Internal Rate of Return Method

COEM 6005
Construction Accounts and Finance

By Hector Martin
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 Irr Method
 The irr method involves the calculation of an interest rate
that is compared against a minimum threshold (i.e., the
Marginal (MARR).
 It is the interest rate at which the NPV is Zero (0).
 Project should be ranked from the higher IRR down.

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 IRR Method
 Advantage
1. It eliminates the need to determine, indeed or argue about,
the appropriate MARR.
2. Its rankings cannot be manipulated by the choice of a
MARR

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 IRR Method
Example: 3-12
 Given Machine A in the previous questions, find the irr and compare it with a
MARR of 15%

Machine A
Initial cost 20,000
Life 5 years
Salvage value 4, 000
Annual receipt 10, 000
Annual disbursements 4400

See other examples in my-elearning

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 Depreciation
The purpose of the depreciation process is to
gradually remove the cost of an asset from the
balance sheet and show it as a cost on the profit and
loss account.

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 Ford Escort 1.4L, 5 Door
Residual Value and Depreciation as %
100

Depreciation
80

60
%

40

20

Residual Value
0
0 1 2 3 4 5 6 7 8
Age in Years

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 Depreciation
 Depreciation can be important - take two transport
companies:
• Company 1 may write down lorries by 25 per cent a year, setting
aside that amount against profits, but Company 2 may write off the
lorries at 20 per cent a year.
• Profits from Company 1 appear to be lower than Company 2's for
the first four years. Of course, Company 1 may be able to run the
lorries for five years. If their value has been written down to nil
after four years,Year 5 requires no depreciation, and profits benefit
sharply.
• Company 2 which will have shown higher profits in Years 1 to 4,
will still be writing off the lorries in Year 5, so profits will then lag
by comparison.
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 Depreciation of Mechanical Plant
There are 3 main methods of calculating
depreciation

1. Straight line
2. Declining Balance
3. Sum of Digits

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 1.Straight line depreciation
 An equal amount of depreciation is assumed each year, e.g. it
is decided to purchase a mechanical excavator costing
£42,000 to work an average of 2,000 hours per year. The life
of the machine is expected to be 10 years after which time
the salvage value will be £2,000.

What is the hourly depreciation for this asset?

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 1.Straight line depreciation (Cont.)

 Purchase price £42,000

 Residual value £ 2,000
 Total depreciation £40,000
 Annual depreciation £ 4,000
 Hourly depreciation £ 2

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 2. Declining Balance
 In this method, the depreciation is made on a fixed
percentage basis rather than the fixed sum.
 Using the previous example, using 26.2% p.a.

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 2. Declining Balance (cont.)
END OF YEAR DEPRECIATION DEP. FOR YEAR BOOK VALUE
(£) (%) (£) (£)
0 26.2 0 42000
1 26.2 11,004 30996
2 26.2 8,121 22875
3 26.2 5,994 16881
4 26.2 4,423 12458
5 26.2 3,264 9194
6 26.2 2,409 6785
7 26.2 1,778 5007
8 26.2 1,312 3695
9 26.2 968 2727
10 26.2 727 2000
Total £40,000

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 4. Sum of Digits
Best shown by example -
Digits =
1 + 2 + 3 + 4 + 5 + 6 + 7 + 8 + 9 + 10 = 55
Depreciation
Year 1 = 10/55
Year 2 = 9/55 etc

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 4. Sum of Digits (cont.)
YEAR FACTOR DEPRECIATION BOOK VALUE
42000
1 10/55 7273 34727
2 9/55 6545 28182
3 8/55 5818 22364
4 7/55 5091 17273
5 6/55 4364 12909
6 5/55 3636 9273
7 4/55 2909 6364
8 3/55 2182 4182
9 2/55 1454 2728
10 1/55 728 2000
Total 40,000

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 Synopsis
 As can be seen from the graph, the declining balance
method and the sum of digits method show that in the
early years, the asset is heavily written down. This is
particularly helpful with construction plant as the repair
and maintenance costs are likely to be low when new but
increase with age and usage.

 It is worth noting, that the method adopted is arbitrary,

and not of crucial importance. However, the company's
profit level is affected by its depreciation policy

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  The effect of depreciation and TAX on project investments
Example 3:18
The Leeds Corporation leases plant facilities in which expandable thermocouples are
manufactured. Because of rising demand, Leeds could increase sales by investing in new
equipment to expand output. The selling price of $10 per thermocouple will remain
unchanged if output and sales increase. On the basis of engineering and cost estimates, the
accounting department provides management with the following cost estimates based on an
annual output of 100,000 units. Should the proposed expansion take place?

Cost of new equipment having an expected life of 5 yrs. $500,000

Equipment installation cost $20,000
Expected salvage value $0
New Operations share of annual lease expenses $10,000
Annual increase in Utility expenses $40,000
Annual increase in labour cost $160,000
Annual additional cost for raw materials $400.000

Use SOYD method of deprecation, Tax rate of 40%; minimum rate of return 20%
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