production economics

ELSEVIER
Int. J. Production Economics 42 (1995) 79-96

A compendium and comparison of 25 project evaluation techniques. Part 1: Net present value and rate of return methods
Donald
Haroqv Mudd College

S. Remer*,

Armando

P. Nieto
CA 9171 I, USA

ofEngineering and

Science, Claremont,

Received August 1994; accepted for publication August 1995

Abstract
This two-part paper presents 25 different methods and techniques used to evaluate the economic desirability of projects. We categorized these 25 methods into 5 types: net present value methods, rate of return methods, ratio methods, payback methods, and accounting methods. We provide insight into the advantages and limitations of these project evaluation methods by comparing and contrasting them. Many examples are included to illustrate the use of these methods. In Part 1, we examine net present value and rate of return methods. In Part 2, we examine ratio, payback, and accounting methods. A recap, comparison, and full summary of all 25 methods is included at the end of Part 2.
Ke_ywords:

Project

evaluation

techniques;

Net present

value methods;

Rate of return

methods

1. Introduction
Profitable capital investment leads to the growth and prosperity of an economy. If profitability is low,

investment will shrink. The investor needs tools to predict the profitability of proposed investments. There are many methods and techniques available to help the investor make wise economic decisions. These evaluation methods and techniques can be applied to independent projects to determine whether or not to invest in each one, or they can be applied to several mutually exclusive projects for the purpose of determining which, if any, should be pursued [l]. Such techniques are especially useful for corporate managers and engineers. Despite the many discussions of these techniques, there does not appear to be one
source which summarizes and compares all the diferent investment yardsticks. It is the primary purpose of this two-part paper to discuss, summarize, and compare 25 project evaluation methods in one central source. This paper will help the reader understand the advantages and disadvantages of these methods, as well as which to use in various applications.

*Corresponding

author.
\<: 1995 Elsevier Science B.V. All rights reserved

0925-5273/95/$09.50

SSDI 0925-5273(95)00104-2

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To understand the use and application of most project evaluation methods, knowledge of basic engineering economics concepts such as equivalence, time value of money (TVM), cash-flow diagrams, and economic evaluation factors is required. Although it is not the intent of this paper to explain the derivation or application of economic evaluation factors, Table 1 presents a summary of these factors, their formulas, symbols and purpose. For additional information regarding basic engineering terminology, cash-flow diagrams, TVM, equivalence and economic evaluation factors, see Refs. [2-91 or consult any engineering economics textbook. An understanding of various project evaluation methods and techniques provides the investor with valuable tools for determining which projects, if any, should be accepted or rejected. Table 2 outlines the typical steps of an economic evaluation [ 1, 6, 10, 111. For additional information on the establishment of the minimum attractive rate of return (MARR), see Refs. [4, 121. For additional information regarding sensitivity analysis, see Refs. [13321]. Once an understanding of the many steps involved in making economic project decisions, as well as the various project evaluation techniques associated with those steps, is obtained, the question of which evaluation methods to use becomes of great interest. The selection of certain project evaluation methods rests primarily on items l-7 listed in Table 2. Yet, once these items have been established, the question of how to determine the best method to use, based on those items, is an economic project in itself. It is not the intent of

Table 1 Summary Factor

of economic

evaluation

factors

[4] Formula 1 Notation Solves for Given

name

Single-payment, Single-payment. Uniform-series. Capital-recovery

present

worth amount

P=F F=P(l

f (1 +i)
+i)

(P.F, ix,

n)

Present Future Present

worth worth worth

Future Present

worth worth worth

compound present

(F/P. i%, n) (PA, i%, n)

worth

P=-III1i;r;,l] A=P[(li(:;t;l]

Annualized

(A/P, i%, II)

Annualized

worth

Present

worth

Sinking

fund A=F[(l +L]

(A/F. i%, n)

Annualized

worth

Future

worth

Uniform-series,

compound

amount

F=A[il+/i-l]

(F/A, i%. n)

Future

worth

Annualized

worth

Table 2 Economic

evaluation

steps [l, IO]

I. Define a set of investment

2. 3. 4. 5. 6. 7. 8. 9.

projects for consideration Establish the planning horizon (or analysis period) for economic study Estimate the cash flow profile for each project Specify the time value of money or minimum attractive rate of return (MARR) Examine the objective and establish criteria to measure effectiveness Apply the project evaluation technique(s) Compare each project proposal for preliminary acceptance or rejection Perform sensitivity analysis Accept or reject a proposal on the basis of the established criteria

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this paper to develop a set of criteria to do this. However, it is the intent of this paper to develop a clear description and understanding of the uses, advantages, disadvantages, and limitations of many different project evaluation techniques. This paper also aims to compare and contrast these methods to provide insight into the economic results of different project evaluation techniques applied to the same project proposal. We also provide a list of references that discuss the subtleties of the evaluation techniques in greater detail than presented here. In Part 1 of this two-part paper, we briefly introduce 25 project evaluation techniques. Then, we examine net present value and rate of return methods. Several examples are included. Part 2 continues with a description of ratio, payback, and accounting methods. Again, several examples are included. Next, we apply almost every technique to one comparative example. Finally, we summarize, compare and contrast all 25 different methods.

