1

Rate of return

Rate of return = yield = internal rate of return = marginal efficiency

of capital

3 definitions:
1) Based on a typical loan transaction
2) Based on the mathematical expression of the PW function
3) Based on the project cash-flow series

2
Definition 1: Interest Earned on Loan
Balance

Rate of return (ROR) is defined as the interest rate earned on

the unpaid (outstanding) balance of an installment loan.

Example: A bank lends $10,000 and receives annual

repayment of $4,021 over 3 years. The bank is said to earn a
return of 10% on its loan of $10,000.

3
Loan Balance Calculation:
A = $10,000 (A/P, 10%, 3) = $4,021
Unpaid Return on Unpaid
balance unpaid balance
at beg. balance Payment at the end
Year of year (10%) received of year

-$10,000
-$10,000 -$1,000 +$4,021 -$6,979
0 -$6,979 -$698 +$4,021 -$3,656
1 -$3,656 -$366 +$4,021 0
2
3
A return of 10% on the amount still outstanding
at the beginning of each year

PW (10%) 10.000 4.021(P / A,10%,3) 0

4
Definition 2: Break-Even Interest
Rate
Rate of return (ROR) is the break-even interest rate, i*, which
equates the present worth of a projects cash outflows to the
present worth of its cash inflows.

Mathematical Relation:
PW (i * ) PW (i * )cash inflows PW (i * )cash outflows
0

Example: PW(10%) 10,000 $4,021(P / A,10%,3) 0

Of course: PW (i * ) FW (i * ) AE (i * ) 0
5
Definition 3: Return on Invested Capital
Internal Rate of Return

The internal rate of return (IRR) is the interest rate earned on the
unrecovered project balance of the investment such that, when
the project terminates, the unrecovered project balance will be
zero.

Example: A company invests $10,000 in a computer system which

results in equivalent annual labor savings of $4,021 over 3 years.
The company is said to earn a return of 10% on its investment of
$10,000.

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 Return on Invested Capital
The firm earns a 10% rate of return on funds that remain internally
invested in the project. Since the return is internal to the project, we
call it internal rate of return.

Funds that remain internally invested in the project

The project brings in enough cash to pay for itself in 3 years and also
to provide the firm with a return of 10% on its invested capital. 7
7.2- Methods of finding the rate of return

7.2.1 - Simple versus Nonsimple Investments

Simple investment Nonsimple investment

Definition: An investment with only Definition: An investment in which
one sign change in the net cash more than one sign change occurs
flow series. in the net cash flow series.

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Example 7.1 Investment Classification

Net Cash Flow

Period
n Project Project Project
A B C
0 -1,000 -1,000 1,000
1 -500 3,900 -450
2 800 -5,030 -450
3 1,500 2,145 -450
4 2,000

Project A: a simple investment

Project B: a nonsimple investment
Project C: a simple borrowing

Not all NPW profiles for nonsimple

investments have multiple crossings 9
of the i-axis.
7.2 - Predicting Multiple i*s

Net Cash Flow Rule of Signs

Accumulated Cash Flow Sign Test

10
7.2 - Predicting Multiple i*s

Net Cash Flow Rule of Signs

The number of real i*s that are greater than -100% for a
project with N periods is never greater than the number of
sign changes in the sequence of the cash flows. A zero cash
flow is ignored.

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 Net Cash-Flow Rule of Signs

Number of real i* (> -100%) : s 3

This implies that the project could have (0, 1, 2, or 3) i*s

but NOT more than 3. 12
7.2 - Predicting Multiple i*s

Accumulated Cash Flow Sign Test

If the rule of cash flow signs indicate multiple i*s, we

should proceed to the accumulated cash-flow test !!!

If the sequence of accumulated cash flow series

starts negatively and changes sign only once, then a
unique positive i* exists.

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 Accumulated Cash-Flow Sign Test

Period Accumulated Sign

n An Cash Flows Change

0 -$100 -$100 0
1 -$20 -$120 0
2 $50 -$70 0
3 $0 -$70 0
4 $60 -$10 0
5 -$30 -$40 0
6 $100 $60 1

In (non-accumulated) cash flow: 3 sign changes.

Number of sign changes = 1, indicating a unique i*.

i* = 10.46% 14
Example 7.2

Predict the number of real positive rates of return for each of the following
cash flow series.

15
No sign 2 sign 1 sign
change changes change
16
(b) Find the number of possible i*.

17
7.2.3 - Computational Methods

1. Direct Solution Method

2. Trial-and-Error Method (works only for simple

investment)

3. Graphical Method

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1 - Direct solution method

Only for a two-flow transaction or a project with a service life of 2

years.

Example 7.3:
n Project A Project B
0 -$2,000 -$2,000
1 0 1,300
2 0 1,500
3 0
4 3,500

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2 - Trial and error method
(works only for simple investment)

First step: make an educated guess at the value of i*.

Second step: calculate PW(i*) and observe whether it is positive

or negative.

Third step: increase/decrease i*.

Repeat the process until PW(i*) is approximately equal to zero.

Use: linear interpolation (with one positive and one negative

values, both close enough to zero). AND CHECK!!!
20
21
Figure 7.3 Cash flow diagram for a simple investment (Example 7.4).

22
Figure 7.3 Cash flow diagram for a simple investment (Example 7.4).

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3 - Graphical method

The most easily generated and understandable graphic method

of solving for i* is to create the NPW profile on a computer.

