EM 531 – Lecture 7

RATE OF RETURN ANALYSİS

Methods for finding rate of return
Internal rate of return (IRR) criterion
Nonsimple investments
Mixed versus pure investment projects
External interest rate for mixed projects
Rate of return measure for mutually exclusive
alternatives
Incremental investment analysis
EM 531 - Lecture Notes 7 Apr. 9, 2013
 Rate of return analysis
 Example: Suppose a bank lends $10,000, which is repaid in installments of $ 4,021 at
the end of each year for three years. What is the interest rate the bank is charging for
this transaction?
 $10, 000 = $ 4, 021(P/A, i%, 3)  10%

 What is the meaning of 10%?

 Observe that 10% is only calculated over the unpaid balance. These 3 annual payments
of $4,021 repay the loan itself and provide a return of 10% on the amount still
outstanding each year.

year Unpaid Balance Return on Payment Balance at

at the beginning unpaid received the end
($) balance ($) ($) ($)
0 -10,000

1 -10,000 -1,000 4,021 -6,979

2 -6,979 -698 4,021 -3,656

3 -3,656 -365 4,021 0

EM 531 - Lecture Notes 7 2 Apr. 9, 2013

 Rate of return analysis
 Example (cont’d):

EM 531 - Lecture Notes 7 3 Apr. 9, 2013

 Rate of return analysis
 Example (cont’d):
 If we calculate the PW of the loan transaction at this rate of return of 10%:
 PW(10%) = −10, 000 + 4, 021(P/A, 10 %, 3) = 0
which indicates that 10% earned on the amount still outstanding each year by the
bank is also the break-even interest rate (largest MARR that can be met by this
loan).
 Definition 2: rate of return is the break-even interest i* (−100% to ∞) at which
the PW of the project is zero.
 PW(i) = PWCash Inflows − PWCash Outflows = 0.
 The i* of a project may be defined as the rate of interest that equates the PW, FW, and
AE of the entire series of cash flows to zero. 
PW(i*) = FW(i*) = AE(i*) = 0.

EM 531 - Lecture Notes 7 4 Apr. 9, 2013

 Rate of return analysis
 Lastly, we will introduce the concept of the rate of return based on the return
on invested capital in terms of a project investment. A project’s return is
referred to as the internal rate of return (IRR) promised by an investment
project over its useful life.
 Definition 3: The IRR is the interest rate charged on the unrecovered project
balance of the investment such that, when project terminates, the unrecovered
project balance will be zero.
 Example: Suppose a company invests $10,000 in a computer with a 3-year
useful life, which will create equivalent annual labor savings of $4,021 at the
end of each year for 3 years. Here, we can view the investing firm as the
lender and the project as the borrower.

EM 531 - Lecture Notes 7 5 Apr. 9, 2013

 Rate of return analysis
year Beginning Return on Cash Project
project balance invested capital generated Balance at
($) ($) from project the end ($)
($)
0 -10,000

1 -10,000 -1,000 4,021 -6,979

2 -6,979 -698 4,021 -3,656

3 -3,656 -365 4,021 0

EM 531 - Lecture Notes 7 6 Apr. 9, 2013

 Rate of return analysis
Example (cont’d):
 Firm earns a 10% rate of return on funds that remain internally invested in
the project.
 Since it is a return internal to the project, it is called IRR.
 Computer project brings in enough cash to pay for itself in three years and
to provide the firm a return of 10% on the invested capital.
 If the computer is financed with funds costing 10% annually, the cash
generated by this investment will be exactly sufficient to repay the principal
and its annual charge on the funds.

EM 531 - Lecture Notes 7 7 Apr. 9, 2013

 Methods for finding rate of return
 First we will classify the types of investment cash flows.
 We classify an investment by counting the number of sign changes in its
net cash-flow sequence. A change from either “-” to “+” or from “+” to
“-” is counted as one sign change. (Ignore the zero cash flows!)
(1) Simple (or Conventional) Investment
 Initial cash flows are negative and only one sign change occurs.
 Unique solution exists.
 Question is: is it real or imaginary? If real, is it in (-100,∞) interval?
 A negative rate of return implies you never recover the initial investment.
(2) Simple Borrowing
 Initial cash flows are positive and only one sign change occurs.
 Unique solution exists, but this is not an investment flow.

