COMPARISON METHODS

Rate of Return Analysis

 Administrative Items
Online Quiz 3:
o Started today, Friday June 09 at 12:00 PM
o Ends, Friday June 16 at 11:59 PM
o Chapters 4 & 5
o Chapters 4 & 5 including PW & AW comparison methods, payback period and
IRR comparison methods and small number of 'review-type' questions from
previous chapters

Mid Term Test:

o Scheduled for Friday, June 16, 7:00 - 9:00 PM (Location BSB B135)
o In-class review session, June 13 & 15, 7:00 - 9:00 PM (Location ETB 230)
o A2L Midterm Study Groups 10 Discussion Forum Groups (self-enrol)
o Chapters 1-4 including bonds and mortgage questions
o This Exam contains 25 multiple choice questions and 4 problems
o This is a closed-book, one single sided hand written 8.5 X 11 crib sheet is
permitted, Midterm 3EE3 Formula Sheet and tables are provided at the end
of the Exam paper, and only McMaster Approved calculators are permitted 2
 Learning Objectives

Introduction
The Internal Rate of Return
Internal Rate of Return Comparisons
IRR for Independent Projects
IRR for Mutually Exclusive Projects
Multiple IRRs
External Rate of Return Methods
When to Use the ERR
Rate of Return and Present/Annual Worth Methods
Why Choose One Method Over the Other?
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 Introduction
Rate of return analysis is widely used in industry.
It provides a measure of a projects desirability in terms
that are easily understood.
Decisions to proceed are often based on the comparison
to a
o Minimum Attractive Rate of Return (MARR)

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 Internal Rate of Return (IRR)
A projects rate of return is defined by IRR.
o Internal Rate of Return (IRR) is the interest rate at which the
present worth and equivalent uniform annual worth are equal to
zero.
o The IRR is the interest rate at which the benefits are equivalent
to the costs.

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 Calculating Rate of Return
Given a cash flow, there are five forms of equations that
can be used to solve for the unknown interest rate:
o PW of benefits PW of costs = 0
o PW of benefits/PW of costs = 1
o Present worth = Net present worth = 0
o EUAW = EUAB EUAC = 0
o PW of costs = PW of benefits
These are the same concepts in five different forms.
T
( Rt Dt ) Rt and Dt are the receipts and
PW 0 disbursements in period t, t =
0,1,,T
t 0 (1 i*) t

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 Calculating Rate of Return
IRR is the interest rate at which project breaks even
We solve for the discount rate at which:
o PW(disbursements) = PW(receipts)
o AW(disbursements) = AW(receipts)
o FW(disbursements) = FW(receipts)

IRR is usually positive. (otherwise project is losing money)

The equation for the IRR is solved by:
o Trial and error alone
o Trial and error along with linear interpolation
o built-in IRR function in many spreadsheet programs (i.e. Excel)

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 Rate of Return: Problem 1
With an initial investment of $6549.32 in a new machine, you will
provide your company with $4000 more incoming dollars over the
next four years. However, over those four years, the maintenance
of the machine will cost $800. Also, in Year 2 a refit of the
machine will cost $5,100.

What is the rate of return?

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 Rate of Return: Problem 2
Calculate the interest rate that is required for accumulating
$20,000 if $1517 per year will be saved over a 10-year period.

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 Plot of NPW versus Interest Rate i
A typical plot for borrowed money:
o Viewpoint of the borrower:

The IRR is located where the plot crosses the NPW = 0

point. 10
 Plot of NPW versus Interest Rate I, contd

A typical plot for invested money:

o Viewpoint of the investor:

The IRR is where the plot crosses the NPW = 0 point. 11

 Rate of Return: Problem 3
New windows at Nottawasaga Fabricating (NF) are
expected to save $400 per year in energy over their 30
year life. The windows have an initial cost of $8,000 and
will have a zero salvage value.
a) Use a spreadsheet to plot the PW of this investment as a
function of the interest rate.
b) Use a spreadsheet to calculate the IRR

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 Internal Rate of Return Comparisons
IRR for Independent Projects

Independent Projects: Invest in a project if IRR equals

or exceeds the MARR.
Similar to the evaluation of independent projects
where PW or AW 0 is acceptable
Recall previous Problem 3 where the IRR of the
project was found to be 2.8%. With a MARR of 8%,
should the investment be made?
NO - The IRR is 2.84% which is < MARR of 8%

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 Internal Rate of Return Comparisons:
Problem 4
IRR for Mutually Exclusive Projects
The analysis gets more complex than previous:
Consider two mutually exclusive investments. The
first costs $10 today and returns $20 in a year. The
second costs $1,000 and returns $1,200 in one year.
MARR is 12%. Which is your preferred investment?

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 IRR Caution
Internal rate of return can be deceiving.
Comparing projects strictly on the IRR of each project can
provide incorrect results and disagree with present worth
or annual worth analysis.
This is why we use the IRR.
o The objective is to maximize the return NOT the rate of
return.
The analysis period needs to be the same as we are
examining the increments between alternatives
Note: Projects can include the do-nothing alternative if
the selection of an alternative is not required.

