Engineering Economic

Analysis

RATE OF RETURN ANALYSIS
1
Three Major Methods of
Economic Analysis
PW - Present Worth
AW - Annual Worth
IRR - Internal Rate of Return
2
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
Calculating Rate of
Return
The IRR is the interest rate at which the present
worth and equivalent uniform annual worth
are equal to 0.

o PW Benefit - PW Cost = 0
o PW Benefit/PW Cost = 1
o NPW = 0
o EUAB - EUAC = 0
o PW Benefit = PW Cost
3
Example: rate of return on
investment
An $8200 investment returned $2000 per year over a
five-year useful life. What was the rate of return?
PW of benefits/PW of costs = 1
2000(P/A), I, 5)/ 8200=1
(P/A,I,5)=4.1
i= 7%

4
Example: rate of return on
investment
An investment resulted in the
following cash flow. Compute
the rate of return.
EUAB-EUAC=0
100+75(A/G,I,4)-700(A/P,I,4)=0
i=5% EUAB-EUAC=208-197=11
i=8% EUAB-EUAC=205-211=-6
i=7% EUAB-EUAC=206-206=0

Year
Cash
Flow
0 -$700
1 100
2 175
3 250
4 325
5
6
7
8
Example: rate of return on
investment
An investment
resulted in the
following cash
flow. Compute
the rate of
return
B Year
Cash
Flow
2 0 -$700
3 1 100
4 2 175
5 3 250
6 4 325
IRR(B2:B6 7%
9
Example
A new corporate bond was initially sold by a
stockbroker to an investor for $1000. The
issuing corporation promised to pay the bond
holder $40 interest on the $1000 face value of
the bond every six month, and to repay the
$1000 at the end of ten years. After one year
the bond was sold by the original buyer for
$950.
A) what rate of return did the original buyer
received on his investment
B) What rate of return the new buyer expect
to receive if e keeps the bond for its remaining
nine-year life?

10
Solution
Try i=1.5%
NPW= -1000+40(P/A,I,2)+950(P/F,I,2)
NPW= -1000+ 40(1.956) + 950(0.9707= 0.41
So interest per six month is 1.5% means nominal
interest rate is 3% per year and effective annual
interest is (1+0.015)^2 -1 = 3.02%
11
Rate of Return Analysis
MARR: minimum attractive rate of return
To evaluate an optional investment compare ROR
with MARR. If ROR>MARR then choose to do the
investment. If ROR < MARR then do not accept the
investment
12
Rate of Return Analysis
If you have more than one option then all feasible
options should have ROR>MARR. To choose the
best compute the incremental rate of return.
13
Rate of Return Analysis
You are given he choice o
selecting one of two
mutually exclusive
alternatives. The
alternatives are as follows:
any money not invested
here may be invested
elsewhere at the MARR of
6%. If you can only choose
one alternative one time,
which one would you
select?

Year Alt. 1 Alt. 2
0 -$10 -$20
1 15 28
14
Rate of Return Analysis
You have $20 in your wallet and two alternative ways of
lending Bill some money.
A) lend Bill $10 with his promise of 50% return. That is,
he will pay you back $15 at the same agreed time.
B) Lend bill $20 with his promise of a 40% return. He will
pay you back $28 at the same agreed time.
You can select whether to lend bill $10 or $20. This is a
one-time situation and any money not lent Bill will
remain in your wallet. Which alternative do you choose?
15
Example 8.4
You have available $70,000 to invest and have been
presented with 5 equal-lived, mutually exclusive
investment alternatives with cash flows as depicted
below. Currently, you are earning 18% on your
investment of the $70,000. Hence, you will not choose to
invest in either of the alternatives if it does not provide a
return on investment greater than 18%.

