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ENME619.

12 Fundamentals of Pipeline Economics

TOPIC 5 INTERNAL RATE OF RETURN (IROR)

Textbook:
• Riggs, J.L., Bedworth, D.D., Randhawa, S.U., and Khan, A.M., Engineering
Economics, 2nd Canadian Edition, McGraw Hill, 1997, Chapter 5.
Supplementary Readings:
• Blank, L., and Tarquin, A., Engineering Economy, 6th Edition, McGraw Hill, 2005,
Chapters 7, 8.
• Park, C.S., Pelot, R., Porteous, K.C., and Zuo, M.J., Contemporary Engineering
Economics, 2nd Canadian Edition, Addison Wesley Longman, 2001, Chapters 4, 5.
• Steiner, H.M., Engineering Economic Principles, 2nd Edition, McGraw Hill, 1996,
Chapters 8.

5.1 Basic concepts


a. IROR method
 Internal rate of return (IROR) method is a complicated and most controversial
method.
 It employs a percentage rate of return as the decision variable.
 It has been widely used by the banking community.

b. Formula
IROR (i*) is a percentage rate that causes the discounted present value of the benefits
in a cash flow to be equal to the discounted present value of the costs.
N N
 Bj( P / F , i*, j)   Cj( P / F , i*, j)
j 0 j 0
The IROR can be also defined as a discount rate that causes the net present value
(NPV) of a cash flow to equal zero.

5.2 Computations of IROR


a. Direct computation of IROR
Case 1: A Merrill-Lynch Ready Assets Trust in the amount of $5,000 was purchased on 11th
November 1993. It was sold on the same date 2 years later for $5,926. What was the
rate of return on the investment, before taxes and inflation were taken into account?
Solution
2 2
 Bj( P / F , i*, j)   Cj( P / F , i*, j)
j 0 j 0
5,926(P/F,i*,2)=5,000(P/F,i*,0)
5,000(1.000)
(P/F,i*,2)=  0.8437
5,926
Data Tables: (P/F,9,2)=0.8417, (P/F,8,2)=0.8573
Interpolation:
 0.8437  0.8417 
i*  9.0    (9.0  8.0)  8.872 %
 0.8573  0.8417 

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or
1 1
(P/F,i,j)= j
0.8437 
(1  i) (1  i*)2
i*=0.0886944=8.87%

b. Complex computation of IROR


Case 2: Computing equipment was purchased 3 years ago for $200,000. Its net benefits to
Development Research Company were estimated at $100,000 per year for the
economic life of the equipment, thought to be 10 years. It now has a zero salvage
value and will be retired. Development Research Company will purchase new
computing equipment for $350,000. This new equipment is estimated to have an
economic life of 5 years, no salvage value, and net benefits per year of $107,000 for
the first year and $214,000 for each of the 4 succeeding years. What is the
prospective rate of return in this situation in a before-tax analysis? Do not consider
inflation. Accuracy to the nearest 1 percent will be sufficient.
Solution:
5 5
 Bj( P / F , i*, j)  Cj( P / F , i*, j)
j 0 j 0
107,000( P / F , i*,1)  214,000( P / A, i*,4)( P / F , i*,1)
 350,000( P / F , i*,0)  350,000
 1   (1  i*)4  1 1 
107,000   214,000 4    350,000
1 i *  i * (1  i*)  1  i * 

Approximate heuristic approach (computational approach)


Step 1: To find the starting point
[4(214,000)+107,000](P/F,i1*,3)=350,000
(P/F,i1*,3)=0.3634; i1*=40%

Step 2: To calculate first trial by i1*=40%


107,000( P / F ,40,1)  214,000( P / A,40,4)( P / F ,40,1)
 107,000(0.7143)  214,000(1.8490)(0.7143)  359,069
Step 3: To calculate second trial by i2*=45%
107,000( P / F ,45,1)  214,000( P / A,45,4)( P / F ,45,1)
 107,000(0.6897)  214,000(1.7200)(0.6897)  327,663
Step 4: Interpolation
350,000  359.069
i*  40  (45  40)  41.44
327,663  359,069

c. Incremental analysis
Case 3: The following after-tax, after-inflation, cash flows occur for two mutually exclusive
alternatives:

