RATE OF RETURN ANALYSIS

1
INTERNAL RATE OF RETURN (IRR)
The Internal Rate of Return (IRR) method sol ves for the interest rate that
equates the equivalent worth of a project's cash outflows (expenditures)
to the equi valent worth of cash inflows (receipts or savings).
2
INTERNAL RATE OF RETURN (IRR)
By definition:
Givenacashflowstream, IRR istheinterest ratei at whichthe
benefitsareequivalent tothecostsor theNPW=0
The Internal Rate of Return is the rate of return that yields a Net Present
Value of zero.
NPW=0
PWof benefits- PWof costs =0
PWof benefits=PWof costs
PWof benefits/ PWof costs=1
EUAB-EUAC=0
3
INTERNAL RATE OF RETURN (IRR)
In other words, the IRR is the interest rate that makes the PW, AW, and FW
of a project's estimated cash flows equal to zero. That is, PW(i') of cash
inflow = PW(i') of cash outflow.
We commonl y denote the IRR by i'.
PW(i' %) = 0
AW(i' %) = 0
FW(i' %) = 0
4
Internal Rate of Return
-$1,000
$350
years
1 2 3 4
$350 $350 $350
( ) ( ) ( ) ( )
15 . 0 0 000 , 1
1
350
1
350
1
350
1
350
4 3 2
= =
+
+
+
+
+
+
+
IRR
IRR IRR IRR IRR
$350
years 1 2 3 4
$350 $350 $350
$1,063
$1,000
15%
12%
Internal Rate of Return
Example: A companyinvests $10,000 in a computer and results
in equivalent annual labor savings of $4,021 over 3 years. The
companyis said to earn a return of 10% on its investment of
$10,000.
PROJECT BALANCE CALCULATION:
0 1 2 3
Beginning
project balance
Return on
invested capital
Payment
received
Ending project
balance
-$10,000 -$6,979 3,656
-$1,000 -$697 -$365
-$10,000 +$4,021 +$4,021 +$4,021
-$10,000 -$6,979 -$3,656 0
The firmearns 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.
INTERNAL RATE OF RETURN (IRR)
8
700 = 100/(1+i) + 175/(1+i)
2
+ 250/(1+i)
3
+ 325/(1+i)
4
.
It turns out that i = 6.09 %.
Suppose you have the following cash flow stream. You
invest $700, and then receive $100, $175, $250, and $325
at the end of years 1, 2, 3 and 4 respectively. What is the IRR
for your investment?
0
1
$700
$100
time
2 3 4
$175
$250
$325
How to calculate IRR?
COMPUTATION OF IRR
Direct Solution
Trial and Error Solution
Computer Solution
9
Internal Rate of Return Method
Internal Rate of Return Method
Internal Rate of Return Method
Management is evaluating a proposal to
acquire equipment costing $97,360. The
equipment is expected to provide annual net
cash flows of $20,000 per year for seven
years.
Management is evaluating a proposal to
acquire equipment costing $97,360. The
equipment is expected to provide annual net
cash flows of $20,000 per year for seven
years.
$97,360
$20,000
=4.868
Determine the table value
using the present value for
an annuity of $1 table.
Internal Rate of Return Method
Internal Rate of Return Method
Internal Rate of Return Method
Amount to be invested
Equal annual cash flow
Present Value of an Annuity of $1
Present Value of an Annuity of $1 Present Value of an Annuity of $1
1 0.943 0.909 0.893 0.870
2 1.833 1.736 1.690 1.626
3 2.673 2.487 2.402 2.283
4 3.465 3.170 3.037 2.855
5 4.212 3.791 3.605 3.353
6 4.917 4.355 4.111 3.785
7 5.582 4.868 4.564 4.160
Year 6% 10% 12% 15%
Internal Rate of Return Method
Internal Rate of Return Method
Internal Rate of Return Method
Find the seven year line on the
table. Then, go across the
seven-year line until the closest
amount to 4.868 is located.
Present Value of an Annuity of $1
Present Value of an Annuity of $1 Present Value of an Annuity of $1
1 0.943 0.909 0.893 0.870
2 1.833 1.736 1.690 1.626
3 2.673 2.487 2.402 2.283
4 3.465 3.170 3.037 2.855
5 4.212 3.791 3.605 3.353
6 4.917 4.355 4.111 3.785
7 5.582 4.868 4.564 4.160
Year 6% 10% 12% 15%
4.868 4.868
Internal Rate of Return Method
Internal Rate of Return Method
Internal Rate of Return Method
Internal Rate of Return Method
Internal Rate of Return Method
Internal Rate of Return Method
Move vertically to the top of the
table to determine the interest
rate.
Present Value of an Annuity of $1
Present Value of an Annuity of $1 Present Value of an Annuity of $1
1 0.943 0.909 0.893 0.870
2 1.833 1.736 1.690 1.626
3 2.673 2.487 2.402 2.283
4 3.465 3.170 3.037 2.855
5 4.212 3.791 3.605 3.353
6 4.917 4.355 4.111 3.785
7 5.582 4.868 4.564 4.160
Year 6% 10% 12% 15%
4.868 4.868
10% 10%
10%
DIRECT SOLUTION
Example
15
n CashFlow
1 -$2,000
2 1300
3 1500
0
) 1 (
1500 $
) 1 (
1300 $
000 , 2 $ ) (
2
=
+
+
+
+ =
i i
i PW
) 1 (
1
i
x Assume
+
=
0 1500 $ 1300 $ 2000 $ ) (
2
= + + = x x i PW
) ( % 160 667 . 1
% 25 % 25 8 . 0
667 . 1 8 . 0
*
ce significan economic no i x
i i x
or x Solving
= =
= = =
=
TRIAL AND ERROR METHOD
Aiming for i that makes PW(i)=0
Guess a value of i
*
Compute the PW of net cash flows
Observe if PW is +, -, or zero
PW(i) is negative, lower the interest
rate
PW(i) is positive, raise the interest rate
Continue until PW(i) is approximately
zero
16
4 Example Continued IRR method
Find i' % such that the PW(i' %) = 0.
0 = -$50,000 + $17,500(P|A, i' %,5) + $10,000(P|F, i' %,5)
PW (20%) = 6354.50 tells us that i' > 20%
PW (25%) = 339.75 > 0, tells us that i' % > 25%
17
PW (30%) = -4,684.24 < 0, tells us that i' % < 30%
25% < i' < 30%
Use linear interpolation to estimate i' %.
18
19
20
Example
0
1 2 3 4 5 6 7 8
Years
(Units in millions)
$10
$1.8 1.8 1.8 1.8 1.8 1.8 1.8
$2.8
After taxnet cash flows
Guess i=8%
PW(8%) =-$10+$1.8(P/A, 8%, 8)+$1(P/F, 8%, 8) =$0.88
Sale value =$1
Since PWis positive, raise the interest rate
Assume i=12%
PW(12%) =-$10+$1.8(P/A, 12%, 8) +$1(P/F, 12%, 8) =-$0.65
Use interpolation
% 3 . 10
) 65 . 0 ( 88 . 0
0 88 . 0
%) 8 % 12 ( % 8
*
=
(

