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METHOD
INTERNAL RATE OF
RETURN
The Internal Rate of Return (IRR) Method is the most
widely used rate of return method for performing
engineering economic analyses. It is sometimes called
by several other names such as the investors method,
the discounted cash flow method, and the profitability
index.
INTERNAL RATE OF
RETURN
This method solves for the interest rate that equates
the equivalent worth of an alternatives cash inflows
(receipts or savings) to the equivalent worth of cash
outflows (expenditures, including investment costs).
Equivalent worth may be computed with any of the
three methods discussed earlier. The resultant interest
rate is termed the Internal Rate of Return (IRR).
INTERNAL RATE OF
RETURN
For a single alternative, from the lenders viewpoint,
the IRR is not positive unless
(1) both receipts and expenses are present in the cash
flow pattern, and
(2) The sum of receipts exceeds the sum of all cash
outflows. Be sure to check both of these conditions
in order to avoid the unnecessary work involved in
finding that the IRR is negative. (Visual inspection of
the total net cash flow will determine whether the
IRR is zero or less)
INTERNAL RATE OF
RETURN (I%)it can be seen that the IRR is the
By using a PW formulation,
(i%) at which
At I = 15%:
PW: -10,000 + 2,311(3.3522) + 2,000(0.4972)
PW = -$1,259
INTERNAL RATE OF
RETURN (I%)
Linear Interpolation:
PW(20%) = $934.29
FW(20%) = $2,324.80
AW(20%) = $312.40
Interpolate:
I% = 21.58%
Thus, we conclude that the new equipment is economically
feasible.
INTERNAL RATE OF
RETURN (I%)
PROBLEM #3
You may also use Excel Spreadsheet to Solve for the IRR and
Shift Solve
INTERNAL RATE OF
RETURN (I%)
Problem #4
Where
Rk = excess of receipts over expenses in period k,
Ek = excess of expenditures over receipts in period
k,
N = project life or number of periods for the study
= external reinvestment rate per period
EXTERNAL RATE OF
ARETURN METHOD
project is acceptable when I% of the ERR method
is greater than or equal to the firms MARR.
The ERR method has two basic advantages over the
IRR method:
(1) It can usually be solved to the possibility of
multiple rates of return.
(2) It can usually be solved directly, without needing
to resort to trial and error
EXTERNAL RATE OF
RETURN METHOD
A piece of new equipment has been proposed by
engineers to increase the productivity of a
certain manual welding operation. The
investment cost is $25,000, and the equipment
will have a market value of $5,000 at the end of
a study period of 5 years. Increased productivity
attributable to the equipment will amount to
$8,000 per year after extra operating costs have
been subtracted from the revenue generated by
the additional production. If the =MARR is 20%
per year. What is the projects ERR, and is the
project acceptable?
EXTERNAL RATE OF
RETURN METHOD
Solution:
I% = 20.88%
Because i%> MARR, the project is justified, but just
barely.
EXTERNAL RATE OF
RETURN
PROBLEM
#1