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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
Discount future amounts to the present by using the interest rate over the appropriateN study period
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
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 )
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
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
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
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
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
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
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.
If is calculated to include some fraction of a year, it is rounded to the next highest year
k= 1
( Rk -Ek) - I > 0
( 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
INVESTMENT-BALANCE DIAGRAM
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, $
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