Module 6: Internal Rate of Return

and Payback Period

SI-4251 Ekonomi Teknik
Muhamad Abduh, Ph.D.
Outline Module 6
 Rate of Return
 Internal Rate of Return (IRR)
 Cash Flow with Single Rate of Return
 Cash Flow with Multiple Rate of Return
 Payback Period
 Discounted Payback Period


2 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Rate of Return
 Rate of Return (ROR) is the rate of interest
paid on all unpaid balance of borrowed
money, or the rate of interest earned on the
unrecovered balance of an investment so
that the final payment or receipt brings the
balance to zero with interest considered
 Internal Rate of Return (IRR) is the interest
rate that causes the equivalent receipts of
a cash flow equal to the equivalent
i*  PR = PP  PR – PP = 0
payments of a cash flow
 FR = FP  FR – FP = 0
EUAW R = EUAW P  EUAW R – EUAW P = 0
3 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
 Finding Internal Rate of Return
1. Draw cash flow diagram
2. Convert all receipts into present, future or EUAW
3. Convert all payments into present, future or EUAW
4. Subtract (3) from (2) and set it equal to zero  find i*
5. Find i* that satisfies (4) by trial and error  interpolation

P O1
I1 SV

A1

0 1 2 3
P R = I 1 ( P / F , i *, 22 ) + SV ( P / F , i *, 36 )

P P = P + A 1 ( P / A , i *, 36 ) + O 1 ( P / F , i *, 8 )

PR - PP = I1(P/F, i*, 22) + SV(P/F, i*, 36) – [P + A1(P/A, i*, 36) + O1(P/F, i*, 8)] = 0
4 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Rate of Return
 The relationship between Rate of Return and the Present Worth
Amount can be graphically describe as follows:
 Present
 worth,
PW



 i*
0
 interest rate, i

 Cash flow shown above assures a single rate of return that:


PW ( i ) > 0 for i < i *

PW ( i ) = 0 for i = i *
PW ( i ) < 0 for i > i *

5 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Cash Flow with Single Rate of Return
For a cash flow will have a single rate of return, if


satisfies the following conditions:

Test # 1:


1. F0 < 0
 (the first non-zero cash is a disbursement)
2 . One change in sign in the sequence F 0 , F 1 , F 2 , … F n
 (the cash flow has an initial disbursement or a series of disbursement followed by
a series of receipts)
3 . PW ( 0 ) > 0
 (the sum of all the receipts is greater than the sum of all the disbursements)
Test # 2:


1. F0 < 0
 (the first non-zero cash is a disbursement)
2 . Find rate of return , i * , for the cash flow ;
 for unknown i*, total unrecovered balance , U t < 0 for t = 0, 1, 2, 3, … n-1


 6 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Cash Flow with Multiple Rate of Return
For a cash flow will have a multiple rate of return, if not satisfies Test


#1 Test #2

Present
 worth,
PW

i* i*
0
interest rate, i

7 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Payback Period
 In business and industry it is common to evaluate
alternatives (assets) in terms of their payback or payout
period.
 Payback without interest  the length of time required to
recover the first cost of an investment from the net cash
flow produce
n by that investment for interest rate of zero

 ∑
t =0
Ft ≥ 0
 This method has disadvantages as it fails to consider:
 the time value of money
 the consequences of the investment following the
payback period
 Payback with interest or discounted payback period this
method determines the length of time required until the
investment’s equivalent receipts exceed the equivalent
capitaln' outlays

∑F (1 +i )
 −t

t ≥0 n’ = the smallest value
that satisfies the
t =0 equation

8 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Payback Period without Interest
 Example:
 Three alternatives of investment are being considered without
interest:
end
 of year A B C
0

- 1.000.000,- - 1.000.000,- - 700.000,-
1 500.000,- 200.000,- - 300.000,-


2 300.000,- 300.000,- 500.000,-

3 200.000,- 500.000,- 500.000,-
4 200.000,- 1.000.000,- 0,-
5 200.000,- 2.000.000,- 0,-
6 200.000,- 4.000.000,- 0,-
Present PW(i)A = PW(i)B = PW(i)C = 0,-
worth,
Paybacki=0 3600.000,-
years 37.000.000,-
years 3 years
period
9 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.
Discounted Payback Period
 Example:
 Alternative A is being considered at the rate of return 15%

end of year

A
0
 - 1.000.000,-
1 500.000,-
2 300.000,-
3 200.000,-
4 200.000,-
5 200.000,-
6 200.000,-
Ft = - 1M + 500K ( P / F , 15 % , 1 ) + 300K ( P / F , 15 % , 2 ) + 200K ( P / F ,
15%, 3) + 200K(P/F, 15%, 4) + 200K(P/F, 15%, 5) > 0

10 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Project Balance
 Evaluation of a proposed project is often done by analyzing
the project balance.
 A project balance describes the equivalent of loss or profit
of the project cash flow as a function of time.
 At any given time, a project balance can be calculated as:
T
PB (i )T = ∑ Ft (1 + i )T −1


t =0

 Visual description of a project balance  project balance
diagram
 Four important characteristics of project balance diagram
are:
 The net future worth of investment
 The time when the equivalent cash flow switch from negative to
non-negative, or vice versa
 The net equivalent cash flow exposed to risk of loss (the area
where PB(i) is negative)
 The net equivalent cash flow earned (the area where the PB(i) is
positive)
11 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

 8M
Project Balance 6M
Project cash flow @ 20% discount rate
 5M
 1M 3M

0 1 2 3 4 5


PB ( 20 ) 5 = 7 . 55M

10M PB ( 20 ) 4 = 3 . 79M

+
- PB ( 20 ) 3 = - 1 . 84M

PB ( 20 ) 2 = - 8 . 2M

PB ( 20 ) 0 = -10M
PB ( 20 ) 1 = -11M

12 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.

Homework #6
1.Work for alternative B and C of the example (slide
#8). Determine the discounted payback
period for each alternative and suggest your
selection.
2.For the same problem investment (#1), calculate
the project balance for each alternative, draw
the project balance diagram, and identify the
future worth and exposure to risk of loss



13 SI-4251 Ekonomi TeknikMuhamad Abduh, Ph.D.