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ROR Notes PDF

This document discusses rate of return calculations and concepts in engineering economy. It defines rate of return as the interest rate at which the present worth of a cash flow pattern reduces to zero. It also discusses minimum acceptable rate of return, internal rate of return calculations and misconceptions, cost of capital concepts, and replacement models. Two sample problems are included to demonstrate calculating the rate of return for new business investments by setting the net present worth equal to zero and interpolating between interest rates.

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PriYansh PaTel
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110 views

ROR Notes PDF

This document discusses rate of return calculations and concepts in engineering economy. It defines rate of return as the interest rate at which the present worth of a cash flow pattern reduces to zero. It also discusses minimum acceptable rate of return, internal rate of return calculations and misconceptions, cost of capital concepts, and replacement models. Two sample problems are included to demonstrate calculating the rate of return for new business investments by setting the net present worth equal to zero and interpolating between interest rates.

Uploaded by

PriYansh PaTel
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Engineering Economy (10IM52)

UNIT - 5
RATE OF RETURN CALCULATIONS: Rate of return, Minimum acceptable rate of return,
IRR, IRR misconceptions, Cost of capital concepts, replacement models.

5.1 Rate of return


The rate of return of a cash flow pattern is the interest rate at which the present worth of that
cash flow pattern reduces to zero. In this method of comparison, the rate of return for each
alternative is computed. Then the alternative which has the highest rate of return is selected
as the best alternative.
In this type of analysis, the expenditures are always assigned with a negative sign and
the revenues/inflows are assigned with a positive sign.
A generalized cash flow diagram to demonstrate the rate of return method of comparison is
shown in Figure 5.1

Figure 5.1 Generalized cash flow diagram

In the above cash flow diagram, P represents an initial investment, Rj the net revenue at the
end of the Jth year, and S the salvage value at the end of the nth year.
The first step is to find the net present worth of the cash flow diagram using the following
expression at a given interest rate, i.

PW(i) = – P + R1/(1 + i)1 + R2/(1 + i)2 + ...+ Rj/(1 + i) j + ..... ..


+ Rn/(1 + i)n + S/(1 + i)n
Engineering Economy (10IM52)

As shown in the figure 5.2 , the present worth goes on decreasing when the interest
rate is increased. The value of i at which the present worth curve cuts the X-axis is the
rate of return of the given proposal/project. It will be very difficult to find the exact
value of i at which the present worth function reduces to zero.

Figure 5.1 Present worth function


So, the analyst has to start with an intuitive value of i and check whether the present
worth function is positive. If so, increase the value of i until PW (i) becomes negative. Then,
the rate of return is determined by interpolation method in the range of values of i for
which the sign of the present worth function changes from positive to negative.
5.2 Minimum acceptable (attractive) rate of return (MARR)
If, as is often the case, the interest rate at which a project should be evaluated is not known, a
target rate, cut-off rate, or valuation rate will be used. This rate is also called the minimum
attractive rate of return (abbreviated MARR). While dependent on general company policy,
the MARR may also be project specific, and will normally increase with the risk attending the
project.
5.3 IRR, IRR misconceptions
Engineering Economy (10IM52)

The consistency of AW and PW comparisons always agree with IRR evaluation when done
correctly and there are some misconceptions
a) Ranking alternatives by indivisual IRR values-The incremental analyaia was ued that
ranking indisual alternaives IRR values
b) More than one possible rate of return-when the cash flow or cummulative cash flow of
a project switches from negative to positive more than once the project may have more
than one roots of the PW equation PW(i)=0
c) Explicit investment rate-an explicit reinvestment rate is a designated interest
percentage appropriate for a specific application.
d) Project balance method-this involves calculation of i* if there are multiple I values
e) Reinvestment question

Problem 1: A person is planning a new business. The initial outlay and cash flow pattern
for the new business are as listed below. The expected life of the business is five years. Find
the rate of return for the new business.
Period 0 1 2 3 4 5
Cash flow –1,00,000 30,000 30,000 30,000 30,000 30,000 (Rs.)

Solution
Initial investment = Rs. 1,00,000
Annual equal revenue = Rs. 30,000
Life = 5 years
The cash flow diagram for this situation is shown in figure 5.3
Engineering Economy (10IM52)

Figure 5.3 Cash flow diagram


The present worth function for the business is
PW (i) = –1, 00,000 + 30,000(P/A, i, 5) When i = 10%,
PW (10%) = –1, 00,000 + 30,000(P/A, 10%, 5)

= –1, 00,000 + 30,000(3.7908)

= Rs. 13,724.

When i = 15%,
PW(15%) = –1,00,000 + 30,000(P/A, 15%, 5)

= – 1, 00,000 + 3 0 , 0 0 0 (3.3522)

= Rs. 566.

When i = 18%,
PW(18%) = –1,00,000 + 30,000(P/A, 18%, 5)

= –1, 00,000 + 3 0 , 0 0 0 (3.1272)

= Rs. – 6,184

566 − 0
i = 15% + 3%
566 − (−6184)

i=15%+0.252%

i=15.252%
Problem 2: A company is trying to diversify its business in a new product line. The life of
the project is 10 years with no salvage value at the end of its life. The initial outlay of the
project is Rs. 20, 00,000. The annual net profit is Rs. 3, 50,000. Find the rate of return for
the new business.
Engineering Economy (10IM52)

Solution
Life of the product line (n) = 10 years
Initial outlay = Rs. 20,00,000
Annual net profit = Rs. 3,50,000
Scrap value after 10 years = 0
The cash flow diagram for this situation is shown in Figure 5.4

Figure 5.4 Cash flow diagram


The formula for the net present worth function of the situation is
PW (i) = –20, 00,000 + 3, 50,000(P/A, i, 10) When i = 10%,
PW (10%) = –20, 00,000 + 3, 50,000(P/A, 10%, 10)

= –20, 00,000 + 3, 50,000(6.1446)

= Rs. 1, 50,610. When i = 12%,


PW (12%) = –20,00,000 + 3,50,000 (P/A, 12%, 10)

= –20,00,000 + 3,50,000 (5.6502)

= Rs. –22,430.

150610 − 0
i = 10% (2%)
150610 − (−22430)

i=11.74%
Therefore, the rate of return of the new product line is 11.74%

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