Lecture # 21

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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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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 Recap

• IRR as project evaluation and selection tool

• Decision Guidelines
Accept if => Economically Viable
Reject if => Economically Not Viable

• IRR is the rate at which , or or

• IRR is simple to calculate for Conventional Cash Flow Series
Possibility of Multiple IRRs
Conventional vs. Non-conventional cash flows
• Conventional Cash Flows: Sign on the net cash flows changes only once
=> Unique IRR

• Non-conventional Cash Flows : Sign on the net cash flows changes more
than once.
=> possibility of multiple IRRs.

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Conventional Cash Flow – Example

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Non-Conventional Cash Flow – Example
Special Considerations for IRR
Multiple Values:
• There may be more than one values.

Reinvestment at IRR:
• PW and AW: Net positive investment is reinvested at the MARR. [realistic]
• IRR: reinvestment at the rate. [sometimes unrealistic if is substantially larger
than MARR]
=>In such cases, the value is not a good basis for decision making. 

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Multiple IRR Values
• Conventional if only one sign change in the net cash flows => Unique IRR
• Non-conventional if more than one sign changes in the net cash flows =>
possibility of multiple IRRs

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How to Solve Multiple IRR Problems?
• Multiple IRR problem can be solved by using  external information. i.e.
information not given in the Cash flow.
• Additional information comes from “outside” the cash flows from which
IRR was calculated. Therefore, the IRR is then called External Rate of
Return (ERR).
• Therefore, ERR refers to IRR that had two values and are converted to
“single value” using some additional external information.

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Additional Information
We use two more types of interest rates
• Investment rate ii is the rate at which extra funds are invested in some
source external to the project. This applies to all positive annual NCF. It is
reasonable that the MARR is used for this rate.

• Borrowing rate ib is the rate at which funds are borrowed from an external
source to provide funds to the project. This applies to all negative annual
NCF. The weighted average cost of capital (WACC) can be used for this
rate.
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Solving Multiple IRR values problems
• Multiple IRR values problem can be solved by calculating External Rate
of Return
• There are two approaches to determine External Rate of Return (ERR)
1. Modified Rate of Return (MRR)
2. Return on Invested Capital (ROIC) 

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Modified Rate of Return Approach (MRR)
Four Steps Procedure:
1. Determine PW in year 0 of all negative CF using
2. Determine FW in year n of all positive CF using
3. Calculate by .
4. If , project is economically justified.

Note: This procedure gives rate of return which is known as External

Rate of Return, and is then compared with MARR for checking the
economic viability of the projects.
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 Example: ERR Using MRR Method

• For the NCF shown below, find the ERR by the

Modified Rate of Return (MIRR) method if and

Year 0 1 2 3
NCF +2000 -500 -8100 +6800
Since of 9%, project is justified
Return on Invested Capital Method

• Measure of how effectively project uses funds that remain internal to project,
ROIC rate (i’’) is determined using net-investment procedure.
Three step Procedure:
1. Develop series of FW relations for each year using t:
where;
if (inflow)
and if (outflow) (for this ...i.e. ROIC is used)

2. Set future worth relation for last year equal to 0 (i.e., ); solve for
3. If , project is justified; otherwise, Reject
Example: ROIC Method
For the NCF shown below, find the ERR by the ROIC) method if and
Year 0 1 2 3
NCF +2000 -500 -8100 +6800

Year 0:  F0= +$2000                                      F0> 0; invest in year 1 at ii = 12%

Year 1: F1= 2000(1.12)‒500 = +$1740      F1> 0; invest in year 2 at ii= 12%
Year 2: F2= 1740(1.12)‒8100 = ‒$6151 F2< 0; use i’’ for year 3 
Year 3: F3= ‒ 6151(1 + i’’) + 6800 Set F3= 0 and solve for i’’
‒ 6151(1 + i’’) + 6800 = 0
i’’= (6800/6151) –1 
i’’= 10.55%
Since i’’ > MARR of 9%, project is justified
 Quick Check
For the cash flow series below, calculate the external rate of return, using the
return on invested capital (ROIC) approach with an investment rate of 14%
per year.
 Solution

Apply the ROIC procedure with F2 = 1420(1 + 0.14) + 1000

= 2618.80 F2 > 0; use ii

ii = 14%.
F3 = 2618.80(1 + 0.14) – 6000
Step 1:
= -3014.57 F3 < 0; use i″
F0 = 3000 F0 > 0; use ii
F4 = -3014.57(1 + i″) + 3800
F1 = 3000(1 + 0.14) - 2000 Step 2:

= 1420 F1 > 0; use ii Set F4 = 0 and solve for i″

0 = -3014.57(1 + i″) + 3800

i″ = 26.1% per year
Five years ago, a company made a $500,000 investment in a new
high-temperature material. The product did poorly after only 1
year on the market. However, with a new name and advertising
campaign 4 years later it did much better. New development
funds have been expended this year (year 5) at a cost of $1.5
million. Determine the external rate of return using the ROIC
approach and an investment rate of 15% per year. The i * rate is
44.1% per year.

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Solution

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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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