+ ~ i
Check PW(i) with this i
*
, iterate if necessary. Computer value =10.18%
Trial
interest
rates
NPW
0 $50.00
5 $26.46
10 $9.24
15 ($3.49)
20 ($12.97)
25 ($20.06)
30 ($25.37)
35 ($29.36)
40 ($32.34)
45 ($34.54)
50 ($36.16)
($50.00)
($40.00)
($30.00)
($20.00)
($10.00)
$0.00
$10.00
$20.00
$30.00
$40.00
$50.00
$60.00
0 5 10 15 20 25 30 35 40 45 50
N
e
t
P
r
e
s
e
n
t
V
a
l
u
e
Year Cash flow
0 ($100.00)
1 $20.00
2 $30.00
3 $20.00
4 $40.00
5 $40.00
21
EXAMPLE2:GRAPHIC SOLUTION
PW of costs =PW of benefits
100=20/(1+i)+30/(1+i)
2
+20/(1+i)
3
+40/(1+i)
4
+40/(1+i)
5
i=13.5%
NPW=-100+20/(1+i)+30/(1+i)2+20/(1+i)3+40/(1+i)4+40/(1+i)5
Internal Rate of Return versus NPV
Example:
-$10,000
$20,000
Project A
-$20,000
$35,000
Project B
( )
( )
000 , 10
1
000 , 20