2. Project evaluation

techniques

There are many different project evaluation techniques; some are more widely used than others. We have categorized many various methods of project evaluation into five basic types: net present value methods, rate of return methods, ratio methods, payback methods and accounting methods. Each of these methods is shown in Table 3 under the appropriate category. The most popular techniques are the net present value criterion methods, the internal rate of return method, external rate of return method, return on investment method, benefit/cost ratio method and payback period method. In 1978 and 1991, surveys of project evaluation techniques used by some of the largest Fortune 500 companies, such as DuPont, Kodak, Ford, IBM and Westinghouse, were taken [22]. According to these surveys, there has been a shift from the use of the internal rate of return method to the net present value criterion methods, and a decrease in the use of the payback period method. For more

Table 3 Project evaluation

techniques Ratio methods Premium worth percentage (S/S) Return on original investment ($/$) Return on average investment (S/S) Conventional benefit/cost (S/S) Modified benefit/cost (S/$) Lorie-savage benefit/cost ($/S) Profit-to-investment (S/S) Savings-to-investment (S/$) Cost effectiveness (S/unit of effectiveness) Payback methods Conventional payback period Discounted payback period Project balance

Net present vulue methods Net present value criterion Present worth Future worth Annual worth Capitalized worth Life cycle costing Maximum prospective value criterion

Rate qf return methods Internal rate of return External rate of return Growth rate of return Accountiny methods Original book method Average book method Year-by-year method Hoskolds method

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information about which techniques are most widely used by todays businesses and corporations, see Refs. [22-251. Other less common methods include the life cycle costing method, maximum prospective value criterion method, growth rate of return method, premium worth percentage method, profit-to-investment ratio method, savings-to-investment ratio method, cost effectiveness method, project balance method, and accounting methods. Results from the same two project evaluation technique surveys mentioned earlier showed that there was an increase in the use of these less common methods from 7% to 21%. Of those companies surveyed in 1991, no project evaluation was ever done without using either the internal rate of return method or the net present value criterion methods [22, 231. A description of the net present value methods will be presented first, followed by the rate of return methods. The ratio methods, the payback methods, and the accounting methods will be discussed in Part 2 of this two-part paper.

I. Net present

value methods

A. Net present value criterion The net present value criterion method (NPV) is also referred to as the net present worth criterion [l, 26, 271. Usually, when reference is made to this method, it encompasses several other similar methods that use the same economic factors (Table l), but resolved for different times. For this reason, equivalent value or equivalent worth is a better term to characterize all the different analysis periods. Equivalent worth methods are also referred to as discounted cash-flow or equivalence methods [4, 10, 111. In the most general terms, the net present value criterion method can be divided into four subtopics or time analysis periods: present worth method, future worth method, annual worth method, and capitalized worth method. The present worth method examines the cash flows of a project over a given time period and resolves them to one equivalent present date cash how through the use of the economic factors listed in Table 1. Similarly, the future worth method resolves them to one equivalent cash flow at a future date. The annual worth method also examines the cash flows of a project, but does not resolve them to any one cash flow at any one date. Instead, the annual worth method resolves all cash flows to an equivalent series of equal, usually annual cash flows over a specified number of years in any analysis period. Similarly, the capitalized worth method resolves all project cash flows to a series of equal annual cash flows, but, over an infinite time period from any given starting date. One assumption that must be made whenever using any of the equivalence methods is that all cash flows received from a project are reinvested at the same fixed rate used to calculate the equivalent worths [4, 181. This is a subtle but very important assumption which will be examined later. The rate referred to is the interest rate, or rate of return, used in the economic factors presented in Table 1. Usually, this rate is called the minimum attractive rate of return (MARR). Since all four methods use the same economic factors, they yield the same results when used to evaluate a project. Therefore, only one of the four methods is needed to judge the profitability of a project. Thus, the use of the term net present value encompasses all of the equivalence methods. Present worth method. Net present value criterion method can either be used to generalize equivalence methods or specifically refer to the present worth method [6, 271. Table 4 shows terms used to describe all four equivalence methods [l, 446, 9, 12, 13, 18, 25-331. The present worth method provides an easy way to evaluate projects by moving all cash present. Table 5 shows the different criteria for determining the efficiency of a project when present worth method [6]. Using the present worth method is sometimes referred to as Similarly, the interest rate used is sometimes referred to as the discount rate [S]. any of the the different flows to the applying the discounting.

