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economics engineering

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You are on page 1of 38

Analysis

Suppose that a bank lends $10,000 and it is repaid

$4021 at the end of each year for 3 years.

How can be the interest rate determined that the

bank charges on this transaction?

P = A (P/A, i, 3)

$10,000 = $4021 (P/A, i, 3)

i = 10%

The bank will earn 10% return on its investment of

$10,000.

The bank calculates the loan balances over the life of loan

as follows.

at unpaid balance Received balance at

Beginning year (10%) End of year

0 - $10,000 $0 $0 - $10,000

1 - $10,000 - $1,000 $4021 - $ 6979

2 - $ 6979 -$ 698 $4021 - $3656

3 - $3656 - $366 $4021 0

additionally provide a return of 10% on the amount still

outstanding each year.

If we calculate the PW of the loan transaction

at its rate of return (10%). We see,

It indicates that,

The bank can break even at a 10% rate of

interest.

Rate of return becomes the rate of interest

that equates the present value of future cash

repayments to the amount of loan.

Investment Balance Diagram

11,000

4021

project balance

7677

Un recovered

4021

10,000

4021

6979

4021

3656

years

0 1 2 3

Rate of Return is the break even interest rate (i*) which

equates the present worth of Projects cash outflows

to the present worth of its cash inflows.

PW (i*) =0

PWcash inflow PWcash outflow = 0

rate of interest that equates the present worth, future

worth, and annual equivalent worth of the entire

series of cash flow to zero.

PW (i*) =0

FW (i*) =0

AW (i*) =0

PW inflow

i*

0 i

PW outflow

What is IRR?

The discounted rate that equates the present

value of a projects expected cash inflows to

the present value of the projects costs

What is IRR?

The discount rate

which sets the

NPV of all cash

flows equal to 0.

Helps to

determine the

YIELD on an

investment.

How do we calculate IRR?

NPV = Net Present Value of the project

Initial Investment

Ct=Cash flow at time t

IRR = Internal Rate of Return

Calculating IRR

Set the NPV = 0

Plug in your Cash Flows & Initial

Investment

Solve for IRR!

This is the same equation used for NPV,

except you know your interest rate, i.

So now what?

Once youve calculated IRR

If IRR is greater than the cost of capital, then youve

got a GOOD project on your hands (go for it!).

If IRR is less than the cost of capital, then youve got

a BAD project on your hands (dont undertake the

project).

If the IRR and cost of capital are equal, then you

should use another method to evaluate the project!

Basically, the higher the IRR, the better the project

Simple vs. non Simple investment

is negative.

Only two sign changes occurs in the net cash flow

series.

A non simple investment is one in which more than

two sign change occurs in the cash flow series.

Example

Type

0 1 2 3 4 5

Simple - + + + + +

Simple - - + + 0 +

Non Simple - + - + + -

Non simple - + + - 0 -

Method of finding i*

Direct Solution Method

Trial and error method

Computer Solution method

Direct Solution Method

with only a two-flow transaction (an

investment followed by a single future

payment) or service life of 2 years of

return, we can apply direct

mathematical solution for determining

the rate of return.

Numerical

Consider two investment projects with the following cash

flow transactions. Compute the rate of return for each project.

(n)

0 - $1,000 -$2,000

1 $0 $1,300

2 $0 $ 1,500

3 $0

4 $1500

Solution

PROJECT 1

FW (i*) =0

FWinflow FWoutflow =0

$1500 - $1,000(F/P,i*,4) = 0

1.5 = (1+i*)4

Solving for i*,

i* =

4

1.5 1

i* = 0.1067 = 10.67%

PROJECT 2

PW (i*) =0

-$2000 + $1300 + $1500 = 0

(1+i*) (1+i*)2

Let, 1/ (1+i*) =X

Solving for X, we get 0.8 or -1.667

i* = 25% and -160%

Since -160% has no economic significance, we

choose i*=25%

Trial and error method

The general procedure of using a PW-

based equation is:

Draw a cash flow diagram

Set up the rate of return equation.

Select values of rate of return by trial

and error until the equation is balanced.

DECISION RULE

To choose the alternative, the calculated rate of return

must be compared with MAAR.

IRR = MARR, remains indifferent

IRR < MARR, reject the project

Numerical

A piece of new equipment has been purposed by

Engineers to increase the productivity of a certain

manual welding operation. The investment cost is

$25000 and equipment will have a salvage value of

$5000 at the end of its expected life of five years.

Increased productivity attribution to the equipment will

amount to $8000 per year after extra operating cost have

been subtracted from the value of additional production.

