Sunteți pe pagina 1din 41

IRR,ERR, AND

PAYBACK PERIOD Engineering Economy

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

Where Rk = net revenues or savings for the kth


year,
Ek = net expenditures, including any
investment costs for the kth year
N = project life (or study period)
INTERNAL RATE OF
RETURN
Once, I% has been (I%)
calculated, it is compared with the
MARR to assess whether the alternative in question is
acceptable.

If I%> MARR, the alternative is acceptable; otherwise,


it is not.
INTERNAL RATE OF
RETURN (I%)
PROBLEM #1
An investment of $10,000 can be made in a project that
will produce uniform annual revenue of $5,311 for five
years and then a market or salvage value of $2,000.
Annual expense will be $3,000 each year. The company is
willing to accept any project that will earn 10% per year or
more on all invested capital. Determine whether it is
acceptable by using the IRR method.
INTERNAL RATE OF
RETURN (I%)
SOLUTION #1
In this example, the sum of the positive cash flows
(13,555) exceeds the sum of negative cash flows
(10,000). Thus, it is likely, that a positive-valued I%
can be determined. By writing an equation for the PW
of the projects total net cash flow and setting it equal
to zero, it can compute the IRR.
INTERNAL RATE OF
RETURN (I%)
Solution:

If the answer has not been known, it would probably try a


relative low I% such as 5%, and a relatively high I, such as
15%. Linear interpolation will be used to solve the I%.
INTERNAL RATE OF
RETURN
At I = 5%: (I%)
PW: -10,000 + 2,311(4.3295) + 2,000(0.7835)
PW = $1,572

At I = 15%:
PW: -10,000 + 2,311(3.3522) + 2,000(0.4972)
PW = -$1,259
INTERNAL RATE OF
RETURN (I%)
Linear Interpolation:

Because the IRR of the project (10.5%) is


greater than the MARR, the project is
acceptable.

You may use SHIFT SOLVE


INTERNAL RATE OF
RETURN (I%)
PROBLEM #2

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, is this proposal a sound one? Use the
IRR of the proposed equipment.
INTERNAL RATE OF
RETURN (I%)
SOLUTION #2

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

Project Long is expected to provide five years if cash


inflows and to require an initial investment of $100,000.
The required rate of return or discount rate that is
appropriate for valuing cash of Project Long is 17 percent.
What is the PLs IRR, and is it a good investment
opportunity?
INTERNAL RATE OF
RETURN (I%)
SOLUTION #3

0 = -100,000 + 70,000(P/F, I, 1) + 30,000 (P/F, I, 2) + 30,000 (P/F,


I, 3)
+ 25,000 (P/F, I, 4) + 10,000 (P/F, I, 5)

IRR = 27.68% Good to invest!


INTERNAL RATE OF
RETURN (I%)
SOLUTION #3

You may also use Excel Spreadsheet to Solve for the IRR and
Shift Solve
INTERNAL RATE OF
RETURN (I%)
Problem #4

APC Associates is a small consulting firm in Oregon, and


they are considering the purchase of a new copying center
for the office than can copy, fax, and scan documents. The
new machine costs $10,010 to purchase and is expected to
provide cash flow savings over the next four years of
$1,000; $3,000; $6,000; and $7,000. The employee in
charge of performing a financial analysis of the proposed
investment has decided to use the IRR as her primary
criterion for making a recommendation to the managing
partner of the firm. If the required rate of return or discount
rate the firm uses to value the cash flows from office
equipment purchases is 15%. Is this a good investment for
the firm?
INTERNAL RATE OF
RETURN (I%)
Solution #4

IRR = 19%, Good to invest!


EXTERNAL RATE OF
RETURN METHOD
The reinvestment assumption of the IRR method may not
be valid in an engineering economy study. For instance, if
a firms MARR is 20% per year and the IRR for a project is
42.4% it may not be possible for the firm to reinvest net
cash proceeds from the project at much more than 20%.
This situation, coupled with the computational demands
and possible multiple interest rates associated with the
IRR method, has given rise to other rate of return
methods that can remedy some of these weaknesses.

*Also known as MIRR Modified Internal Rate of Return


EXTERNAL RATE OF
RETURN METHOD
One such method is the external rate of
return method (ERR). It directly takes into
account the interest rate () external to a
project at which net cash flows generated or
required by the project over its life can be
reinvested (or borrowed). If this external
reinvestment rate, which is usually the firms
MARR, happens to equal the projects IRR,
then the ERR method produces results
identical to those of the IRR method.
EXTERNAL RATE OF
RETURN METHOD
In general, three steps are used in the calculating
procedure. First, all net cash outflows are discounted
to time 0 (the present) at % per compounding
period. Second, all net cash inflows are compounded
to period N at %. Third, the external rate of return,
which is the interest rate that establishes
equivalence between the two quantities, is
determined.
The absolute value of the present equivalent worth of
the net cash outflows at % (first step is used in the
last step. In equation form, the ERR is the I% at
which:
EXTERNAL RATE OF
RETURN
Modified internal rate of return (MIRR) assumes that
positive cash flows are reinvested at the firm's cost of
capital, and the initial outlays are financed at the firm's
financing cost. By contrast, the traditionalinternal rate of
return (IRR)assumes thecash flowsfrom a project are
reinvested at the IRR. The MIRR more accurately reflects
the cost and profitability of a project.
EXTERNAL RATE OF
RETURN METHOD

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

MARR = 17%, Is the project justifiable?