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Table 4 Terms used to describe Equivalence Present worth method method

net present

value or equivalence as

methods

Also known

Net present worth, net present value criterion, net present worth criterion, present worth analysis, net present value profit, venture worth, present worth amounts, general present value model, general, discounted cash flow model, discounted cash flow measures Future worth analysis, future worth-cost, future cost, terminal worth, net future value, net future worth uniform annual uniform annual method

Future Annual

worth worth

method method

Net equivalent uniform annual value criterion, annual equivalent criterion, equivalent worth evaluation, annual worth analysis, equivalent uniform annual cost, equivalent benefit, annualized cash flow method, levelized annual cash flow method Capitalized equivalence worth analysis, capitalized cost method, capitalized

Capitalized

worth

method

equivalence

Table 5 Present worth Resources Fixed input Fixed output

criteria

for determining Constraints

project

efficiency

[6] Criterion Maximize present wortha of benefits or other outputs Minimize present worth of costs of other inputs Maximize present worth of benefits minus costs (i.e., maximize the net present worth)

and limitations

Neither input nor output is fixed The criterion

Amount of resources is fixed There is a fixed task, benefit or other output to be accomplished Neither resources, nor amount of benefits or other outputs is fixed as

holds for the future worth

well as the annual equivalence worth methods

As shown in Table 5, depending upon the situation, maximizing or minimizing the net present worth of a project will provide the most efficiency, and therefore, the most profitability, under the application of the present worth method. When using any project evaluation method, there are three different analysis-period situations to be considered. 1. The useful life of each alternative equals the analysis period. 2. The alternatives have useful lives different from the analysis period, and usually different from each other. 3. There is an infinite analysis period. The useful life of any project is simply the estimated amount of time that the project will be in use (i.e., generate a cash flow, negative or positive). Example 1 demonstrates the use of the present worth method for items 1 and 2 above. An example for item 3 will be presented later when discussing the capitalized worth method, which, by definition, describes a project with an infinite analysis period. To apply the present worth method, the following procedure listed in Table 6 must be followed [27]. In general, a project is accepted if the net present value is positive and rejected if the net present value is negative. If the net present value is equal to zero, then the investor is indifferent to the project. Also, if two or more projects are considered, the project which has the greater present value is generally selected. However, depending on the project situation as described in Table 5, the project with a lower present worth may be better [26, 341. Example la demonstrates the use of the present worth method. For simplicity, most examples in this paper consider the initial investment of the project to be the only negative net cash flow.

84 Table 6 Steps for applying 1. Determine attractive 2. Estimate 3. Estimate 4. Calculate 5. Calculate

D.S. Remer, A.P. Nieto/Int.

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the present

worth

method

[27] rate of return or minimum

the interest rate for which all future cash flows can be reinvested. This is known as the required rate of return (MARR) the economic useful life of the project the positive and negative cash flows for each period over the analysis period the net cash flows of each period the present worth of each of the net cash flows determined above in 4

Example la. Present worth analysis of two projects with equal lioes. The cash flows for two proposed Projects A and B are shown below. (Note: These cash flows will be frequently referred to throughout this paper.) Year Investment ($) Income ($) Operating and maintenance costs ($) Misc. costs ($) Salvage value ($) Net cash flow 6)

Project 0 1 2 3 4 5 Project 0 1 2 3 4 5

A 1000 0 0 0 0 0 B 1000 0 0 0 0 0 0 475 475 375 325 125

0 0 0 0 0 0

375 375 375 375 325

40 40 40 40 40

35 35 35 35 35

0 0 0 0 0

50

- 1000 300 300 300 300 300 - 1000 400 400 300 250 100

30 30 30 30 30

45 45 45 45 45

0
0 0 0

50

Each of these projects has been proposed to accomplish the same purpose. The MARR for both projects is 10%. Using the notation described in Table 1, the present worth of Projects A and B can be expressed as follows: Present worth of Project A: 5) = $137

PWA = - 1000 + 300 (P/A, lo%, Present worth of Project B:

PWB = - 1000 + 400(P/F, + lOO(P/F, lo%,

lO%, 1) + 400(P/F, 5) = $152. present

lO%, 2) + 300(P/F,

lo%,

3) + 250(P/F,

lO%, 4)

Both projects are favorable because they PWB > PWA, Project B should be chosen.

worth

values

greater

than

zero.

However,

since

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An important point to remember is that when using any of the equivalence methods, the same interest rate must be used for comparing both projects. Another important point is that all projects must be compared over equal time periods. However, sometimes the projects to be compared do not always have equal lives. Example lb illustrates this situation.
Example lb. Present worth analysis of two projects with unequal lives The cash flows for two Projects C and D are show below.

Year Project 0 1 2 3 4 5 C

Investment

($)

Net cash flow ($)

