ROR & BCR

ANALYSIS
Engineering Economy
Monday, April 16, 18
Course outline
l  ROR Analysis
l  Incremental ROR Analysis

l  Benefit-Cost Ratio (BCR) Analysis

Interpretation of a Rate of Return Value
In rate of return problems you seek an
unknown interest rate (i*) that satisfies
the following:
u PWi*(+ cash flows) – PWi*( - cash flows)
=0
u This means that the interest rate – i*, is
an unknown parameter and must be solved
or approximated.
Unrecovered Investment Balance
u ROR is the interest rate earned/charged on the
unrecovered investment balance of a loan or
investment project

Consider the following loan

•  You borrow $1,000 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=$1,000(A/P,10%,4) = $315.47
The Loan Schedule
Year BOY Bal Payment Interest Prin. Red. Un-Paid
Amount Amount Balance

0 $1,000 0 -- --- $1,000

1 1,000 315.47 100.00 215.47 784.53

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

Unrecovered Investment Balance
For this loan the unpaid loan balances at
the end of each year are:
0 $1,000

1 784.53

2 547.51
Unpaid loan balance
3 286.79 is now “0” at the
end of the life of the
4 0 loan
Unrecovered Investment Balance
u The UIBt = 4 is exactly 0 at a 10% rate

0 $1,000

1 784.53

2 547.51

3 286.79

4 0
Reconsider the Following
u Assume you invest $1,000 over 4 years
u The investment generates $315.47/year
u Draw the cash-flow diagram
A = +315.47

0 1 2 3 4

P=$-1,000
Investment Problem
u What interest rate equates the future
positive cash flows to the initial
investment?
u We can state:
§  -$1,000= 315.47(P/A, i*,4)
§  Where i* is the unknown interest rate
that makes the PW(+) = PW(-)
Investment Problem

u $1,000= 315.47(P/A, i*,4)

u Solve the above for the i* rate
u (P/A,i*,4) = 1,000/315.47 = 3.16987
u Given n = 4, what value of i* yields a P/
A factor value = 3.16987?
u Interest Table search yields i*=10%
Investment Problem

u i*=10% per year

u Just like the loan problem, we can
calculate the unrecovered investment
balances that are similar to the unpaid
loan balances.
Unrecovered Investment
Balances (UIB)
u set up the following table
t C.F(t) Future Value for 1 year UIBt

0 -1,000 ---- -1,000

1 +315.47 -1,000(1.10)+315.47= -784.53

2 +315.47 -784.53(1.10)+315.47= -547.51

3 +315.47 -547.51(1.10)+315.47= -286.79

4 +315.47 -286.79(1.10)+315.47= 0
UIB’s for the Example

t C.F(t) UIBt • The unrecovered

investment balances
0 -1,000 -1,000 have been calculated
at a 10% interest rate.
1 +315.47 -784.53
• Note, the investment
2 +315.47 -547.51 is fully recovered at
the end of year 4.
3 +315.47 -286.79
• The UIB = 0 at a 10%
4 +315.47 0 interest rate.
UIB’s for the Example

t C.F(t) UIBt
• The 10% rate is the
0 -1,000 -1,000 only interest rate that
will cause the UIB at
1 +315.47 -784.53 the end of the
project’s life to equal
2 +315.47 -547.51 exactly “0”
3 +315.47 -286.79

4 +315.47 0
UIB’s for the Example

t C.F(t) UIBt
• Note, all of UIB’s are
0 -1,000 -1,000 negative at the 10%
rate.
1 +315.47 -784.53
• This means that the
2 +315.47 -547.51 investment is
unrecovered
3 +315.47 -286.79 throughout the life.
4 +315.47 0
Pure Investment
u  The basic definition of ROR is the
interest rate that will cause the investment
balance at the end of the project to exactly
equal “0”.
u The interest rate paid on the unpaid
balance of a loan such that the payment
schedule makes the unpaid loan balance
equal to zero when the final payment is made
ROR – Explained

u ROR is the interest rate earned on the

unrecovered investment balances
throughout the life of the investment.

