Engineering Economic Analysis

9th Edition

Chapter 7
RATE OF RETURN ANALYSIS

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 Three Major Methods of
Economic Analysis
• PW - Present Worth
• AW - Annual Worth
• IRR - Internal Rate of Return

If PW = A(P/A,i,n)
Then (P/A,i,n) = PW/A
Solve for (P/A,i,n) and look up interest in
Compound Interest Tables

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 Internal Rate of Return
Lender’s Viewpoint
• The interest rate on the balance of a loan
such that the unpaid loan balance equals
zero when the final payment is made.

Plan
Year A B C D
0 $ (5,000.00) $ (5,000.00) $ (5,000.00) $ (5,000.00)
1 $ 1,400.00 $ 400.00 $ 1,252.28 $ -
2 $ 1,320.00 $ 400.00 $ 1,252.28 $ -
3 $ 1,240.00 $ 400.00 $ 1,252.28 $ -
4 $ 1,160.00 $ 400.00 $ 1,252.28 $ -
5 $ 1,080.00 $ 5,400.00 $ 1,252.28 $ 7,346.64

IRR 8.00% 8.00% 8.00% 8.00%

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 Internal Rate of Return
Investor’s Viewpoint
• The interest rate earned on the unrecovered
investment such that the unrecovered
investment equals zero at the end of the life
of the investment.
Unrecovered
Return on Investment Unrecovered
investment at
Year Cash flow unrecovered repayment at investment at
beginning of
investment end of year end of year
year
0 ($5,000.00)
1 $1,252.28 $5,000.00 $400.00 $852.28 $4,147.72
2 $1,252.28 $4,147.72 $331.81 $920.47 $3,227.25
3 $1,252.28 $3,227.25 $258.18 $994.10 $2,233.15
4 $1,252.28 $2,233.15 $178.65 $1,073.63 $1,159.52
5 $1,252.28 $1,159.52 $92.76 $1,159.52 ($0.00)

IRR 8.00% Total $1,261.40 $5,000.00

Reset the cash flow to determine the IRR.

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 Calculating Rate of Return

• The IRR is the interest rate at which the

benefits equal the costs. IRR = i*
• PW Benefit - PW Cost = 0
• PW Benefit/PW Cost = 1
• NPW = 0
• EUAB - EUAC = 0
• PW Benefit = PW Cost

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 Calculating IRR

• PWB/PWC = 1
• 1252.28(P/A,i,5)/5000 = 1
• (P/A,i,5) = 5000/1252.28 = 3.9927
From Compound Interest Tables
Example 7-1
Interest rate (P/A,i,5)
7% 4.100
8% 3.993
9% 3.890
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 Calculating IRR
EUAB - EUAC = 0
100 + 75(A/G,i,4) - 700(A/P, i, 4) = 0
Look up and iterate, book answer is 7%
Example 7-2
Unrecovered
Return on Investment Unrecovered
investment at
Year Cash flow unrecovered repayment at investment at
beginning of
investment end of year end of year
year
0 ($700.00)
1 $100.00 $700.00 $48.37 $51.63 $648.37
2 $175.00 $648.37 $44.81 $130.19 $518.18
3 $250.00 $518.18 $35.81 $214.19 $303.99
4 $325.00 $303.99 $21.01 $303.99 $0.00
5 $0.00 $0.00 $0.00 $0.00 $0.00

IRR 6.91% Total $150.00 $700.00

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 Calculating IRR
Example 7-3 Unrecovered
investment at
Return on Investment Unrecovered
Year Cash flow unrecovered repayment at investment at
beginning of
investment end of year end of year
year
The 0
1
($100.00)
$20.00 $100.00 $13.47 $6.53 $93.47
iterations 2
3
$30.00
$20.00
$93.47
$76.07
$12.59
$10.25
$17.41
$9.75
$76.07
$66.32
may be 4
5
$40.00
$40.00
$66.32
$35.25
$8.93
$4.75
$31.07
$35.25
$35.25
($0.00)
graphed IRR 13.47% Total $50.00 $100.00
and the
true IRR Trial
interest NPW $60.00
will be rates $50.00
0 $50.00 $40.00
indicated 5 $26.46 $30.00
Net Present Value

10 $9.24 $20.00
at the point 15 ($3.49) $10.00
20 ($12.97) $0.00
where the 25 ($20.06) ($10.00) 0 5 10 15 20 25 30 35 40 45 50
30 ($25.37) ($20.00)
NPW 35 ($29.36) ($30.00)
40 ($32.34)
curve = 0.
($40.00)
45 ($34.54) ($50.00)
50 ($36.16)

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 Calculating IRR - Bond

Example 7-4a
Period rate
1000 = 40(P/A,i,2) + 950(P/F,i,2)
By lookup and interpolation i*  1.5%
Nominal rate = 2 x 1.5% = 3%
Effective rate = (1 + 1.5%)2 - 1 = 3.02%