1000 0
0 0 0 0

1000
300 300 300 300 300

Project D 0 1 2 3 4 5 6 7 8 9 10

1000
0 0

0
0 0 0 0 0 0 0

- 1000 400 400 300 250 100 250 250 250 250 250

As before, the MARR is assumed to be 10%. The problem of two projects with unequal lives can be overcome by assuming that one project can simply be repeated to provide a longer time period equal to the other project or projects. This is referred to as the repeated projects assumption. Therefore, the best analysis period to consider is equal to the lowest common denominator of the two lives of the project or projects involved. In this example, the lowest common denominator of the two projects is 10 years. In choosing 10 years as the analysis period, Project C must be repeated twice. PWc = - 1000 + 300(P/A, = $222, PWn = - 1000 + 1152 + 250(P/A, lo%, 5)(P/F, lo%, 5) = $741. Again, both projects are favorable because their present worths are greater PW, > PWc, Project D should be chosen lO%, 5) - lOOO(P/F, lO%, 5) + 300(P/A, lO%, 5)(P/F, lO%, 5)

than zero. However,

since

One disadvantage of the present worth method is the repeated projects assumption. This assumes that the cost of the project, if repeated, remains constant throughout the analysis period. Depending upon the project, this assumption may be incorrect. As was assumed in Example lb, the initial investment of Project C was unchanged at the end of five years. However, if the project proposal was to purchase a new computer system, the probability of the costs remaining unchanged over the span of five years is unlikely. In addition,

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a company will probably not want to buy the same computer system after five years. One way to compensate for this drawback is to use cost indexes and cost-capacity equations. A cost index is a ratio of the cost of something today to its cost at some time in the past. The equations of cost capacity relate the size of the project to its cost. Both of these tools can be used to generate a more realistic value for the cost of a project than simply making the repeated projects assumption [30]. For more information on cost indexes and cost-capacity equations, see Refs. [30, 35-411. Future worth method. The present worth method can be thought of as a way to determine the present consequences of an investment. Similarly, the future worth method determines the future consequences of an investment [6]. This method is also known as future worth analysis [6], the future value method [S] and future worth-cost [ll]. See Table 4. The process for calculating the future worth of a project is similar to Table 6, except that all cash flows are compounded or resolved to a future date, usually the end of the projects life [31]. The factors used when making these calculations are listed in Table 1. Just as with the present worth method, the amount measured as the future worth must be evaluated on the basis of Table 5. In general a project is accepted if the future worth is positive, rejected if the future worth is negative. As before, if the future worth is zero, the investor is indifferent to the project [31]. Example 2 shows the use of the future worth method. Since the future worth method is very similar to the present worth method, only one example will be presented. Example 2. Future worth analysis of two projects with equal lives Using the same cash flows as given in Example 1, the future worth of Projects Future worth of Project A: 5) + 300(F/A, lo%, 5) = $221

A and B can be expressed

as:

FWA = - lOOO(F/P, lo%, Future worth FW, of Project B:

= - lOOO(F/P, lo%, + 250(F/P, lo%,

5) + 400(F/P, lo%, 4) + 400(F/P, lo!!, 3) + 300(F/P, IO%, 2) 1) + 100 = $246 are greater than zero. However, since FWB is greater

Both projects are favorable as their future worths than FWA, Project B should be chosen.

As with the present worth method, the future worth method does not distinguish between the sizes of the projects. Also, the problem of the repeated projects assumption is still encountered, although it can be resolved in the same manner described earlier. Annual worth method. The annual worth method is a variation of the two previous discussed methods. Instead of resolving or compounding all cash flows to one present or future date, respectively, this method converts all cash flows to a series of equal, usually annual, cash flows over a specified time, generally the projects life. The factors used to determine the annual worth (shown in Table 1) were derived based on the reasoning that the present worth of the calculated equal annual cash flows must equal the present worth of the original cash flows. The criteria for accepting or rejecting a project are the same as for the present and future worth methods 17311.The criteria for analyzing (i.e., maximizing or minimizing) the annual equivalent amount is the same as that listed in Table 5. Example 3 illustrates the use of the annual worth method Cl]. Example 3. Annual worth analysis of two projects with equal lives Using the same cash flows represented Annual worth of Project in Example 1, the annual worth can be expressed as:

A: AWA = - lOOO(A/P, lo%,

5) + 300 = $36

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To calculate the annual worth of Project B, the problem can be written as in Example 2. However, it can also be incorporated with the present worth method by using the present worth value to calculate the equivalent annual worth. Annual worth of Project B: AW, however, = 152(A/P, lo%, 5) = $40 B should be chosen.

Both projects

are favorable,

since AW, > AWA, Project

Although this method usually requires that the present (or future) worth first be calculated, one advantage of the annual worth method is that there is no need to choose an appropriate number of years (usually the least common multiple of years between projects, see Example lb). It does not matter if the analysis period stretches over one life cycle or two life cycles of the project because the cash flows will be the same each year [4]. Although the repeated projects assumption described earlier still exists, it can be handled in the same way as explained under present worth method. Another advantage of this method is the simplicity of its results. It is sometimes easier to understand the prospects of a project by examining its yearly costs (or benefits) per dollar, than it is to understand the meaning of just one cash flow resolved to the present or a future date. This is especially true for people who are unfamiliar with the meanings of the present and/or future worth of a project. Therefore, the annual worth method can be very useful when explaining the results to people with little or no knowledge of engineering economics. The annual worth method is sometimes referred to as the annual equivalence worth method, net equivalent uniform annual value criterion [12], annual equivalent criterion [31], and equivalent uniform annual worth evaluation [4], (see Table 4). Frequently, in engineering economy literature, it is also referred to as either the equivalent uniform annual cost method or the equivalent annual benefit method. The only difference between these two terms is that the first refers to minimizing the annual worth of costs, while the second refers to maximizing the annual worth of benefits [12]. Capitalized worth method. The capitalized worth method is simply the annual worth method evaluated over an infinite time period. Once the present worth of a project has been established, the annual equivalent cash flow can be calculated (and vice versa), provided the interest rate used remains constant over time. The equation or factor needed to make this calculation is derived from Table 1. It can be expressed in the following way: A = Pi, where A is the capitalized equivalent, P is the present a capitalized cost is shown in Example 4. worth and i is the interest rate [l, 4,121. An example of