u ROR (i*) rate will also cause the NPV(i*)

of the cash flow to = “0”.
ROR using Present Worth
• PW definition of ROR
• PW(-CF’s) = PW(+CF’s)
• PW(-CF’s) - PW(+CF’s) = 0
• AW definition of ROR
• AW(-CF’s) = AW(+CF’s)
• AW(-CF’s) - AW(+CF’s) = 0
ROR using Present Worth

• Finding the ROR for most cash flows is a

trial-and-error effort.
• The interest rate, i*, is the unknown
• Solution is generally an approximation
effort
• May require numerical analysis
approaches
ROR using Present Worth

+$1,500

+$500

0 1 2 3 4 5

-$1,000
• Assume you invest $1,000 at t = 0: Receive $500 @ t=3 and
$1,500 at t = 5. What is the ROR of this project?
ROR using Present Worth
Write a present worth expression, set equal to “0”
and solve for the interest rate that satisfies the
formulation.
1,000 = 500(P/F, i*,3) +1,500(P/F, i*,5)

• Can you solve this directly for the value of i*?

• NO!
• Resort to trial-and-error approaches
ROR using Present Worth
1,000 = 500(P/F, i*,3) +1,500(P/F, i*,5)

•  Guess at a rate and try it

•  Adjust accordingly
•  Bracket
•  Interpolate
•  i* approximately 16.9% per year on the
unrecovered investment balances
 Trial-and Error-Approach
•  Iterative procedures require an initial guess for i*
•  One makes an educated first guess and calculates the
resultant PV at the guess rate.
•  If the NPV is not = 0, then another i* value is
evaluated…. Until NPV “close” to “0”.
•  The objective is to obtain a negative PV for an i* guess
value then.
•  Adjust the i* value to obtain a positive PV given the
adjusted i* value.
•  Then interpolate between the two i* values
•  If the NPV is not = 0, then another i* value is
evaluated.
•  A negative NPV generally indicates the i* value is too
high.
•  A positive NPV suggests that the i* value was too low.
ROR Criteria

•  Determine the i* rate

•  If i* => MARR, accept the project
•  If i* < MARR, reject the project
The MARR is a minimum return the
company will accept on the money it
invests

The MARR is usually calculated by

financial analysts in the company and
provided to those who evaluate projects

It is the same as the interest rate used

for Present Worth and Annual Worth
analysis.
Rate of Return Analysis
l  Rate of return:
l  the interest rate paid on the unpaid balance of a loan such
that the payment schedule makes the unpaid loan balance
equal to zero when the final payment is made
l  interest rate earned on the unrecovered investment such
that the payment schedule makes the unrecovered
investment equal to zero at the end of the life of the
investment
l  is the interest rate at which the benefits are equivalent to
the costs
Calculating Rate of Return

PW of benefits - PW of costs = 0
PW of benefits
PW of cost = 1
Net Present Worth = 0

PW of costs = PW of benefits
Calculating Rate of Return
l  Example:
An $8200 investment returned $2000 per year over a 5-year
useful life. What was the ROR on the investment?

PW of benefits 2000(P/A,i,5)
=1 =1
PW of cost 8200

8200
(P/A,i,5) = = 4.1 i (P/A,i,5)
2000
6% 4.212

i = 7% 7% 4.100
8% 3.993
Cautions when using the ROR Method
Computational Difficulties

• ROR method is computationally more

difficult than PW/AW
• Can become a numerical analysis problem
and the result is an approximation
• Conceptually more difficult to understand
Cautions when using the ROR Method
Special Procedure for Multiple Alternatives

• For analysis of two or more alternatives,

when using ROR one must resort to a
different analysis approach as opposed to
the PW/AW methods.
• For ROR analysis of multiple alternatives,
one must apply an incremental analysis
approach.
Cautions When Using the ROR Method:
ROR Is More Difficult!

