Chapter 7

Rate of Return
One Project
Lecture slides to accompany

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin

© 2012 by McGraw-Hill All Rights Reserved

7-1
 LEARNING OUTCOMES
1. Understand meaning of ROR
2. Calculate ROR for cash flow series
3. Understand difficulties of ROR
4. Determine multiple ROR values
5. Calculate External ROR (EROR)
6. Calculate r and i for bonds
© 2012 by McGraw-Hill All Rights Reserved
7-2
 Interpretation of ROR
Rate paid on unrecovered balance of borrowed money
such that final payment brings balance to exactly zero
with interest considered

ROR equation can be written in terms of PW, AW, or FW

Use trial and error solution by factor or spreadsheet

Numerical value can range from -100% to infinity

© 2012 by McGraw-Hill All Rights Reserved

7-3
 ROR Calculation and Project Evaluation
 To determine ROR, find the i* value in the relation

PW = 0 or AW = 0 or FW = 0

 Alternatively, a relation like the following finds i*

PWoutflow = PWinflow

 For evaluation, a project is economically viable if

i* ≥ MARR
© 2012 by McGraw-Hill All Rights Reserved
7-4
 Finding ROR by Spreadsheet Function
Using the RATE function Using the IRR function
= RATE(n,A,P,F) = IRR(first_cell, last_cell)

P = $-200,000 A = $-15,000
n = 12 F = $435,000

Function is
= RATE(12,-15000,-200000,450000)
= IRR(B2:B14)

Display is i* = 1.9%

© 2012 by McGraw-Hill All Rights Reserved

7-5
 ROR Calculation Using PW, FW or AW
Relation
ROR is the unique i* rate at which a PW, FW, or AW relation equals exactly 0

A company bought a certain amount of shares

for $100,000 in a new startup company. The
company was able to sell its shares for $1.2
Million after 7 years, find the rate of return for
this investment.

PW = -100K+1.2M(P/F,i*,7)

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

1-6
 ROR Calculation Using PW, FW or AW Relation

ROR is the unique i* rate at which a PW, FW, or AW relation equals exactly 0

Example: An investment of $20,000 in new equipment will

generate income of $7000 per year for 3 years, at which time the
machine can be sold for an estimated $8000. If the company’s
MARR is 15% per year, should it buy the machine?

Solution:: The ROR equation, based on a PW relation, is:

0 = -20,000 + 7000(P/A,i*,3) + 8000(P/F,i*,3)
Solve for i* by trial and error or spreadsheet: i* = 18.2% per year
Since i* > MARR = 15%, the company should buy the machine
© 2012 by McGraw-Hill All Rights Reserved
7-7
Special Considerations for ROR
May get multiple i* values (discussed later)

i* assumes reinvestment of positive cash flows

earn at i* rate (may be unrealistic)

Incremental analysis necessary for multiple

alternative evaluations (discussed later)

© 2012 by McGraw-Hill All Rights Reserved

7-8
 Multiple ROR Values
Multiple i* values may exist when there is more than one sign
change in net cash flow (CF) series.
Such CF series are called non-conventional

Two tests for multiple i* values:

Descarte’s rule of signs: total number of real i* values

is ≤ the number of sign changes in net cash flow series.

Norstrom’s criterion: if the cumulative cash flow starts off

negatively and has only one sign change, there is only one
positive root .
© 2012 by McGraw-Hill All Rights Reserved
7-9
Plot of PW for CF Series with Multiple ROR Values

i* values at
~8% and ~41%
© 2012 by McGraw-Hill All Rights Reserved
7-10
 Example: Multiple i* Values
Determine the maximum number of i* values for the cash flow shown below
Year Expense Income Net cash flow Cumulative CF
0 -12,000 - -12,000 -12,000
1 -5,000 + 3,000 -2,000 -14,000
2 -6,000 +9,000 +3,000 -11,000
3 -7,000 +15,000 +8,000 -3,000
4 -8,000 +16,000 +8,000 +5,000
5 -9,000 +8,000 -1,000 +4,000

Solution:

The sign on the net cash flow changes The cumulative cash flow begins
twice, indicating two possible i* values negatively with one sign change
Therefore, there is only one i* value ( i* = 8.7%)
© 2012 by McGraw-Hill All Rights Reserved
7-11
 Removing Multiple i* Values
Two new interest rates to consider:
Investment rate ii – rate at which extra funds
are invested external to the project

Borrowing rate ib – rate at which funds are

borrowed from an external source to provide
funds to the project

Two approaches to determine External ROR (EROR)

