Lecture # 19

Engineering Economics (MS-291)

Chapter 7
Rate of Return Analysis: One Project

Dr. Muhammad Ullah

Assistant Professor
Department of Management Sciences GIKI
Learning Outcomes
• Understand meaning of ROR
• Calculate ROR for cash flow series
• Understand difficulties of ROR
• Determine multiple ROR values
• Calculate External ROR (EROR)
• Calculate yields for bonds

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 Present Worth Analysis
Present Worth = Sum of Present Worth of all cash inflows and cash
outflows.
Decision guidelines:
Accept if
: The project just meets the expectation of MARR
: The project exceeds the expectation of MARR

Reject: if
: The project does not meet the expectation of MARR

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 Rate of Return (ROR)
• ROR may be considered a relative measure, while PW and AW are
absolute measures
• The rate of return is the interest rate that makes the present worth or
annual worth of a cash flow series exactly equal to 0.
• The ROR is known by other names such as the internal rate of return
(IRR), which is the technically correct term, and return on investment
(ROI).
• The most commonly quoted measure of economic worth for a project or
alternative is its rate of return (ROR).
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 Internal Rate of Return (IRR)

Two definitions
1. IRR is the rate at which we just recover the total cost, i.e. the rate that
equates “Sum of Present Worth of Cash inflows” to “Present worth of
Cash Outflows”.
2. IRR is the rate at which the net PW/FW/AW becomes Zero.

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PW and IRR
Decision Guideline IRR

is the minimum attractive rate of return; therefore, it serves as a hurdle rate/ cut-
off rate / benchmark rate.
=> So, firms compare with .
Guidelines
Accept if => Economically Viable
Reject if => Economically Not Viable
These criteria guarantee that the selected alternative will earn at least its required
return.
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Why compare IRR with MARR?

• MARR is a minimum rate of return that the company want to earn at least
on its projects. It’s also called hurdle rate , benchmark rate or cutoff rate.

• IRR is the breakeven rate of return for the firms. That’s why they  compare
it with MARR because IRR equates PW of Inflow to PW of Outflows.

• In USA about 75% firms use IRR for evaluating their financial projects.

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IRR is Relative Measure
• We used MARR to calculate PW, AW in actual monetary units, say, dollars
or euros. => PW and AW are absolute measures.
• MARR is established independent of any particular project’s cash flows.
• For the IRR values are calculated by using only the cash flows themselves of
a particular project/alternative.
• IRR is shown as a percentage => IRR is a relative measure.
• Since, IRR depends only on the cash flows of the project/alternative itself,
the correct term for it is internal rate of return (IRR); however, the term ROR
is used interchangeably.
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Calculating IRR
Methods for Calculating IRR
• Microsoft Excel
– Visual
– Spreadsheet Function
– Solver
• By hand using interpolation/trial-and-error
Example
Engineers with Monarch Paints have recommended to management an
investment of $200,000 now in novel methods 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
using manual solutions.
Cash Flow Diagram
Cash Flow Diagram

IRR is the rate at which

How do we solve for
IRR is the rate at which

• Solution through:
– Microsoft Excel
o Visual
o Spreadsheet Function Refer to Excel
Sheet
o Solver

– By hand using Interpolation/Trial-and-Error Method

By Hand: Trial-and-Error
 How do we choose the 1st trial?

• Combine all inflows and

Outflows
• Ignore time value of money

Outflow = -200,000
Inflows=300,000+15,000 x 10 = 450,000

200,000=450,000(P/F,i, n) => (P/F,i, n) = 0.44

For n=10, the rate for which the P/F factor comes close to 0.44 is 9% i.e. (P/F,9%, 10)=0.4224
First Trial is 9%

For (Try a higher and are inversely related)

For
Interpolation

9% 22,986 For
𝒙 𝟐𝟐,𝟗𝟖𝟔
2% IRR
For
0 28,988

11% -6,002

How to remember?

=> Please note that 10.58% is an approximation

 Thank You

Any Questions?
Email: Muhammad.ullah@giki.edu.pk
References
• Engineering Economy 7th Edition by Leland Blank, Anthony Tarquin
[ISBN-10: 0073376302] and accompanying PowerPoint slides

• Videos from Dragon’s Den are copy righted. We are using it only for
educational purposes.

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