Engineering Economy

Chapter 6
Fall 2018

Dr.Ako Rashed Hama

11/19/2018
 Engineering Economy
Chap 6: Rate of Return Analysis

1. Rate of Return (ROR)

ROR is considered when investing or lending!
same as i interest rate which is important for borrower

interest rate paid on the unpaid balance of a loan

interest rate earned on the unrecovered balance of an investment

interest rate i* at which the benefits are equivalent to the costs

PWbenefits – PWcosts= 0
PW(i*) = PW(i*)cash inflows– PW(i*)cash outflows = 0

ROR also known as:

Internal Rate of Return (IRR), Return on Investment (ROI), Profitability Index (PI)
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Chap 6: Rate of Return Analysis

Why ROR measure is so popular?

Which statement is easier to understand?!
This project will bring in a 15% rate of return on investment.

This project will result in a net surplus of $10,000 in NPW.

Example 1
In 1970 a company went public and an investment of 100 shares cost
$1,650. That investment would have been worth $12,283,904 on January
31, 2002.
What is the ROR on that investment?
P = $1,650 F = $12,283,904 n = 32 >>> find i = ?
From Ch. 1: F = P (1+i)n
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Chap 6: Rate of Return Analysis

Example 1

n
F 12283094
F=P 1+i → −1 =i→i= − 1 → i = 0.3212
P 1650
= = . %
F = $12,283,904

n=0 i = ROR = 32.12%

n = 32

P = $1,650

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Chap 6: Rate of Return Analysis

Example 2
Suppose that someone invested that amount ($1,650) in a savings
account at 6% per year. Then, he could have only $10,648 on January,
2002.
What is the meaning of this 6% interest here?
This is 6% interest in his opportunity cost, if putting money in savings
account was the best he can do at that time!
In 1970, as long as he earn more than 6% interest in another investment,
he will take that investment.
That 6% is viewed as a minimum attractive rate of return = MARR
we can apply the following decision rule:
to check if the proposed investment is a good one
11/19/2018 ROR (32.12%) > MARR (6%)
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Chap 6: Rate of Return Analysis

2. Return of Investment
interest rate earned on the unpaid balance of an installment loan
Example 3
A bank lends $10,000 and receives annual payment of $4,021 over 3
years. The bank is said to earn a return of 10% on its loan of $10,000.
Compute the amount of the rate of return on unpaid balance.

P = $10,000 i = 10% n = 3 >>> find A = ?

From Ch. 2: A = P (A/P,i,n) = 10,000 (A/P,10%,3) = $4,021 per year
The borrower is to make 3 equal end of year payments, which is $4,021
to pay off this loan.

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Chap 6: Rate of Return Analysis

Example 3
A = $4,021 per year

Unpaid Return Unpaid

balance on unpaid balance
at the beg. balance Payment at the end
Year of year (a) (10% of a=b) Received (c) of year (a+b+c)
0 -$10,000 -$10,000
1 -$10,000 -$1,000 +$4,021 -$6,979
2 -$6,979 -$698 +$4,021 -$3,656
3 -$3,656 -$365 +$4,021 0

a return of 10% on the amount still outstanding final payment makes

at the beginning of each year, totally $2063 unpaid balance zero
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Chap 6: Rate of Return Analysis

3. ROR Calculation
setting up PW, AW or FW equivalence >>> solve for interest rate, i*
identifying rate by i* that makes the cash flows equivalent

e.g. finding i* is rewrite of PW relation for receipts R and disbursements D

PWR – PWD = 0

Methods to determine i*:

• Trial and error: cash flow diagram
bracket ‘0’ with different i values
interpolation to obtain i*
• Spreadsheet: use either Excel function - RATE or IRR
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= RATE (n,A,P,F)
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Chap 6: Rate of Return Analysis

Example 4

finding PW and then equalizing to ‘0’ leads to PWR – PWD = 0

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Chap 6: Rate of Return Analysis

Example 4
0 = PWR – PWD

i*, % PW, $
5 6,946
i* 0
6 -35,519

5–6 6,946 – (– 35,519)

5 – i* 6946 – 0

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when applying RATE function i* = 5.16%
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Chap 6: Rate of Return Analysis

Finding ROR by Spreadsheet Function

Using the IRR function
Using the RATE function
= IRR(first_cell, last_cell)
= RATE(n,A,P,F)

13 Cash Flows:
n = 12 A = $-15,000
begin at B2
P = $-200,000 F = $450,000

Excel Function on this data:

end at B14
= RATE(12,-15000,-200000,450000)

the ROR is i* = 1.88%

= IRR(B2:B14)
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Example 5
An investment of $20,000 in new equipment will generate income of
$7,000 per year for 3 years, at which time the machine can be sold for an
estimated $8000. If the company’s MARR is 15% per year, should it buy
the machine?
F = $8,000 The ROR equation based on a PW relation:
0 = -20,000 + 7000(P/A,i*,3) + 8000(P/F,i*,3)
A = $7,000
i* by trial and error or spreadsheet:
n=0 i* = 18.24% per year
n=3
MARR = 15% i* (18.24%) > MARR (15%)
P = $20,000 the company should buy the machine
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4. Cautions When Using ROR

 ROR always results in the same economic decision
regardless of PW, AW, and FW method
 ROR can be computationally difficult and/or lead to incorrect decisions!

