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Engineerig Econoomy - Lecture 7 - Chapter 7

Chapter 7 discusses the concept of Rate of Return (ROR), which is the rate earned on unrecovered investments or paid on borrowed money. It outlines methods for calculating ROR using Present Worth (PW) or Annual Worth (AW) equations, emphasizing the importance of comparing the calculated ROR with the Minimum Acceptable Rate of Return (MARR) to determine economic viability. Several examples illustrate the application of these calculations in different investment scenarios.

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0% found this document useful (0 votes)
3 views7 pages

Engineerig Econoomy - Lecture 7 - Chapter 7

Chapter 7 discusses the concept of Rate of Return (ROR), which is the rate earned on unrecovered investments or paid on borrowed money. It outlines methods for calculating ROR using Present Worth (PW) or Annual Worth (AW) equations, emphasizing the importance of comparing the calculated ROR with the Minimum Acceptable Rate of Return (MARR) to determine economic viability. Several examples illustrate the application of these calculations in different investment scenarios.

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mina2002sameh
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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You are on page 1/ 7

4/7/2023

Chapter 7

Rate of Return Analysis:


Single Alternative

April, 2023 Dr. Mansour Abou Gamila 1

7. 1 Rate of Return - Introduction

Rate of return “ROR” is the rate paid on the unpaid


balance of borrowed money, or the rate earned on the
unrecovered balance of an investment, so that the final
payment or receipt brings the balance to exactly zero with
interest considered.

 1 0 0 %  i*   
In terms of investment, a return of I = -100% means the
entire amount is lost.

April, 2023 Dr. Mansour Abou Gamila 2


4/7/2023

7. 1 Rate of Return - Introduction

The rate of return is based on:


 The unrecovered balance.
 The initial investment.

It is very important to know on what base the rate of return


is calculated.

April, 2023 Dr. Mansour Abou Gamila 3

7.2 Rate of Return Calculation Using a PW or


To calculate i*: AW Equation
– Draw a cash flow diagram
– Set up an ROR equation using either PW or AW relations
and equate to zero:
PW disbursements = PW receipts
0 = - PWD + PWR

AW disbursements = AW receipts
0 = - AWD + AWR
– Select the values of i by trial and error until the equation
is balanced.

April, 2023 Dr. Mansour Abou Gamila 4


4/7/2023

7.2 Rate of Return Calculation Using a PW or


AW Equation
• determine
To . if the alternative’s cash flow series is viable,
compare i* with the established MARR.
If i*≥ MARR, accept the alternative as economically
viable.
If i*< MARR, the alternative is not economically viable

April, 2023 Dr. Mansour Abou Gamila 5

7.2 Rate of Return Calculation Using a PW or


AW Equation
Assume you deposit $1,000 now; to receive $500 three years from now
and $1500 five years from now. What is the ROR of this project?
I=? $1,500

$500

0 1 2 3 4 5

PW=0

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


$1,000
1000 = 500(P/F, i*,3) +1500(P/F, i*,5)

The PW expression must be solved by trial and error  i*= 16.9%

April, 2023 Dr. Mansour Abou Gamila 6


4/7/2023

7.2 Rate of Return Calculation Using a


PW or AW Equation
 Guess at a rate and try it
 A negative NPV generally indicates the i* value is
too high
 A positive NPV suggests that the i* value was too
low
 Repeat for values of i until “0” is bracketed
 Then interpolate between the two i* values
 i* approximately 16.9% per year on the unrecovered
investment balances

April, 2023 Dr. Mansour Abou Gamila 7

7.2 Rate of Return Calculation Using a


PW or AW Equation
Example 7.2, Page 177
Applications of green, lean manufacturing techniques coupled
with value stream mapping can make large financial differences
over future years while placing greater emphasis on
environmental factors. Engineers with Monarch Paints have
recommended to management an investment of $200,000 now
in novel methods that will reduce the amount of wastewater,
packaging materials, and other solid waste in their consumer
paint manufacturing facility. Estimated savings are $15,000 per
year for each of the next 10 years and an additional savings of
$300,000 at the end of 10 years in facility and equipment
upgrade costs. Determine the rate of return using hand and
spreadsheet solutions.
April, 2023 Dr. Mansour Abou Gamila 8
4/7/2023

