Professional Documents
Culture Documents
1
Rate of Return Method
• Another method for evaluation of different competin
g alternatives, especially in the area of investments.
• In general, rate of return may be regarded as an inde
x of profitability. The following terms are commonly e
ncountered.
• MARR (Minimum attractive rate of return),
• IRR (internal rate of return),
• IRoR (Incremental rate of return), and
• ERR (external rate of return)
2
Minimum Attractive Rate of Return (MARR)
3
Internal rate of return (IRR)
4
Computation of IRR
• In principle, IRR can be determined by equatin
g the net present worth of the cash flow to zer
o, i.e., setting the difference of the benefits an
d cost of the present worth to zero, as shown
below:
5
STEPS FOR COMPUTING IRR
• Step 1 Assume a trial rate of return (i*).
6
STEPS FOR COMPUTING IRR
• Step 4 Adjust the estimate of the trial rate o
f return and go to step 2 again until one value
of i is found that results in a positive equivalen
t net worth and another higher value of i is fo
und with negative equivalent net worth.
• Step 5 Solve for the applicable value of i* by
interpolation.
7
8
Cash flow to illustrate IRR
Birr. 220
Birr. 240
Birr.370
Birr. 400
Birr. 1000
Computation of IRR
(PW)benefits –(PW)cost =0
Let IRR be i*
NPW = -1000 + 400 (P/F, i*,1) + 370 (P/F, i*,2) + 240 (P/
F, i*,3) + 220 (P/F, i*,4)=0
Assuming i* = 10%
NPW = -1000 + 400 x 0.9090 + 370 x0.8264 + 240 x 0.75
13 + 220 x 0.6830
=0
• We find that i*= 10% in the above example is
a special interest rate which has reduced the n
et present worth of given cash flow to zero. Th
us i*=10% is the Internal rate of return for this
example.
9
• It represents the percentage or rate of interest earned on
the unrecovered balance of an investment, at any point o
f time and further the earned recovered balance is reduc
ed to zero at the end of the project.
10
Illustration of IRR
0 -1000 - - -1000
1 400 -1000 -100 -700
2 370 -700 -70 -400
3 240 -400 -40 -200
4 220 -200 -20 0
11
10% is the IRR
Important point
• It is not possible to calculate the rate of return
for the cash flows involving cost alone or reve
nue alone as can be observed from equation 1.
• IRR method should not be used for ranking of
projects , it may give erroneous results, not in
line with the results obtained from other meth
ods of analysis
12
13
Calculate the IRR for the following cash flo
$15000 $1500
$850
$1500 $850
$1500 $850
$1500 $850
$1500 $850
w diagram?
$80000
Solution
• Assuming a trial rate of return of 15%,
• N.P.W. = -$80,000 - $ 850 * (P/A,15%,5) + $ 15
00 * (P/A,15%,5) + $150000 * (P/F,15%,5)
= -$80,000 - $850 * 3.3522 + $1500 * 3.
3522 + $150000 * 0.4972
= - $3241.07
• Since it gives negative value of N.P.W. let us as
sume a lower value of rate of return, say 14%.
14
• N.P.W. = - $80,000 - $850 * (P/A,14%,5) + $1500 * (P/
A,14%,5) + 150,000 * (P/F,14%,5)
= - $80,000 - $850 * 3.4331 + $1500 *3.4331
+ 150,000 * 0.51937
= $136.8
• Thus, the IRR at which N.P.W. becomes zero i.e. the v
alue of i at which exactly same return is met, lies som
ewhere between 14% and 15 % which can be found
out by interpolation.
16
Assumptions
• The analysis makes the assumptions that suffi
cient funds are available to finance the alterna
tives with the highest investment
• There are opportunities available to utilize the
surplus funds at a rate higher than the MARR,
should there be any excess funds after financi
ng the alternative with the lower investment c
osts.
17
Steps involved in the incremental analysis
Step 1
•List out all the alternatives in ascending order o
f their first cost or initial investment.
•It may be pointed out at this stage that in most
cases alternatives with the lowest investment ar
e likely to turn out to be the ‘do nothing’ alterna
tive.
18
Steps involved in the incremental anal
ysis …cont’d
Step 2
•Compare the rate of return of all alternatives wi
th the assumed MARR, and check if the rate of r
eturn is at least equal to the MARR. If not, the al
ternative is dropped and not considered in the f
urther analysis.