Horizontal axis: the interest rate

Vertical axis: NPW

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Example 7.5

Consider the cash flow series shown in the following table.

Estimate the rate of return by generating the NPW profile on
a computer.

Period Cash
flow
0 -10.000
1 20.000
2 20.000
3 -25.000

25
Figure 7.4 Graphical solution to rate-of-return problem for a typical nonsimple
investment (Example 7.5).

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7.3 Internal-rate-of-return criterion

For i < i* PW(i) > 0 project should be accepted

For i > i* PW(i) < 0 project should be rejected

27
 Accept the project in regions: A, C
Reject the project in regions: B, D

28
 In simple projects: i* can serve as an appropriate index
for accepting/rejecting the investment.

BUT in nonsimple projects, it is not clear which i* to use

to make an accept/reject decision.

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7.3.2 Net-investment test: pure vs. mixed investments

NET INVESTMENT (pure investment):

the project balances computed at the projects i* values are 0
throughout the life of the investment [PB(i*) n 0 ]
the first cash flow is negative [A0<0]
Simple investments will always be pure investments

PURE BORROWING:
the project balances computed at the projects i* values are 0
throughout the life of the investment [PB(i*) n 0 ]
the first cash flow is negative [A0>0]

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 NET INVESTMENT (pure investment):
PB(i*) n 0
A0<0

If any of the PB(i*) n is > 0 the project is not a pure

investment.

This is a mixed investment.

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 Example 7.6

32
33
 A B C D
n
Cash flow PB (i*) Cash flow PB (i*) Cash flow PB (i*) Cash flow PB (i*)
0 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -1000
1 -1000 -2336,41 1600 380,4743 500 -799,531 3900 2800
2 2000 -1122,41 -300 163,9982 -500 -1539,02 -5030 -1950
3 1500 0 -200 0 2000 0 2145 0
i* 0,3364 0,2195 0,2995 0,1 / 0,3 / 0,5

Example : Proyect A
PB(33, 64%)0 1000
PB(33, 64%)1 1000(1 0,3364) (1000) 2336
PB(33, 64%) 2 2336(1 0,3364) 2000 1122,36
PB(33, 64%)3 1122,36(1 0,3364) 1500 0

34
7.3.3 Decision rule for pure investments

For i < i* PW(i) > 0 project should be accepted

For i > i* PW(i) < 0 project should be rejected

i* serves as a benchmark interest rate knowing it we can

decide whether to accept/reject the project
35
7.3.3 Decision rule for pure investments

If IRR > MARR accept the project

If IRR = MARR remain indifferent
If IRR < MARR reject the project

36
 Projected annual net savings = $ 871.500
Projected after-tax salvage value at the end of year 15 = $ 80.000

a) What is the projected IRR on this fabrication investment?

b) If Mercos MARR is known to be 18%, is this investment justifiable?

37
38
7.3.3 Decision rule for mixed investments

We can use an external interest rate that will allow us to

calculate a single, accurate rate of return.
OR, once we have predicted multiple i*s we can
apply the NPW or AE analysis for determining the
projects acceptability.

39
7.4 Mutually exclusive alternatives

The project with the highest IRR may NOT be the preferred
alternative.
Example:

Problem: NPW, NFW, and AE are absolute (dollar) measures

of investment worth, whereas the IRR is a relative
(percentage) measure and cannot be applied in the same way.
40
7.4.2 The incremental investment analysis

For a pair of mutually exclusive projects (A and B, being B

the most costly option):

If IRRB-A > MARR select B

If IRRB-A = MARR select either project
If IRRB-A < MARR select A

where B-A is an investment increment the first value of

the cash flow of B-A MUST be negative!!

41
7.4.2 The incremental investment analysis

If a do-nothing alternative is allowed the smaller cost

option must be profitable (IRRA > MARR) at first.

This means that we should compute the rate of return

of each alternative and eliminate the alternatives
whose IRR are < than the MARR before applying the
incremental analysis.

42
 Example 7.10

43
44
 Example 7.11

45
 Example 7.12

46
7.4.3 Handling unequal service lives

The IRR measure can be used to compare projects with

unequal service lives, as long as we can establish a
common analysis period.

47
 n Project A Project B
Problem 1
0 -1000 -1000
1 400 0
2 600 0
3 800 1500

1. Calculate i* for both projects.

2. If MARR = 12%, are the projects acceptable?
3. Which one is better?

Problem 2 n Project A Project B

0 -1200 -1000
1 0 0
2 600 0
3 1200

1. Calculate i* for both projects.

2. If MARR = 12%, are the projects acceptable?
48
Problem 7.20

Consider the investment project given in Table P7.20. Assume that MARR
= 12% for the following questions.
a) Identify the pure investment(s).
b) Identify the mixed investment(s).

49
Problem 7.27

You are considering an investment that costs $2.500. It is expected to

have a useful life of three years. You are very confident about the
revenues during the first two years ($1.250 and $1.500, respectively) but
you are unsure about the revenue in year 3. If you hope to make at least a
10% rate of return on your investment, what should be the minimum
revenue in year 3?

50
Problem 7.40

Consider the two mutually exclusive alternatives given in table P7.40. If

the firms MARR is 10%, which alternative is the best choice?
(IIRA1=17,27%, IRRA2=20,30%)

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