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Alternative
Years 1 2
0 -800 -1,500
1-5 +400 +700
The null (do nothing) alternative must also be considered.
1) At 30% minimum attractive rate of return (MARR), and by using the internal
rate of return method, what alternative, if any, should be selected?
2) At 35%?
3) At 40%?
4) At 45%?
Solution:
1)
Alternative 1:
400( P / A, i1*,5)  800; i1*  41%
Alternative 2:
700( P / A, i2*,5)  1500; i2*  37%
Wrong decision: Alternative 1 is better than Alternative 2

Incremental analysis: (Alternative 2 - Alternative 1)


(700  400)( P / A, i21*,5)  (1500  800); i21*  32%
Since i21* =32%>30% (MARR), alternative 2 is chosen over alternative 1.
2)
When MARR=35%, alternative 1 is accepted (since 41%>35%) and alternative 2 is
rejected (since 32%<35%).
3) Alternative 1 is chosen.
4) Both alternatives are rejected.

5.3 IROR method agrees with present-worth method


Case 4: Two mutually exclusive alternatives have the cash flows shown in Figure 5.3.1.
Table 5.3.1 displays the calculation of the data necessary to draw a present-worth
(net present value) profile. A present-worth (PW) profile results when the NPV of a
cash flow is plotted against the discount rate, as shown in Fig. 5.3.2. Where the
profile cuts the horizontal axis, that is, where NPV=0, is the IROR of the cash flow.

18,000
12,000
10,000
8000
6000 2000

1 2 2-1

10,000 10,000

20,000
Figure 5.3.1 Cash flows.

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Table 5.3.1
i% NPV1 NPV2 NPV 2-1
0 4000 8000 4000
10 2231 3966 1735
20 832 832 0
25 240 -480 -720
27 19 -966 -985
30 -296 -1657 -1361
40 -1225 -3673 -2448

Figure 5.3.2 Present worth vs. IROR.


Decision: i=0%, alternative 2, i=10%, alternative 2, i=20%, alternatives 1, 2,
i=25%, alternative 1, i=27%, alternative 1, i>27%, alternative 0.

5.4 Applications of IROR


a. Rate of return on a bond
Case 5: Let us assume that a bond has a face value of $5,000 to be sold at price of $4,750.
The bond is payable in 20 years and the interest at a nominal rate of 8% is to be paid
semi-annually. The MARR is 10%. Shall we buy this bond?
Solution:
(5000  0.08  2)( P / A, i0.5*,40)  5000( P / F , i0.5*,40)  4750
i0.5 * =4.26%, i*  (1  i0.5 *) 2  1  (1  0.0426) 2  1  8.7015%  10%
We shall not buy this bond.

b. Multiple rates of return

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Case 6: One of the alternatives for improving an operation is following the cash flow as
shown in the following table.
End of year Cash flow, $
0 3,000
1 0
2 -10,000
3 2,000
4 2,000
5 2,000
6 2,000
What rate of return can be expected from this alternative?
Solution:
N N
From  Bj( P / F , i*, j)   Cj( P / F , i*, j)
j 0 j 0
We have:
3000  2000( P / A, i,4)( P / F , i,2)  10,000( P / F , i,2)
Let’s assume
NPV (i )  3000  2000( P / A, i,4)( P / F , i,2)  10,000( P / F , i,2)
By changing i from 0 to 51, we have the following drawing
1200

1000

800

600

400

200

0
0 9.4 20 30 40 51
-200

-400

-600

Comments:
 There are two IRORs, 9.4% and 51%;
 For 9.4% i 51%, NPV(i)0;

c. Descartes’ rule of signs

N
For the equation  P   A j X j  0 has N roots, which can be positive, negative, or
j 1

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imaginary. If the polynomial with real A’s has m sign changes, then the number of positive
roots will be m-2k, k=0, 1, 2, 3, ….

According to Descartes’ rule of signs


Number of sign changes m Number of positive roots x Number of positive i*
0 0 0
1 1 1 or 0
2 2 or 0 2,1, or 0
3 3 or 1 3, 2, 1, or 0

Rule: There will be as many internal rates of return as there are sign changes in the cash
flow.

For case 5, if MARR is between 0 and 9.4%, or more than 51%, the project will be
accepted. Otherwise, the project will be rejected.

