering Economy

n = 10 years

14
 Solution

IEN 505 - Advanced Engineering Economy Dr. Yaser AlAlawi

15
 Dr. Yaser AlAlawi
Cautions When Using IRR

• When applied correctly, the IRR method will always

result in a good decision and should be consistent with
PW, AW, or FW methods.
• However, for some types of cash flows the IRR method
can be computationally difficult and/or lead to

IEN 505 - Advanced Engineering Economy

erroneous decisions.
• Reinvestment assumption is at i* for the IRR method;
not the MARR. If MARR is far from i*, must use a
composite rate.
• Some cash flows will result in multiple i* values. Raises
questions as to which, if any, i* value is the proper
value. 16
 Dr. Yaser AlAlawi
IRR for Multiple Alternatives

• For analysis of two or more alternatives using IRR,

resort to a different analysis approach as opposed to
the regular PW or AW method.
• Must apply an incremental analysis approach to
guarantee a correct decision, i.e., same as PW or AW.

IEN 505 - Advanced Engineering Economy

• A class of IRR problems exists that will possess
multiple i* values.
• Capability to predict the potential for multiple i*
values.
• Two tests can be applied prior to the analysis.
17
 Dr. Yaser AlAlawi
Tests for Multiple i* values

Predicting the likelihood of multiple i* values:

1. Cash Flow Rule of Signs (Descartes’ Test)
 The total number of real value i*’s is always less than
or equal to the number of sign changes in the original
cash flow series

IEN 505 - Advanced Engineering Economy

2. Cumulative Cash Flow Rule of Signs (Norstrom’s Test)
 Form the cumulative cash flow of the investment and
count the number of sign changes in the cumulative
cash flow series
 Must perform both tests to be sure of one i* > 0
18
 Dr. Yaser AlAlawi
Test 1: Cash Flow Rule of Signs

• Examples of sign test for maximum i* values

• Signs on cash flows by year

1 2 3 4 5 6 Max i*

IEN 505 - Advanced Engineering Economy

values
– + + + + + 1

– + + + – – 2

+ – + – + + 4

19
 Dr. Yaser AlAlawi
Example 4: C.F. Rule of Signs

Year Cash Flow, $

0 2,000 + Result: 2 sign
1 – 500 – changes in the
2 – 8,100 – Cash Flow
3 6,800 +

IEN 505 - Advanced Engineering Economy

• Means we can have a maximum of 2 real potential i*
values for this problem.
• Beware: This test is fairly weak and the second test
must also be performed
20
 Dr. Yaser AlAlawi
Test 2: Cumulative Cash Flow (CCF) Signs

A sufficient, but not necessary, condition for a single

positive i* value is:
• Initial cash flow has negative sign

IEN 505 - Advanced Engineering Economy

• The CCF value at year n is > 0
• and there is exactly one sign change in the CCF
series

21
 Dr. Yaser AlAlawi
Example 5: Accumulated CF signs

Year Cash Flow, $ Cum. Cash Flow, $

0 2,000 2,000 + Result: 2 sign
1 – 500 1,500 + changes in the
2 – 8,100 – 6,600 – C. Cash Flow
3 6,800 200 +

IEN 505 - Advanced Engineering Economy

If the number of sign changes in the C.CF is 2 or greater
this strongly suggests that multiple rates of return exist.
• Strong evidence that we have multiple i* values
• CCF(t=3) = $200 > 0 suggests positive i* (s)
22
Excel Analysis

Dr. Yaser AlAlawi

Year Cash Flow, $
0 2,000 We find two i* values:
1 – 500 { 7.47%, 41.35% }
2 – 8,100
3 6,800
Sum + 200

IEN 505 - Advanced Engineering Economy

ROR-Guess 0% First i* using a guess
ROR 7.47% value of 0%
NPV= $200.00

Second i* value using

ROR-Guess 30%
guess value of 30%
ROR 41.35%
23
 Dr. Yaser AlAlawi
NPV Plot

250.000

200.000 i*1 = 7.47%

150.000 i*2 =41.35%
PV - $$

100.000

50.000

IEN 505 - Advanced Engineering Economy

0.000
Interest Rate
-50.0000.00 0.20 0.40 0.60

-100.000

-150.000

24
Investment (Project) Balance

Dr. Yaser AlAlawi

Examine the Investment or Project balances at each i* rate
Inv Bal Inv Bal
i-rate 7.47% i-rate 41.35%

Year Project Balances Year Project Balances

@ i* Rate @ i* Rate

IEN 505 - Advanced Engineering Economy

0 $2,000.00 0 $2,000.00
1 $1,649.36 1 $2,327.04
2 -$6,327.47 2 -$4,810.69
3 $0.00 3 $0.00

• Terminal IB(7.47%) = 0
• Terminal IB(41.35%) = 0
• Both i*’s yield terminal IB’s equal to 0! 25
 Dr. Yaser AlAlawi
Investment Balances at both i*’s

Important Observations:
• The IB’s for the terminal year (3) both equal 0; Means
that the two i* values are valid IRR’s for this problem
• The IB amounts are not all the same for the two i*
values.

