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Class 22 - Rate of Return Analysis

Here is an example of a children's education plan using a rate of return analysis: - College expenses are estimated to be $20,000 per year for 4 years from age 18-22 - Parents want to start a fund now and contribute annually for 20 years to save for college - Assumed rate of return on the fund is 9% annually The parents would need to contribute $4,800 annually over 20 years at a 9% rate of return to have $80,000 saved by the time their child turns 18 to cover the $20,000 per year in college expenses from ages 18-22.

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Swastik
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84 views

Class 22 - Rate of Return Analysis

Here is an example of a children's education plan using a rate of return analysis: - College expenses are estimated to be $20,000 per year for 4 years from age 18-22 - Parents want to start a fund now and contribute annually for 20 years to save for college - Assumed rate of return on the fund is 9% annually The parents would need to contribute $4,800 annually over 20 years at a 9% rate of return to have $80,000 saved by the time their child turns 18 to cover the $20,000 per year in college expenses from ages 18-22.

Uploaded by

Swastik
Copyright
© © All Rights Reserved
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Rate of Return Analysis: Single

Project
ROR
• The most commonly quoted measure of economic worth for a project

or alternative is its rate of return (ROR).

• Whether it is an engineering project with cash flow estimates or an

investment in a stock or bond, the rate of return is a well accepted

way of determining if the project or investment is economically

acceptable.

• The ROR is known by other names such as the internal rate of return

(IRR), which is the technically correct term, and return on investment

(ROI).
ROR Contd..
• Rate of return (ROR) is the rate paid on the unpaid
balance of borrowed money, or the rate earned on
the unrecovered balance of an investment, so that the
final payment or receipt brings the balance to exactly
zero with interest considered. (Refer to EMI example)
• The rate of return is expressed as a percent per
period, for example, i = 10% per year.
Using a PW or AW Relation
• The rate of return is the interest rate that makes the present
worth or annual worth of a cash flow series exactly equal to 0.
• To determine the rate of return, develop the ROR equation
using either a PW or AW relation, set it equal to 0, and solve
for the interest rate.
• Alternatively, the present worth of cash outflows (costs and
disbursements) may be equated to the present worth of cash
inflows (revenues and savings)
Contd..
• The i value that makes these equations numerically
correct is called i*.

• It is the root of the ROR relation.

• To determine if the investment project’s cash flow series


is viable, compare i* with the established MARR.

• If i* >MARR, accept the project as economically viable.

• If i* < MARR, the project is not economically viable.


Example
• Deposit $1000 now and receive payments of $500 three
years from now and $1500 five years from now, the rate
of return relation using PW factors and Equation:

• 1000 = 500(P/F,i*,3) + 1500(P/F,/i*,5)

• If the $1000 is moved to the right side of Equation:

• 0 = -1000 + 500(P/F,i*,3) + 1500(P/F,i*,5)

• The equation is solved for i* = 16.9% by hand using trial


and error or using a spreadsheet function
i* Using Trial and Error Method
• If the cash flows are combined in such a manner that the income and
disbursements can be represented by a single factor such as P/F or
P/A, it is possible to look up the interest rate (in the tables)
corresponding to the value of that factor for n years.

1. Convert all disbursements into either single amounts (P or F) or


uniform amounts (A) by neglecting the time value of money.

2. Convert all receipts to either single or uniform values.

3. Find the approximate interest rate at which the P/F, P/A, or A/F value
is satisfied. The rate obtained is a good estimate for the first trial.
Example
• An initial investment of 200000, annual savings of
15000 for 10 years period and additional savings
of 300000 at the end of 10 years. What is the rate
of return of the project.
• Trial-and-error procedure based on a PW equation

• 0 = -200,000 + 15,000(P/A, i*, 10) + 300,000(P/F,


i*,10)
• All income will be regarded as a single F in year 10 so that the
P/F factor can be used.

• Only for the first estimate of i, define P = $200,000, n = 10, and


F = 10(15,000) + 300,000 = $450,000.

• 200,000 = 450,000(P/F,i, 10)

• (P/F, i, 10) = 0.444

• The roughly estimated i is between 8% and 9%.

• Use 9% as the first trial

• 0 = -200,000 + 15,000(P/A ,9%, 10) + 300,000(P/F,9%,10)

• 0 < $22,986
• The result is positive, indicating that the
return is more than 9%. Try i = 11%.
• 0 = -200,000 + 15,000(P/A,11%,10) +
300,000(P/F,11%,10) =0 > $-6002
• Linearly interpolate between 9% and 11%.

