0 Up votes0 Down votes

7 views5 pagesNov 30, 2013

© Attribution Non-Commercial (BY-NC)

PDF, TXT or read online from Scribd

Attribution Non-Commercial (BY-NC)

7 views

Attribution Non-Commercial (BY-NC)

- Best Practice on Measuting ROI of Marketing
- Victoria Chemicals PLC Case Analysis
- Lockeed 5 Star
- Capital Budgeting.pdf
- Peanut Products Profile
- 1205003087_PM0010
- Week 3-Project Selection and Portfolio Management [Compatibility Mode]
- BussMaster Business Plan -
- Course Work
- DEFININATION OF SMALL SCALE INDUSTRY.docx
- Story of Eclark 2014
- Prefabricated Building Manufacturing
- UOP Capital Investment Presentation
- Using Aspen to Evaluate Process Economics
- 23. Bed Cover
- Assigment HR4.docx
- Project Initiation
- 90219429-ch26
- P2 PEG M2008 Final Version
- Final

You are on page 1of 5

I. Internal Rate of Return A. Formally defined: Internal Rate of Return is that interest rate which reduces the net present value of an investment to zero. 1. Finding the internal rate of return : The solution of the internal rate of return does not analytically exist. Methods for finding the internal rate of return are, thus, numerical search techniques or iterative processes. a. Simple approach: Numeric gradient (i.) Compute the NPV of an investment at two points, or for two interest rates. {The solution technique works best if one point has a positive NPV and the other a negative NPV}. (ii.) Compute the line between the two points and find where the line equals zero. Assume i2 >i1 and NPV1 >NPV2 . NPV1 NPV2 i3 = i1 i1 i1 i2

or NPV1 NPV2 i3 = i2 i2 i1 i2

NPV

i3 i1

i2

(iii.)

Decide whether the NPV is close enough to zero-Stop if yes, go back to step (ii) if no. {If the NPV at i3 is positivereplace i1 , if it is negative, replace i2 }.

AEB 6145 Lecture III Professor Charles B. Moss Problems: The procedure does not have a good convergence {it may take a long time}. It may be difficult to find a good starting place-you need two interest rates that bound the zero (one positive NPV and another with a negative NPV). (v.) Advantage: It is robust- it will always work. b. Newtons Method NPV ( ik ) ik +1 = ik NPV ( i) i i =i

k

(iv.)

(i.)

For a reference to Newtons method see Burington, R. S. Handbook of Mathematical Tables and Formulas Fifth Edition (New York: McGraw-Hill Book Company, 1973): 189. See also my lecture notes on Newtons Method from AEB 6533. http://128.227.113.61/chuck/aeb6533.mathprogramming/l ecture9.pdf. N NCFt NPV ( i) = t t =0 (1 + i ) NPV ( i ) i = t

t =1 N

(1 + i )

NCFt

t 1

=

t =1

(1 + i )

tNCFt

t 1

Choose an initial i. Apply the formula to compute a new i. Check to see if the NPV is close to zero. If no reiterate, if yes stop. This technique is similar to the first, except an analytical slope is substituted for the numerical slope.

NPV

i1

i2 i3

Comments: This method is relatively quick and is robust if the net cash flows are smooth. Unfortunately, it is possible to stick the algorithm and it may break down if NPV has multiple optimum. B. Why is it wrong to IRR. 1. Remember that the IRR is simply the i that reduces the NPV to zero. I want to show that: a. Under certain conditions IRR and NPV yield the same results, i.e. in the case of conventional investments. b. I can show that under certain conditions IRR yields an inferior investment decision that NPV correctly identifies. c. Thus, NPV dominates IRR as an investment criteria. 2. Assume that Big Green manufacturing comes out with a lease system that charges lease payments for 3 years and then requires the investor to purchase the machine. This machine generates revenue with cash flows. The total cash flows for the investment are presented in table 1. Table 1. Cash Flows for Big Green Machinery Investment Year Cash Flow 0 750 1 750 2 1,000 3 1,250 4 -15,000 The IRR for this investment is .7014 and the NPV at a discount rate of 5% is 898.14. Next, I want to generate the unrecovered balance for 3

(vi.)

