EKONOMIKA TEKNIK

Rate of Return Analysis

What have we learnt so far?

Three major methods of economic analysis

(1) Present Worth Analysis
(2) Annual Cash Analysis
(3) Rate of Return Analysis

Before we go into Rate of Return Analysis, it is

important to know the concept of Rate of Return
and MARR.

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 Rate of Return (1)
Rate of return is the return that a company would earn if it
invested in itself, rather than investing that money elsewhere.

Take a look at this example :

In October 1, 1970, when Wal-mart Stores Inc. went public,
an investment of 100 shares cost $1,650. That investment
would have been worth $9,113,600 on September 30, 2006.

What is the rate of return on that investment?

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 Rate of Return (2)
Finding the Unknown Interest Rate

Given : P = $1,650

F = $9,113,600

n = 36

Find i : F = P (1 + i)n

i = 27.04%

i = 27.04%  Rate of return

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 Rate of Return (3)
If you invested the $1,650 in a savings account, how
much would you have 36 years later?

Suppose that you invested that amount ($1,650)

in a savings account at 6% per year. Then, you
could have only $13,443 in September, 2006.

What is the meaning of this 6% interest here?

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 Rate of Return (4)
In 1970, as long as you earn more than 6% interest
in another investment, you would take that
investment.

Therefore, that 6% is viewed as a minimum

attractive rate of return (MARR) or required rate of
return.

So you can apply the following decision rule, to see if

the proposed investment is a good one.

ROR (27,04%) > MARR (6%).

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Internal Rate of Return (1)
Definition from the perspective of loan :

Internal Rate of Return is defined as 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.

On the investment side :

Internal Rate of return is defined as the 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.

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 Internal Rate of Return (2)
An 8% rate of return is not the same as 8% annual return. Take
a look at this table.
Year Cash Flow Unrecovered 8% return on Investment Unrecovered
Investment at Unrecovered Repayment Investment
Beginning of Year Investment at the End of at End of
Year Year
0 -$5000
1 +1252 5000 400 852 4148
2 +1252 4148 331 921 3227
3 +1252 3227 258 994 2233
4 +1252 2233 178 1074 1159
5 +1252 1159 93 1159 0
1260 5000

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Internal Rate of Return (3)

Although, the two definitions of internal rate of return

are stated differently, one in terms of a loan and the
other in terms of an investment, there is only one
fundamental concept being described.

It is that the internal rate of return is the interest

rate at which the benefits are equivalent to the
costs or the present worth (PW) is 0.

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Calculating Rate of Return
• To calculate a rate of return on an investment, we must
convert the various consequences of the investment into a
cash flow. Then we solve the cash flow for the unknown
value of the Internal Rate of Return.

• Five form of cash equation :

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 Example-Calculating Rate of
Return (1)
An $8200 investment $2000 per year over a 5 year useful life.
What was the rate of return on the investment?

PWB/PWC = 1

2000(P/A, i, 5)/8200 =1

(P/A, i, 5) = 4.1
From Compound Interest Tables
Interest rate (P/A,i,5)

6% 4.212
7% 4.100
8% 3.993
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 Example-Calculating Rate of
Return (2)
An investment resulted in the following cash flow. Compute the
rate of return. Use fourth equation!

Year Cash Flow

0 -$700
1 +100
2 +175
3 +250
4 +325

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Example-Calculating Rate of
Return (3)

Sometimes we have more than one factor in our equation. When that happens we
cannot solve for just one factor.

If we use: EUAB - EUAC = 0

100 + 75(A/G, i, 4) - 700(A/P, i, 4) = 0

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 Example-Calculating Rate of
Return (4)
• No direct method for calculating. Use trial and error and iterate
to get answer.
• Try i = 5%:
100 + 75(A/G, 5%, 4) - 700(A/P, 5%, 4) = + 11
+ 11 is too high. The interest rate was too low

• Try i = 8%
100 + 75(A/G, 8%, 4) - 700(A/P, 8%, 4) = - 6
- 6 is too low. The interest rate was too high

• Try i = 7%
100 + 75(A/G, 8%, 4) - 700(A/P, 8%, 4) = 0
Therefore IRR = 7%

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 Plot of NPW versus Interest
Rate i (1)
For a cash flow representing investment
Year Cash followed by benefits from the investment,
Flow the plot of NPW versus i will decrease at
decreasing rate and have a zero value i (the
0 -P interest at NPW = 0)
1 +Benefit
A
2 +A
3 +A
4 +A
… …

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 Plot of NPW versus Interest
Rate i (2)
For borrowed money, the NPW plot will
Year Cash Flow increase at a decreasing rate and have a
zero value at unique value i (the interest
0 +P rate at NPW = 0)

1 +Repayment
A
2 -A

3 -A

4 -A

… …

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 Rate of Return Analysis (1)
Consider the following statements about a project :

1. The net present worth of the project is $32,000

2. The equivalent uniform annual benefit is $2,800

3. The project will produce a 23% rate of return

The third statement is perhaps the most understood since it gives measure
of desirability of the project in terms that are readily understood. Therefore
the rate of return analysis is probably the most frequently used analysis.

