Engineering

Economics
Module No. 10
Rate of Return

By
Muhammad Shahid Iqbal

Introduction of Rate of Return

The internal rate of return (IRR) is a rate of return used in capital

budgeting to measure and compare the profitability. Internal rates
of return are commonly used to evaluate the desirability of
investments or projects. The higher a project's internal rate of
return, the more desirable it is to undertake the project.
Assuming all other factors are equal among the various projects,
the project with the highest IRR would probably be considered the
best and undertaken first.
In the context of savings and loans the IRR is also called the
effective interest rate.
The term internal refers to the fact that its calculation does not
incorporate environmental factors.
An investment is considered acceptable if its IRR is greater than an
established cost of capital.

Break-Even Interest Rate

The IRR on an investment or project is the "annualized effective
compounded return rate" or discount rate that makes the net present
value of all cash flows (both positive and negative) from a particular
investment equal to zero.
Rate of return (ROR) is the break-even interest rate, i*, which
equates the present worth of a projects cash outflows to the present
worth of its cash inflows.
Mathematical Relation:

PW (i* ) = PW (i* ) cash inflows - PW (i* ) cash outflows = 0

Example: A bank lends $10,000 and receives annual repayment of
$4,021 over 3 years. what is ROR?

PW(i%) = -10,000 + $4,021(P / A,10%,3) = 0

Rate of Return
The first step is to find the net present worth of the cash flows:
PW = - P + R1/(1 + i)1 + R2/(1 + i)2 + .+ Rj/
(1 + i)j +.+ Rn /(1 + i)n + S/(1 + i)n
P = Initial investment
Rj = Net revenue at the end of jth year.

S = Salvage value at the end of nth year.

In this analysis expenditures are always assigned negative
sign and revenues/inflows are assigned positive signs.
The above function is to be evaluated for different values of
I until the present worth function reduces to zero.

Rate of Return

Using Trial and Error: The general procedure of using a

PW-based equation is as follows:
Draw a cash flow diagram.
Set up the rate of return equation
Select values of i by trial and error until the equation
is balanced.
1.
The NPV is calculated using discount rate r.
2.
If the NPV is close to zero then r is the IRR.
3.
If the NPV is positive r is increased.
4.
If the NPV is negative r is decreased.

Rate of Return Decision Rules

IRR I L +
Criterion for a
Single Project:
If IRR > MARR,
accept the project.
If IRR = MARR,
remain indifferent.
If IRR < MARR,
reject the project.

PWL
PWL -PWH

(I H -I L )

Decision

PW i =$1,250,000+$731,500 P A, i,15
$80,000(P / F,i,15)
=0
i*
Since i* >MARR(18%), accept the investment.

Rate of Return Decision Rules

A person is planning a new business. The initial outlay

and cash flow pattern is given below. The expected life of
business is five years. Find the rate of return for the new
business.

Period

Cash
flow

100,000

30,000

30,000

30,000

30,000

30,000

Rate of Return

A company is trying to diversify its business in a new

product line.
The life of the project is ten years with no salvage value at
the end of its life.
The initial outlay of the project is Rs. 20,00,000.
The annual net profit is Rs. 3,50,000.
Find the rate of return for the new business.

Rate of Return

A firm has identified three mutually exclusive investment

proposals whose details are as follows. The life of is five
years with negligible salvage value. The minimum
attractive rate of return is 12%.
Alternative
A1

A2

A3

Investment

1,50,000

2,10, 000

2,55,000

Ann. Net Income

45,570

58,260

69,000

Find the best alternative based on the rate of return

comparison.

Rate of Return

For the cash flow diagram shown in Fig. Compute the

rate of return.

1,250

150

300

450

600

750

Rate of Return

A company is planning to expand its present business. it

has two alternatives, the corresponding cash flows are
given below. Each alternative has a life of five years and
negligible salvage value. The minimum attractive rate of
return is 12%. Suggest the best alternative.
Initial Investment

Yearly revenue

Alternative 1

5,00,000

1,70,000

Alternative 2

8,00,000

2,70,000

Rate of Return

Engineers with Monarch Paints have recommended an investment of

$200,000 now that will reduce the amount of wastewater, packaging
materials and other solid waste in their consumer paint manufacturing
facility. Estimated savings are $15,000 per year for each of the next 10
years and an additional savings of $300,000 at the end of 10 years in
facility and equipment upgrade costs. Determine the rate of return?
PW = - 200,000+15,000(P/A,9%,10)+300,000(P/F,9%,10)
PW = 22,986
The result is positive, indicating that return is more than 9%. Try i = 11%.
PW = - 200,000+15,000(P/A,11%,10)+300,000(P/F,11%,10)
PW = - 6002
Interest rate of 11% is too high, linearly interpolate between 9% and 11%.

Other Computational Methods

Direct Solution Direct Solution Trial & Error
Method
Log
n

Project A

Quadratic
Project B

Project C

-$1,000

-$2,000

-$75,000

1,300

24,400

1,500

27,340

1,500

55,760

Direct Solution Methods

Project A
$1,000 $1,500(P / F,i,4)
$1,000 $1,500(1 i)4
0.6667 (1 i)4
ln0.6667
ln(1 i)
4
0.101365 ln(1 i)
e0.101365 1 i
i e0.101365 1
10.67%

Project B

$1,300 $1,500
PW(i) $2,000

0
2
(1 i) (1 i)
1
Let x
, then
1 i
PW(i) 2,000 1,300x 1,500x2
Solve for x:
x 0.8 or -1.667
Solving for i yields
1
1
0.8
i 25%, 1.667
i 160%
1 i
1 i
Since 100% i , the project's i* 25%.

Trial and Error Method Project

Step 1: Guess an interest

rate, say, i = 15%
Step 2: Compute PW(i)
at the guessed i value.
PW (15%) = $3,553

Step 3: If PW(i) > 0, then

increase i. If PW(i) <
0,
then decrease i.
PW(18%) = -$749

Note: This method works only

for finding i* for simple investments.

Step 4: If you bracket the

solution, you use a linear
interpolation to
approximate
the solution
$3,553
0
-$749
15%

18%

3,553

i 15% 3%

3,553 749
17.45%