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3,500
2,000 2,000
1 2 9 18
3,100
18,000 18,000
1 2 13 18 23 26
5000
8000 8000
15,000 15,000
50,000
1,50,000
Step 2
• Find the PW of non-recurring Expenditures
• P1 = Rs. 1,62,360
Step 3
• Convert Recurring Payment of Rs. 15,000
every 13 years into EUAW over 13 years
• A1 = Rs. 437
Step 4
• Divide the EUAW by the interest rate to
obtain capitalized cost
• Consider 2 series
– A series of Rs. 5000 + 437 for perpetuity
– A series of Rs. 3000 starting from year 5
• P2 = A/i = 5437/0.15 = Rs. 36,247
• P3 = A/i(P/F,i,4) = (3000/0.15)(P/F,15%,4)
– P3 = Rs. 11,436
Step 5
• Add the various present worths
• PT = P1 + P2 + P3
1 2 8
900
8000 =
0 1 2 8
EUAW=?
Calculations
• A1 = Annual cost of Investment
– A1 = 8000(A/P,20%,8) = Rs. 2084.88
• A2 = Annual Value of Salvage
– A2 = 500(A/F,20%,8) = Rs. 30.31
• A3 = AOC = Rs. 900
• EUAW = A1-A2+A3 = Rs. 2955 (approx)
Compare the following using
EUAW. i=15%
Eqpt A Eqpt B
First Cost (Rs.) 26,000 36,000
Annual Maintenance Cost 800 300
(Rs.)
Annual Labour Cost (Rs.) 11,000 7,000
Extra Income Taxes (Rs.) - 2,600
Salvage Value (Rs.) 2,000 3,000
Life (years) 6 10
Calculations
• EUAWA = 26,000(A/P,15%,6) –
2,000(A/F,15%,6) + 800 + 11,000
– EUAWA = Rs. 18,442
• EUAWB = 36,000(A/P,15%,10) –
3,000(A/F,15%,10) + 300 + 7,000 + 2600
– EUAWB = Rs. 16,925
Eqpt A Eqpt B
First Cost (Rs.) 26,000 36,000
Annual Maintenance Cost 800 300
(Rs.)
Annual Labour Cost (Rs.) 11,000 7,000
Extra Income Taxes (Rs.) - 2,600
Salvage Value after 4 12,000 15,000
years (Rs.)
Life (years) 6 10
Internal Rate of Return
• The internal rate of return (IRR) is the rate
of return paid on unpaid balance of a loan
or borrowing such that the equivalent sum
of all the cash flows becomes zero.
5000
Solution
1. 5000 = 100(P/A,i,10) + 7000(P/F,i,10)
2. For a start, add up all the receipts
1. 10x100 + 7000 = 8000
3. Try 5000 = 8000(P/F,i,10)
1. (P/F,i,10) = 0.625
2. i is between 4% and 5%
3. Use i=5% in equation 1
4. Test -5000+ 100(P/A,5%,10) + 7000(P/F,5%,10)
1. = Rs. 70 (approx)
2. Too high – use a higher discount rate of 6%
5. Test -5000+ 100(P/A,6%,10) + 7000(P/F,6%,10)
1. = Rs. -355 (approx)
2. Too low
6. Interpolating between 70 and -355, we get i=5.16%
Solving the Same Using EUAW
• EUAWD=5000(A/P,i,10)
• EUAWR=100 + 7000(A/F,i,10)
• 5000(A/P,i,10)=100 + 7000(A/F,i,10)
• 0 = 100 + 7000(A/F,i,10) - 5000(A/P,i,10)
• Iteratively solving for i yields IRR=5.16%
Points to Note
1. If there are fluctuating positive and negative
cash flows over time, there could be multiple
solutions for IRR. Pick the most reasonable
2. Organizations usually set a Minimum Attractive
Rate of Return (MARR) that they compare
IRRs to
1. Hopefully IRR>MARR
3. IRR assumes that any receipts are reinvested
at the IRR. This may not be true and receipts
may be invested at other rates. A composite
rate of return can then be calculated
What can I do with IRR?