Example 4. Capitalized worth analysis of two projects with equal lives Using the same cash flows from Example 1, the annual worth of Project A was found to be $36 (Example 3). If the repeated projects assumption is made, then $36 equals the capitalized annual equivalent. Capitalized annual worth of Project A:

CWA = PWA. i = $36 The present worth of Project A can then be expressed as:

PWA = (CW,/i)

= (36/0.10) = $360. worth of Project B is equal to

Similarly, if the repeated projects assumption is made, the capitalized annual $40 (Example 3). The present worth of Project B can then be expressed as PWB = (CW,/i) = (40/0.10) = $400. B should be chosen.

Since PWB > PWA, Project

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If no repeated projects assumption is made and an infinite life of the project is assumed instead, then the capitalized annual equivalent worth of the project can be found based upon the original present worth of the project. From Example 1, the present worth of Project A was found to be $137, while the present worth of Project B was found to be $152. The capitalized equivalents of each project can then be expressed as cw* cw, = PW*. i = (137)(0.10) = $13.70, = PWn. i = (152)(0.10) = $15.20.

Since PWs > PWA, Project B should be chosen. In this example, both the assumptions of repeated projects and infinite lives may be unrealistic. These assumptions were made only to illustrate the uses of this method. However, there is no need to use this method when any of the other equivalent methods will suffice. The capitalized worth method is usually used on projects which really do have very long lives, such as parks, football stadiums or other public works projects. Under this method, the present worth of the project is commonly referred to as the capitalized cost, while the annual equivalent cash flow is referred to as the perpetuity or equivalent uniform annual cost (or benefit). Other names for this method include the capitalized cost method and capitalized equivalence worth method

WI.
As stated earlier, the net present value criterion methods (NPV) have become more popular over the last 16 years. Out of 27 companies surveyed in 1978, only 52% reported using NPV, whereas out of 33 companies surveyed in 1991, 97% reported using NPV [22, 231. Each of the equivalence methods selected the same project from Examples l-4. Therefore, for the purposes of selecting a project, only one of these methods is required. Depending on the situation, however, one equivalence method may provide more insight than another. Table 7 compares the different uses, advantages and disadvantages among each of the equivalence methods. The net present value may be calculated in four ways using discrete cash flows or continuous cash flows with discrete interest or continuous interest. For simplicity, in this paper, we are only considering discrete cash flows and discrete compounding. For information about finding the net present value using the other

Table I Uses. advantages Equivalence Present worth

and disadvantages Uses Discounts date

among

equivalence

methods Advantages Disadvantages Ignores size of project. Repeated projects assumption. Usually, not understood by people unfamiliar with engineering economics Same as above Ignores size of project. projects assumption Repeated

method

all cash flows to present

Uses TVM. Shows present consequence of a project

Future Annual

worth worth

Compounds all cash flows to a future date Converts all cash flows to a series of equal, usually annual cash Rows Determines equal. usually annual. cash flows equivalent of an infinite lived project

Capitalized

worth

Uses TVM. Shows future consequence of a project Uses TVM. Shows yearly consequence of a project. Easier understood by people unfamiliar with engineering economics. Uses TVM. Shows yearly consequence of an infinite project life

Ignores

size of project

* TVM = Time value of money

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Table 8 Life cycle costing

checklist

[1 S] cost Service reliability Benefits and penalties for quality Salvage value Distribution expense General and administrative expense Conformity with trends Safety and ecological considerations Government rules and regulations Uncertainty and risk

Purchase or manufacturing Transportation cost Installation costs Direct costs Indirect costs Maintenance costs Inventory for materials Inventory for parts Periodic overhauls Supervision