Another advantage to rate of return analysis is that no interest is introduced

in the calculations. Whereas both PW and annual cash flow require the use
of an interest rate, which might be difficult.

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 Rate of Return Analysis (2)
• In rate of return analysis, no interest is introduced into the
calculations. Instead we compute a rate of return (IRR) from
the cash flow.

• To decide how to proceed, the calculated rate of return is

compared with a preselected minimum attractive rate of
return (MARR).

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 Example-Rate of Return Analysis
in selecting alternatives (1)
You must select one of two mutually exclusive alternatives. The
alternatives are 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%. Which alternative would you select?

a) Using PW analysis

b) Using rate of return

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Example-Rate of Return Analysis
in selecting alternatives (2)
a) Using PW analysis:
Alt.1: NPW = 15(P/F, 6%, 1) – 10 = 15(0.9434) – 10 = 4.15
Alt. 2: NPW = 28(P/F, 6%, 1) – 20 = 28(0.9434) – 20 = 6.415
Based on the PW analysis one should select Alt. 2.

b) Using Rate of Return:

Alt. 1: PW of cost of Alt. 1 = PW of benefit of Alt. 1
10 = 15(1+ i )-1 ►► i = 50%
i.e. the rate of return for Alt. 1 is 50%

Alt. 2: PW of cost of Alt. 2 = PW of benefit of Alt. 2

20 = 28(1+ i )-1 ►► i = 40%
i.e. the rate of return for Alt. 1 is 40%

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Example-Rate of Return Analysis
in selecting alternatives (3)
Based on the rate of return results one should select alternative 1
which contradicts with the PW analysis results.

What should we follow; the PW analysis or the rate of return?

Since we know that the PW analysis is correct, the previous

example leads to to the conclusion that something went wrong in the
rate of return approach.

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Rate of Return Analysis (cont.)

• When there are two alternatives, rate of return

analysis is performed by computing the
incremental rate of return (∆IRR) on the
difference between the alternatives.
• The cash flow for the difference between the
alternatives is computed by taking the higher
initial-cost alternative minus the lower initial-cost
alternative.

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Rate of Return Analysis (cont.)
• If ∆IRR is the same or greater than the MARR, choose the
higher cost alternative. If ∆IRR is less than the MARR,
choose the lower cost alternative

Two-Alternative Situation Decision

∆IRR ≥ MARR Choose the higher cost
alternative
∆IRR < MARR Choose the lower cost
alternative

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 Example-Rate of Return Analysis
in selecting alternatives (4)
Lets go back to our example :
Year Alt. 1 Alt. 2 Alt.2 – Alt.1
0 -$10 -$20 -$20-(-$10) = -$10
1 +15 +28 +28 – (+15) = +13

For the cost of differences cash flow (Alt 2 – Alt 1), compute the IRR.

10 = 13 (P/F,i,1)  (P/F,i,1) = 0.7692

From the compound interest tables i = 30% and since ∆IRR ≥ MARR, choose
alternative 2 (the higher cost alternative).

The 30% rate of return on the difference between the alternatives is far
higher than the 6% MARR. In other words, the additional $10 investment at
(30% IRR) is superior to investing the $10 elsewhere at 6%.
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 Example-Rate of Return Analysis
in selecting alternatives (5)
A firm considering which of two devices to install to
reduce costs in a particular situation. Both devices
cost $1000, and both have useful lives of 5 years
and no salvage value. Device A can be expected to
result in $300 savings annually. Device B will provide
cost savings of $400 the first year but will decline
$50 annually, making the second year savings $350,
the third-year savings $300 and so forth. For a 7%
MARR, which device should the firm purchase?

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 Reference
• Newnan, Donald G; Eschenbach, Ted G; Lavelle, Jerome P. 2004.
Engineering Economic Analysis. 9th Edition. Oxford University Press, New
York.

• Pujawan, I Nyoman. Ekonomi Teknik. 2009. Guna Widya.Surabaya,

• Park, Chan S. 1997. Contemporary Engineering Economics. 2nd Edition.

Addison-Wesley.

• Sharma, Kal Renganathan. 2015. An Introduction to Engineering

Economics. Cognella Academic Publishing. San Diego

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