AEB 6145 Lecture III Professor Charles B. Moss the investment in each year. The unrecovered balance is defined like a savings account. Departing from the investment example in table 1, consider an investment with a normal cash flow pattern as depicted in table 2. Table 2. Unrecovered Balance for Investment with Normal Cash Flow Patterm Interest Cash on Unrecovered Year Flow Balance Balance 0 -15000.00 -15000.00 1 5000.00 -750.00 -10750.00 2 5000.00 -537.50 -6287.50 3 5000.00 -314.38 -1601.88 4 5000.00 -80.09 3318.03 As presented in table 2, the year 0 cash flow for this investment is 15,000 (corresponding with an initial investment). At the end of year 0 (beginning of year 1) this negative cash flow would have accrued an interest chare of 750. Adding the positive cash flow in period 1 (5,000) to the interest charge and the unrecovered balance of 15,000 yields an unrecovered balance at the beginning of period 1 of 10,750. Applying this technique to cash flows in table 1, but using two interest rates (5% as in NPV and .7014 as in the IRR). Table 3. Unrecovered Balance Using Two Interest Rates. Unrecovered Unrecovered Year Cash Flow Balance .7014 Balance .05 0 750 1,276 788 1 750 3,447 1,614 2 1,000 7,566 2,745 3 1,250 15,000 4,195 4 -15,000 0 -10,805 The higher the ending balloon payment, the higher the IRR and the lower the NPV also the more undesirable the investment. 3. There exist certain legitimate investment questions for which the IRR does not exist. a. For the IRR to exist both positive and negative cash flows must occur. However, several important and relevant investments may exist that have all negative or all positive cash flows. b. Examples: (i.) All negative cash flows: Suppose a farmer is evaluating the purchase of two tractors. Also assume that he is not currently constrained in tractor time so that the additional revenue of either tractor is zero. The farmer wants a technique that chooses the tractor with the least cost through time.

AEB 6145 Lecture III Professor Charles B. Moss Table 4. Comparison of Tractor Costs Year Tractor I Tractor II 0 -15,000 -10,000 1 -250 -100 2 -250 -200 3 -700 -1,000 4 -1,250 -1,500 5 -1,500 -2,000 NPV at 5% -18,950 -14,800 (ii.) No negative cash flows and the extremely profitable investment. Table 5. No Negative Cash Flows and an Extremely Profitable Investment Year No Negative Extremely Cash Flows Profitable 0 0 -100 1 100 200 2 200 400 3 300 600 4 400 800 IRR 268.63 8 NPV 1,629.75 864.88 C. Conclusions 1. IRR is defined as the discount rate that reduces the NPV of an investment to zero. 2. Problems: a. It does not handle mixed investment flows appropriately. b. It may not exit or may have several IRRs.

- Best Practice on Measuting ROI of MarketingUploaded byGausMohiuddin
- Victoria Chemicals PLC Case AnalysisUploaded byLesika Q. Mintz
- Lockeed 5 StarUploaded byAjay Singh
- Capital Budgeting.pdfUploaded bySenthil Kumar
- Peanut Products ProfileUploaded byak123456
- 1205003087_PM0010Uploaded byAjeeth Kumar
- Week 3-Project Selection and Portfolio Management [Compatibility Mode]Uploaded bySabri Jamil
- BussMaster Business Plan -Uploaded bypandared
- Course WorkUploaded bychaz7z
- DEFININATION OF SMALL SCALE INDUSTRY.docxUploaded byAnoop Sharma
- Story of Eclark 2014Uploaded byspectrum_48
- Prefabricated Building ManufacturingUploaded byBehailu Feleke
- UOP Capital Investment PresentationUploaded byamin
- Using Aspen to Evaluate Process EconomicsUploaded bypallavi
- 23. Bed CoverUploaded byabel_kayel
- Assigment HR4.docxUploaded byahmedomerredha
- Project InitiationUploaded byGeorge
- 90219429-ch26Uploaded byasem shaban
- P2 PEG M2008 Final VersionUploaded byPoppi HS
- FinalUploaded byMohammad
- Engineering Economy 16 Juni 2016Uploaded byiqbal m fariz
- 4. Frozen Vegetable ProcessingUploaded byVikash Trivedi
- Copy of Tristar CaseUploaded bySelva Ram
- Term LoanUploaded bymevrick_guy
- ch02.pdfUploaded byPual
- Unit 8 - Capital BudgetingUploaded byParul Srivastav
- Ppt Unit 08 Mbf201Uploaded byAkhilesh Mathur
- WEEK 10-PRINCIPLES OF CAPITAL BUDGETING.pptUploaded byAlok Verma
- Question S4Uploaded bynaman chauhan
- 3 WheelerUploaded bybig john