three ways, see Ref. [7]. When evaluating a project, the cash flows can be analyzed using probability methods [l, 4, 12, 34, 27, 28, 373 or fuzzy logic [21, 421. Although inflationary effects should usually be considered, they are ignored in this paper. For information about how to handle inflation, see references [43, 441. B. Life cycle costing General Administration Bulletin No. FPMR E-153 requests that all federal agencies adopt life cycle costing (LCC) as a basis for procuring supplies and services. Used principally by the government, or by large contractors to the government, such as the defense industry [4, 181, life cycle costing is almost the same as the present worth method. All computational methods are the same as those for the present worth method, except that life cycle costing considers all costs in its calculations [4, 181. Table 8 shows a list of some of the specific costs considered when performing life cycle costing [ 181. The project which has the lowest life cycle cost is chosen. The learning curve is also often used with life cycle costing. For information on the uses of learning curves and life cycle costing, see Refs. [45, 473. The similarity of life cycle costing to the present worth method eliminates the need for a separate example. If the costs listed as miscellaneous in Example 1 include the remaining costs listed in Table 8, then the life cycle costing calculation would be identical to the present worth calculation. For more information on the procedure for life cycle costing, see Ref. [47]. C. Maximum prospective value criterion The maximum prospective value criterion method (MPVC) is also very similar to the present worth method. The only difference is that this method examines the reinvestment assumption of the present worth method in greater detail. In addition to assuming that all future cash flows are reinvested at the same interest rate used in the calculations, the maximum prospective value criterion method assumes that there is an investment period available between the actual cash flow reinvestments made for each time period. In other words, the present worth method assumes that there is a cash flow available for reinvestment at equally spaced time intervals, usually years. For discrete compounding and discrete cash flows, the maximum prospective value criterion method assumes that there are short-term investments that can be made, within the equally spaced time intervals, such that a greater cash flow is available at the end of the time interval than would have been otherwise. Therefore, when calculating the maximum prospective value of a project, two interest rates are used. The first interest rate used represents the short-term investment rate [9]. The second interest rate usually represents the MARR, as long as the following three conditions apply: (1) Many short-term investment proposals are being simultaneously considered. (2) Only a small amount of the cash available for short-term investment is allocated to each proposal. (3) The investment return from each proposal is available on a regular periodic basis.

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By offering the advantage of investing now in light of future anticipated opportunities, this method is better at maximizing the capital growth rate. Also, the use of two rates reflects relationships frequently encountered in practice [9]. An example of this method will not be given because of the complexity involved in determining the additional cash flows resulting from the short term investments. However, once these new cash flows are calculated, the application of this method is the same as that explained in Examples l-4. See Ref. [9] for an example of this method. Now that we have discussed net present value methods, we will now consider rate of return methods.

II. Rate of return methods A. Internal rate of return The internal rate of return method (IRR) is a measure of investment worth which calculates the interest rate for which the present worth of a project equals zero [4, 28, 31, 38,48,49]. The term internal implies that the interest rate does not represent any external factors, such as the MARR, but only internal confines of the cash flow [l]. Other names for this method include the rate of return method, discounted cash flow rate of return, interest rate of return, return on investment, investors method, break-even rate of return and profitability index [l, 41. Table 9 shows the different terms used to describe the internal rate of return method and other rate of return methods. In the same 1978 survey discussed earlier in this paper, use of the internal rate of return method was reported by all 27 companies. The 1991 survey showed a decrease in the use of the IRR method from 100% to 90% [22, 231. Although this method does not incorporate the MARR in the calculations, the criteria for accepting or rejecting a project does depend on the available MARR, as shown in Table 10. If the calculated internal rate of return, or the discount rate, i*, is greater than the MARR, i, the project is acceptable. If the calculated discount rate equals the MARR, then the investor remains indifferent to the project. Otherwise, the project is

Table 9 Terms used to describe Rate of return Internal method

rate of return

methods as

Also known

rate of return

External Growth

rate of return rate of return

Rate of return method, discounted cash flow rate of return, interest rate of return, return on investment, investors method, break-even rate of return, profitability index, yield to maturity (for bonds) Composite rate of return, modified rate of return, Solomons average rate of return, overall rate of return No other names found

Table 10 Criteria for the internal Condition

i* > MARR, i i i

rate of return

method

(i* = discount

rate)

Decision Accept project Remain indifferent Reject project

i* = MARR, i* < MARR,

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91

rejected [31]. Since the calculations are based on the net present value criterion method, those same assumptions of immediately reinvesting all future cash flows at the same interest rate must still hold. The procedure for calculating the internal rate of return is demonstrated in Example 5. Example 5. Internal rate of return analysis for two projects with equal lives Again, using the same Projects A and B, as well as the same 10% MARR given in Example worth of a project can be expressed as follows: PWA = - 1000 + 300(P/A, To find the internal implies 1000 = 300(P/A,
iz, 5). i*, of any project,

1, the present

rate of return,

the present

worth

must be set equal to zero. This

ii,

5)

or

(P/A, ix, 5) = 3.333.

In general, the value for i* of any project can be found either by using the exact formula given in Table 1 and solving directly for i*, or by using tables of interest factors for various interests rates (which, prior to programmable calculators and computers, usually required a trial-and-error method). For more information on how to perform either of these two techniques for solving for i*, see Ref. [4] or any other engineering economics textbook. After performing a trial-and-error solution, ix is found to be 15.5%. Similarly, the present worth of Project B can be expressed as follows: PW, = - 1000 + 400(P/F,
iB*, 1) + 400(P/F, iB*, 2) + 300(P/F, i& 3) + 250(P/F, i& 4) + lOO(P/F, i& 5).