+
=
r
r NPV
A
year
1
year 1
( )
( )
000 , 20
1
000 , 35

+
=
r
r NPV
B
NPV(A) and NPV(B) as function of the discount rate
Example:
Project
Cash flows ($)
IRR
NPV at
10%
t=0 t=1
A -10,000 +20,000 100 +8,182
B -20,000 +35,000 75 +11,818
Internal Rate of Return versus NPV
IRR
NPV at 10%
Internal Rate of Return versus NPV
Another example:
-$9,000
$3,500
Project C
$6,000
Project D
( )
( ) ( ) ( )
000 , 9
1
000 , 4
1
000 , 5
1
000 , 6
3 2

+
+
+
+
+
=
r r r
r NPV
D
year 1
( )
( )
000 , 9
1
500 , 3
5
1

+
=

= n
n
C
r
r NPV
$3,500 $3,500 $3,500 $3,500
2 3 4 5
$5,000
$4,000
-$9,000
-4000
-2000
0
2000
4000
6000
8000
10000
0 10 20 30 40 50
Project C
Project D
Another example:
Project
Cash flows ($)
IRR
NPV at
10%
t=0 t=1 t=2 t=3 t=4 t=5
C -9,000 +6,000 +5,000 +4,000 0 0 33 +3,592
D -9,000 +3,500 +3,500 +3,500 +3,500 +3,500 27 +4,268
NPV(C) and NPV(D) as function of the discount rate
IRR NPV at 10%
26
Rateof ReturnAnalysis
Examplestatementsabout aproject:
1. Thenet present worthof theproject is$32,000.
2. Theequivalent uniformannual benefit is$2,800.
3. Theproject will producea23%rateof return
Thethirdstatement isperhapsmost widelyunderstood.
Rate of return analysis isprobablythemost frequentlyusedanalysis
techniqueinindustry.
Itsmajor advantageisthat it providesafigureof merit that isreadily
understood.
27
MotivatingExample.
Banks1and2offer youthefollowingDeals1and2respectively:
Deal 1.
Invest $2,000 today. At the end of years 1, 2, and 3 get $100,
$100, and $500 in interest; at the end of year 4, get $2,200
in principal and interest.
Deal 2:
Invest $2,000 today. At the end of years 1, 2, and 3 get $100,
$100, and $100 in interest; at the end of year 4, get $2,000 in
principal only.
Question. Which deal is the best?
Rateof ReturnAnalysis
28
Deal 1:
Findout theimplicit interest rateyouwouldbereceiving;
that is, solvefor
2000=100/(1+i)
1
+100/(1+i)
2
+500/(1+i)
3
+2200/(1+i)
4
IRR: i =10.7844%.
Thisistheinterest ratefor thePV of your paymentstobe$2,000.
Deal 2:
Wefindi for which
2000=100/(1+i)
1
+100/(1+i)
2
+100/(1+i)
3
+2000/(1+i)
4
IRR: i =3.8194%.
Whichdeal wouldyouprefer?
Rateof ReturnAnalysis
29
J udgingproposedinvestments
IRR getsmorecomplicatedwhen
comparingmultiplealternatives
(Rather thanevaluatingasingleproject)
Why?
Desirabilitydependsonboth
IRR
and
sizeof initial investment
30
Example
Consider twoalternatives:
Invest $1 at anIRR of 100%
Invest $1,000,000at anIRR of 20%
Whichinvestment wouldyouprefer?
31
Example
Consider twoalternatives:
Invest $1 at anIRR of 100%
Invest $1,000,000at anIRR of 20%
Themoreexpensiveproject has:
Smaller IRR
but
Larger present worth!
32
J udgingproposedinvestments
If youaregoingtopickonlyonealternative
fromseveral,
Needtocomparethemagainst eachother!
(basedondifferencesincost)
not onlyagainst thebaserateof returni*
Needtoevaluateeachincremental
investment toseeif it isworthwhile
33
ACFSAnalysis
We have two CFSs.
1. Number them CFS
1
and CFS
2
, with CFS
1
having the largest year 0
cost (in absolute value).
2. Compute ACFS = CFS
1
CFS
2
. (Its year 0 entry must be negative.)
3. Find the IRR for ACFS, say AIRR .
4. If AIRR > MARR, choose CFS
1