• ROR is computationally more difficult

• But is a popular method with financial
managers
• ROR is used internally by a substantial
number of firms
• Suggest using PW/AW methods where
possible
Incremental Analysis
l  is the examination of the differences between
alternatives
l  Relationship between two alternatives:
l  Higher-cost alt. = lower-cost alt. + difference
between them
l  Graphical solution vs Incremental ROR
analyisis
Multiple Alternative Problems
Two-Alternative Analysis

A
Better
B Better

C Best of 4
Alternatives

D
Multiple Alternative Problems
l  Example:
Consider the 3 mutually alternatives below

A B C
Initial cost $2000 $4000 $5000
Uniform annual benefit 410 639 700

Each alternative has a 20-year life and no salvage

value. If the MARR is 6%, which alternative should
be selected
Multiple Alternative Problems

Annual Benefits:
- A = $ 410
- B = $ 639
- C = $ 700
0 20

Initial cost:
- A = $2,000
- B = $4,000
- C = $5,000
Incremental ROR Analysis
Alternative A:
2000 = 410 (P/A,i,20)
(P/A,i,20) = 2000 / 410 = 4.878
i = 20%

Alternative B:
4000 = 639 (P/A,i,20)
(P/A,i,20) = 4000 / 639 = 6.259
i = 15%
Incremental ROR Analysis
Alternative C:
5000 = 700 (P/A,i,20)
(P/A,i,20) = 5000 / 700 = 7.143
i = is between 12% and 15%
i = 12% + [(7.469-7.143) / (7.469 - 6.259)]
i = 12.8%

As the 3 alternatives exceed the MARR of 6%

therefore they are all acceptable.
Incremental ROR Analysis
l  Arrange the 3 alternatives in order of increasing initial cost
A B C
Initial cost $2000 $4000 $5000
Uniform annual benefit 410 639 700
Rate of Return 20% 15% 12.8%

Using A as the baseline, calculate the incremental cost,

incremental uniform annual benefit, and then incremental ROR

Increment B-A
Incremental cost $4000 - $2000 = $2000
Incremental Uniform annual benefit 639 – 410 = 229
Incremental ROR Analysis
l  Incremental ROR for B-A:
2000 = 229 (P/A,i,20)
(P/A,i,20) = 2000 / 229 = 8.734
ΔROR = 9.6%

As ΔROR > MARR, therefore A is discarded and B is selected,

and then is used as baseline for comparing alternative C

Increment C-B
Incremental cost $5000 - $4000 = $1000
Incremental Uniform annual benefit 700 – 639 = 61
Incremental ROR Analysis
l  Incremental ROR for C-B:
1000 = 61 (P/A,i,20)
(P/A,i,20) = 1000 / 61 = 16.393
ΔROR = 2.0%

As ΔROR < MARR, therefore C is discarded and B is still a

better alternative, which means the best of the 3 alternatives
Elements in Incremental ROR Analysis
1  Identify all alternatives
2  Compute ROR for each alternative
•  rejects any alternative with ROR < MARR
3  Arrange accepted alternatives in ascending order
of investment
4  Make a two-alternative analysis for the first two
alternatives
•  If DROR > MARR, retain the higher-cost alternative
•  If DROR < retain the lower-cost alternative
Elements in Incremental ROR Analysis
5  Take the preferred alternative from Step 4, and the
next alternative from the list created in Step 3,
then perform the two-alternative analysis
6  Continue until all alternatives have been examined
and the best of multiple alternatives has been
identified
BENEFIT – COST RATIO
l  Usually this analysis is used for public
projects
•  Costs : Construction, operations,
maintenance less est. salvage values, Initial
costs fairly well known, Future O&M are less
known and must be estimated
•  BENEFITS to the public (users) must be
estimated in terms of periodic dollar values ;
Benefits = the advantages to the public
stated in $$ ; Owners – generally the public
•  Disbenefits Expected undesirable (negative)
consequences to the owners (public)
 9.2 B/C Formulations

•  Assignable life, N - years

•  Estimate costs ($)
•  Estimate benefits in ($)
•  Estimate disbenefits in ($)
•  Assign an interest rate – i (%/year)

45 Blank & Tarquin: 5th Edition. Ch. 9 Authored by:

Dr. Don Smith, Texas A&M University.
Benefit-Cost Ratio Analysis
l  Based on the ratio of benefits to costs using either
present worth or annual cash flow analysis