- Haim Shaked, Chen Schechter Auth. Systems Thinking for School Leaders Holistic Leadership for Excellence in EducationUploaded bykaren dejo
- Lab WASModelUploaded bykaren dejo
- Introduction to ModelingUploaded bykaren dejo
- Bumn DereckUploaded bykaren dejo
- Simulation and Analysis of power system transientsUploaded bydeepak_27
- Kon-41 4011 Correction Detailed ExersicesUploaded bykaren dejo
- 01-Study on Smart Grid System5986-15207-2-PB.pdfUploaded bykaren dejo
- kadoya2005.pdfUploaded bykaren dejo
- UM-Ch4-5edUploaded bykaren dejo
- UM-Ch2-5edUploaded bykaren dejo
- SlidesJDMUploaded bykaren dejo
- Historia PL PLEUploaded bykaren dejo
- UM-Ch1-5edUploaded bykaren dejo
- TrainingManual EnglishUploaded bykaren dejo
- 411-1713-2-PB-expansion-.pdfUploaded bykaren dejo
- KIT [27]Uploaded byZoran Ivančić
- Session_5Uploaded bykaren dejo
- Frequency and Regression Analysis of Hydrologic Data_oosterbaanUploaded bykaren dejo
- Benders Decomposition in Restructured Power SystemsUploaded bywvargas926
- QuickInstallationGuide 15.1 MultiUploaded bythanatitos
- QuickInstallationGuide 15.2 MultiUploaded bykaren dejo
- Answers Instructions Week 5Uploaded bykaren dejo
- econ-4930-seminar-3.pdfUploaded bykaren dejo
- Answers-Instructions-week-4.pdfUploaded bykaren dejo
- Kon-41 4011 Modeling RequirementsUploaded bykaren dejo
- IM Case IntroductionUploaded bykaren dejo
- HW392m_Midterm05Uploaded bykaren dejo
- BC Modeling Kickoff MeetingUploaded bykaren dejo

- How to Take MySql Database Backup Using MySql WorkbenchUploaded byhaidaroracle
- drbd8Uploaded bySean Thon
- Murali Krishna Kona (1)Uploaded bynagarajuvcc123
- Schedule Lines AB1 RoutineUploaded byphanak74
- TechNote_VMware_IOFencingUploaded byVelmurugan Gurusamy Pandian
- A Novel Approach a Hybrid SemanticUploaded byAIRCC - IJNSA
- A Study on Video Data MiningUploaded byvladislav
- Introduction to CUploaded byAntonio Rivera Mabini Jr.
- pcs7.pdfUploaded byNguyễn Anh Tú
- 18f4550 Pwm ExampleUploaded bysalilpn2
- Www.studydroid.com PrinterFriendlyViewPack.php PackId=170516Uploaded byFrederick Albert Skettini
- EC3021 Virtual Memory P1 05Uploaded byavula girish
- Case Studies on Cryptography and SecurityUploaded bynooti
- System Software28.11.13.pdfUploaded byslogeshwari
- Unit 4Uploaded bymvdurgadevi
- Insertion and Deletion in ArraysUploaded byakash chaudhary
- Microsoft Visual Studio 2005 TutorialUploaded byAidee84
- C# CHAPTER 5Uploaded byVinay Singh
- Instrução para Usar ADB e FastbootUploaded byGesemp
- LBS Data Entry and Office Automation NotesUploaded byNIJEESH RAJ N
- Artificial IntelligenceUploaded bychantib
- Kuka Brochure iiwaUploaded byPrayogaBudhi
- Cisco Nexus 1000V TroubleshootingUploaded bydeepak_1117
- Chef Discussions in ProgrammingUploaded byClaire Negro
- System Administration ToolkitUploaded byBiswajit Das
- DS_LM.pdfUploaded byAzim Khan
- The Internet, Intranets And ExtranetsUploaded byM.WASEEM YOUSAF
- Spr17 P310 Student ScheduleUploaded byDanolanater
- Using Remote Function Calls as External ServicesUploaded byglibtalker
- Viper for Windows 10 Safe and Moderate TweakUploaded byJayakar Gadi

## Much more than documents.

Discover everything Scribd has to offer, including books and audiobooks from major publishers.

Cancel anytime.