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MINIMUM ATTRACTIVE RATE OF RETURN ( MARR ) ECR 433: Engineering Economics and Finance Lec 04: APPLICATIONS OF MONEY-TIME

RELATIONSHIPS
An interest rate used to convert cash flows into equivalent worth at some point(s) in time Usually a policy issue based on:
- amount, source and cost of money available for investment - number and purpose of good projects available for investment - amount of perceived risk of investment opportunities and estimated cost of administering projects over short and long run - type of organization involved

MARR is sometimes referred to as hurdle rate


Course instructor: Rumana Hossain
Course: ECR433; Faculty-Rumana Hossain

PRESENT WORTH METHOD ( PW )


Based on concept of equivalent worth of all cash flows relative to the present as a base All cash inflows and outflows discounted to present at interest -- generally MARR PW is a measure of how much money can be afforded for investment in excess of cost PW is positive if dollar amount received for investment exceeds minimum required by investors

Discount future amounts to the present by using the interest rate over the appropriateN study period

FINDING PRESENT WORTH


PW =
k=0

Fk ( 1 + i ) - k

i = effective interest rate, or MARR per compounding period k = index for each compounding period Fk = future cash flow at the end of period k N = number of compounding periods in study period interest rate is assumed constant through project The higher the interest rate and further into future a cash flow occurs, the lower its PW

Course: ECR433; Faculty-Rumana Hossain

Course: ECR433; Faculty-Rumana Hossain

BOND AS EXAMPLE OF PRESENT WORTH


The value of a bond, at any time, is the present worth of future cash receipts from the bond The bond owner receives two types of payments from the borrower:
-- periodic interest payments until the bond is retired ( based on r ); -- redemption or disposal payment when the bond is retired ( based on i );

The present worth of the bond is the sum of the present values of these two payments at the bonds yield rate
Course: ECR433; Faculty-Rumana Hossain

For a bond, let Z = face, or par value C = redemption or disposal price (usually Z ) r = bond rate (nominal interest) per interest period N = number of periods before redemption i = bond yield (redemption ) rate per period VN = value (price) of the bond N interest periods prior to redemption -- PW measure of merit VN = C ( P / F, i%, N ) + rZ ( P / A, i%, N ) Periodic interest payments to owner = rZ for N periods -- an annuity of N payments When bond is sold, receive single payment (C), based on the price and the bond yield rate ( i )

PRESENT WORTH OF A BOND

Course: ECR433; Faculty-Rumana Hossain

Pause and Solve???!!!???


A bond with a face value of $5000 pays interest of 8% per year. This bond will be redeemed at par value at the end of its 20 years life, and the first interest payment is due one year from now. a) How much should be paid for this bond in order to receive a yield of 10% per year on the investment? b) If this bond is purchased now for $4,600, what annual yield would the buyer receive?
Course: ECR433; Faculty-Rumana Hossain

FUTURE WORTH METHOD (FW )


FW is based on the equivalent worth of all cash inflows and outflows at the end of the planning horizon at an interest rate that is generally MARR The FW of a project is equivalent to PW FW = PW ( F / P, i%, N ) If FW > 0, it is economically justified
N

FW ( i % ) =k F ( 1 + i ) N-k =0 k
i = effective interest rate k = index for each compounding period Fk = future cash flow at the end of period k N = number of compounding periods in study period
Course: ECR433; Faculty-Rumana Hossain

ANNUAL WORTH METHOD ( AW )


AW is an equal annual series of dollar amounts, over a stated period ( N ), equivalent to the cash inflows and outflows at interest rate that is generally MARR AW is annual equivalent revenues ( R ) minus annual equivalent expenses ( E ), less the annual equivalent capital recovery (CR) AW ( i % ) = R - E - CR ( i % ) AW = PW ( A / P, i %, N ) AW = FW ( A / F, i %, N ) If AW > 0, project is economically attractive AW = 0 : annual return = MARR earned
Course: ECR433; Faculty-Rumana Hossain