Evaluate the IRR of purpose equipment. Is the

investment a good one? Recall the MARR is 20% per

year.

Solution:

Numerical

Agdist Corporation distributes agricultural equipment.

The board of directors is considering a proposal to

establish a facility to manufacture an electronically

controlled intelligent crop sprayer invented by a

professor at a local university. This crop sprayer

project would require an investment of $10 million in

assets and would produce an annual after tax net

benefit of $1.8million over a service life of 8 years.

When the project terminates, the corporation would

earn $1 million from the assets. Compute the Internal

rate of return generated by this project, if the

corporation MARR is 10%. Should the corporation

accept this project? Show the investment balance

diagram also.

Step 1 Cash Flow Diagram

$1

0 1 2 3 4 5 6 7 8

$ 10

Step 2 Setting up rate of return equation

PW (i*) = 0

PW inflow PW outflow = 0

1.8 (P/A, i*%, 8) + 1 (P/F, i*%, 8) -10 = 0

Lets select interest rate = 8%

PW (8%) = 1.8 (P/A, 8%, 8) + 1 (P/F, 8%, 8) 10 = $ 0.88

Since PW is positive, the value of i is raised,

Lets suppose interest rate =12%

PW (12%) = 1.8 (P/A, 12%, 8) 1 (P/F, 12%, 8) 10 = - $ 0.65

By linear interpolation,

i* = 10.30%

The value of i* lies between 8% and 10.30%.

By linear interpolation,

i* = 10.18%

PW (10.18%) = 1.8 (P/A, 10.18, 8) +1(P/A, 10.18, 8) 10 = $ 0.0007

11.018

Un recovered project balance

1.8 10.156

9.207

1.8

8.161

1.8

9.218

$ 10

8.356 7.008

1.8

7.407 5.738

1.8

6.361 4.339

1.8

5.208

2.8

1.8

3.938

2.539

2.8

0 1 2 3 4 5 6 7 8

Years

DRAWBACKS OF IRR

The recovered funds are re-invested at i*% rather

than MARR, which leads to the concept of

External rate of return (ERR).

It needs trial and error approach for the

calculation.

If the algebraic sum of the cash flow changes in

the middle of the project more that two times, we

might obtain multiple IRR.

When choosing between the mutually exclusive

alternatives, IRR method can be misleading and

does not compare the scale of investment.

EXTERNAL RATE OF RETURN/

MODIFIED IRR

The drawback of the IRR method (reinvestment

assumption) may not be valid in the engineering economy.

For example, if a firms MARR is 20% per year and the

IRR for a project is 42.4%, it may not be possible for the

firm to reinvest net cash proceeds from the project at

much more than 20%.

This situation, coupled with the computational demands

and possible multiple interest rates associated with the

IRR method, has given rise to other rate of return methods

that can remedy this weakness which is referred as

External rate of Return or Modified IRR.

The External Rate of Return (i) is the

unique rate of return for a project that

assumes that net positive cash flows, which

represent money not immediately needed by

the project, are reinvested at the

reinvestment rate %.

The reinvestment rate depends upon the

market rate available for investments.

Steps of ERR Calculation

zero (present) at % per compounding

period.

All cash inflows are Compounded to period

N at %

ERR is the interest rate that equivalence

between the two equation.

N

i Rk (F/P, %, N-k)

k o

Rk

0 k N

Ek

k o

Ek (P/F, %, k)

Ek (P/F, %, k) (F/P, i, N) = Rk (F/P, %, N-k)

Where,

Rk = receipts in period k

Ek = expenditures in period k

N = project life or number of study period

% = external reinvestment rate per period.

Accept /Reject Decision Rule

ERR = MARR, remain indifferent

ERR < MARR, reject the project

Numerical

Consider the following cash flow of the project

RS 6000

0 1 2 3 4 5 6

RS 1000 RS 1000

RS 5000

reinvestment rate % =15%. Is the project accepted?

Solution

Discounting all the cash outflows to the time zero at

15%.

1,000 + 5,000 (P/F, 15%, 1)

= 1,000 + 5,000 (1+0.15)-1 = 5,347.82

Compounding all the cash inflows to the year 6 at 15%

5,000 (F/A, 15%, 5)

= 5,000 {(1.15)5 -1 / 0.15} = 33,711.90

Establishing the equivalence between the two

equation

5,347.82 (F/P, i, 6) = 33,711.90

5,347.82 (1+i) 6 = 33,711.90

(1+i) 6 = 6.303

i = 1.359 -1 = 35.91% is the ERR of the project.

Here ERR (35.91%) > MARR (20%), the project is accepted.

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