IEN 505 - Advanced Engineering Economy

• IB amounts are a function of the interest rate used to
calculate the investment balances.

26
 Dr. Yaser AlAlawi
Comments on IRR

• Multiple i* values lead to interpretation problems.

• If multiple i*’s – which one, if any is the “correct” one to

use in an analysis?

• Serves to illustrate the computational difficulties

IEN 505 - Advanced Engineering Economy

associated with ROR analysis.

27
 Dr. Yaser AlAlawi
NPV Plot - continued
If the MARR is
between the two i*
values this investment
would be rejected!
250.000

200.000
NPV < 0
150.000

IEN 505 - Advanced Engineering Economy

100.000

50.000

0.000

0.00
-50.000 0.20 0.40 0.60
-100.000

-150.000

28
Techniques to

Dr. Yaser AlAlawi

Remove Multiple IRR

The techniques developed here are used under the following

conditions:
• The PW or AW value at the MARR is determined and could be
used to make the decision, but information on the IRR is
deemed necessary to finalize the economic decision.

IEN 505 - Advanced Engineering Economy

• The two tests of cash flow sign changes (Descartes’ and
Norstrom’s) indicate multiple roots (i* values) are possible.
• More than one positive i* value or all negative i* values are
obtained when the PW graph and IRR function are developed.
• A single, reliable rate of return value is required by
management or engineers to make a clear economic decision.

29
 Dr. Yaser AlAlawi
Ways to remove multiple i* values

Fact:
• The result of follow-up analysis to obtain a single ROR
value when multiple, non-useful i* values are present
does not determine the internal rate of return (IRR) for
nonconventional net cash flow series.

IEN 505 - Advanced Engineering Economy

• The resulting rate is a function of the additional
information provided to make the selected technique
work, and the accuracy is further dependent upon the
reliability of this information.

30
Ways to remove multiple i * values

Dr. Yaser AlAlawi

• We will refer to the resulting value as the External Rate of Return
(ERR) as a reminder that it is different from the IRR obtained in all
previous sections.
• You are the project manager, and the project generates some years to
produce positive NCF, and you want to invest the excess money at the
investment rate ii. Also called the Reinvestment rate.
• Other years, the NCF will be negative, and you must borrow funds
from some source to continue. The interest rate you pay is called the
borrowing rate ib, or the Finance rate.

IEN 505 - Advanced Engineering Economy

• Each year, you must consider the time value of money, which must
utilize either the investment rate or the borrowing rate, depending
upon the sign on the NCF of the preceding year.
• Two approaches that rectify the multiple i * situation.
• The resulting ROR value will not be the same for each method,
because slightly different additional information is necessary, and the
cash flows are treated in slightly different fashions from the time
value of money viewpoint.
31
 Dr. Yaser AlAlawi
1. Modified IRR (MIRR) Approach

• This is the easier approach to apply, and it has a spreadsheet

function that can find the single ERR value quickly. However,
the investment and borrowing rates must be reliably estimated,
since the results may be quite sensitive to them.
• The symbol i will identify the result.
• Investment rate ii is the rate at which extra funds are invested
in some source external to the project. This applies to all

IEN 505 - Advanced Engineering Economy

positive annual NCF. It is reasonable that the MARR is used for
this rate.
• Borrowing rate ib is the rate at which funds are borrowed from
an external source to provide funds to the project. This applies
to all negative annual NCF. The weighted average cost of capital
(WACC) can be used for this rate.
• Commonly MARR > WACC, so usually ii > ib
32
 Dr. Yaser AlAlawi
Approach:

To determine a single ERR i’:

1. PW @ 0 of all negative NCF at ib .
2. FW @ n of all positive NCF at ii
3. Calculate the MIRR i’ at which the PW and FW values are