EM 531 - Lecture Notes 7 8 Apr. 9, 2013

 Methods for finding rate of return

(3) Nonsimple (or Nonconventional) Investment

 more than one sign change occurs.
 Multiple i* s can occur.
 Example: Classify the following three cash flow series.

Period n Project A Project B Project C

0 -1,000 -1,000 1,000
1 - 500 3,900 -450
2 800 -5,030 -450
3 1,500 2,145 -450
4 2,000 0 0

 Project A is a simple investment (one sign change)

 Project B is a nonsimple investment (three sign changes)
 Project C is a simple borrowing (one sign change)

EM 531 - Lecture Notes 7 9 Apr. 9, 2013

 Methods for finding rate of return
 Example (cont’d):
Period Project Project Project C -Project A: simple investment (1 sign change)
n A B -Project B: nonsimple investment (3 sign changes)
0 -1,000 -1,000 1,000
-Project C: simple borrowing (1 sign change)

1 - 500 3,900 -450

2 800 -5,030 -450
3 1,500 2,145 -450
4 2,000 0 0

EM 531 - Lecture Notes 7 10 Apr. 9, 2013

 Methods for finding rate of return
 Computational methods
 Direct solution method:
 Example:
1,500

0 1 2 3 4

1,000

 FW(i)= - 1,000(F/P,i*,4)+1,500=0
1,500=1,000 (1+i*)4  (1+i*)4 =1.5
 i*= 4√1.5 - 1= 10.67 %

EM 531 - Lecture Notes 7 11 Apr. 9, 2013

 Methods for finding rate of return
 Computational methods
 Direct solution method:
1,500
 Example: 1,300

0 1 2

2,000
 PW(i)= - 2,000+ 1,300/(1+i) + 1,500 /(1+i) 2=0
 Let x= 1/(1+i). Then PW(i)= - 2,000 +1,300 x + 1,500 x 2=0  a quadratic equation.
 x=[-1,300±√1,3002-4(1,500)(-2,000)] / 2 (1,500) = 0.8 or -1.667.
 0.8=1/(1+i)  i=25%
 - 1.667 = 1 / (1+i)  i = - 160 %  has no economic significance (less than -100 %)
 Hence, i*=25 %.

EM 531 - Lecture Notes 7 12 Apr. 9, 2013

 Methods for finding rate of return

 Computational methods
 Trial-and-error method:
 This method does not work for nonsimple investments in which the NPW
function is not monotonically decreasing function of interest rate.

 Example: A project in agricultural equipment manufacturing. A facility will

be established to manufacture a crop sprayer.
 Investment in assets : 10 million dollars.
 Annual benefit of $ 1.8 million over a service life of 8 years.
 When the project terminates, the salvage value : $1 million.
 Rate of return of this project? i*= ?

EM 531 - Lecture Notes 7 13 Apr. 9, 2013

 Methods for finding rate of return
 Example:

2.8 M

1.8 M

0 1 2 3 4 5 6 7 8

Simple investment project

10 M

EM 531 - Lecture Notes 7 14 Apr. 9, 2013

 Methods for finding rate of return
 Example:
 Start with a guessed interest rate of 8%.
 PW(8%)=-10+1.8(P/A,8%,8)+1(P/F,8%,8)=0.88 very close to zero.
 If we raise the interest rate, the PW approaches 0.
 Try i=12 %.
 PW(12%)=-10+1.8(P/A,12%,8)+1(P/F,12%,8)=-0.65.
 Therefore, PW(i) will be zero at i such that 8% < i < 12%.
 Using linear interpolation,
i*=8%+(12%-8%) [(0.88-0) / 0.88-(-0.65)]=10.30%.
 PW(i=10.30%)= - 0.045.
 We may go on with another round of linear interpolation.
 With Excel, you can evaluate the IRR for the project.
 Many spreadsheet packages have i* functions.

EM 531 - Lecture Notes 7 15 Apr. 9, 2013

 Internal rate of return (IRR) criterion

PW(i)

accept reject
i
*
 Project should be accepted for interest rates below i*.
 For interest rates above i*, it should be rejected.
 But for nonsimple investment, it is not clear which i* to use to make an
accept/reject decision.

EM 531 - Lecture Notes 7 16 Apr. 9, 2013

 Internal rate of return (IRR) criterion
Simple investments:
 The decision for a simple project is:
 If IRR > MARR, accept the project.
 If IRR = MARR, remain indifferent.
 If IRR < MARR, reject the project.