Special Procedures Needed for:

Multiple alternatives – more than one alternative
special procedure for evaluating
Multiple i* values – more than one real-number root to ROR equation
special procedure for evaluating
Reinvestment assumption – return of i*, not MARR, is assumed by ROR
finding ROR for any ‘leftover funds’ at end of each year
11/19/2018 if i* >> or << MARR, or multiple i*s exist, this is unrealistic
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Chap 6: Rate of Return Analysis

5. Recommended approach
use MARR to determine PW, AW or FW
if i* needed - find it with cautions considered and appropriate procedure

e.g. ►MARR = 15% & PW > 0; find exact i* if requested

►MARR = 15% & PW << 0; no need to find exact i*

6. Incremental ROR Analysis:

selection of one mutually exclusive (ME) alternative from several using ROR
 incremental cash flows be evaluated
 equal service assumption is enforced by using LCM of lives
 unused funds assumed to earn at the resulting i* rate, not MARR
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Chap 6: Rate of Return Analysis

7. Performing Incremental ROR Analysis

 determining incremental cash flow series
 finding ∆i* which is expected return on extra investment of larger cost
alternative

if ∆i* > MARR - select larger investment alternative

Otherwise - select smaller investment alternative

Convenient format for manual or spreadsheet ROR analysis:

 years from now (0) to n (equal lives) or LCM (unequal lives)
 larger initial investment alternative termed B, second is A
 incremental cash flow: ∆CF = CFB - CFA
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Example 6
Tabulate the incremental cash flow or ∆CF series.
PA = $-70,000 ; AOCA = $-9,000 ; SA = $5,000 ; nA = 3 nA ≠ nB & LCM=6
PB = $-95,000 ; AOCB = $-7,000 ; SB = $10,000 ; nB = 6 larger initial investment

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8. Multiple Mutual Exclusive Alternatives

 Multiple ME revenue alternatives
positive and negative cash flows are estimated
 determining i* for each alternative
 removing any with i* < MARR (return too low)
 performing incremental analysis on those remaining
 Multiple ME cost alternatives
only costs are estimated
 including all alternatives in incremental analysis
 Independent Projects
no incremental analysis
 accepting all projects with i* ≥ MARR
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9. ROR Analysis of ≥ 2 ME Alternatives

selecting alternative that has both properties:
1. requires largest initial investment, and
2. has incremental ROR ∆i* ≥ MARR

alternative cash flow type and evaluation

 Cost - comparing alternatives against each other
 Revenue - first comparing to DN, than against each other

Selecting one ME alternative from two or more cost or revenue alternatives

using PW-based ROR equations needs a specific procedure!

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10. Procedure for ROR Analysis of ≥ 2 ME Alternatives

1. Ordering alternatives by increasing initial investment amount;
for revenue alternatives, adding DN with P = $0
2. For first two, determining incremental CF over LCM using
∆CF = CFB - CFA
3. Determining ∆i* using PW-based relation of ∆CF series
4. If ∆i* ≥ MARR, eliminating A; B is survivor
If ∆i* < MARR, A is survivor; eliminating B
5. Comparing survivor with next alternative;
continuing steps (2) – (4) until only 1 alternative survives
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Example 7
A company with an MARR of 13.5% needs a specific machine and 4 offers
are on the table. Use incremental ROR analysis to determine which
manufacturer offers the best economic choice.

1. Cost alternatives are ordered by first cost

2. Determining ∆CF for B – A over 8-year life

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Example 7
3. PWB-A: 0 = -1500 + 300(P/A,∆i*,8) + 400(P/F, ∆i*,8)
by trial and error or Excel function =RATE(8,300,-1500,400)
∆i* = 14.57%
4. 14.57% > 13.5%; eliminating A, B survives
5. Comparing C to B (back to step 2)
2. Determine ∆CF for C – B over 8-year life
Incremental Cash
Year Cash Flow Machine B Cash Flow Machine C
Flow for (C - B)
0 $-6,500 $-10,000 $-3,500
1-8 -3,200 -3,000 +200
8 +900 +700 -200
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Example 7
3. PWC-B: 0 = -3500 + 200(P/A,∆i*,8) - 200(P/F, ∆i*,8)
by trial and error or Excel function =RATE(8,200,-3500,-200)
∆i* = -18.77%
4. -18.77% << 13.5%; eliminating C, B survives
5. Comparing D to B (back to step 2)
2. Determine ∆CF for D – B over 8-year life
Incremental Cash
Year Cash Flow Machine B Cash Flow Machine D
Flow for (D - B)
0 $-6,500 $-15,000 $-8,500
1-8 -3,200 -1,400 +1,800
8 +900 +1,000 +100
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Example 7
3. PWD-B: 0 = -8500 + 1800(P/A,∆i*,8)+100(P/F, ∆i*,8)
by trial and error or Excel function =RATE(8,200,-3500,-200)
∆i* = 13.60%
4. 13.6% > 13.5%; eliminating B, D survives
5. Selecting D by a small marginal of ROR
Example 8
Use incremental ROR analysis to find the best alternative for a company
with an MARR of 12%. Revenues with different lives!