19
Steps involved in the incremental anal
ysis …cont’d
Step 3
•Prepare the cash flow diagram on incremental
basis between the alternatives which is being ex
amined & the current alternative (to begin with
we have taken the alternative with the lowest ini
tial investment).
20
Steps involved in the incremental anal
ysis …cont’d
Step 4
•When an alternative which has just been exami
ned is acceptable (rate of return is more than th
e MARR) it becomes the current best replacing t
he earlier one. The new best is examined with th
e next higher investment alternative.
21
Steps involved in the incremental anal
ysis …cont’d
Step 5
•In case rate of return is less than MARR, the alt
ernative under examination is ruled out and the
current alternatives remain the lucrative one. Th
e current best is compared to the next higher inv
estment.
22
Steps involved in the incremental anal
ysis …cont’d
Step 5
•The process mentioned through steps 1 to 5 is r
epeated till all the alternatives have been looked
into and the best alternative is selected.
23
Illustration
• A Construction Company is purchasing Aluminum Doors at Rs.
3550 per piece from a vendor. The annual demand for the doo
rs is 350 pieces.
In order to develop the in-house capabilities for production of
Aluminum Doors the company requires investment in equipm
ent to produce Aluminum Doors at an initial cost of Rs. 1,050,
000 initially, Rs. 925,000 at the end of first year and Rs. 612,5
00 each year at the end of year 2 and 3. The equipment will h
ave no salvage value at the end of year 3.
Should the company develop in-house capabilities or continu
e to buy Aluminum Doors from its vendors. Use MARR=15%
24
Cash flow diagram for vendor option
28
Example
Solve the problem using PW, annual cost, and interna
l rate of return for the given cash flow data. Check yo
ur results with incremental rate of return method. Th
e minimum attractive rate of return is 10%.
EOY 0 1 2 3 4
Project X -50,000 5000 17,500 30,000 42,500
29
Cash flow diagram for X
30
Cash flow diagram for Y
31
Present Worth Analysis
For X,
•N.P.W = - 50000 + 5000 * (P/F,10%,1) + 17500 * (P
/F,10%,2) + 30000 * (P/F,10%,3) + 42500 * (P/F,10
%,4)
•N.P.W = - 50000 + 5000 * 0.9091 + 17500 * 0.826
4 + 30000 * 0.7513 + 42500 * 0.6830
•N.P.W. = 20,574
32
Present Worth Analysis
For Y,
•N.P.W = - 50000 + 50000 * (P/F,10%,1) + 10000 * (P/F,1
0%,2) + 10000 * (P/F,10%,3) + 10000 * (P/F,10%,4)
•N.P.W = - 50000 + 50000 * 0.9091 + 10000 * 0.8264 +
10000 * 0.7513 + 10000 * 0.6830
N.P.W. = 18,062
•Hence, choose X as N.P.W. for X is more.
33
Annual Cost Analysis
For X,
• Equivalent Annual Cost = - 50000 * (A/P,10%,4) + 5000 * (P
/F,10%,1)(A/P,10%,4) + 17500 * (P/F,10%,2)(A/P,10%,4) + 3000
0*(P/F,10%,3)(A/P,10%,4) + 42,500 * (P/F,10%,4)(A/P,10%,4)
• Equivalent Annual Cost = - 50000 * 0.3155 + 5000 * 0.
9091 * 0.3155 + 17500 * 0.8264 * 0.3155 + 30000 * 0.
7513 * 0.3155 + 42,500 * 0.6830 * 0.3155
Equivalent Annual Cost = 6490
34
For Y, Annual Cost Analysis
•Equivalent Annual Cost = - 50000 * (A/P,10%,4) + 50000 * (P
/F,10%,1)(A/P,10%,4) + 10000 *(P/F,10%,2)(A/P,10%,4) + 10000
*(P/F,10%,3)(A/P,10%,4) + 10000 * (P/F,10%,4)(A/P,10%,4)
•Equivalent Annual Cost = -50000 * 0.3155 + 50000 * 0.
9091 * 0.3155 + 10000 * 0.8264 * 0.3155 + 10000 * 0.7
513 * 0.3155 + 10000 * 0.6830 * 0.3155
Equivalent Annual Cost = 5698.5
Hence, choose X as equivalent annual cost for X is hig
her.