 Example:
Project investment cost: $ 1,250,000.
project annual net savings: $ 731,500.
salvage value: $ 80,000 at the end of year 15.
IRR=? If MARR=18%, is the investment justifiable?
Project is a simple investment.  unique IRR.
PW(i)=-1,250,000+731,500(P/A,i%,15)+80,000(P/F,i%,15) = 0
EM 531 - Lecture Notes 7 17 Apr. 9, 2013
 Internal rate of return (IRR) criterion
 Example (cont’d):

using trial-and-error method:

PW(50%)=209,842

PW(60%)=-31,822.

 IRR=58.71 %. IRR > MARR  attractive project.

EM 531 - Lecture Notes 7 18 Apr. 9, 2013

 Nonsimple investments

 The number of real i*s that are greater than -100% for a project
with N periods is never greater than the number of sign
changes in the cash flow series.
 The accumulated cash flow series is the sum of the net cash
flows up to, and including a given time.
 If the rule of cash flow signs indicates multiple i*s, we should
proceed to “accumulated cash flow sign test” to eliminate some
possibility of multiple rates of return.
 If the accumulated series starts negatively and changes sign only
once, a unique positive i* exists.

EM 531 - Lecture Notes 7 19 Apr. 9, 2013

 Mixed versus pure investment projects
 A project is a pure investment project when the project
balances computed at the project’s i* values, PB(i*)n ≤ 0
throughout the life of the investment.
 This type of project is a pure investment project, since the firm
does not overdraw on its return at any time and hence is not
indebted to the project.
 pure borrowing case: PB(i*)n ≥ 0.

EM 531 - Lecture Notes 7 20 Apr. 9, 2013

 Mixed versus pure investment projects

Simple versus nonsimple

Pure pure mixed

If any PB(i*)n > 0, the project is not a pure investment.

PB(i*)n > 0 means that at some time during the project life, the
firm acts as a borrower, rather than an investor.
This type of investment is a mixed investment.

EM 531 - Lecture Notes 7 21 Apr. 9, 2013

 Mixed versus pure investment projects
Example:
Project C n cash flow
0 - 1000
1 500
2 - 500
3 2000
i*=29.95 %.
PB(29.95%)0= - 1000
PB(29.95%)1= - 1000(1+29.95%) + 500= - 799.5
PB(29.95%)2= - 799.5(1+29.95%) - 500= - 1538.95
PB(29.95%)3= - 1538.95(1+29.95%) + 2000= 0
(-,-,-,0)  pure investment.
EM 531 - Lecture Notes 7 22 Apr. 9, 2013
 Mixed versus pure investment projects

Example:
Project D n cash flow
0 - 1000
1 3900
2 - 5030
3 2145
i*= 10 %, 30 %, 50 %.
PB(50 %)0= - 1000
PB(50 %)1= - 1000(1+50 %) + 3900= 2400
PB(50 %)2= 2400(1+50 %) - 5030= - 1430
PB(50 %)3= - 1430(1+50 %) + 2145= 0
(-,+,-,0)  mixed investment.
EM 531 - Lecture Notes 7 23 Apr. 9, 2013
 Mixed versus pure investment projects
Take project C.
i*=29.95 %. MARR=15 %.
C is a pure investment project. PB(29.95%)n ≤ 0.
29.95 % is the true IRR.
IRR > MARR, then the project is acceptable.
PW(15%)=-1000+500(P/F,15%,1)-500(P/F,15%,2)+2000(P/F,15%,3)=$ 371.74.
Since PW(15%) > 0, the project is also acceptable under the NPW criterion.
The IRR and NPW criteria always give the same decision, if the criteria are
applied correctly.
In the pure investment projects, since PB(i*)n ≤ 0, at no time the firm
withdraws money from the project.
The IRR is earned on the funds that remain internally invested in the project.

EM 531 - Lecture Notes 7 24 Apr. 9, 2013

 External interest rate for mixed projects

 It is assumed that money released from a project can be

reinvested to yield a rate of return equal to that received from
the project.
 It may be necessary to compute the project balances for a
project’s cash flow at two rates of interest:
 One on the internal investment
 One on the external investment.
 By separating the interest rates, we can measure the true rate of
return of any internal portion of investment project.  true IRR or
return on invested capital.

EM 531 - Lecture Notes 7 25 Apr. 9, 2013

 External interest rate for mixed projects

 When PB(i%)n > 0, this money can be put into the firm’s investment pool
until it is needed in the project.
 The i% of this investment pool is the interest rate at which the money can be
invested outside the project MARRexternal i.