7.2 Rate of Return Calculation Using a PW or


AW Equation
Example 7.2, Page 177 $300,000
I=?
$ 15,000

0 1 2 3 4 5 6 7 8 9 10

$200,000
0 =-200,000 +15,000(P/A,i*,10) + 300,000(P/F,i*,10)
Trial and error until the equation is balanced .
Multiply the $15,000 Annuity by 10 to transform to future,
200000 = 450000(P/F,I,10)
(P/F,I,10) = 0.444
(the roughly estimated for I is between 8%, 9%
i=9% , 0 =-200,000 +15,000(P/A,9%,10) + 300,000(P/F,9%,10)
0< $22,986, the result is positive, indicating the return is more than 9%, try 11%
i=11%, 0 =-200,000 +15,000(P/A,11%,10) + 300,000(P/F,11%,10)
0 > $-6002
22,986- 0
i* 9 (2)  9  1.58  10.58%
22,986- (-6002) 9
April, 2023
Dr. Mansour Abou Gamila

7.2 Rate of Return Calculation Using a PW or


AW Equation
Example
The HVAC engineer for a company constructing one of the world’s tallest
buildings (Shanghai Financial Center in the Peoples’ Republic of
China) has requested that $500,000 be spent now during construction
on software and hardware to improve the efficiency of the
environmental control systems. This is expected to save $10,000 per
year for 10 years in energy costs and $700,000 at the end of 10 years in
equipment refurbishment costs. Use AW computations to find the rate
of return for the cash flows
AWD = -500,000(A/P,i,10)
AWR = 10,000+700,000(A/F,i,10)
0 = -500000(A/P, i*,10) + 10000+700000(A/F, i*,10)
i = 5%, 0< $900
i = 6%, 0 > $-4826
900 - 0
i*5
April, 2023
(1)  5.16% 10
900 - (-4826) Dr. Mansour Abou Gamila
4/7/2023

Example
Swagelok Enterprises is a manufacturer of miniature fittings and
valves. Over a 5-year period, the costs associated with one product
line were as follows: first cost of $30,000 and annual costs of
$18,000. Annual revenue was $27,000, and the used equipment was
salvaged for $4000. What rate of return did the company make on
this product?
Solution:
0 = -30,000 + (27,000 – 18,000)(P/A,i%,5) + 4000(P/F,i%,5)
0 = -30,000+9,000(P/A, i%,5) +4,000(P/F, i%,5) $4,000
I = 10%, - -30,000+9000(3.791)+4000(0.6209) = 6,602 i* = ?
I =15 -30,000+9000(3.352)+4000(0.4972) = 2156 $27,000
1= 18% -30,000+9000(3.127)+4000(0.4371) = -108.6
Solve by interpolation 0 1 2 3 4 5
i= 15 + [(2156-0)/(2156-(-108.6))](3)
i* = 17.85 % $18,000
$30,000
April, 2023 Dr. Mansour Abou Gamila 11

Example
In 2010, the city of Houston, Texas, collected $24,232,372 in fines from
motorists because of traffic violations caught by red-light cameras. The
cost of operating the system was $8,432,372. The net profit, that is, profit
after operating costs, is split equally (that is, 50% each) between the city
and the operator of the camera system. What will be the rate of return over
a 3-year period to the contractor that paid for, installed, and operates the
system, if its initial cost was $20,000,000 and the profit for each of the 3
years is the same as it was in 2010?
Profit = (24,232,372 - 8,432,372)(0.5) = $7,900,000

0 = -20,000,000 + 7,900,000(P/A,i,3)
(P/A,i,3) = 2.53
Find i from equation, table, or spreadsheet

i = 9%

April, 2023 Dr. Mansour Abou Gamila 12


4/7/2023

Example
A plaintiff in a successful lawsuit was awarded a judgment of
$4800 per month for 5 years. The plaintiff needs a fairly large
sum of money now for an investment and has offered the
defendant the opportunity to pay off the award in a lump-sum
amount of $110,000. If the defendant accepts the offer and pays
the $110,000 now, what rate of return will the defendant have
made on the “investment”? Assume the next $4800 payment is
due 1 month from now.

0= -110000+4800(P/A, I, 60)
(P/A, I, 60) = 22.91667
Using the formula
 (1  i ) n  1 
P  A n 
fo r i  0
 i (1  i ) 
I = 3.932 per month

April, 2023 Dr. Mansour Abou Gamila 13

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