Solving for ig is more difficult than solving for ix because of the additional terms involved. However, it can still be done either by solving directly for i$ or using tables of interest factors and a trial-and-error method. Setting PW, equal to zero and solving, ig is found to be 17%. Both of these projects are favorable because their internal rates of return are greater than the MARR. However, since ig > ii, Project B should be chosen. When evaluating among mutually exclusive projects, an incremental analysis of the internal rate of return method may be used [4]. This examines the incremental rate of return of a second project as compared with the first project. Normally, incremental analysis is performed when there are differences in the initial investments of two or more projects. In the previous example, there was really no need to perform this type of analysis because the initial investments of Projects A and B are equal. However, consider the following two sets of cash flows for two mutually exclusive projects:

Year
0

Project

Project

1 IRR PW

- $2000 $4000 100% $818

- $10000 $14000 40% $1364

Using a MARR of lo%, the internal rate of return and present worth for Projects X and Y are calculated. Project X has a higher rate of return, yet Project Y has a higher present worth. This inconsistency can be explained by the need for incremental analysis when comparing mutually exclusive projects with different initial investments. Incremental analysis begins by first examining the project with the lowest initial investment. Then, the project with the second lowest initial investment is examined to determine if the extra incremental

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investment Year 0 1 IRR

is favorable.

The incremental Project

cash flows are found X

to be:

Y - Project

- $8000 $10000 25%

The internal rate of return for the incremental cash flows was calculated to be 25%, which is greater than the 10% MARR. This implies that the incremental investment for Project Y is favorable because the extra $8000 of investment yields a 25% rate of return. Therefore, Project Y should be selected. Of course, the present worth method already established that Project Y was better; however, this illustrates the fact that any rate of return is only a relative percentage measure which ignores the scale of investment. For additional information about incremental analysis and the internal rate of return method, see Refs. [4, 11, 12, 27, 501. Many times, the internal rate of return method offers solutions with multiple roots. Therefore, choosing the correct root is extremely important. For more information concerning this problem, see Refs. [l, 51,24, 121. Also, the assumption of reinvesting all project funds at the determined internal rate of return may not always be realistic, especially when the internal rate of return is very high. For example, a small company may not have other projects which can yield a high internal rate of return. The higher the internal rate of return and the smaller the company, the more likely that this assumption is not realistic. The external rate of return method compensates for these situations [25]. B. External rate of return A variation of the internal rate of return method is the modified or external rate of return method (ERR) [31]. This is almost identical to the internal rate of return method except that the external rate of return method does not assume that all cash flows are immediately reinvested at the calculated internal rate of return. Instead, it assumes that all cash flows are reinvested at another rate (i.e., an external rate of return). This external rate of return is set equal to the MARR providing the investor with q m re realis,:c return on the investment [ll]. The external rate of return method calculates the interest rate for which the future worth of the initial project investment equals the future worth of all other cash flows invested at the MARR [31]. The criteria for accepting or rejecting a project are identical to that described in Table 10. Other names for this method include the composite rate of return, Solomons average rate of return [4, 3 11, and the overall rate of return Cl]; see Table 9. Example 6 demonstrates how to apply the external rate of return method. Example 6. External rate of return analysis of two projects with equal lives Using the same cash flows from Example 1, the future worth of all cash flows after the initial investment Project A can be expressed as FW Alncome= 300(F/A, Solving, i, 5), where i represents the MARR = 10%. for

FWAlncome = $1832. of the initial

= -

The future worth FW

Ahvestment

investment

can be expressed

as the external rate of return. 2. Adding FWAIncome and

lOOO(F/P, ii 5), where ia represents to those

FW~,nvestment

The calculations involved are now similar and setting equal to zero: 1832 - lOOO(F/P, ia, 5) = 0 or

performed

in Example

lOOO(F/P, ix, 5) = 1832.

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Solving, ia, the external rate of return, is found to be equal to 12%, which is less than the internal rate of return, ix of 15.5%. Similarly, the future worth of all cash flows after the initial investment for Project B can be expressed as FW aincome = 400(F/P, Solving, FWBlncome = $1856. of the initial investment can be expressed as the external rate of return.
i, 4) + 400(F/P, i, 3) + 300(F/P, i, 2) + 250(F/P, i, 1) + 100.

The future worth

FW BInvestment = Summing

lOOO(F/P, ii, 5), where i; represent

FWBlncome and FWBlnvestment and setting

equal to zero:

lOOO(F/P, ib, 5) = 1856. Solving, iB is found to be equal to 13%, which is less than the internal rate, ig of 17%. Again, both of these projects are favorable as their external rates of return are greater than the MARR. However, since ik > ia, Project B should be chosen. The lower and more conservative rates given by external rate of return analysis represent the minimum amount of return each of the projects will yield. Usually, when comparing two or more projects, an incremental analysis may be performed. However, for the same reasons given previously, there was really no need to do so here. For information on how to perform incremental analysis, see Refs. [4, 11, 12, 27, 501, or any other engineering economics text book. By assuming that all project funds are reinvested at the MARR, the external rate of return provides more certainty than the internal rate of return because it determines the minimum guaranteed return of the project.
C. Growth rate of return