PB

MARR

IRR time
IRR

EM 531 - Lecture Notes 7 26 Apr. 9, 2013

 Mixed investment

Example: a mixed investment project. MARR= 15%.

 Cash flows of the project:
Year cash inflow cash outflow net cash flow
0 1,000,000 -1,000,000
1 4,300,000 2,000,000 2,300,000
2 3,000,000 4,320,000 -1,320,000
 The project has multiple rates of return. i*=10% or i*=20%.

PW(i)

PW(i)>0 Neither 10% nor 20% is the true IRR.

10% 20% i

EM 531 - Lecture Notes 7 27 Apr. 9, 2013

 External interest rate for mixed projects

Example (cont’d):
 Since the project is a mixed project, we need to find the true IRR.
 Net investment test: i*=10%, unit=1000

periods 0 1 2
Beg. Balance 0 -1000 1200
Return on invest. 0 -100 120
Payment -1000 2300 -1320
Ending balance -1000 1200 0

EM 531 - Lecture Notes 7 28 Apr. 9, 2013

 External interest rate for mixed projects

Example (cont’d):
 n=0 PB(i,15%)0=-1,000,000
 n=1 PB(i,15%)1=-1,000,000(1+i)+2,300,000
=1,300,000-1,000,000 i
=1,000,000(1.3-i)
Is PB(i,15%)1 > 0 or < 0?
(1) if i < 1.3, PB(i,15%)1 > 0.
In this case, the cash released from the project will grow at MARR,
until it is required in the project.
PB(i,15%)2=1,000,000(1.3-i)(1+0.15)-1,320,000
= 175,000 – 1,150,000i=0  IRR=15.22 %.

EM 531 - Lecture Notes 7 29 Apr. 9, 2013

 External interest rate for mixed projects

Example (cont’d):
(2) if i > 1.3, PB(i,15%)1 < 0.
The firm is still in investment mode.
PB(i,15%)2=1,000,000(1.3-i)(1+i)-1,320,000
=-20,000 + 300,000i – 1,000,000 i2=0 
IRR=0.1 or 0.2 < 1.3, which violates i > 1.3.

Therefore case (1) is the correct situation.

Case (1): IRR > MARR, so the project would be acceptable.
The same decision is obtained by the NPW.

EM 531 - Lecture Notes 7 30 Apr. 9, 2013

 External interest rate for mixed projects

Example (cont’d):

PB

1000

15 %
0
1 2
15.22 % time

-1000

EM 531 - Lecture Notes 7 31 Apr. 9, 2013

 Trial-and-error method for computing IRR

Example: For a mixed investment, find IRR by trial-and-error method.

MARR=6%. IRR= ?
n An
0 -1000
1 3900
2 -5030
3 2145
Suppose i=8%.
PB(8%,6%)0=-1000
PB(8%,6%)1=-1000(1+0.08)+3900=2820
PB(8%,6%)2=2820(1+0.06)-5030=-2040.80
PB(8%,6%)3=-2040.8(1+0.08)+2145=-59.06
 i=8% is not correct.

EM 531 - Lecture Notes 7 32 Apr. 9, 2013

 Trial-and-error method for computing IRR

Example (con’d):
After many trials, IRR=6.13 % (verify this).
Since IRR > MARR, the project is acceptable.
PW(6%)=-1000+3900(P/F,6%,1)-5030(P/F,6%,2)+2145(P/F,6%,3)=3.55 > 0.
PW(i)

0
10 % 30 % 50 % i
Accept Accept
Reject
Reject

EM 531 - Lecture Notes 7 33 Apr. 9, 2013

 rate of return measure for
mutually exclusive alternatives

We will compare two or more mutually exclusive projects

based on the rate of return measure.
 Alternatives with the same economic service life
 Alternatives that have unequal economic service lives.

EM 531 - Lecture Notes 7 34 Apr. 9, 2013

 Flaws in project ranking by IRR

Under NPW and AE analysis, the alternative with the

highest worth was preferred.
But in IRR analysis, the project with the highest IRR
may not be the preferred alternative.
Suppose there are two mutually exclusive alternatives,
each with one-year service life (as shown in the next
slide).