IEN 505 - Advanced Engineering Economy

equivalent over the n years using:
FWn = PW0 ( F/P , i’ , n )
The guideline for economic decision-making compares the ERR or i’ to
MARR.
 if i’ > MARR, the project is economically justified.
 If i’< MARR, the project is not economically justified.
 i’ = MARR, there is indifference to the project’s economic
acceptability. 33
 Dr. Yaser AlAlawi
Example
• Revisit Example 7.4 There are two positive i* values that satisfy the
PW relation, 7.47% and 41.35% per year.
• Use the MIRR method to determine the ERR value. If Honda has a
WACC of 8.5% per year and that projects with an estimated return
of less than 9% per year are routinely rejected. Due to the nature
of this contract business, any excess funds generated are expected
to earn at a rate of 12% per year.

IEN 505 - Advanced Engineering Economy

• MARR: 9% per year
• Investment rate, ii : 12% per year
• Borrowing rate, ib : 8.5% per year

34
Solution

Dr. Yaser AlAlawi

Step 1. PW0 of -NCF @ ib = 8.5%:
PW0 = – 500( P/F ,8.5%,1) – 8,100( P/F ,8.5%,2) = – $7,342
Step 2. Find FW3 of +NCF @ ii = 12%.
FW3 = 2,000( F/P ,12%,3) + 6,800 = $9,610
Step 3. Find the rate i’ @ which the PW and FW are equivalent.
PW0 (F/P, i’,3) + FW3 = 0

IEN 505 - Advanced Engineering Economy

– 7,342(1 + i’)3 + 9,610 = 0
i’ = 9.39%  MIRR
Step 4. Since i’ > MARR, the project is economically justified with ERR
approach.

35
 Dr. Yaser AlAlawi
2. Return on Invested Capital (ROIC) Approach

• Return on invested capital (ROIC) is a rate-of-return

measure of how effectively a project utilizes the funds
invested in it, that is, funds that remain internal to the
project.

IEN 505 - Advanced Engineering Economy

• For a corporation, ROIC is a measure of how effectively
it utilizes the funds invested in its operations, including
facilities, equipment, people, systems, processes, and all
other assets used to conduct business.

36
Example

Dr. Yaser AlAlawi

• Revisit Example 7.4 There are two positive i* values that
satisfy the NPV relation, 7.47% and 41.35% per year.
• Use the ROIC method to determine the ERR value. The
MARR is 9% per year, and any excess funds generated by
the project can earn at a rate of 12% per year.

IEN 505 - Advanced Engineering Economy

37
 Dr. Yaser AlAlawi
Solution
Step 1.
Year 0: F0 = 2,000 > 0, externally invest in year 1 at ii = 12%.
Year 1: F1 = 2,000 (1.12) – 500 = 1,740 > 0, use ii = 12% for year 2.
Year 2: F2 = 1,740 (1.12) – 8,100 = – 6,151 < 0, use i” for year 3.
Year 3: F3 = – 6,151 (1 + i”) +6,800 = 0  solve for i”.

IEN 505 - Advanced Engineering Economy

Step 2. i” = 10.55%  ROIC
Step 3. ROIC > MARR 9%, the project is economically justified.

38
 Dr. Yaser AlAlawi
Facts
• None of the details of the modified ROR (MIRR)
technique or the return on invested capital (ROIC)
technique are necessary if the NPV or AW method of
project evaluation is applied at a specific MARR.

IEN 505 - Advanced Engineering Economy

• When the MARR is established, this is, in effect, fixing
the i* value. Therefore, a definitive economic decision
can be made directly from the NPV or AW value.

39
Rate of Return of a

Dr. Yaser AlAlawi

Bond Investment
• Bonds Face Value (V):
bonds are usually issued in amounts of $1000, $5000, or $10,000.
• Bond dividend (I) or Bond Interest:
is paid periodically between the time the money is borrowed and the
time the face value is repaid. The bond dividend is paid c times per year.
Expected payment periods are usually semiannually or quarterly.
• Bond Coupon Rate (b):

IEN 505 - Advanced Engineering Economy

The amount of interest is determined using the stated dividend or
interest rate.
V
I

0 ½ 1 1½ 2 ... 5

V 40
 Dr. Yaser AlAlawi
Summary

• IRR analysis is often used but not always well

understood by practitioners
• IRR can be computationally difficult manually; a
spreadsheet model helps reduce solution time

IEN 505 - Advanced Engineering Economy

• IRR problems may involve multiple i* rates
• Requires the determination of the composite rate to
solve
• If an exact ROR is not necessary use the PW, AW, or FW
methods

41