An easier way > 7-4a & 7b

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 Rate of Return (ROR) Analysis

• Most frequently used measure of merit in

industry
• More accurately called Internal Rate of
Return (IRR)

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 Calculating ROR

• Where two mutually exclusive alternatives will

provide the same benefit, ROR is performed
using an incremental rate of return-DROR-on
the difference between the alternatives.
Two-alternative situation Decision

ROR MARR Choose higher-cost alternative

ROR MARR Choose lower-cost alternative

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 ROR on Alternatives with
Equivalent Benefits
Example 7-5 Cash flow on difference
Unrecovered
Return on Investment Unrecovered
Cash flow - Cash flow - Cash flow - investment at
Year unrecovered repayment at investment at
alternative A alternative B alternative B-A beginning of
investment end of year end of year
year
0 ($1,000.00) ($2,783.00) ($1,783.00)
1 $200.00 $1,200.00 $1,000.00 $1,783.00 $142.83 $857.17 $925.83
2 $200.00 $1,200.00 $1,000.00 $925.83 $74.17 $925.83 ($0.00)
3 $1,200.00 $1,200.00 $0.00 ($0.00) ($0.00) $0.00 ($0.00)
4 $1,200.00 $1,200.00 $0.00 ($0.00) ($0.00) $0.00 ($0.00)
MARR 5 $1,200.00 $1,200.00 $0.00 ($0.00) ($0.00) $0.00 ($0.00)

= 10% IRR/period 48.72% 32.60% 8.01% Total $217.00 $1,783.00

Trial interest
NPW
rates $300.00
0 $217.00 $200.00
5 $72.77
$100.00
Net Present Value

10 ($43.15)
15 ($136.77) $0.00
0 5 10 15 20 25 30 35 40 45 50
20 ($212.69) ($100.00)
25 ($274.40) ($200.00)
30 ($324.66)
($300.00)
35 ($365.60)
40 ($398.94) ($400.00)
45 ($426.01) ($500.00)
50 ($447.93)

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 Criterion Is to Maximize Return
Not ROR
Examples 7- 6, 7 & 8 Cash flow on difference

What Year
Cash flow - Cash flow - Cash flow -
Unrecovered
investment at
Return on
unrecovered
Investment
repayment at
Unrecovered
investment at
alternative A alternative B alternative B-A beginning of

happens to 0 ($10.00) ($20.00) ($10.00)

year
investment end of year end of year

NPW when
1 $15.00 $28.00 $13.00 $10.00 $3.00 $10.00 $0.00
2 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
3 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00

MARR is 4
5
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00
$0.00

varied? Try IRR/period

MARR =
50.00%
6.00 %
40.00% 30.00% Total $3.00 $10.00

NPW = $4.15 $6.42 $2.26

6, 30 & Trial interest

NPW

35%.
rates $3.50
0 $3.00 $3.00
5 $2.27 $2.50
Ne t Pre s e nt Value

10 $1.65 $2.00
15 $1.13 $1.50
20 $0.69 $1.00
25 $0.32 $0.50
30 $0.00 $0.00
35 ($0.27) ($0.50) 0 5 10 15 20 25 30 35 40 45 50
40 ($0.51) ($1.00)
45 ($0.71) ($1.50)
50 ($0.89)

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 Fixed Input and Differing Outputs
Example 7-9 Cash flow on difference

Choose the
Unrecovered
Return on Investment Unrecovered
Cash flow - Cash flow - Cash flow - investment at
Year unrecovered repayment at investment at
alternative A alternative B alternative B-A beginning of

ranking so
investment end of year end of year
year
0 ($1,000.00) ($1,000.00) $0.00

that the 1
2
3
$400.00
$350.00
$300.00
$300.00
$300.00
$300.00
($100.00)
($50.00)
$0.00
$0.00
$100.00
$150.00
$0.00
($0.00)
($0.00)
($100.00)
($50.00)
$0.00
$100.00
$150.00
$150.00
difference 4
5
$250.00
$200.00
$300.00
$300.00
$50.00
$100.00
$150.00
$100.00
($0.00)
($0.00)
$50.00
$100.00
$100.00
($0.00)

represents IRR/period 17.47% 15.24% 0.00% Total ($0.00) $0.00

MARR = 7.00 %
an increment NPW = $257.75 $230.06 ($27.69)

of Trial interest
rates
NPW
$0.00
0 5 10 15 20 25 30 35 40 45 50
0 $0.00
investment; 5
10
($20.10)
($32.72) Net Present Value
($10.00)

($20.00)

goes from - 15
20
($40.40)
($44.80) ($30.00)

to + over
25 ($47.00)
($40.00)
30 ($47.75)
35 ($47.52)

time.
($50.00)
40 ($46.66)
45 ($45.40) ($60.00)
50 ($43.90)

