Three Sample Rate of Return Problems and their Solutions

Problem 1. (Qu. 5.31 from 3rd edition of textbook) The heating system in Jacobs building has worn out and he has to get a new one. All the alternatives are gas-fired furnaces, but they vary in efficiency. Model A is leased at $500/year. It has installation charges of $500, and saves $200 a year compared with his previous system. Model B is purchased for $3600, including installation. After 10 years it will have a salvage value of $1000. It saves $500 a year compared with the old system. Model C is purchased at a total cost of $8000, half paid now, half paid in two years time. It has a salvage value of $1000 after ten years, and saves $1000/year compared with the current system. Assuming an MARR of 12% and using the IRR method, which furnace should Jacob get? Solution 1. The obvious problem with this question is that all of the models cost more money than they save, so they all have negative rates of return. But Jacob still has to get one of them, otherwise his building will freeze. We could represent the benefit of not freezing by a large, fictitious, annual cash inflow, but we can actually solve the problem without that. Since weve got to get one of them, lets assume we get Model A. Before signing the lease agreement, we look at the differential costs of upgrading to Model B. Assume the lease payments are made at the beginning of every year, and the energy savings are realised at the end of the year. Year Upgrade A to B Upgrade B to C 0 500+500-3600= -2600 3600-4000= -400 1 500+(500-200)=800 500 2 800 500-4000 3 800 500 4 800 500 5 800 500 6 800 500 7 800 500 8 800 500 9 800 500 10 1000+300 500 So the IRR for upgrading from A to B is the interest rate i for which -2600 + 800(P/A,i,9) + 1300(P/F,i,10) = 0 From the spreadsheet lecture8.xls, we see that the rate of return for this upgrade is about 30%, so we should do it. Now, before ordering Model B from the supplier, we construct the column of the table showing the cost of upgrading from B to C. We see that we should do this if the interest rate i is greater than the MARR, where i is the solution to: -400+500(P/A,i,10)-4000(P/F,i,2) = 0

Again looking at the spreadsheet, we see that the IRR for this upgrade is less than 4%, so we dont do it. Problem 2. After a long period of unemployment, Jamal signs a contract to work in the distant nation of Placidia. The job requires him to be away from home for two years, and the majority of his pay is held back until he has completed the contract. If he leaves before this, he gets nothing. He receives an immediate signing bonus of Rs 70 000, but he has to spend Rs 30 000 of this on an air ticket to Placidia. The rest he gives to his family. Once in Placidia, he is provided with food and board, but after working for a year, there are unexpected difficulties in renewing his work permit. Eventually he has to pay Rs 150 000 in fees and bribes, for which he has to re-mortgage his house back home. At the end of his second year he is paid Rs 170 000. Air fares have gone up in the meantime, so he spends another Rs 35 000 on an air ticket and flies home. Regarding the entire trip as a business investment, what is Jamals IRR? If there are multiple solutions, you should also calculate his approximate and his exact ERR. You should assume that he can invest his funds at 12.5%. Solution 2. The net cashflows involved are Rs 40 000 income, then an expenditure of Rs 150 000 at the end of the first year, then income of Rs 135 000 at the end of the second year. So to find his IRR, Jamal will find i such that: 40 000 150 000(P/F,i,1) + 135 000(P/F,i,2) =0 from which we deduce 4(1+i)2 -15(1+i) + 13.5 = 0 This equation has two solutions: IRR = 50%, or IRR = 125%. The latter solution seems unreasonably high: to have realised this rate of return, Jamal would have had to invest his initial payment at 125% interest, and there is no reason to think such an opportunity was available. To obtain the approximate ERR, we find the rate at which the future worth of the project would be zero, given that all receipts are brought to the end of the period at the explicit or `auxiliary rate of return, 12.5%. This is the solution to: 40 000(F/P,0.125,2) 150 000(F/P, i*ae, 1) + 135 000 = 0 from which we deduce: 4(1.2656) 15(1+ i*ae) + 13.5 = 0, and hence i*ae = 23.7%. If we want a more exact figure for his ERR, we must keep track of his accounts over the two-year period. Suppose that he had invested the initial payment at the rate we know he had available, 12.5%, then after a year this would have yielded Rs 45 000. Paying for the renewal of his work permit would have consumed all of this, plus a further Rs 105 000 from the re-mortaging of his house. So his exact ERR on his funds would be given by:

105 000 + 135 000(P/F, i*e, 1) = 0 which can be solved to get i*e = 28.3% Problem 3. Yan invests 10 000 000 to build a casino in Macao. In the first year he makes a profit of 20 000 000. But in the second year, a syndicate of card-counters infiltrate his casino, and he loses 15 000 000. In the third year he is able to eliminate the card-counters, and makes a profit of 50 000 000. Assume that his income and his losses occur continuously throughout each year, and that they are all continuously compounded. What is his IRR? Any money he does not invest in the casino, he can put in his cousins banking business, where he can earn 15%. What is his approximate ERR?

Solution 3. We have the difficulty that Yans continuous cash flows change from year to year, while all the formulae we have for calculating the present value of a continuous, continuously compounded cashflow assume that the flow rate is constant over the study period. To deal with this, note that we can describe Yans cashflows as an inflow of 50 000 000 a year, throughout the three years; superimposed on this, an outflow of 65 000 000 a year for the first two years; and superimposed upon this, an inflow of 35 000 000 in the first year. So the present value of Yans cashflows is, in millions of yen: PW = -10 + 50(e3r-1)/re3r - 65(e2r-1)/re2r + 35(er-1)/rer Where r is the nominal per-year internal rate of return. We multiply through by r and plot a graph, using the attached spreadsheet, S5.7(IRR).xls: PW( r) = -10r + 50(e3r-1)/ e3r - 65(e2r-1)/e2r + 35(er-1)/er = 0 (Multiplying through by r avoids a possible divide-by-zero error when r=0. For r > 0, the graph of PW(r) will cross the x-axis at the same point as the graph of PW, so both equations have the same solution.)

From the graph, we see that PW( r) passes through zero at a nominal interest rate of about 150% per year. This seems unreasonably high, so we would like to calculate the external rate of return. Finding the exact external rate of return would be rather difficult we would have to find the exact point in the second year in which Yans cash balance became negative so we settle for the approximate rate of return. To do this, we will again describe Yans cashflows as a superimposed series: an inflow of 20 000 000 over the three years, plus an outflow of 35 000 000 000 for the last two years, plus an inflow of 65 000 000 in the final year. We then write down an expression for the final value of the casino investment, on the assumption that all receipts are invested at Yans external rate of return, 15%, and that this rate is available as a continuous cash flow, continuously compounded: FW = -10e3r+ 20(e3(0.15)-1)/r - 35(e2r-1)/r + 65(e0.15-1)/r Multiplying through by r and equating to zero, we have FW(r) = -10e3r r+ 20(e0.45-1) - 35(e2r-1) + 65(e0.15-1) = 0 This is graphed in the accompanying worksheet, S5.7(ERR).xls, and we see that the approximate ERR for Yans casino project is about 21%.