4.1.

Rate of Return Method

Our first method for making economic studies is the Rate of Return (ROR)
Method.
 

ROR equation:
 

Rate of Return = Net Annual Profit / Capital Invested

 

ROR is the ratio between the money gained or lost on an investment and
the amount of money invested. The other three methods for making
economy studies are based on the investment’s rate of return.
 

The rate of return is a measure of effectiveness of an investment of capital

and it is a financial efficiency.  The computed ROR is used to justify the
investment.
 

We have the MARR or minimum acceptable rate of return which is the

minimum return level at which the capital project must provide in order for
it to be feasible. An organization's MARR is just that, the lowest internal rate
of return the organization would consider to be a good investment. The
MARR is a statement that an organization is confident it can achieve at least
that rate of return.
 
This method is controlled by the following conditions: 
  - a single investment of capital at the beginning of the first year of the
project life,
  - identical revenue and cost data for each year.
 

The capital invested is the total amount of capital investment required to

finance the project, whether equity or borrowed.
 

Let's take this problem as an example for this whole module.

 

Problem:
An investment of P270,000 will produce an annual revenue of P185,400 for
5 years and have a salvage value of 10% of the investment. Operations and
maintenance costs is P81,000 per year.  Taxes & insurance is 4% of the first
cost per year. Expected ROR is 25% before income taxes. Is this a desirable
investment?
 

Solution:
Annual Revenue = P185,400
 

Annual Costs:
Depreciation = (270,000 – 27,000)x .25/(1.255 – 1) = 29,609
Operation & maintenance = 81,000
Taxes & insurance (0.04 x 270,000) = 10,800
Total annual costs = 121,409
 

Net annual profit = 185,400 – 121,409 = 63,991

Projected ROR = (63,991 / 270,000) x 100  =  23.70%
 

Since the projected ROR is less than expected ROR of 25%, the investment
is not justified.

4.2. Basics of Rate of Return

In finance, return is a profit on an investment.

 

Rate of return(ROR) is a profit on an investment over a period of time,

expressed as a proportion of the original investment.
 

Internal Rate of Return(IRR) is calculating ROR taking only internal factors

and not considering external factors like inflation and cost of capital.
Generally speaking, the higher a project's internal rate of return, the more
desirable it is to undertake. Assuming the costs of investment are equal
among the various projects, the project with the highest IRR would probably
be considered the best and be undertaken first.
 

You can think of internal rate of return as the rate of growth a project is
expected to generate. While the actual rate of return that a given project
ends up generating will often differ from its estimated IRR, a project with a
substantially higher IRR value than other available options would still
provide a much better chance of strong growth.
 

One popular use of IRR is comparing the profitability of establishing new

operations with that of expanding existing ones. For example, an energy
company may use IRR in deciding whether to open a new power plant or to
renovate and expand a previously existing one. While both projects are
likely to add value to the company, it is likely that one will be the more
logical decision as prescribed by IRR.
 

The External Rate of Return (ERR) is the ROR on a project where any excess

cash from a project is assumed to earn interest at a pre-determined explicit
rate —usually the Minimum Acceptable ROR (MARR). Computing an exact
ERR is difficult.
 

The ERR method should be used whenever multiple IRRs are possible.
Unfortunately, it is sometimes hard to know in advance when there are
multiple IRRs. However, most investments will have a cash flow structure
which excludes multiple IRRs. If a project is a simple investment, it will have
at most one positive IRR.
 

Simple investment is an investment characterized by one or more periods of

cash outflows, followed by one or more periods of cash inflows. If a project
is not a simple investment, there maybe more than one IRR. If the sign of
successive cash flows changes n no. of times (say 11) there may be up to n
no. of IRRs (also 11).
 

Remember  three (3) things:

1. Use a regular IRR computation for simple investments or for

investments for which you have ruled out multiple IRRs by plotting
the PW for many interest rates.

2. Use an ERR computation if you have found multiple IRRs with a

plot, or if you are not sure.

3. The use of the approximate ERR for decision making will produce
decisions consistent with the exact ERR and PW methods. (e.g.,
invest or don’t invest).
 

4.3. Annual Worth Method

Annual Worth (AW) Method is a uniform annual series of net cash flows for
a certain period of time that is equivalent in amount to a particular schedule
of cash inflows (receipts or savings) and/or cash outflows (disbursements or
opportunity cost) under consideration.
 

In this method, interest on the original investment is included as cost.

 

Criterion: If AW ≥ 0, the project is feasible, otherwise, it is not.

The investment is justified if the excess in annual cash inflows over annual
cash outflows is positive (or Net profit is positive).
 

The AW method is controlled by the following conditions: 

  - a single investment of capital at the beginning of the first year of the
project life,
  - uniform revenue and cost data throughout the life of the investment.
 

Problem:
An investment of P270,000 will produce an annual revenue of P185,400 for
5 years and have a salvage value of 10% of the investment. Operations and
maintenance costs is P81,000 per year.  Taxes & insurance is 4% of the first
cost per year. Expected ROR is 25% before income taxes. Is this a desirable
investment?
 

Solution:
 

Annual Revenue (or Cash Inflows) = P185,400

 

Annual Costs:
Depreciation = (270,000 – 27,000)x .25/(1.255 – 1) = 29,609
Operation & maintenance = 81,000
Taxes & insurance (0.04 x 270,000) = 10,800
Interest on capital = 270,000 x 0.25 = 67,500
Total annual costs (or Cash Outflows) = 188,909
 

Net annual profit = 185,400 – 188,909 = - 3,509

(Cash Inflows – Cash Outflows)
 

Since the net annual profit is negative, the investment is not justified.
 

