Internal and External

Rate of Return
 Internal Rate of Return (IRR Method)
▪ This method solves for the interest rate that equates the equivalent
worth an alternative’s cash inflows (receipts or savings) to the
equivalent worth of cash outflows (expenditures, including invest
costs).

𝑁 𝑁
𝑃 ′ 𝑃 ′
෍ 𝑅𝑘 , 𝑖 %, 𝑘 = ෍ 𝐸𝑘 ( , 𝑖 %, 𝑘)
𝐹 𝐹
𝑘=0 𝑘=0
 Internal Rate of Return (IRR Method)

Where 𝑅𝑘 = net revenue or savings for the 𝑘 𝑡ℎ year;

𝐸𝑘 = net expenditures, including any investment costs for the
𝑘 𝑡ℎ year
N = Project file (study period)
i’ = IRR

IRR Decision Rule: If IRR ≥ MARR, the project is economically justified.

 Internal Rate of Return (IRR Method)
Ex. A piece of new equipment has been proposed by engineers to increase
the productivity of a certain manual welding operation. The investment cost
is $25,000, and the equipment will have a market (salvage) value of
$5,000 at the end of its expected life of five years. Increased productivity
attributable to the equipment will amount to $8,000 per year after the extra
operating costs has been subtracted from the value of the additional
production. Determine the IRR of the project. Is the investment a good
one? Recall that the MARR is 20% per year.
Internal Rate of Return (IRR Method)
 External Rate of Return (ERR Method)
▪ This method directly take into account the interest rate (∈) external to
a project at which net cash flows generated (or required) by the
project over its life can be reinvested (or borrowed).

𝑁 𝑁
𝑃 𝐹 ′ 𝐹
෍ 𝐸𝑘 ( , ∈ %, 𝑘) , 𝑖 %, 𝑁 = ෍ 𝑅𝑘 ( , ∈ %, 𝑁 − 𝑘)
𝐹 𝑃 𝑃
𝑘=0 𝑘=0
 External Rate of Return (ERR Method)
Where 𝑅𝑘 = net revenue or savings for the 𝑘 𝑡ℎ year;
𝐸𝑘 = net expenditures, including any investment costs for the
𝑘 𝑡ℎ year
N = Project file (study period)
∈ = external reinvestment rate per period

ERR Decision Rule: If ERR ≥ MARR, the project is economically

justified.
 External Rate of Return (ERR Method)
Steps in calculating the ERR:
1. All net cash outflows are discounted to time zero (the present) at ∈%
per compounding period.
2. All net cash inflows are compounded to period N at ∈%.
3. The ERR (i’), which is the interest rate that establishes equivalence
between the two quantities, is determined.
 External Rate of Return (ERR Method)
Ex. A piece of new equipment has been proposed by engineers to
increase the productivity of a certain manual welding operation. The
investment cost is $25,000, and the equipment will have a market
(salvage) value of $5,000 at the end of its expected life of five years.
Increased productivity attributable to the equipment will amount to
$8,000 per year after the extra operating costs has been subtracted
from the value of the additional production. Suppose that ∈ = MARR =
20% per year. What is the project’s ERR, and is the project acceptable.
External Rate of Return (ERR Method)