35
Internal Rate of Return Method
For X,
Assume i = 20%
•N.P.W = - 50000 + 5000 * (P/F,20%,1) + 17500 * (P/F,20
%,2) + 30000 * (P/F,20%,3) + 42500 * (P/F,20%,4)
•N.P.W = - 50000 + 5000 * 0.8333 + 17500 * 0.6944 + 3
0000 * 0.5787 + 42500 * 0.4823
N.P.W. = 4177.25
36
Assume i = 25%
•N.P.W = - 50000 + 5000 * (P/F,25%,1) + 17500 *
(P/F,25%,2) + 30000 *(P/F,25%,3) + 42500 * (P/F,2
5%,4)
•N.P.W = - 50,000 + 5000 * 0.8 + 17500 * 0.64 + 3
0000 * 0.512 + 42500 * 0.4096
•N.P.W. = - 2032
•By interpolation, i = 23.364%
37
For Y,
Assume i = 35%
•N.P.W = - 50,000 + 50000 * (P/F,35%,1) + 10000 *
(P/F,35%,2) + 10000 *(P/F,35%,3) + 10000 * (P/F,35
%,4)
•N.P.W = - 50000 + 50000 * 0.7407 + 10000 * 0.548
7 + 10000 * 0.4064 + 10000 * 0.3011
•N.P.W. = - 43
38
Assume i = 30%
•N.P.W = - 50000 + 50000 * (P/F,30%,1) + 10000
* (P/F,30%,2) + 10000 * (P/F,30%,3) + 10000 * (P
/F,30%,4)
•N.P.W = - 50000 + 50000 * 0.7692 + 10000 * 0.5
917 + 10000 * 0.4552 + 10000 * 0.3501
•N.P.W. = 2430
•By interpolation, i = 34.9%
•Hence, choose Y as it gives higher rate of retur
n.
39
Cash flow diagram for X
40
Cash flow diagram for Y
41
Incremental Rate of Return Method
Assume i = 15%
•N.P.W. = -45000 + 7500/(1+0.15) + 20000/(1+0.
15)2 + 32500/(1+0.15)3 = - 1986
•By interpolation, i = 12.9%
•Since 12.9% (Exact value of i) > 10% (MARR), Pr
efer X over Y.
43
Thank-you!
44
EFFECT OF TAXATION ON COMPARISON OF ALTERNA
TIVES
• In the discussion so far, any affect that a taxation reg
ime may have as far as comparison and evaluation of
economic alternatives is considered has not been ta
ken into account.
• It should however be borne in mind that prevailing t
ax laws impose taxes on companies on the basis of t
he annual income generated through conduct of bus
iness.
• Not only the rates of taxes vary from time to time, b
ut also certain incentives and relief in taxes are provi
ded on certain expenditures for various reasons.
45
EFFECT OF TAXATION ON COMPARISON OF ALTERNA
TIVES…cont’d
• Companies often take advantage of such sche
mes and use available funds in a manner so as
to optimize their interests.
• Though it is not the intention here to discuss t
axation rules at any length, the example below
is included only to place in perspective on the
discussion on taxation and alternative compari
son.
46
Illustration
S.No Item $ A B Comments
2 Admissible expenses 50 25
(AE)
47
BRIEF DISCUSSION ON DEPRECIATION
• In a general sense, ‘depreciation’ discusses the di
fferent issues related to this gradual change (reductio
n) in the value of an asset.
• Formally, there are a number of definitions for depre
ciation, although each one conveys similar meanings.
• For example, according to one definition ‘depreciat
ion is the allocation of the cost of an asset over a peri
od of time for accounting and tax purposes’.
48
BRIEF DISCUSSION ON DEPRECIATION…cont’d
49
BRIEF DISCUSSION ON DEPREC
IATION…cont’d
• In general a company ‘owns’ various assets in the
form of buildings, office furniture, machinery and equ
ipment, etc., all of which are acquired at a certain val
ue, and they depreciate over time. In the end, they ce
ase to be of any monetary value, and can only be scra
pped and a certain value extracted (salvaged!) from t
he scrap.