The growth rate of return method (GRR) determines a projects rate of return at any instance during the projects life. This method answers the question, How fast must this investment grow in order to equal a desired cash Row at a specific date ? To apply this method, a point in time during the projects life (usually a specified year) must be selected for analysis. We shall refer to this point in time as the year of analysis. Two cash flows are then calculated. One cash flow represents the present worth of all negative only cash flows before the year of analysis. The second cash Row represents the value of all other cashjows discounted back (or compounded forward) to the year of analysis. (It should be noted that only the positive cash flows before the year of analysis will be compounded forward.) Both cash flows should be calculated using the MARR. The growth rate of return can then be calculated in manner similar to that described for the internal and external rate of return methods. The criteria for this method are similar to those for the internal rate of return method shown in Table 10 [34]. The results given by the growth rate of return method are identical to those given by the net present value criterion method. Example 7 outlines the procedure for using the growth rate of return method and graphically illustrates its concept. Example 7. Growth rate of return analysis for two projects with equal lives As before, the same set of cash flows given in Example 1 will be used. Since the growth rate of return method can only be applied to one given year at a time, a decision has to be made according to the goals of the company for which Projects A and B are being considered. For this example, the third year has been arbitrarily chosen as the year of analysis. Only the results for Project B will be shown graphically (see Figs. 1 and 2). The first cash flow represents the present worth of all negative cash flows before the year of analysis. In this example, the initial investment is the only negative cash flow before the year of analysis for both Projects A and B. Therefore, no calculation is necessary to find the first cash flow because the initial

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-1 0 1 2
Years

Fig.

1. Original

cash flow of project

B.

Fig. 2. GRR analysis

for year 3.

investment

is already

at the present.

The first cash flow for Projects

A and B can then be represented

as

PW of negative

cash flows before year 3 = PW3ANeg = PW3BNeg = - $1000

Next, the second cash flow must be calculated. This cash flow represents the value of all other cash flows discounted back (or compounded forward) to year 3 or year of analysis. For Project A, all remaining cash flows must be compounded or discounted (at the MARR = 10%) to year 3. This can be expressed as follows: Cash flow at year 3 = CF,, = 300(F/A, i, 3) + 300(P/A, i, 2), where i = MARR = 10%.

Solving, CF,* is found to be $1514. Having found the first and second cash flows, the procedure to calculate the growth rate of return to that described for the internal and external rate of return methods (see Examples 5 and 6). The flow represents a present worth. The second cash flow represents some future worth (year 3 for our The growth rate of return is simply the rate at which the first cash flow must grow in order to second cash flow. This can be expressed as follows: lOOO(F/P, iGA, 3) = 1514, where ioA equals the growth rate of return for Project A.

is similar first cash example). equal the

Solving, iGA is found to be 14%. For Project B, the first cash flow, representing the present worth of all negative cash flows before the year of analysis, was shown to be equal to the initial investment of $1000. To find the second cash flow, the remaining cash flows must be compounded or discounted to year 3. This can be expressed as Cash flow of at year 3 = CFAB = 400(F/P, i, 2) + 400(F/P, i, 1) + 300 + 250(P/F, i, 1) + lOO(P/F, i, 2),

where i = MARR = 10% Solving, CF,, is found to be $1534. Having determined the first and second cash flows, we can calculate the rate at which the first cash flow must grow in order to equal the second cash flow (i.e., the growth rate of return). This can be represented as lOOO(F/P, icB, 3) = 1534, where i GBequals the growth rate of return for Project the question, How fast must this investment grow to equal $1534 by year 3? Solving, ioB is found to be 15% B. Therefore, iGB answers

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Both Projects A and B are favorable because their growth rates of return are greater than the MARR. However, since ice > iGA, Project B has a better growth rate and should be chosen. If the year of analysis was chosen to be year 5, the growth rate of return would have been equal to the external rate of return calculated in Example 6. Similarly, if the year of analysis was year 0, the growth rate of return would have equaled the internal rate of return calculated in Example 5. Also, in this example, the decision to select Project B would not have been different for an analysis performed at any other year because the initial investments were the only negative cash flows. This may not always be the case as different project proposals may have other negative cash flows in addition to the initial investments. Thus, depending on the year selected for analysis, a project may prove to be most favorable at one year, while another project may be more favorable at different year. The growth rate of return method depends solely upon the time period or year of analysis chosen for discounting and/or resolving all cash flows. Therefore, it only yields one growth rate of return for each selected time period or year of analysis. However, it does provide the investor with a method for calculating the rate of return a project promises to give at a certain time for a given investment. The rate of return methods calculate the rate of return by solving for 7. Part 2 of this two-part paper continues with a description of the Ratio Methods which calculate the rate of return from ratios usually based upon equivalent worth values. Part 2 also discusses payback and accounting methods and provides a recap, comparison, and full summary of all 25 project evaluation techniques presented in this two-part paper.

References
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