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 Analysis Period

• Just as in PW and AW analysis, the analysis

period must be considered:
• Useful life of the alternative equals the analysis
period
• Alternatives have useful lives different from the
analysis period
• The analysis period is infinite, n = ¥

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 Engineering Economic Analysis
9th Edition

Chapter Appendix 7A
Difficulties Solving for an Interest Rate

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 Multiple IRR
Example 7A-1
Unrecovered
Return on Investment Unrecovered
investment at

Occurs
Year Cash flow unrecovered repayment at investment at
beginning of
investment end of year end of year
year
0 $19.00

when a 1
2
$10.00
($50.00)
($19.00)
($30.95)
($1.95)
($3.17)
$11.95
($46.83)
($30.95)
$15.88
3 ($50.00) $15.88 $1.63 ($51.63) $67.51

cash flow 4
5
$20.00
$60.00
$67.51
$54.43
$6.91
$5.57
$13.09
$54.43
$54.43
$0.00

produces
Guess
IRR/period 10.24% 10.00% Total $9.00 ($19.00)
IRR/period 47.30% 50.00%

more than Trial interest

rates
NPW
$10.00

one point 0
5
10
$9.00
$3.28
$0.11
Ne t Pre s e nt V alue $8.00

$6.00

at which 15
20
($1.50)
($2.14)
$4.00

$2.00
25 ($2.20)

NPW = 0 30
35
($1.91)
($1.44)
$0.00

($2.00)
0 5 10 15 20 25 30 35 40 45 50
40 ($0.88)
45 ($0.28) ($4.00)
50 $0.32

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 Cash Flow Rule of Signs
• May be converted to a polynomial
• Then, by Descartes’ rule
Number of sign Number of positive
changes, m values of X
0 0
1 1
2 2 or 0
3 3 or 1
4 4, 2 or 0
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 Cash Flow Rule of Signs Expands
on This Notion
• There may be as many positive values of “i”
as there are sign changes in the cash flow.
• Sign changes are counted when:
• + to -
• - to +
• A zero cash flow is ignored

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 Cash Flow Rule of Signs
- Possibilities -

Number of sign changes, Number of positive values

m of “i”

0 0
1 1 or 0
2 2, 1 or 0
3 3, 2, 1 or 0
4 4, 3, 2, 1 or 0
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 Zero Sign Changes

• Receiving a gift
• Giving your friend a loan and not being paid
back

In either case, no “i” can be computed.

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 One Sign Change
The Normal Situation
Year A B C D E F
0 ($50.00) ($50.00) ($50.00) $50.00 $50.00 $50.00
1 $20.00 $20.00 $20.00 ($20.00) ($20.00) ($20.00)
2 $10.00 $20.00 $20.00 ($10.00) ($20.00) ($20.00)
3 $11.00 $20.00 ($11.00) ($20.00)
4 $12.00 ($12.00)
5
Sign
change 1 1 1 1 1 1

Guess IRR IRR IRR IRR IRR IRR

0 NPV 1.09% 17.64% NPV 1.09% 17.64%
10 NPV 1.09% 17.64% NPV 1.09% 17.64%
20 NPV 1.09% 17.64% NPV 1.09% 17.64%
30 NPV 1.09% 17.64% NPV 1.09% 17.64%
40 NPV 1.09% 17.64% NPV 1.09% 17.64%
50 NPV 1.09% 17.64% NPV 1.09% 17.64%
60 NPV 1.09% 17.64% NPV 1.09% 17.64%
70 NPV 1.09% 17.64% NPV 1.09% 17.64%
80 NPV 1.09% 17.64% NPV 1.09% 17.64%
90 NPV 1.09% 17.64% NPV 1.09% 17.64%
100 NPV 1.09% 17.64% NPV 1.09% 17.64%
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 Two or More Sign Changes
• More than one IRR may exist
• Use an NPW plot to determine how many exist
Unrecovered
Return on Investment Unrecovered
investment at
Year Cash flow unrecovered repayment at investment at
beginning of
investment end of year end of year
year
0 $19.00
1 $10.00 ($19.00) ($1.95) $11.95 ($30.95)
2 ($50.00) ($30.95) ($3.17) ($46.83) $15.88
3 ($50.00) $15.88 $1.63 ($51.63) $67.51
4 $20.00 $67.51 $6.91 $13.09 $54.43
5 $60.00 $54.43 $5.57 $54.43 $0.00
Guess
IRR/period 10.24% 10.00% Total $9.00 ($19.00)
IRR/period 47.30% 50.00%

Trial interest
NPW
rates $10.00
0 $9.00
Ne t Pr e s e n t V a lu e

$8.00
5 $3.28
10 $0.11 $6.00
15 ($1.50) $4.00
20 ($2.14)
25 ($2.20) $2.00

30 ($1.91) $0.00
35 ($1.44) 0 5 10 15 20 25 30 35 40 45 50
($2.00)
40 ($0.88)
45 ($0.28) ($4.00)
50 $0.32

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