EXTERNAL RATE OF
RETURN
SOLUTION
#1

By solving, the ERR is 21% and good to invest!


PAYBACK (PAYOUT)
PERIOD METHOD
All methods presented thus far reflect the profitability
of a proposed alternative for a study period of N. The
payback method, which is often called the simple
payout method, mainly indicates a projects liquidity
rather than its profitability.
Historically, the payback method has been used as a
measure of a projects riskiness, since liquidity deals
with how fast an investment can be recovered. A
riskiness, since liquidity deals with how fast an
investment can be recovered. A low-valued payback
period is considered desirable.
PAYBACK (PAYOUT)
PERIOD METHOD
Quite simply, the payback method calculates the
number of years required for cash inflows to just equal
cash outflows. Hence, the simple payback period is the
smallest value of ( < or = N) for which this
relationship is satisfied under our normal end-of-year
cash flow convention. For a project where all capital
investment occurs at time 0, we have
PAYBACK (PAYOUT)
PERIOD METHOD
The simple payback period, , ignores the time value of money and
all cash flows that occur after
If this method is applied to the investment project.
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 E =MARR is
20% per year. What is the projects ERR, and is the project
acceptable?
PAYBACK (PAYOUT)
PERIOD METHOD
The number of years required for the undiscounted sum of cash
inflows to exceed the initial investment is 4 years. This calculation is
shown in the table
EOY k Net Cash Cumulative PW of Cash Cumulative
Flow PW of Cash Flow at PW at i=20%
Flow at i=20% per per year,
i=0% per year through
year year K.
through
year k
0 -25,000 -25,000 -25,000 -25,000
1 8,000 -17,000 6,667 -18,333
2 8,000 -9,000 5,556 -12,777
3 8,000 -1,000 4,630 -8,147
4 8,000 7,000* 3,858 -4,289
5 13,000 5,223 934**
PAYBACK (PAYOUT)
PERIOD METHOD
* - 4 years because the cumulative balance turns positive at
EOY 4.
** - 5 years because the cumulative discounted balance turns
positive at EOY 5

The payback period does not indicate anything about project


desirability except the speed with which the investment will be
recovered. The payback period can produce misleading results, and it
is recommended as supplemental information only in conjunction with
one or more of the five methods previously discussed.
Sometimes, the discounted payback period, ( < or = N), is
calculated so that the time value of money is considered.
DISCOUNTED PAYBACK
PERIOD
To deal with the criticism that the payback period
ignores the time value of money, some firms use the
discounted payback period approach. The discounted
payback period approach is similar to the traditional
payback period except that it uses discounted cash
flows (using the same discount rate used in calculating
the PW) to calculate the payback period. Thus, the
discounted payback period is defined as the number of
years needed to recover the initial cash outlay from
the discounted cash flows.
PROJECT LONG
PROBLEM
PAYBACK (PAYOUT)
PERIOD METHOD

Where i% is the MARR, I is the capital investment usually


made at the present time (k=0), and is the smallest
value that satisfies on the equation.
PAYBACK (PAYOUT)
PERIOD METHOD
A proposed manufacturing plant will require a fixed
capital investment of P6M and an estimated working
capital of P1M. Annual depreciation is estimated to be
5% of the fixed capital investment. If the annual profit
is P3M, determine the rate of return on the total
investment and the minimum payback period.
PAYBACK (PAYOUT)
PERIOD METHOD
A) ROR = net annual profit / capital invested
ROR = [3M (0.05*6M)] / (6M+1M)
ROR = 38.57%
B) Payback period = investment salvage value / net
annual cash flow
Payback period = 7M / 3M = 2.33 years.
PROBLEM #1
An existing machine in a factory has an annual
maintenance cost of P40,000. A new and more efficient
machine will require an investment of P90,000 and is
estimated to have a salvage value of 30,000 at the end
of 9 years. Its annual expenses for maintenance and
upkeep etc., total P22,000. If the company expects to
earn 12% on its investment, will it be worthwhile to
purchase the new machine using PW Method and Rate
of Return Method?
SOLUTION #1
PW
PW for existing machine:
-40,000 (P/A, 12%, 8) = -198, 700
PW for new machine:
-90,000 - 22,000(P/A, 12%, 8) +30,000(P/F, 12%, 8) =
-187,170

Thus it is better to invest in the new machine.


SOLUTION
Rate of Return:
Annual Cost for existing machine: 40,000
Annual Cost for new machine:
Depreciation: (90,000-30,000)(A/F, 12%, 8) : 4,880
Annual maintenance, etc.: 22,000
Total annual cost: 26,880
Annual Saving is 13,120
ROI = 13,120/90,000*100% = 14.6%>12%
It is wise to purchase the new machine

S-ar putea să vă placă și