CAPITAL RECOVERY ( CR )
CR is the equivalent uniform annual cost of the capital invested CR is an annual amount that covers:
Loss in value of the asset Interest on invested capital ( i.e., at the MARR )

CR ( i % ) = I ( A / P, i %, N ) - S ( A / F, i %, N ) I = initial investment for the project S = salvage ( market ) value at the end of the study period N = project study period

Course: ECR433; Faculty-Rumana Hossain

INTERNAL RATE OF RETURN METHOD ( IRR ) IRR solves for the interest rate that equates the equivalent worth of an alternatives cash inflows (receipts or savings) to the equivalent worth of cash outflows (expenditures) Also referred to as:
investors method discounted cash flow method profitability index

INTERNAL RATE OF RETURN METHOD ( IRR ) IRR is i %, using the following PW formula:
N k= 0

R k ( P / F, i %, k ) = E k ( P / F, i %, k )
k= 0

IRR is positive for a single alternative only if:


both receipts and expenses are present in the cash flow pattern the sum of receipts exceeds sum of cash outflows
Course: ECR433; Faculty-Rumana Hossain

R k = net revenues or savings for the kth year E k = net expenditures including investment costs for the kth year N = project life ( or study period ) If i > MARR, the alternative is acceptable To compute IRR for alternative, set net PW = 0
N N

PW = R k ( P / F, i %, k ) - E k ( P / F, i %, k ) = 0 k= 0 k= 0 i is calculated on the beginning-of-year unrecovered investment through the life of a project Course: ECR433; Faculty-Rumana Hossain

INTERNAL RATE OF RETURN PROBLEMS The IRR method assumes recovered funds, if not consumed each time period, are reinvested at i %, rather than at MARR The computation of IRR may be unmanageable Multiple IRRs may be calculated for the same problem The IRR method must be carefully applied and interpreted in the analysis of two or more alternatives, where only one is acceptable
Course: ECR433; Faculty-Rumana Hossain

Pause and solve??!!??


You are faced with the decision on an investment proposal. Specifically, the estimated additional income from the investment is $180,000 per year, the investment cost is $640,000 and the estimated annual expenses are $44,000 which begin decreasing by $4000 per year starting at the end of the third year. Assume an 8 year analysis period, no salvage value and MARR=15% per year. a) What is present worth of this proposal? b) What is IRR of this proposal?

Course: ECR433; Faculty-Rumana Hossain

THE EXTERNAL RATE OF RETURN METHOD ( ERR )

CALCULATING EXTERNAL RATE OF RETURN ( ERR )


1. All net cash outflows are discounted to the present (time 0) at % per compounding period. 2. All net cash inflows are discounted to period N at %. 3. ERR -- the equivalence between the discounted cash inflows and cash outflows -- is determined. The absolute value of the present equivalent worth of the net cash outflows at % is used in step 3. A project is acceptable when i % of the ERR method is greater than or equal to the firms MARR

ERR directly takes into account the interest rate ( ) external to a project at which net cash flows generated over the project life can be reinvested (or borrowed ). If the external reinvestment rate, usually the firms MARR, equals the IRR, then ERR method produces same results as IRR method

Course: ECR433; Faculty-Rumana Hossain

Course: ECR433; Faculty-Rumana Hossain

CALCULATING EXTERNAL RATE OF RETURN ( ERR ) N Ek ( P / F, %, k )( F / P, i %, N ) k= 0


N k=

Pause and solve??!!??