EM 531 - Lecture Notes 7 35 Apr. 9, 2013

 Flaws in project ranking by IRR

2,000 7,000

1
1,000
A1:
A2:
PW(10%)=$ 818
IRR=100% 5,000 PW(10%)=$1,364
IRR=40%

EM 531 - Lecture Notes 7 36 Apr. 9, 2013

 Flaws in project ranking by IRR

 If you have enough money in your investment pool to select

either one, would you prefer A1 because its IRR is higher? Based
on PW, A2 is the preferred alternative.
 This inconsistency in ranking occurs because PW, AE, and FW
are absolute ($) measures of investment worth, while IRR is a
relative (%) measure and cannot be applied in the same way; that
is, IRR ignores the scale of the investment.
 Therefore, A1 is not preferred.
Another approach is needed: INCREMENTAL ANALYSIS.

EM 531 - Lecture Notes 7 37 Apr. 9, 2013

 Incremental investment analysis

 Going on with the same example:

 If you invest in A1 alternative:

$ 1,000 will be drawn from the investment pool.
Remaining $ 4,000 will continue to earn 10% interest.
With an investment of 1,000 + 4,000 (=5,000), in year 1, you
will have FW(10%)=2,000+4,000(1+0.10)=$6,400.
Its PW(10%)=-5,000+6,400(P/F,10%,1)=$818.

EM 531 - Lecture Notes 7 38 Apr. 9, 2013

 Incremental investment analysis

 If you invest in A2 alternative:

$ 5,000 will be drawn from the investment pool, leaving no
money in the pool.
PW(10%)=-5,000+7,000(P/F,10%,1)=$1,364.

 In the second alternative, A2, by investing the additional

$4,000, you would make an additional $5,000, which is
equivalent to earning at the rate of 25%  the incremental
investment can be justified.

EM 531 - Lecture Notes 7 39 Apr. 9, 2013

 Incremental investment analysis

 For a pair of mutually exclusive projects (A and B, B being the

more costly alternative):
 B = A + (B-A)

the incremental component

 The only situation in which B is preferred to A is when the rate-

of-return on (B-A) ≥ MARR.
 Therefore, for two mutually exclusive projects, rate-of-return
analysis is made by computing the IRR on incremental
investment (IRR∆) between the projects.

EM 531 - Lecture Notes 7 40 Apr. 9, 2013

 Incremental investment analysis

 Then the decision rule :

 if IRRB-A > MARR, select B.
 if IRRB-A = MARR, select either one.
 if IRRB-A < MARR, select A.
 B-A: investment increment (negative cash flow).
 If a “do-nothing” alternative is allowed, the smaller cost option
must be profitable first (its IRR > MARR).
 This means: compute the IRR for each alternative in the
alternatives group, and then eliminate the alternatives whose
IRRs are less than MARR, before applying the incremental
analysis.

EM 531 - Lecture Notes 7 41 Apr. 9, 2013

 Incremental investment analysis

 Example: A small-scale painting business during off-school

hours.
 Two options: B1 and B2.
 B1: do most of the painting by himself by limiting his business to
only residential painting jobs.
 B2: purchase more painting equipment and hire some helpers to do
both residential and commercial painting jobs.
 In either case, he expects to fold up the business in 3 years when he
graduates from college.

EM 531 - Lecture Notes 7 42 Apr. 9, 2013

 Incremental investment analysis

 Example (cont’d):

n B1 B2 B2-B1
0 -3,000 -12,000 -9,000
1 1,350 4,200 2,850
2 1,800 6,225 4,425
3 1,500 6,330 4,830
IRR 25% 17.43%
 Both B1 and B2 are revenue projects. MARR= 10%.
 Both projects are profitable at 10%.
 Find IRRB2-B1.

EM 531 - Lecture Notes 7 43 Apr. 9, 2013

 Incremental investment analysis
 Example (cont’d):
 n B1 B2 B2-B1
0 -3,000 -12,000 -9,000
1 1,350 4,200 2,850
2 1,800 6,225 4,425
3 1,500 6,330 4,830
IRR 25% 17.43%
 -9,000+2,850(P/F,i,1)+4,425(P/F,i,2)+4,830(P/F,i,3)=0
 if i*B2-B1=15%.
 The incremental cash flow indicates that it is a simple investment.
Therefore, IRRB2-B1=i*B2-B1=15% > MARR.
 select B2.

EM 531 - Lecture Notes 7 44 Apr. 9, 2013

 Incremental investment analysis
 Example (cont’d):

At MARR ≥ 25%,
neither project
is acceptable.

EM 531 - Lecture Notes 7 45 Apr. 9, 2013