Using the internal rate of return method, which (if either)
would you choose? What is its rate of return?
Data for Example 8.4
With an 18% MARR, which investment would
you choose?
Investment 1 2 3 4 5
Initial Investment $15,000.00 $25,000.00 $40,000.00 $50,000.00 $70,000.00
Annual Return $3,750.00 $5,000.00 $9,250.00 $11,250.00 $14,250.00
Salvage Value $15,000.00 $25,000.00 $40,000.00 $50,000.00 $70,000.00
Internal Rate of Return 25.00% 20.00% 23.13% 22.50% 20.36%
Solution to Example 8.4
Investment 1 2 - 1 3 - 1 4 - 3 5 - 4
Investment
$ 1 5 , 0 0 0 . 0 0 $ 1 0 , 0 0 0 . 0 0 $ 2 5 , 0 0 0 . 0 0 $ 1 0 , 0 0 0 . 0 0 $ 2 0 , 0 0 0 . 0 0
Annual Return
$ 3 , 7 5 0 . 0 0 $ 1 , 2 5 0 . 0 0 $ 5 , 5 0 0 . 0 0 $ 2 , 0 0 0 . 0 0 $ 3 , 0 0 0 . 0 0
Salvage Value
$ 1 5 , 0 0 0 . 0 0 $ 1 0 , 0 0 0 . 0 0 $ 2 5 , 0 0 0 . 0 0 $ 1 0 , 0 0 0 . 0 0 $ 2 0 , 0 0 0 . 0 0
IRR
25.00% 12.50% 22.00% 20.00% 15.00%
> MARR? Yes No Yes Yes No
Defender 1 1 3 4 4
Present Worths with 10-Year Planning Horizon
Investment 1 2 3 4 5
Initial Investment $15,000.00 $25,000.00 $40,000.00 $50,000.00 $70,000.00
Annual Return $3,750.00 $5,000.00 $9,250.00 $11,250.00 $14,250.00
Salvage Value $15,000.00 $25,000.00 $40,000.00 $50,000.00 $70,000.00
Present Worth $4,718.79 $2,247.04 $9,212.88 $10,111.69 $7,415.24
Present Worths with 10-Year Planning Horizon
Investment 1 2 3 4 5
Initial Investment $15,000.00 $25,000.00 $40,000.00 $50,000.00 $70,000.00
Annual Return $3,750.00 $5,000.00 $9,250.00 $11,250.00 $14,250.00
Salvage Value $15,000.00 $25,000.00 $40,000.00 $50,000.00 $70,000.00
Present Worth $4,718.79 $2,247.04 $9,212.88 $10,111.69 $7,415.24
PW = $11,250(P|A 18%,10) + $50,000(P|F 18%,10) - $50,000
=PV(18%,10,-11250,-50000)-50000
Rate of Return Analysis
A firm is considering which of two devices to
install to reduce costs in a particular situation.
Both devices cost $1000, have useful lives of
five years and no salvage value. Device A
can be expected to result in $300 saving
annually. Device B will provide cost savings of
$400 the first year but will decline $50
annually, making the second-year savings
$350, the third year saving $300, and so forth.
For a 7% MARR, which device should the firm
purchase?
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Solution
Year Device A Device B A-B
0 -1000 -1000 0
1 300 400 -100
2 300 350 -50
3 300 300 0
4 300 250 50
5 300 200 100
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Example 8.7
Three mutually exclusive investment alternatives
are being considered; the cash flow profiles are
shown below. Based on a 15% MARR, which
should be chosen?
EOY CF(1) CF(2) CF(3)
0 -$100,000 -$125,000 -$150,000
1 $20,000 -$25,000 -$35,000
2 $20,000 $75,000 $75,000
3 $20,000 $70,000 $75,000
4 $20,000 $60,000 $75,000
5 $120,000 $55,000 $95,000
Example 8.7 (Continued)
EOY CF(1) CF(2) CF(3) CF(2-1) CF(3-2)
0 -$100,000 -$125,000 -$150,000 -$25,000 -$25,000
1 $20,000 -$25,000 -$35,000 -$45,000 -$10,000
2 $20,000 $75,000 $75,000 $55,000 $0
3 $20,000 $70,000 $75,000 $50,000 $5,000
4 $20,000 $60,000 $75,000 $40,000 $15,000
5 $120,000 $55,000 $95,000 -$65,000 $40,000
IRR =
20.00% 19.39% 18.01% 16.41% 13.41%
PW
1
(15%) =PV(0.15,5,-20000,-100000)-100000 = $16,760.78
PW
2
(15%) =NPV(0.15,-25,75,70,60,55)*1000-125000 = $17,647.70
PW
3
(15%) =NPV(0.15,-35,75,75,75,95)*1000-150000 = $15,702.99
Recommend Alternative 2
-$2,000
-$1,500
-$1,000
-$500
$0
$500
$1,000
$1,500
$2,000
-
7
0
%
-
6
0
%
-
5
0
%
-
4
0
%
-
3
0
%
-
2
0
%
-
1
0
%
0
%
1
0
%
2
0
%
P
W

(
x

$
1
0
,
0
0
0
)

MARR
Incremental IRR Comparison of Alternatives
CF(2-1) CF(3-2)
Incremental IRR Comparison of Alternatives
-$2
-$1
$0
$1
$2
$3
$4
$5
$6
$7
$8
-
1
0
%
-
5
%
0
%
5
%
1
0
%
1
5
%
2
0
%
2
5
%
MARR
P
W

(
x

$
1
0
,
0
0
0
)
CF(2-1) CF(3-2)
Quiz
True of False: If PW(A) > PW(B) > $0, then IRR(A) >
IRR(B) > MARR
Quiz
True of False: If PW(A) > PW(B) > $0, then IRR(A) >
IRR(B) > MARR



Answer: False
IRR is not a rank order method; it is an incremental
method. In Example 8.7, PW(2) > PW(1) > PW(3)
and IRR(1) > IRR(2) > IRR(3). Knowing the rank
order of PW tells us nothing about the rank order
of IRR.
Rate of Return Analysis
Two machines are being considered
for purchase. If the MARR is 10%,
which machine should be bought?

Machine X Machine Y
Initial Cost $200 $700
Uniform annual benefit 95 120
End-of-useful-life salvage value 50 150
Useful life in years 6 12
29
Rate of Return (ROR)
Analysis
Most frequently used measure of merit in industry
More accurately called Internal Rate of Return (IRR)
30
Analysis Period
Just as in PW and AW analysis, the analysis period
must be considered:
o Useful life of the alternative equals the analysis period
o Alternatives have useful lives different from the analysis period
o The analysis period is infinite, n =

31