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SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Outline Module 6

Rate of Return Internal Rate of Return (IRR) Cash Flow with Single Rate of Return Cash Flow with Multiple Rate of Return Payback Period Discounted Payback Period

2

SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Rate of Return

Rate of Return (ROR) is the rate of interest paid on all unpaid balance of borrowed money, or the rate of interest earned on the unrecovered balance of an investment so that the final payment or receipt brings the balance to zero with interest considered Internal Rate of Return (IRR) is the interest rate that causes the equivalent receipts of a cash flow equal to the equivalent PR – PP = 0 i* PR = PP payments of a cash flow FR = FP FR – FP = 0

EUAW R = EUAW P EUAW R – EUAW P = 0

SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

3

**Finding Internal Rate of Return
**

1. Draw cash flow diagram 2. Convert all receipts into present, future or EUAW 3. Convert all payments into present, future or EUAW 4. Subtract (3) from (2) and set it equal to zero find i* 5. Find i* that satisfies (4) by trial and error interpolation

P

A1

O1

I1

SV

0

1

2

3

P R = I 1 ( P / F , i *, 22 ) + SV ( P / F , i *, 36 ) P P = P + A 1 ( P / A , i *, 36 ) + O 1 ( P / F , i *, 8 )

PR - PP = I1(P/F, i*, 22) + SV(P/F, i*, 36) – [P + A1(P/A, i*, 36) + O1(P/F, i*, 8)] = 0

4 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Rate of Return

The relationship between Rate of Return and the Present Worth Amount can be graphically describe as follows:

Present worth,

PW

0

i*

interest rate, i

Cash flow shown above assures a single rate of return that:

**PW ( i ) > 0 for i < i * PW ( i ) = 0 for i = i * PW ( i ) < 0 for i > i *
**

5 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

**Cash Flow with Single Rate of Return
**

For a cash flow will have a single rate of return, if satisfies the following conditions:

Test # 1: 1. F0 < 0

**(the first non-zero cash is a disbursement)
**

(the cash flow has an initial disbursement or a series of disbursement followed by a series of receipts)

**2 . One change in sign in the sequence F 0 , F 1 , F 2 , … F n
**

3 . PW ( 0 ) > 0

(the sum of all the receipts is greater than the sum of all the disbursements)

Test # 2: 1. F0 < 0

**(the first non-zero cash is a disbursement)
**

for unknown i*, total unrecovered balance , U t < 0 for t = 0, 1, 2, 3, … n-1 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

**2 . Find rate of return , i * , for the cash flow ;
**

6

**Cash Flow with Multiple Rate of Return
**

For a cash flow will have a multiple rate of return, if not satisfies Test #1 Test #2

Present worth,

PW

i*

0

i*

interest rate, i

7

SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Payback Period

In business and industry it is common to evaluate alternatives (assets) in terms of their payback or payout period. Payback without interest the length of time required to recover the first cost of an investment from the net cash flow produce by that investment for interest rate of zero n Ft ≥ 0 t =0 This method has disadvantages as it fails to consider: the time value of money the consequences of the investment following the payback period Payback with interest or discounted payback period this method determines the length of time required until the investment’s equivalent receipts exceed the equivalent capital ' outlays n − t n’ = the smallest value

∑

F ∑ (1 +i )

t= 0 t

≥0

8

SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

that satisfies the equation

**Payback Period without Interest
**

Example:

A - 1.000.000,500.000,300.000,200.000,200.000,200.000,200.000,PW(i)A = 3 years 600.000,B - 1.000.000,200.000,300.000,500.000,1.000.000,2.000.000,4.000.000,PW(i)B = 3 years 7.000.000,C - 700.000,- 300.000,500.000,500.000,0,0,0,PW(i)C = 0,3 years

Three alternatives of investment are being considered without interest:

** end of year 0 1 2 3 4 5 6 Present worth, i = 0 Payback period
**

9

SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

**Discounted Payback Period
**

Example:

A - 1.000.000,500.000,300.000,200.000,200.000,200.000,200.000,-

Alternative A is being considered at the rate of return 15%

end of year 0 1 2 3 4 5 6

**Ft = - 1M + 500K ( P / F , 15 % , 1 ) + 300K ( P / F , 15 % , 2 ) + 200K ( P / F , 15%, 3) + 200K(P/F, 15%, 4) + 200K(P/F, 15%, 5) > 0
**

10 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Project Balance

Evaluation of a proposed project is often done by analyzing the project balance. A project balance describes the equivalent of loss or profit of the project cash flow as a function of time. At any given time, a project balance can be calculated as:

PB (i )T = ∑ Ft (1 + i )T −1

t =0

T

Visual description of a project balance project balance diagram Four important characteristics of project balance diagram are:

The net future worth of investment The time when the equivalent cash flow switch from negative to non-negative, or vice versa The net equivalent cash flow exposed to risk of loss (the area where PB(i) is negative) The net equivalent cash flow earned (the area where the PB(i) is positive)

SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

11

Project Balance

Project cash flow @ 20% discount rate

8M 5M

2 3 4

6M 3M

5

PB ( 20 ) 5 = 7 . 55M

1M

0 1

10M

PB ( 20 ) 4 = 3 . 79M

+ PB ( 20 ) 2 = - 8 . 2M PB ( 20 ) 0 = -10M PB ( 20 ) 1 = -11M PB ( 20 ) 3 = - 1 . 84M

12

SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Homework #6

1.Work for alternative B and C of the example (slide #8). Determine the discounted payback period for each alternative and suggest your selection. 2.For the same problem investment (#1), calculate the project balance for each alternative, draw the project balance diagram, and identify the future worth and exposure to risk of loss

13

SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

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