Scribd
Upload
12 views

Topic 4 - Rate of Return - Revised

The document discusses different methods for evaluating investment project alternatives using economic measures like present worth, rate of return, and annual worth. It provides examples of applying these methods to compare two or more alternatives and explains when incremental analysis is necessary to get consistent results.

Uploaded by

Tain WeiSheng
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
12 views

Topic 4 - Rate of Return - Revised

The document discusses different methods for evaluating investment project alternatives using economic measures like present worth, rate of return, and annual worth. It provides examples of applying these methods to compare two or more alternatives and explains when incremental analysis is necessary to get consistent results.

Uploaded by

Tain WeiSheng
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 19

Rate of Return

TOPIC 4
Revisited PW, FW, AW analyses
Summary of the decision rules

Economic measure Notes Decision Rule


of merit
PW, AW, FW All are functions of the MARR If PW (or AW, FW) ≥ 0
accept the project; otherwise,
reject it
ROR Solve for unknown interest rate, i* If i* ≥ MARR
accept the project; otherwise,
reject it

2
Rate of Return One Project
Definition: The rate of return is the break-even interest rate, i* which equates the present
worth of a project’s cash outflows to the present worth of its cash inflows.

𝑃𝑊 𝑖 ∗ 𝑐𝑎𝑠ℎ 𝑖𝑛𝑓𝑙𝑜𝑤𝑠 = 𝑃𝑊 𝑖 ∗ 𝑐𝑎𝑠ℎ 𝑜𝑢𝑡𝑓𝑙𝑜𝑤𝑠

𝑃𝑊 𝑖 ∗ = 0
Example
Rate of Return of Multiple Alternatives
Examples of Rate of Return Multiple Alternatives Alternatives A B
First Cost, $ ─ 60,000 ─ 73,000
Compare the alternatives using the following methods:
(a) PW analysis at MARR is 10% per year Annual Revenue, $/year 22,000 26,225
(b) Rate of Return analysis
Life, year 4 4

(a) PW analysis at MARR is 10% per year


𝑃
𝑃𝑊𝐴 = −60000 + 22000 , 10%, 4 = $9738
𝐴
𝑃
𝑃𝑊𝐵 = −73000 + 26225 , 10%, 4 = $10131
𝐴

(b) Rate of Return analysis


𝑃 ∗ 𝑃 ∗
A: 0 = −60000 + 22000 ,𝑖 ,4 𝑩: 0 = −73000 + 26225 ,𝑖 ,4
𝐴 𝐴
𝑃 ∗
, 𝑖 , 4 = 2.727 15% 2.855 𝑃 ∗ 15% 2.855
𝐴 , 𝑖 , 4 = 2.784
i* 2.727 𝐴 i* 2.784
𝑖 ∗ = 17.3 % 18% 2.690 𝑖 ∗ = 16.3 % 18% 2.690

7
Why Incremental Analysis is Necessary?
The Inconsistent Ranking Problem

8
ROR Incremental Analysis

𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 = 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑩 − 𝑐𝑎𝑠ℎ 𝑓𝑙𝑜𝑤 𝑨

This incremental ROR is


Where alternative B is the larger initial investment identified as ∆𝒊∗
Alternatives Incremental
A B
B-A The ROR on the extra
$13,000 investment
First Cost, $ ─ 60,000 ─ 73,000 ─ 13,000
in B determines which
Annual Revenue, $/year 22,000 26,225 4,225 alternative to select.
𝑃
Incremental (B - A): 0 = −13,000 + 4225 , ∆𝑖 ∗ , 4
𝐴

10% 3.169 𝑃
, ∆𝑖 ∗ , 4 = 3.077
∆i* 3.077 𝐴
The extra investment of B is justified,
12% 3.037 ∆𝑖 ∗ = 11.4 % ≥ 𝑀𝐴𝑅𝑅 thus select Alternative B

9
Equal-service life
are necessary when
performing ROR
analysis.

Therefore, the LCM


must be used.
11
12
𝑃 𝑃 𝑃
−5000 + 1900 , ∆𝑖 ∗ , 10 − 11000 , ∆𝑖 ∗ , 5 + 2000 , ∆𝑖 ∗ , 10 = 0
𝐴 𝐹 𝐹

𝐴𝑠𝑠𝑢𝑚𝑒 𝑖 ∗ = 12% −5000 + 1900 5.6502 − 11000 0.5674 + 2000 0.3220 = 137.98 ≠ 0

𝐴𝑠𝑠𝑢𝑚𝑒 𝑖 ∗ = 14% −5000 + 1900 5.2161 − 11000 0.5194 + 2000 0.2697 = −263.41 ≠ 0

PW will be zero between 12% and 14%.


Use straight-line interpolation: ∆𝑖 ∗ = 12.68% > MARR
Vendor B is selected.

@aziatulniza 14
Summary
Alternatives
Independent
Mutually Exclusive Alternatives
Alternatives
Revenue Cost Multiple Alternatives
Cash Flow Cash Flow More than one can be
Alternatives Alternatives selected
Select all with PW > 0
PW, AW , FW ROR PW, AW , FW ROR
ROR
Multiple Alternatives Multiple Alternatives Multiple Alternatives Multiple Alternatives 1. Compare each
Select one with 1) Lowest initial Select one with less 1) Compare against alternative with DN
numerically largest investment negative value PW, each other (NO incremental
PW, AW , FW compared with DN AW, FW (incremental analysis)
2) Then compare analysis) 2. Select all if i* ≥
If PW, AW, FW < 0 against each other DN is not an option 2) ∆ i*B-A ≥ MARR MARR
Select DN (incremental 3) Select Alt B, the
analysis) extra investment
3) ∆ i*B-A ≥ MARR of B is justified
4) Select Alt B, the
extra investment
of B is justified
16
Example of Multiple Alternatives

Solution:

You might also like