50
BRIEF DISCUSSION ON DEPR
ECIATION…cont’d
51
METHODS OF CALCULATING DEPRECIATIO
N
52
Book Depreciation Method(BDM)
a) Straight line Method
Rate of depreciation (Rn) = 1/N
Dn= (P-S)Rn=(P- S)/N
where Dn= Annual Amount of Deprecation for n years
N=number of years
P=Purchase
S= Salvage value
Rn= Depreciation rate=1/N
Book value at any time n, BVn=P-(n*Dn)
53
Calculation of depreciation using
straight line method
Year Opening book Annual depr Closing book v
(m) value (BVm-1) eciation (Dm alue (BVm)
)
0 0 0 200,000
1 200,000 30,000 170,000
2 170,000 30,000 140,000
3 140,000 30,000 110,000
4 110,000 30,000 80,000
5 80,000 30,000 50,000
54
Sum of Years Digits Method(SOYD)
This is also Book Depreciation Method
SOYD=1+2+3+..................+N
SOYD=N+(N-1)+(N-2)...............+1
are added
2(SOYD)=(N+1)+(N-1+2)+(N-2+3).....(N+1)
N(
N 1
)
2(SOYD)=N(N+1)→
SOYD
2
Rate of depreciation Rn=N/SOYD, N-1/SOYD, …1/SOYD
D=(P-S)*Rn
55
Calculation of depreciation using
sum of years digit method
Year Opening b Annual rate Annual dep Closing book
(m) ook value of depreciati reciation value (BVm)
(BVm-1) on (Rm) (Dm)
0 0 0 0 200,000
1 200,000 5/15 50,000 150,000
2 150,000 4/15 40,000 110,000
3 110,000 3/15 30,000 80,000
4 80,000 2/15 20,000 60,000
5 60,000 1/15 10,000 50,000
56
Declining Balance Method
• This is a book depreciation method that provides larger portio
ns of the cost of the asset to be written off in the early years.
• Declining multiplies α, range between 1.25 to 2 (double declin
ing balance) decided by the life of the asset
1.25 to 2
N
Double declining Balance method
Rate of depreciation (Rm) = 2/N
D= Pm*Rm
57
Calculation of depreciation
using double declining balance method
(BVn < S)
Year Opening b Annual rate of Annual dep Closing book valu
(m) ook value depreciation reciation (D e (BVm)
(BVm-1) (Rm) m)
0 0 0 0 200,000
1 200,000 0.4 80,000 120,000
0 0 0 0 200,000
Salvage value 0 0
61
Pre tax cash flow diagram for Equipment A
3 X105 Birr
62
Computations for deriving Post tax cash flow dia
gram for Equipment A
Sl. Description Amount Explanation
63
Post tax cash flow diagram of Equipme
nt A
64
Pre tax cash flow diagram for Equipme
nt B
5.5X105
7.5X105
65
Computations for deriving Post tax cash flow dia
gram for Equipment B
Sl Description Amount Explanation
200,000
7.5X105
67
Evaluation using Present worth method
68
Evaluation using Annual worth method
69
Evaluation using Incremental rate of re
turn method
• Preferring equipment A over B: (considering post tax
cash flow diagrams of equipments A and B)
175,000
70
SOLUTION CONTINUED
• Assume i = 10%
N.P.W. = - 5 + 1.75 x (P/A,10%,5)
= - 5 + 1.75 x (3.7908)
= 1.633 *105
• Assume i = 20%
N.P.W. = - 5 + 1.75 x (P/A,20%,5)
= - 5 + 1.75 x (2.9906)
= 0.233 *105
71
SOLUTION CONTINUED
• Assume i = 25%
N.P.W. = - 5 + 1.75 x (P/A,25%,5)
= - 5 + 1.75 x (2.68928)
= - 0.294 *105
• By interpolation i = 21.53%
• Since this is more than MARR = 10%, hence it
will be preferable to choose equipment A.
• Thus, all the three methods gave same result t
hat of choosing equipment A.
72
Case 1: Income alone is given
• We assume that some equipment has been pu
rchased for Rs. 3.5 Lakhs and its accounting lif
e and service life happens to be 5 years. The p
redicted salvage value is nil.
• The gross income for all the five years is assum
ed to be Rs. 2.5 Lakhs and expenses are assum
ed to be nil for all these five years.
