Rate of Return Calculations

Comparison of alternatives
Same Life
Comparing Alternatives

Present Worth
Comparisons LCM
Different Life

Planning Horizon

Infinite life Capital Cost

Comparison
Rate of Return
Analysis
Rate of Return
Analysis
Introduction
• If you earn Rs. 110 in one year over an investment
of Rs. 100, how much is rate of return on the
investment?

• If you earn 210 in one year over an investment of

Rs. 200, how much is rate of return on the
investment?
How to calculate IRR
• Draw the cash flow diagram
• Get all the positive cash flows (benefits) and
negative cash flows (costs
• Find the interest rate “i” such that
• PW of costs = PW of benefits
• Net present worth = 0
• EUAB – EUAC = 0
• PW of costs / PW of benefits = 1
Example
• Rs 8200 investment is returned at Rs. 2000 per year
over 5 years. What is the rate of return on the
investment?

• PW of costs = Rs. 8200

• PW of benefits = Rs. 2000 (P/A, i, 5)

• PW of costs = PW of benefits
• 8200 = 2000 (P/A, i, 5) => (P/A, i, 5) = 4.1
Internal Rate of Return
definition

Internal rate of return is the rate of return paid on the

unrecovered balance of an investment such that the
equivalent sum of all the cash flows become zero.
 IRR explained
Year Cash flow Unrecovered 7% return Investment Unrecovere
Investment at on repayment d
the beginning of unrecovere at the end investment
the year d of year at the end
investment of year

0 -8200

1 +2000 8200 574 1426 6774

2 +2000 6774 474.18 1525.82 5248.18

3 +2000 5248.18 367.37 1632.63 3615.55

4 +2000 3615.55 253.09 1746.91 1868.64

5 +2000 1868.64 130.80 1869.19 -0.55*
Example
• A Rs. 700 investment gives cash flows of 100 in year 1,
175 in year 2, 250 in year 3, 325 in year 4. Compute the
rate of return?

• EUAB – EUAC = 0
• 100 + 75(A/G, i, 4) – 700 (A/P, i, 4) = 0
• Which “I” will solve this equation?
• The solution for IRR is iterative
• Excel can solve it for you easily.
• Ans: i = 7%
Solving for IRR
• It is an iterative process
• How to choose initial IRR
• By trial and error
• Aggregate all future disbursements and treat is as one
future value at the end of the project (thumb rule!)
Example
• An investment of Rs. 5000 now would give me an
income of Rs. 100 per year for 10 years and Rs.
7000 at the end of 10 years. What is IRR?

• What are all the future disbursements?

• Rs. 100 X 10 + Rs. 7000 = Rs. 8000
• If we equate Rs. 5000 = Rs. 8000 (P/F, i, 10)
(P/F, i, 10) = 0.625
Get the initial estimate of I
Ans: i = 5.16%
Some points on IRR
• What value of “i” is good?
• MARR – Minimum Attractive Rate of Return

• How can I compare multiple alternatives?

• Is IRR better or worse than PW comparisons?
Minimum Acceptable Rate of
Return (MARR)
• Lower limit of investment acceptability set by an
organization
• Usually a rate above the cost of capital. Includes
the desirable profit to the organization as well.
Advantages of IRR
• Single number
• No controversy in choosing the interest rate.

• Can we choose an alternative based on IRR alone?

How do you choose among
alternatives A and B?
• If your MARR is 10%, you have Rs. 100 to invest.
Project A requires an investment of Rs. 100 and
gives you Rs. 120 at the end of one year. Project B
requires an investment of Rs. 50 and gives you Rs.
65 at the end of one year, which project will you
choose?
What should I do in this case?
• Perform an incremental rate of return analysis.
• Calculate the net cash flows as difference between
two alternatives in question.

Project A Project B Net

-100 -50 -50
120 65 55
Incremental Rate of Return
(IROR) Analysis
• No organization has all the funds required to
entertain all competing proposals.
• Sometimes it might be physically impossible to
select multiple alternatives
• Each of this alternatives might be individually
attractive (IRRoption > MARR)
• How to choose among the various alternatives and
allocate the budget?
IROR of cost only alternatives
• Consider the net cash flows directly.
• We are looking at the savings gained by additional
initial investment in a larger initial cost option
• If the savings we achieve are earning us a return
greater than MARR, we choose the higher initial
cost alternative.
• Otherwise, the lower one should be choosen.
Incremental Rate of Return
(IROR)
• Your MARR is 15%
Net Cash Flows – Draw the
Cash Flow Diagram

Calculate IRR = 12.65% < MARR hence select Eqpt A

What if we have more than 2
alternatives?
• MARR = 10%
Solution
• Arrange in the increasing order of initial costs.
• Calculate IRR for Option C
• If IRR>MARR than Option C is defender or else it is
eliminated.
• IRR for C = 9.63% < MARR => Eliminate C
• Consider IRR of A
• IRR(A) = 10.49% > MARR => A is defender
• Compare B to A by net cash flows
• IROR(B over A) = 17.28% => Choose B as defender now
• Compare D over B by net cash flows
• IROR(D over B) = 8.55% < MARR => Choose B only.
Example #1
Project 0 1 2 3 4
X -1000 100 350 600 850
Y -1000 1000 200 200 200

Choose which project is better when MARR is 10%.

PWx = 411.52, PWy = 361.34 IRRx = 23.4%, IRRy = 34.36%

 IRR assumes re-investment of cash flows at the same IRR.

Ex #2 Sometimes, this may not be possible with high IRRs

A
21970

0 1 2 3
10,000

13,000 B

10,000 MARR = 15%

 Ex #3a

330 132.825

0 1 2 3
100 362.75

i=?