4.4. Present Worth Method

 
This PW Method is based on the concept of equivalent worth of all cash
flows relative to some base or beginning point in time called the present.
That is, all cash inflows and outflows are discounted back at an interest rate
that is generally the minimum acceptable rate of return (M.A.R.R.)
 

Criterion: if AW ≥ 0, the project is feasible, otherwise, it is not.

 

If the present worth of the net cash flows (cash inflows less cash outflows)
is equal to or greater than zero, the project is justified economically ( or its
net profit is positive).
 

The PW method is flexible and is used extensively in making economic

studies in the public works field, where long-lived structures are involved.
 

Problem:
An investment of P270,000 will produce an annual revenue of P185,400 for
5 years and have a salvage value of 10% of the investment. Operations and
maintenance costs is P81,000 per year.  Taxes & insurance is 4% of the first
cost per year. Expected ROR is 25% before income taxes. Is this a desirable
investment?
 

Solution:
PW of Revenue = P185,400/0.25 x (1 – 1.25-5) = 498,593
PW of salvage value = 27,000 x 1.25-5 =       8,848
Total PW of Cash Inflows = 507,441
 

Annual Costs (excluding depreciation and interest on capital):

  Operation & maintenance = 81,000
  Taxes & insurance (0.04 x 270,000) = 10,800
PW of annual costs = 91,800/0.25 x (1 – 1.25-5) = 246,876
 

PW of Cash Outflows = 270,000 + 246,876  =  516,876

PW of CI – PW of CO = 507,441 – 516,876 = - 9,435
 

Since the net annual profit is negative, the investment is not justified.
 

4.5. Future Worth Method

This FW Method is exactly comparable to the present worth method except

that all cash inflows and outflows are compounded forward to a reference
point in time called the future.
 

Criterion: If FW ≥ 0, the project is feasible, otherwise, it is not. 

If the future worth of the net cash flows (cash inflows less cash outflows) is
equal to or greater than zero, the project is justified economically (or its net
profit is positive).
 

All cash inflows and outflows are compounded forward to a reference point
in time called the future. 
 

Problem:
An investment of P270,000 will produce an annual revenue of P185,400 for
5 years and have a salvage value of 10% of the investment. Operations and
maintenance costs is P81,000 per year.  Taxes & insurance is 4% of the first
cost per year. Expected ROR is 25% before income taxes. Is this a desirable
investment?
 

Solution:
FW of Revenue = P185,400/0.25 x (1.255 – 1) = 1,521,584
FW of salvage value = 27,000            
Total FW of cash inflows = 1,548,584
 

Annual Costs (excluding depreciation and interest on capital):

  Operation & maintenance  = 81,000
  Taxes & insurance (0.04 x 270,000)  = 10,800
FW of annual costs = 91,800/0.25 x (1.255 – 1) = 753,406
 

FW of cash outflows = 270,000 x 1.255 + 753,406 =  1,577,381

FW of CI – FW of CO = 1,548,584 – 1,577,381= - 28,797
 

Since the net annual profit is negative, the investment is not justified.

4.6. Payback Period Method

 
The PB period method is defined as the length of time required to recover
the first cost of an investment from the net cash flow produced by the
investment.
 

Payback Period (years) = (Investment – salvage value) / net profit = (C O –

CL) / Net annual income
 

Problem:
An investment of P270,000 will produce an annual revenue of P185,400 for
5 years and have a salvage value of 10% of the investment. Operations and
maintenance costs is P81,000 per year.  Taxes & insurance is 4% of the first
cost per year. Expected ROR is 25% before income taxes. Is this a desirable
investment?
 

Solution:
 

Total annual revenue = 185,400

 

Total Annual Costs (excluding depreciation and interest on capital):

  Operation & maintenance = 81,000
  Taxes & insurance (0.04 x 270,000)  = 10,800
Total annual net cash flows or net annual profit  = 185,400 – 91,800 =
93,600
 

Payback Period = ( Co – CL ) / net profit = ( 270,000 – 27,000 )/ 93,600 = 2.6

years
 

Although the investment is not justified, if pushed thru, the investment can
be recovered in 2.6 years.
4.7. Benefit-Cost Ratio

A benefit-cost ratio (BCR) is a ratio used in a cost-benefit analysis to

summarize the overall relationship between the relative costs and benefits
of a proposed project. BCR can be expressed in monetary or qualitative
terms. If a project has a BCR greater than 1.0, the project is expected to
deliver a positive net present value to a firm and its investors.
 

Benefit-cost ratios (BCRs) are most often used in capital budgeting to

analyze the overall value for money of undertaking a new project. However,
the cost-benefit analyses for large projects can be hard to get right, because
there are so many assumptions and uncertainties that are hard to quantify.
This is why there is usually a wide range of potential BCR outcomes.
The BCR also does not provide any sense of how much economic value will
be created, and so the BCR is usually used to get a rough idea about the
viability of a project and how much the internal rate of return (IRR) exceeds
the discount rate, which is the company’s weighted-average cost of
capital (WACC) – the opportunity cost of that capital.
The BCR is calculated by dividing the proposed total cash benefit of a
project by the proposed total cash cost of the project. Prior to dividing the
numbers, the net present value of the respective cash flows over the
proposed lifetime of the project – taking into account the terminal values,
including salvage/remediation costs – are calculated.