PW of benefits - PW of costs > 0

Could be stated as a ratio of benefits to costs

PW of benefits
Benefit-cost ratio (BCR) = >1
PW of cost
 9.2 Notes Regarding Signs

•  By convention:
•  Revenues are assigned (+) signs
•  Costs are assigned (+) signs
•  Salvage values are subtracted from costs
•  Disbenefits are treated more than one way

47 Blank & Tarquin: 5th Edition. Ch. 9 Authored by:

Dr. Don Smith, Texas A&M University.
 9.2 Handling Disbenefits

1.  Disbenefit values are subtracted from

benefits
2.  Disbenefit values are added to costs
3.  Either approach will result in a consistent
analysis – but be consistent throughout an
analysis

48 Blank & Tarquin: 5th Edition. Ch. 9 Authored by:

Dr. Don Smith, Texas A&M University.
 9.2 Decision Rule

•  IF B/C ratio (=>) 1.00

•  Conditionally accept the alternative
•  IF B/C ratio (<) 1.00, conditionally reject the
alternative
•  IF B/C ratio “close” to 1.00, then intangible
factors may sway the decision to accept or
reject

49 Blank & Tarquin: 5th Edition. Ch. 9 Authored by:

Dr. Don Smith, Texas A&M University.
 9.2 Conventional B/C Ratio

•  The conventional B/C Ratio is:

Benefits - disbenefits B − D
B/C = =
Costs C

50 Blank & Tarquin: 5th Edition. Ch. 9 Authored by:

Dr. Don Smith, Texas A&M University.
 9.2 Modified B/C Ratio

•  Modified B/C subtracts the maintenance and

operations costs in the numerator

Benefits - disbenefits-M&O costs

B / Cmodified =
Costs

51 Blank & Tarquin: 5th Edition. Ch. 9 Authored by:

Dr. Don Smith, Texas A&M University.
 9. 2 Convention vs. Modified?

•  It makes no difference which approach is

used
•  However, the ratio values will differ
(magnitude)
•  But, the same absolute (accept/reject)
decision will be the same

52 Blank & Tarquin: 5th Edition. Ch. 9 Authored by:

Dr. Don Smith, Texas A&M University.
Benefit-Cost Ratio Analysis
Example:
Two mutually exclusive alternative as follows

Year Alternative 1 Alternative 2

0 -$10 -$20
1 +15 +28

Any money not invested here may be invested

elsewhere at the MARR of 6%. If you can only
choose one alternative one time, which one you
select
Benefit-Cost Ratio Analysis
Alternative 1:

PW of cost = $10
PW of benefit = $15(P/F,6%,1) = 15(0.9434) = $14.15
PW of benefits
BCR = = 1.415
PW of cost
Alternative 2:

PW of cost = $20
PW of benefit = $28(P/F,6%,1) = 28(0.9434) = $ 26.42
PW of benefits
BCR = PW of cost = 1.321
Benefit-Cost Ratio Analysis
Incremental BCR
Year Alternative 1 Alternative 2 Alt. 2 – Alt. 1
0 -$10 -$20 -$20 – (-$10 ) = -$10
1 +15 +28 +$28 – (+$15) = $13

ΔPW of cost = $10

ΔPW of benefit = $13(P/F,6%,1) = 13(0.9434) = $12.26
PW of benefits
ΔBCR = = 1.226
PW of cost
ΔBCR (alt. 2 - alt. 1) > 1 choose alt. 2
Choosing an Analysis Method
l  MARR should be set before choosing any analysis
method
l  PW analysis & Annual cash flow analysis often
require far less computation than ROR analysis
l  Depend on company policy
TUGAS INDIVIDU
l  BUAT RINGKASAN TENTANG INFLASI
(EFFECTS OF INFLATION) DAN BERI
CONTOH KASUS PENGGUNAAN ASPEK
INFLASI PADA ANALISA EKONOMI TEKNIK
l  Minimal 3 halaman kertas A4
l  Tulis referensi yang digunakan
l  DIKUMPUL: 27 APRIL 2018 (via SCELE)
l  PR soal tentang ROR dan BCR akan
diberikan via SCELE