73
Case 1: Computations
Year Depreciation Gross inc Expen Net taxable income Tax paid Net income
om s
SLD DDB SOY
e e SLD DDB SOY SLD DDB SOY SLD DDB SOY
1 0.70 1.40 1.17 2.50 0.00 1.80 1.10 1.33 0.72 0.44 0.53 1.78 2.06 1.97
2 0.70 0.84 0.93 2.50 0.00 1.80 1.66 1.57 0.72 0.66 0.63 1.78 1.84 1.87
3 0.70 0.50 0.70 2.50 0.00 1.80 2.00 1.80 0.72 0.80 0.72 1.78 1.70 1.78
4 0.70 0.38 0.47 2.50 0.00 1.80 2.12 2.03 0.72 0.85 0.81 1.78 1.65 1.69
5 0.70 0.38 0.23 2.50 0.00 1.80 2.12 2.27 0.72 0.85 0.91 1.78 1.65 1.59
74
Case 2: Operating expense alone is given
75
Case 2: Computations
Year Depreciation Gross inc Expen Net taxable income Tax Post tax net expense
om s
e e
SLD DDB SOY SLD DDB SOY SLD DDB SOY SLD DDB SOY
1 0.7 1.4 1.17 0 1.0 -1.70 -2.40 -2.17 -0.68 -0.96 -0.87 0.32 0.04 0.13
2 0.7 0.84 0.93 0 1.0 -1.70 -1.84 -1.93 -0.68 -0.74 -0.77 0.32 0.26 0.23
3 0.7 0.50 0.70 0 1.0 -1.70 -1.50 -1.70 -0.68 -0.60 -0.68 0.32 0.40 0.32
4 0.7 0.38 0.47 0 1.0 -1.70 -1.38 -1.47 -0.68 -0.55 -0.59 0.32 0.45 0.41
5 0.7 0.38 0.23 0 1.0 -1.70 -1.38 -1.23 -0.68 -0.55 -0.49 0.32 0.45 0.51
Total
76
Case 3: Income and expense both are give
n
• As before, we assume that some equipment h
as been purchased for Rs. 3.5 Lakhs and its acc
ounting life and service life happens to be 5 ye
ars. The predicted salvage value is nil.
• Let’s further assume gross income and expe
nse to be 2.5 Lakhs and 1 lakh respectively on
an annual basis.
77
Case 3: Computations
Year Depreciation Gross in Expe Net taxable income Tax paid Net income Operating Cash Flow = N
c n et income + Depre
o s ciation
m e
e
SLD DDB SOY SLD DDB SOY SLD DDB SOY SLD DDB SOY SLD DDB SOY
1 0.7 1.40 1.17 2.5 1.0 0.80 0.10 0.33 0.32 0.04 0.13 .48 0.06 .2 1.18 1.46 1.37
2 0.7 0.84 0.93 2.5 1.0 0.80 0.66 0.57 0.32 0.26 0.23 .48 .4 .34 1.18 1.24 1.27
3 0.7 0.50 0.70 2.5 1.0 0.80 1.00 0.80 0.32 0.40 0.32 .48 .6 .48 1.18 1.1 1.18
4 0.7 0.38 0.47 2.5 1.0 0.80 1.12 1.03 0.32 0.45 0.41 .48 .67 .62 1.18 1.05 1.09
5 0.7 0.38 0.23 2.5 1.0 0.80 1.12 1.27 0.32 0.45 0.51 .48 .67 0.76 1.18 1.05 .99
78
EFFECT OF INFLATION ON CASH FLOW
• Construction projects by large take number of month
s and during this period, the cost of labour, materials,
plant and machinery may undergo an inflationary tre
nd.
• Inflation in general is defined as the increase in the p
rice level resulting in decrease in purchasing power o
f money.
• Since general inflation results in the price rise in all g
oods, the relative prices remain constant. Hence, it is
possible to disregard escalation.
79
EFFECT OF INFLATION ON CASH FLOW
• In India, it is normal practice to use 12% as discount r
ate. According to IRC:SP:61-2004, where there is a lar
ge difference between the rate of inflation and intere
st, the discount rate is evaluated using the following
expression:
• Modified discount rate= [ {(1+ interest rate %)÷(1 + i
nflation rate%)} – 1] x 100%
• Considering an interest rate of 12% and an inflation r
ate of 8%, the modified discount rate = [{(1+ 12%) ÷
(1+ 8%)- 1}] x 100% = 3.70%
80
Thank you!
81