• (1) Modified ROR (MIRR)
• (2) Return on Invested Capital (ROIC)
© 2012 by McGraw-Hill All Rights Reserved
7-12
Modified ROR Approach (MIRR)
Four step Procedure:
Determine PW in year 0 of all negative CF at ib

Determine FW in year n of all positive CF at ii

Calculate EROR = i’ by FW = PW(F/P,i’,n)

If i’ ≥ MARR, project is economically justified

© 2012 by McGraw-Hill All Rights Reserved

7-13
 Example: EROR Using MIRR Method
For the NCF shown below, find the EROR by the MIRR method if
MARR = 9%, ib = 8.5%, and ii = 12%
Year 0 1 2 3
NCF +2000 -500 -8100 +6800

Solution: PW0 = -500(P/F,8.5%,1) - 8100(P/F,8.5%,2)

= $-7342

FW3 = 2000(F/P,12%,3) + 6800

= $9610
PW0(F/P,i’,3) + FW3 = 0
-7342(1 + i’)3 + 9610 = 0
i’ = 0.0939 (9.39%)
Since i’ > MARR of 9%, project is justified
© 2012 by McGraw-Hill All Rights Reserved
7-14
 Example: EROR Using MIRR Method
For the NCF shown below, find the EROR by the MIRR method if
MARR = 9%, ib = 8.5%, and ii = 12%
Year 0 1 2 3 4
NCF +2000 -500 -8100 +6800 +1207

© 2012 by McGraw-Hill All Rights Reserved

7-15
Return on Invested Capital Approach (ROIC)
Measure of how effectively project uses funds that remain internal to project

ROIC rate, i’’, is determined using net-investment procedure

Three step Procedure

(1) Develop series of FW relations for each year t using:
Ft = Ft-1(1 + k) + NCFt
where: k = ii if Ft-1 > 0 and k = i’’ if Ft-1 < 0

(2) Set future worth relation for last year n equal to 0 (i.e., Fn= 0); solve for i’’

(3) If i’’ ≥ MARR, project is justified; otherwise, reject

© 2012 by McGraw-Hill All Rights Reserved
7-16
 ROIC Example
For the NCF shown below, find the EROR by the ROIC method if
MARR = 9% and ii = 12%
Year 0 1 2 3
NCF +2000 -500 -8100 +6800

Solution:
Year 0: F0 = $+2000 F0 > 0; invest in year 1 at ii = 12%
Year 1: F1 = 2000(1.12) - 500 = $+1740 F1 > 0; invest in year 2 at ii = 12%
Year 2: F2 = 1740(1.12) - 8100 = $-6151 F2 < 0; use i’’ for year 3
Year 3: F3 = -6151(1 + i’’) + 6800 Set F3 = 0 and solve for i’’

-6151(1 + i’’) + 6800 = 0

i’’= 10.55%
Since i’’ > MARR of 9%, project is justified
© 2012 by McGraw-Hill All Rights Reserved
7-17
 ROIC Example
For the NCF shown below, find the EROR by the ROIC method if
MARR = 9% and ii = 12%
Year 0 1 2 3 4
NCF +2000 -500 -8100 +6800 +1207

Solution: i’’ = 26%

© 2012 by McGraw-Hill All Rights Reserved

7-18
 Important Points to Remember
About the computation of an EROR value
 EROR values are dependent upon the
selected investment and/or borrowing rates
 Commonly, multiple i* rates, i’ from MIRR and
i’’ from ROIC have different values

About the method used to decide

 For a definitive economic decision, set the
MARR value and use the PW or AW method
to determine economic viability of the project
7-19 © 2012 by McGraw-Hill All Rights Reserved
 Qustion

Consider the following business, if ii = 12%

and ib = 8% and the MARR is 15% would you
invest in the following business:

0 1 2 3 4 5 6 7 8 9 10 11

EOY
-200 -200 380 380 380 380 -200 -200 -200 -200 -200 -200
CF

© 2012 by McGraw-Hill, New York, N.Y All Rights Reserved

1-20
 © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
1-21
 Summary of Important Points
ROR equations can be written in terms of PW, FW, or AW and
usually require trial and error solution

i* assumes reinvestment of positive cash flows at i* rate

More than 1 sign change in NCF may cause multiple i* values

Descarte’s rule of signs and Norstrom’s criterion useful when

multiple i* values are suspected

EROR can be calculated using MIRR or ROIC approach.

Assumptions about investment and borrowing rates is required.

General ROR equation for bonds is

0 = - P + I(P/A,i*,nxc) + V(P/F,i*,nxc)
© 2012 by McGraw-Hill All Rights Reserved
7-23