Eqpt A Eqpt B
First Cost (Rs.) 8000 13,000
Annual Op Cost 3500 1600
Salvage Value 0 2000
Life (Years) 10 5
Procedure
1. Let the option requiring the larger initial
investment be Option 2
2. Prepare a Net Cash Flow Tabulation for
Option 2 – Option 1
3. Draw a Net Cash Flow Diagram
4. Find the IRR that sets these Net Cash
Flows to 0
5. Compare this IRR with MARR = 15%
Net Cash Flow Table
Year Eqpt A Eqpt B Difference (B-
A)
0 -8000 -13000 -5000
1 -3500 -1600 1900
2 -3500 -1600 1900
3 -3500 -1600 1900
4 -3500 -1600 1900
5 -3500 -1600+2000- 1900-11000
13000
6 -3500 -1600 1900
7 -3500 -1600 1900
8 -3500 -1600 1900
9 -3500 -1600 1900
10 -3500 -1600+2000 1900+2000
Net Cash Flow Diagram
2000
1900
1 2 5
10
5000
11000
Calculating IRR
• Using PW analysis
– 0 = -5000 + 1900(P/A,i,10) – 11000(P/F,i,5) +
2000(P/F,i,10)
• Solve for i
– Start with 5000 = 10000(P/F,i,5)
– i is between 14% and 15%
– Iterating we find i=12.65%
• IRR<MARR
– Hence Select Option A
• Excel can calculate IRR quite easily
• You can also do this using EUAW
Selecting from more than 2
alternatives
1. Order the alternatives in increasing order of initial investment
costs
2. For alternatives with positive cash flows, select the first alternative
and calculate the IRR and compare it with MARR
1. If IRR>MARR, set this option as the defender and the next
option as the challenger
2. If IRR<MARR eliminate this alternative and go back to Step 2
above
3. At the end of this exercise, if only one option exists, then this
must be selected. If no options exist, then no option is selected
3. Determine Net Incremental Cash Flow between Challenger and
Defender
4. Calculate the IRR
1. If IRR>MARR, then challenger becomes defender. The next
available option is the challenger
2. If IRR<MARR, challenger is eliminated and next available
option is the challenger
5. Repeat until only one option remains
Example:
• 4 building locations have been suggested below.
If the MARR is 10%, use an incremental rate of
return analysis to select a building location
A B C D
Life (yrs) 30 30 30 30
Solution
• Arranging in Increasing order of Initial
Costs, we get C-A-B-D
• Since they have revenues, first calculate
IRR of C
– 1,90,000 = 19,500(P/A,i,30)
– (P/A,i,30)= 9.74
– i = 9.63%
• Since IRR<MARR, eliminate C
Solution
• Next Consider IRR of A
– 2,00,000 = 22000(P/A,i,30)
– (P/A,i,30)= 9.09
– i = 10.49%
• Since IRR>MARR, A is the Defender
– B is the Challenger
• Compare A and B (B minus A)
B Minus A
• Looking at the Net Cash Flows
– Incremental Building Cost = Rs. 75,000
– Incremental Income = Rs. 13,000
• Formulating IRR Equation
– 75,000 = 13000(P/A,i,30)
– (P/A,i,30) = 5.77
– i = 17.28%
• Since IRR>MARR, B is now the Defender
– D is the Challenger
• Compare B and D (D minus B)
D Minus B
• Looking at the Net Cash Flows
– Incremental Building Cost = Rs. 75,000
– Incremental Income = Rs. 7,000
• Formulating IRR Equation
– 75,000 = 7000(P/A,i,30)
– (P/A,i,30) = 10.71
– i = 8.55%
• Since IRR<MARR, B remains the Defender
– D is eliminated and no more options are available
• Select Option B
• Can also do this using EUAW method
Miscellaneous
• You can use either method – NPV or IRR, there are no
hard and fast rules
• IRR assumes only one constant rate of return
throughout the project. That is a limitation when
compared with NPV
• If there are only disbursements and no revenues (i.e.
only an investment), then do not compare an
alternative with MARR. Start comparing them
straightaway with one another as challenger and
defender
– At least one must be selected, even if all are poor
– If Revenues exist, then you may end up with a situation where
you do not select any of the alternatives
• If the lives are not the same, use the LCM of the lives
of the options
Class Exercise: MARR is 13.5%
per year. Which will you choose?
Eqpt 1 Eqpt 2 Eqpt 3 Eqpt 4