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**(Multiple Rates of Return Problem)
**

Lecture No. 20 Professor C. S. Park Fundamentals of Engineering Economics Copyright © 2005

000.Return on Invested Capital • Definition 3: Return on invested capital is defined as the interest rate earned on the unrecovered project balance of an investment project. It is commonly known as internal rate of return (IRR).021 over 3 years. .000 in a computer and results in equivalent annual labor savings of $4. • Example: A company invests $10. The company is said to earn a return of 10% on its investment of $10.

000 -$1. we call it internal rate of return.021 -$6.Project Balance Calculation: 0 Beginning project balance Return on invested capital Payment received -$10.000 balance The firm earns a 10% rate of return on funds that remain internally invested in the project.000 +$4.979 2 -$6.656 -$365 +$4.000 1 -$10. .021 -$3.021 0 Ending project -$10. Since the return is internal to the project.656 3 -$3.979 -$697 +$4.

how would you make an accept/reject decision? .Multiple Rates of Return If a project has more than one rate of return.

Example: -$100. and only than one sign changes one sign change in the remaining cash occurs in the net cash flow series. ROR: A possibility of +. +) multiple RORs ROR: A unique ROR .Investment Classification Nonsimple Investment Simple Investment Def: Initial cash flows Def: Initial cash flows are negative. but more are negative. -) $250. -$120 (-. flows series. Example: -$100. $300 (-. +. $300.

Project B is a nonsimple investment.000 -$1.000 -500 800 1. .145 +$1.Period Project A Project B Project C (N) 0 1 2 3 4 -$1. Project C is a simple borrowing.030 2.000 3.000 -450 -450 -450 Project A is a simple investment.500 2.900 -5.

320 $2. 300 PW ( i) = − $1.000 • Find the rate(s) of return: $1.300 $1.Example 7. 320 − 2 (1 +i ) .6 Multiple Rates of Return Problem $2. 000 + 1+ i =0 $1.

320 PW (i ) = −$1.300 $1.320 x 2 =0 Solving fo r x yields.1 Let x = .000 +$2 . x =10 / 11 or x =10 / 12 Solving fo r i yields i =10% or 20% .300 x −$1.000 + − (1 +i ) (1 +i ) 2 = −$1. 1 +i $2 . Then.

PW Plot for a Nonsimple Investment with Multiple Rates of Return .

100 n=2 +$1.000 Cash borrowed (released) from the project is assumed to earn the same interest rate through external investment as money that remains internally invested.100 +$220 -$1. .320 $0 -$1.000 -$200 +$2. Balance Interest Payment Ending Balance n=1 -$1.Project Balance Calculation i* =20% n=0 Beg.300 +$1.000 -$1.

the 20% is also true IRR for the project. In order to calculate i*. we assumed that all cash released from the project can be invested at the i* instead of MARR. Then. the answer is “yes”. • Conclusion: Neither 10% nor 20% is a true IRR.Conceptual Issue: Can the firm be able to invest the money released from the project at 20% externally in Period 1? • If the firm’s MARR is exactly 20%. • Suppose the firm’s MARR is 15% instead of 20%. The assumption used in calculating i* is no longer valid. . . because it represents the rate at which the firm can always invest the money in its investment pool.

000 + $2. 2 ) = $1. 1) .320 (P/F.$1. follow the procedure outlined in Appendix 7A. or use the Cash Flow Analyzer. 15%.300 (P/F.89 > 0 Accept the investment • If you want to find the true rate of return (or return on invested capital) to the project.How to Proceed: • If you encounter multiple rates of return. If NPW criterion is used at MARR = 15% PW(15%) = -$1. . 15%. abandon the IRR analysis and use the PW criterion.

Finding the True ROR for Nonsimple Projects with Cash Flow Analyzer MARR of 15% Nonsimple Investment Cash Flows 0 -$1.320 Return on invested capital 15.21% at MARR of 15% .000 1 2.300 2 -1.

Accept PW (i) i* i If PW(i) plot looks like this. PW (i) i* i* i . If PW (i) plot looks like this. then. Then.Decision Rules for Nonsimple Investment A possibility of multiple RORs. IRR = ROR. IRR ≠ ROR (i*). If IRR > MARR. • Find the true IRR by using the procedures in Appendix A or. • Abandon the IRR method and use the PW method.

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