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Module 6 Irr and Payback Period

This document outlines Module 6 of a course on engineering economics. The module covers internal rate of return and payback period. It defines key terms like rate of return, internal rate of return, cash flow with single/multiple rates of return, and payback period. Examples are provided to illustrate how to calculate internal rate of return using trial and error, analyze cash flows with single vs multiple rates of return, and compute payback periods with and without discounting. The document also discusses using project balances to evaluate investment alternatives, showing how to calculate and diagram project balances over time. Homework questions at the end ask students to apply these concepts to examples provided in the module.

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Sulaim Al Kautsar
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169 views4 pages

Module 6 Irr and Payback Period

This document outlines Module 6 of a course on engineering economics. The module covers internal rate of return and payback period. It defines key terms like rate of return, internal rate of return, cash flow with single/multiple rates of return, and payback period. Examples are provided to illustrate how to calculate internal rate of return using trial and error, analyze cash flows with single vs multiple rates of return, and compute payback periods with and without discounting. The document also discusses using project balances to evaluate investment alternatives, showing how to calculate and diagram project balances over time. Homework questions at the end ask students to apply these concepts to examples provided in the module.

Uploaded by

Sulaim Al Kautsar
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
You are on page 1/ 4

01/10/2010

Outline Module 6

Module 6: Internal Rate of Return and Payback Period


SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Rate of Return Internal Rate of Return (IRR) Cash Flow with Single Rate of Return Cash Flow with Multiple Rate of Return Payback Period Discounted Payback Period

6-2

SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Rate of Return

Finding Internal Rate of Return


1. 2. 3. 4. 5.

Rate of Return (ROR) is the rate of interest paid on all unpaid balance of borrowed money, or the rate of interest earned on the unrecovered balance of an investment so that the final payment or receipt brings the balance to zero with interest considered Internal Rate of Return (IRR) is the interest rate that causes the equivalent receipts of a cash flow equal to the equivalent payments of a cash flow
i* PR = PP PR PP = 0 FR FP = 0 EUAWR EUAWP = 0
SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Draw cash flow diagram Convert all receipts into present, future or EUAW Convert all payments into present, future or EUAW Subtract (3) from (2) and set it equal to zero find i* Find i* that satisfies (4) by trial and error interpolation

P
A1

O1

I1

SV

1
PR= I1(P/F, i*, 22) + SV(P/F, i*, 36) PP= P + A1(P/A, i*, 36) + O1(P/F, i*, 8)

FR = FP
EUAWR = EUAWP
6-3

PR - PP = I1(P/F, i*, 22) + SV(P/F, i*, 36) [P + A1(P/A, i*, 36) + O1(P/F, i*, 8)] = 0
6-4 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

01/10/2010

Rate of Return

Cash Flow with Single Rate of Return


For a cash flow will have a single rate of return, if satisfies the following conditions:
Test # 1: 1. F0 < 0
(the first non-zero cash is a disbursement)

The relationship between Rate of Return and the Present Worth Amount can be graphically describe as follows:
Present worth,

PW

i*
interest rate, i

2. One change in sign in the sequence F0, F1, F2, Fn


(the cash flow has an initial disbursement or a series of disbursement followed by a series of receipts)

3. PW(0) > 0
(the sum of all the receipts is greater than the sum of all the disbursements)

Cash flow shown above assures a single rate of return that: PW (i) > 0 for i < i* PW (i) = 0 for i = i* PW (i) < 0 for i > i*
6-5 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Test # 2:
1. F0 < 0
(the first non-zero cash is a disbursement)

2. Find rate of return, i*, for the cash flow;


for unknown i*, total unrecovered balance, Ut < 0 for t = 0, 1, 2, 3, n-1 6-6 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Cash Flow with Multiple Rate of Return


For a cash flow will have a multiple rate of return, if not satisfies Test #1 Test #2
Present worth,

Payback Period

PW

In business and industry it is common to evaluate alternatives (assets) in terms of their payback or payout period. Payback without interest the length of time required to recover the first cost of an investment from the net cash flow produce by that investment for interest rate of zero n

F
t 0

i*
0

i*
interest rate, i

This method has disadvantages as it fails to consider: the time value of money the consequences of the investment following the payback period Payback with interest or discounted payback period this method determines the length of time required until the investments equivalent receipts exceed the equivalent capital outlays

F 1 i
t 0 t
6-7 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D. 6-8

n'

n = the smallest value that satisfies the equation

SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

01/10/2010

Payback Period without Interest


Example:
Three alternatives of investment are being considered without interest:
end of year 0 1 2 A - 1.000.000,500.000,300.000,B - 1.000.000,200.000,300.000,C - 700.000,- 300.000,500.000,-

Discounted Payback Period


Example:
Alternative A is being considered at the rate of return 15%
end of year 0 A - 1.000.000,-

1
2 3 4 5 6

500.000,300.000,200.000,200.000,200.000,200.000,-

3
4 5 6 Present worth, i=0 Payback period
6-9

200.000,200.000,200.000,200.000,PW(i)A = 600.000,3 years

500.000,1.000.000,2.000.000,4.000.000,PW(i)B = 7.000.000,3 years

500.000,0,0,0,PW(i)C = 0,3 years

Ft = - 1M + 500K(P/F, 15%, 1) + 300K(P/F, 15%, 2) + 200K(P/F, 15%, 3) + 200K(P/F, 15%, 4) + 200K(P/F, 15%, 5) > 0
6-10 SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

Project Balance

Project Balance
Project cash flow @ 20% discount rate

8M 5M 6M 3M
3 4 5
PB(20)5= 7.55M

Evaluation of a proposed project is often done by analyzing the project balance. A project balance describes the equivalent of loss or profit of the project cash flow as a function of time. At any given time, a project balance can be calculated as:

1M
0 1 2

PB (i)T Ft (1 i )T 1
t 0

10M

PB(20)4= 3.79M

Visual description of a project balance project balance diagram Four important characteristics of project balance diagram are:

The net future worth of investment The time when the equivalent cash flow switch from negative to non-negative, or vice versa The net equivalent cash flow exposed to risk of loss (the area where PB(i) is negative) The net equivalent cash flow earned (the area where the PB(i) is positive)

+
PB(20)2= -8.2M PB(20)0 = -10M PB(20)1= -11M PB(20)3= -1.84M

6-11

SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

6-12

SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

01/10/2010

Homework #6
1.

2.

Work for alternative B and C of the example (slide #9). Determine the discounted payback period for each alternative and suggest your selection. For the same problem investment (#1), calculate the project balance for each alternative, draw the project balance diagram, and identify the future worth and exposure to risk of loss

6-13

SI-4251 Ekonomi Teknik Muhamad Abduh, Ph.D.

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