• = 9.00 + 1.58 = 10.58%


• Alternatively you may use RATE or IRR
function in excel
Special Considerations When Using the ROR Method
• Multiple i* values: Depending upon the sequence of net cash
inflows and outflows, there may be more than one real-number
root to the ROR equation, resulting in more than one i* value.

• Reinvestment at i*: Both the PW and AW methods assume that


any net positive investment is reinvested at the MARR.
However, the ROR method assumes reinvestment at the i* rate.

• When i* is not close to the MARR this is an unrealistic


assumption. In such cases, the i* value is not a good basis for
decision making.
Observation

• From an engineering economic study perspective, the AW or PW

method at a stated MARR should be used in lieu of the ROR method.

• However, there is a strong appeal for the ROR method because rate

of return values are very commonly quoted. And it is easy to

compare a proposed project’s return with that of in-place projects.

• As an illustration, if a project is evaluated at MARR = 15% and has

PW < 0, there is no need to calculate i*, because i* < 15%. However,

if PW is positive, calculate the exact i* and report it along with the

conclusion that the project is financially justified.


Multiple Rate of Return Values

• Conventional cash flow series: Signs on the net cash flows


changes only once, usually from minus in year 0 to plus at
some time during the series.

• Nonconventional cash flow series: Net cash flows switch


between positive and negative from one year to another, so
there is more than one sign change.

• When there is more than one sign change in the net cash
flows, it is possible that there will be multiple i* values in the
-100% to plus infinity range.
Finding Multiple i Values
• Test 1: (Descartes’) rule of signs states that the total number of
real-number roots is always less than or equal to the number of
sign changes in the series.

• Test 2: Cumulative cash flow sign test, also known as


Norstrom's criterion, states that only one sign change in a series
of cumulative cash flows which starts negatively indicates that
there is one positive root to the polynomial relation.
Example
• A project has a first cost of 400000 and an additional cost of
300000 on 10th year. It has cash inflow of 75000 every year.
Perform ROR which provides the following:

1. Type of cash flow series and possible number of ROR values

2. Actual i* values determined using the ROR relation and


spreadsheet function

3. Conclusions that can be drawn about the correct rate of return


from this analysis

• (Excel Sheet)
Solution

• One: The series is nonconventional based on the sign


changes throughout the series.
• Test 1: There are two sign changes in the NCF series,
which indicates a possible maximum of two roots to the
polynomial equation or i* values for the ROR equation.
• Test 2: There is one sign change in the cumulative NCF
series, which indicates a unique positive root or one
positive i* value.
Contd..
• Using the P/F factor, the initial i value is indicated to be
1.25%.
• i* by spreadsheet function: i,* = -18.70% and i*= 4.53%
• The positive i* = 4.53% is accepted as the correct
internal rate of return (IROR) for the project. The
negative value is not useful in economic conclusions
about the project.
Measures used in Fundamental Analysis

• Return On Investment – ROI: Benefit (return)


of an investment is divided by the cost of the
investment; the result is expressed as a
percentage or a ratio. 
EBIT
• Earnings Before Interest and Taxes (EBIT): An indicator of a
company's profitability, calculated as revenue minus
expenses, excluding tax and interest.

• An important factor contributing to the widespread use of


EBIT is the way in which it nulls the effects of the different
capital structures and tax rates used by different companies.

• EBIT = Revenue – Cost Of Goods Sold- Operating Expenses -


Depreciation & Amortization
Return On Capital Employed – ROCE
•  It indicates the efficiency and profitability of a
company's capital investments.

• Current Liability is a company's debts or


obligations that are due within one year
• ROCE should always be higher than the rate at
which the company borrows, otherwise any
increase in borrowing will reduce
shareholders' earnings
Return On Risk-Adjusted Capital – RORAC
• Riskier projects and investments are evaluated
based on the capital at risk. RORAC makes it
easier to compare and contrast projects with
different risk profiles.

• Allocated risk capital = The firm's capital,


adjusted for a maximum potential loss based on
the probability of future returns or volatility of
earnings.
Risk-Adjusted Return On Capital – RAROC
• An adjustment to the return on an investment
that accounts for the element of risk

• Income from capital = (capital charges)*(risk-


free rate)
Expected loss = average anticipated loss over
the measurement period 
Work out the example
• Give the example of children’s education plan
• From 18 to 22 year per year college expenses
• Create an annual fund at 9% ROR for 20 years.

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