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Example 8
1.Ordering alternatives by first cost; adding DN as first alternative
Order is DN, 4, 2, 1, 3
2. DN cash flows are all 0; ∆CF4-DN same as for 4
3. PW for 4 over 4 years: 0 = -20,000 + (29,000 – 21,000)(P/A,∆i*,4)
∆i* = 21.9%
4. 21.9% > 12%; eliminating DN, 4 survives
5. Comparing 4 to 2 over LCM of 4 years (back to step 2)
2. Determining ∆CF for 2 - 4 over 4-year LCM

Year alternative 4 alternative 2 incremental CF (2 - 4)

0 $-20,000 $-50,000 $-30,000
1-4 total A4 = 8,000 total A2 = 17,000 +9,000
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Example 8
2. Determining ∆CF for 2 - 4 over 4-year LCM
3. PW2-4: 0 = -30,000 + 9,000(P/A,∆i*,4)
∆i* = 7.7%
4. 7.7% < 12%; eliminating 2, 4 survives
5. Comparing 1 to 4 (back to step 2)
2. Determining ∆CF for 1 - 4 over 4-year LCM

Year alternative 4 alternative 1 incremental CF (1 - 4)

0 $-20,000 $-80,000 $-60,000
1-4 total A4 = 8,000 total A1 = 33,000 +25,000

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Example 8
3. PW1-4: 0 = -60,000 + 25,000(P/A,∆i*,4)
∆i* = 24.1%
4. 24.1% > 12%; eliminating 4,1 survives
5. Comparing 3 to 1 (back to step 2)
2. Determining ∆CF for 3–1 over 8-year LCM

Year alternative 1 alternative 3 incremental CF (3 - 1)

0 $-80,000 $-145,000 $-65,000
4 -80,000 0 +80,000
1-8 total A1 = 33,000 Total A3 = 35,000 +2,000

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Example 8

PW3-1: 0 = -65,000 + 80,000(P/F, ∆i*,4) + 2,000(P/A,∆i*,8)

∆i* = 10.1%
4. 10.1% < 12%; eliminating 3,1 survives
11/19/2018 5. Selecting alternative 1
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Chap 6: Rate of Return Analysis

11. Multiple ROR Values

PW = P + A (P/A,i,n) + S (P/F,i,n)

an nth-order polynomial;
multiple and real-number roots between 100% and ∞ may exist
types of cash flow series based on sign
 Conventional (simple) only one sign change over series
disregard zero cash flows
 Nonconventional (nonsimple) more than one sign change
may have multiple roots
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11. Multiple ROR Values

Year number of
Cash flow type
0 1 2 3 4 5 sign changes
Conventional − − + + + + 1
Nonconventional − + + + − − 2
Nonconventional + − + + − + 4

Conventional series: commonly start with a negative cash flow

Nonconventional cash flow series: possible presence of multiple ROR

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11. Multiple ROR Values

tests indicating the number of ROR values

1. Cash Flow Rule of Signs (Descartes’ rule):

Maximum number of real i* values is equal to the number of sign
changes in the cash flow series

2. Cumulative Cash Flow Test (Norstrom’s criterion):

One nonnegative i* can be found if the S series (cumulative cash
flow series) changes signs only once and Sn ≠ 0
cumulative cash flow series S0, S1, S2, …, Sn

When necessary: perform both tests to determine if a unique i* ≥ 0 exists

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Example 9
Based on the following cash flows:
a. Determine maximum number of i* values applying two tests.
b. Using PW find approximate i* from the PW-i* diagram.
Year 0 1 2 3
Cash Flow, $ +2,000,000 -500,000 -8,100,000 +6,800,000

=CF1+CF2
=CF1+CF2+CF3
=Sn=CF1+CF2+CF3+CF4
11/19/2018 Sign change 2 2
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Chap 6: Rate of Return Analysis

Example 9
a. Determination of maximum number of i* values:
more than one sign change > from rule of signs test there are as many as
two ROR values

b. From PW equation (P and 3 single payments):

selecting of i for finding the two i* values (plotting PW vs i)

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Example 9

Typical graph of the polynomial;

two intersections at (approximation):
i = i*1 = 8% and i = i*2 = 41%

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