Find the ERR for the following cash flows: End of year net cash flow 0 -$450,000 1 - 42,500 2 92,800 3 386,000 4 614,600 5 - 202,200 where =10%, MARR=10%.
Course: ECR433; Faculty-Rumana Hossain

Rk ( F / P, %, N - k )

Rk = excess of receipts 0 over expenses in period k Ek = excess of expenses over receipts in period k N = project life or period of study

= external reinvestment rate per period


0
N k= 0

i %= ? Time

k = 0k

R ( F / P, %, N - k )

N
Course: ECR433; Faculty-Rumana Hossain

Ek ( P / F, %, k )( F / P, i %, N )

ERR ADVANTAGES
ERR has two advantages over IRR: 1. It can usually be solved for directly, rather than by trial and error. 2. It is not subject to multiple rates of return.

PAYBACK PERIOD METHOD


Sometimes referred to as simple payout method Indicates liquidity (riskiness) rather than profitability Calculates smallest number of years ( ) needed for cash inflows to equal cash outflows -- break-even life ignores the time value of money and all cash flows which occur after

If is calculated to include some fraction of a year, it is rounded to the next highest year

k= 1

( Rk -Ek) - I > 0

Course: ECR433; Faculty-Rumana Hossain

Course: ECR433; Faculty-Rumana Hossain

Which one to choose?


All three have the same payback period.
Any problems with Payback Period? Period 1 2 3 Proj. 1 -20 10 10 Proj. 2 -20 10 10 Proj. 3 -20 0 20 4 NPV(10%) 100 72.49 0 -2.64 0 -3.47 PB(yrs) 2 2 2

PAYBACK PERIOD METHOD


The payback period can produce misleading results, and should only be used with one of the other methods of determining profitability A discounted payback period ( where < N ) may be calculated so that the time value of money is considered

( Rk - Ek) ( P / F, i %, k ) - I > 0
k= 1

i is the MARR I is the capital investment made at the present time ( k = 0 ) is the present time is the smallest value that satisfies the equation

Course: ECR433; Faculty-Rumana Hossain

Course: ECR433; Faculty-Rumana Hossain

INVESTMENT-BALANCE DIAGRAM

INTERPRETING IRR USING INVESTMENTBALANCE DIAGRAM


[ P (1 + i) - (R1 - E1) ] (1 +i) Unrecovered 1 + i 1 + i Investment 1 + i Balance, $ (R1 - E1)
(R2 - E2) (R3 - E3) (RN-1 - EN-1)

P (1 + i)

Describes how much money is tied up in a project and how the recovery of funds behaves over its estimated life.
Course: ECR433; Faculty-Rumana Hossain

Initial investment =P

1 + i
(RN - EN)

$0 0 1 2 3 N downward arrows represent annual returns (Rk - Ek) : 1 < k < N dashed lines represent opportunity cost of interest, or interest on BOY investment balance IRR is value i that causes unrecovered investment balance to equal 0 at the end of the investment period.

Investment Balance, $

INVESTMENT-BALANCE DIAGRAM EXAMPLE


Capital Investment ( I ) = $10,000 Uniform annual revenue = $5,310 Annual expenses = $3,000 Salvage value = $2,000 MARR = 5% per year

5,000

MARR = 5%
$2,001 ( = FW )

Years
0 1 2 3 4 5

+ $4,310

- 5,000

- $2,199 Area of Negative - $2,310 Investment - $2,310 $4,294 Balance - $6,290 - $8,190 - $2,310 - $2,310 - $2,310 - $6,604 - $8,600 - $4,509

- 10,000 -$10,500
Course: ECR433; Faculty-Rumana Hossain

Course: ECR433; Faculty-Rumana Hossain

Pause and solve??!!??


Uncle Wilbor,s trout range is now for sale for 40,000. annual property taxes, maintenance, supplies are so on are estimated to continue to be 6000 per year. Revenues from the range are expected to be 10,000 next year and then to decline 500 per year thereafter through the tenth year. If you brought the range you would plan to keep it for only five years and at that time to sell it for the value of the land, which is $15000. if your desired annual rate of return is 12%, should you become a trout ranger? Use PW method. What is the IRR for this problem?

Course: ECR433; Faculty-Rumana Hossain

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