5.5 Tutorial questions


a. Problem 1
The following cash flow was experienced by an investor:
Year
0 -1,000
1 300
2 300
3 300
4 300
1) What is the internal rate of return of this cash flow?
2) If a salvage value of $400 is received at the end of year 4, what is the IROR
of the cash flow? All percentage rates should be carried out to one decimal
point.

b. Problem 2
A solar hot water system cost $3,000 after credits were deducted. A 3-year payback
– the number of years it takes a system to pay for itself in fuel savings – meant
$1,000 per year must be saved. Actually, the system is saving only $500 per year.
The owner could have invested this $3,000 at 15 percent. The life of the system is
estimated to be 20 years, with no salvage value. What rate of return is the system
making?

c. Problem 3
A letter in Money (May, 1981) said:
I recently paid $9,578.70 for a 3-month Treasury bill with a so-called discount rate
of 16.67 percent. I figured the yield to be 20 percent; my broker says it’s closer to 18
percent but doesn’t know why. How do I calculate the return on my investment?
C. Swan Weber
Chevy Chase, MD
The reply said:

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Treasury bills are sold for less than the $10,000 face value you collect on maturity,
and this discount, expressed as a percentage of face value and converted to an annual
rate, is the discount rate. Your return, however, is the yield, or the discount
expressed as a percentage of the purchase price – in this case, $421.30 divided by
$9,578.70 to annualise the return, you multiply the result by 365 and divide by 91 –
the number of days in 3 months. Your broker was right: Your yield is 17.64 percent.
Was the broker right? What is the correct effective annual rate of return?

d. Problem 4
Evaluate the following cash flows by
1) Present-worth method
2) Annual-worth method
3) Benefit/cost ratio
4) Internal rate of return
The opportunity cost of capital is 12 percent
Year(s) Item Cash flow ($000)
0 First cost -120
1-6 Net annual receipts 30
6 Salvage value 40
An internal rate of return to the nearest whole percent is required.

e. Problem 5
The following two models of a turbine are under consideration by the Potenz Power
Company:
Characteristics Model A Model B
Economic life (years) 15 15
First cost ($) 5,000,000 5,100,000
Annual operations and maintenance cost ($) 100,000 80,000
Major overhaul cost at year 5 ($) 0 700,000
Major overhaul cost at year 7 ($) 2,806,000 0
Major overhaul cost at year 10 ($) 0 2,894,000
Use the rate of return method to recommend a turbine model, given that
1) No taxes are to be considered since Potenz is government owned.
2) The MARR (opportunity cost of capital) of Potenz is 12 percent.
3) One of the two models is certain to be selected.
4) Both models are suitable in a technical sense.

f. Problem 6
You are considering two mutually exclusive investments. The first alternative has a
first cost of $102,000. At the end of year 1 it will net $50,000, and at the end of year
2 it will net $100,000. The second alternative has a first cost of $175,000. At the end
of year 1 it will net $215,000, and year 2 will end with a net of $10,000. The
economic life for both alternatives is 2 years. With an opportunity cost of capital of
15 percent and without considering taxes and inflation, which investment will you
select? One must be chosen. An IROR methodology is required, with IRORs to the

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nearest whole percentage point. Attempt an algebraic solution.

Answers to tutorial questions


Problem 1 1) i*=7.72%; 2) i*=18.61%
Problem 2 i*=16%.
Problem 3 iM=(10,000-9578.70)/9578.70=0.043983.
iY= (1  iM ) M  1 =18.788%; r=4(4.3983)=17.5932%,
The Money editor means nominal rate.
Problem 4 1) PW=$23,594; 2) AW=$5742; 3) B/C=1.20; 4) i*=17.93%.
Problem 5
NPV(B-A)=(-5100+5000)+(-80+100)(P/A,i*,15)-700(P/F,i*,5)+2806(P/F,i*,7)-
2894(P/F,i*,10).
i*(%) 0 5 10 12 14 15 20 25 …
NPV(B-A) -588 -223.4 -58.3 -23.68 0.03 8.45 27.90 25.53 …
For MARR=12%, NPV(B-A) is negative. Reject B and accept A.
Problem 6 Select alternative 2 at 15% MARR.

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