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Internal Rate of Return Comparisons
IRR for Mutually Exclusive Projects
The IRR for the first project is higher than the second, but the
second has a higher PWsecond is preferred!
When mutually exclusive, tempting to pick higher IRR!
Incorrect: does not consider magnitude
overlooks projects where IRR > MARR and due to magnitude
of return represents higher PW
therefore have to consider incremental investment.
Does the incremental investment earn at least MARR?
If so, this is the better investment.

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 Incremental Analysis
Comparing Mutually Exclusive Alternatives
1. Sort the projects from the lowest first cost to the
highest. Call this lowest first cost the current
best.
2. Challenge the current best with the next most
expensive project. If the challenger is successful,
i.e., if the incremental investment has an IRR
MARR, then make the challenger the current
best.
3. Repeat Step 2 until there are no further
challengers.

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 Incremental Analysis, contd
The decision is then based on the MARR:
o If IRR >= MARR choose the higher initial cost alternative.
This indicates that the additional cost is justified.
o If IRR < MARR choose the lower initial cost alternative.
This indicates that the additional cost is NOT justified.
The opposite is true if the viewpoint is from the borrowing
perspective instead of the investment perspective.

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 Incremental Analysis, contd
Flowchart for Comparing Mutually Exclusive Alternatives:

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Incremental Analysis: Problem 4 Revisited
Consider two mutually exclusive investments. The first costs
$10 today and returns $20 in a year. The second costs $1,000
and returns $1,200 in one year. MARR is 12%. Which is your
preferred investment?

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 Multiple IRR: Problem 5
Another challenge of implementing IRR method is
there may be more than one IRR.
Suppose a project pays $2,500 today, costs $12,500
one year from now and pays $15,000 in two years.
What is the IRR?

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 Multiple Solutions for Rate
Cash flows that contain more than one change in sign can
also have more than one solution for the IRR.
Equation for PW = 0, given some cash flows:
o 0 = CF0 + CF1(1 + i)-1 + CF2(1 + i)-2 + . . . + CFn(1 + i)-n
More generally:
o 0 = CF0 + CF1x1 + CF2x2 + . . . + CFnxn
This is a nth order polynomial.

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 Descartes Rule
If a polynomial with real coefficients has m sign changes,
then the number of positive roots will be m2k, where k is
an integer between 0 and m/2.
o This means the calculation of IRR for cash flows with more than
one sign change results in the possibility that multiple IRR are
possible.
o Projects often have a variety of cash flows that include more
than one sign change.

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 Multiple IRR, contd
Positive project cash flows are invested elsewhere,
probably at MARR (not 100% or 200%).
Need to consider what return is earned by cash flow
associated with project but not invested in project.
Assumption is that funds are invested elsewhere and earn
an explicit rate of return (usually MARR).
External rate of return (ERR), denoted by i*e , is rate of
return where any excess cash earns interest at an explicit
rate usually the MARR.

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 Exact ERR: Problem 6
A project pays $1,000 today, costs $5,000 a year from
now, and pays $6,000 in two years. What is the rate of
return? Assume MARR = 25%.

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 External Rate of Return Methods
Computing an exact ERR can be difficult:
To get an approximate ERR:
1. Take all net receipts forward at the MARR to the time of
the last cash flow.
2. Take all net disbursements forward at the unknown rate
iea* (approximate ERR) to the time of the last cash flow.
3. Set FW(receipts) = FW(disbursements) and solve for iea*.
4. The value for iea* is the approximate ERR for the project.

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Approximate ERR: Problem 5 Revisited
Consider Practice Problem 5 again: A project has cash
flows of $2,500 now, $12,500 in one year and $15,000
in two years. If the MARR is 25%, find the approximate
ERR.

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Approximate ERR: Problem 6 Revisited
A project pays $1,000 today, costs $5,000 a year from
now, and pays $6,000 in two years. What is the rate of
return? Assume MARR = 25%.

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 When to Use the ERR
ERR method should be used whenever multiple IRRs are possible
Unfortunately, hard to know in advance when multiple IRRs exist
Fortunately, most investments are simple, with one positive IRR.
Simple investment: characterized by one or more periods of cash outflows,
followed by one or more periods of cash inflows.
If a project is not simple investment, may be more than one IRR
If sign of successive cash flows changes X times, may be X IRRs.
A plot of PW (or AW, FW) vs interest rate may show multiple IRRs
If a plot does not show the multiple IRRs, a more complex method is necessary
(see Appendix 5-A)
use of approximate ERR for decision making will produce decisions consistent
with exact ERR and PW methods (i.e. invest or dont)

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Rate of Return and PW/AW Methods
A comparison of Rate of Return and PW/AW methods
leads to two important conclusions:
1. The two sets of methods, when properly used, give the same
decision.
2. Each sets of methods has its own advantages and
disadvantages.
3. If an independent project has a unique IRR, the IRR method
and the PW method give the same decision.

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Rate of Return and PW/AW Methods

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Rate of Return and PW/AW Methods
Now consider two simple, mutually exclusive projects,
A and B, where the first cost of B is greater than the
first cost of A.
If the increment from A to B has a unique IRR, then we
can readily demonstrate that the IRR and the PW
methods lead to the same decision.

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Rate of Return and PW/AW Methods

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Why Choose One Method Over the Other?

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Questions Period

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