. If not, choose CFS
2
.
Example: there are two cash flows: (-20,28) and (-10,15). MARR = 6%.
1. CFS
1
= (-20,28), CFS
2
= (-10,15)
2. ACFS = CFS
1
-CFS
2
=(-10,13)
3. AIRR = 30%.
4. AIRR > MARR => we choose CFS
1
= (-20,28).
34
WhyweuseIRR inIRR analysis
Years
0
1
A
-10
15
B
-20
28
B-A
-10
13
IRR
B-A
30% MARR < IRR
B-A
Select B
MARR=6%
IRR 50% 40%
NPV 3.92 6.05
Select B
Select A
Although the rate of return of A is higher than B, B got $8 return from
the $20 investment and A only got $5 return from $10 investment.
Project B: you put $20 in project B to get a return $8.
Project A: you put $10 in project A (and $10 in your pocket) to get a
return $5.
35
Example:
n B1 B2 B2-B1
0 -$3,000 -$12,000 -$9,000
1 1,350 4,200 2,850
2 1,800 6,225 4,425
3 1,500 6,330 4,830
IRR 25% 17.43%
MARR=10%
0 i,3) , $4,830(P/F
i,2) , $4,425(P/F i,1) , $2,850(P/F $9,000
=
+ + +
Solve and obtain i
*
B2-B1
=15% (simple investment)
Since IRR
B2-B1
>MARR, we select B2
Alternativelycould have measured for B
1
and B
2
the NPWat MARR and accepted the
largest NPWin excess of zero.
36
NPW
Interest Rate,%
0
i
*
B2-
B1
=15%
Select B2
Select B1
PW(i)
B2
>PW(i)
B1
B2
B1
NPWProfiles
37
Example
CompareoptionsA andB:
A: First cost = $1420
Annual benefit = $256/year for 40years
Rateof return = 18%
B: First cost = $1684
Annual benefit = $300/year for 40years
Rateof return = 17.8%
Youcanonlydoone of these!
38
Example
OptionB has:
Slightlylower rateof return,
but
Higher initial investment
Present worthof benefit maybegreater
thanoptionA!
39
Example
Needtoevaluatetheincremental investment
toseeif it isworthwhile:
Deltafirst cost = $1684- 1420=$264
Deltaannual benefit =$300- 256=$44
(for 40years)
Rateof return = 16.6%
IsoptionB worthwhile?
(Dependsoni*)
40
Example
OptionA hasIRR 18%, first cost $1420
(B - A) hasIRR 16.6%, first cost $264
If i* =15%, then:
OptionA isworthwhile
Thedeltafor optionB isalsoworthwhile
If i* =17%, then:
OptionA isworthwhile, but not B
41
Example
OptionA hasIRR 18%
(B - A) hasIRR 16.6%
If i* =20%, then:
Neither optionA nor optionB isgood
42
Example
OptionA hasIRR 18%
(B - A) hasIRR 16.6%
If i* =20%, then:
Neither optionA nor optionB isgood
Investment Classification
SimpleInvestment
Def: Initial cashflows
arenegative, andonly
onesignchangeoccurs
inthenet cashflows
series.
Example: -$100, $250,
$300 (-, +, +)
ROR: A uniqueROR
NonsimpleInvestment
Def: Initial cashflows
arenegative, but more
thanonesignchangesin
theremainingcashflow
series.
Example: -$100, $300, -
$120 (-, +, -)
ROR: A possibilityof
multipleRORs
Perio
d (N)
Project A Project B Project
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 is a simple investment.
Project B is a nonsimple investment.
Project C is a simple borrowing.
Example7.6MultipleRatesof ReturnProblem
Find the rate(s) of return:
2
$2,300 $1,320
( ) $1,000
1 (1 )
0
PW i
i i
= +
+ +
=
$1,000
$2,300
$1,320
L et Then,
Solving for yields,
or
Solving for yields
or 20%
x
i
PW i
i i
x x
x
x x
i
i
=
+
= +
+

+
= +
=
= =
=
1
1
000
300
1
320
1
000 300 320
0
10 11 10 12
10%
2
2
.
( ) $1,
$2,
( )
$1,
( )
$1, $2, $1,
/ /
PWPlot for aNonsimpleInvestment withMultiple
Ratesof Return