Rate of Return Calculations

Syllabus:
Rate of return, Minimum acceptable rate of
return, IRR, IRR misconceptions, Exercises
and Discussion.
 Introduction
• A Rate of Return (ROR) is the net gain or loss of an investment over a specified
time period, expressed as a percentage of the investment’s initial cost.
• When calculating the rate of return, the percentage change from the
beginning of the period until the end is determined.
• The rate of return (RoR) is used to measure the profit or loss of an investment
over time.
• The metric of RoR can be used on a variety of assets, from stocks to bonds,
real estate, and art etc.
• The effects of inflation are not taken into consideration in the simple rate of
return calculation but are in the real rate of return calculation.
• The formula to calculate the rate of return (RoR) is:
 Rates of return that appear frequently in
engineering economy
• Minimum Acceptable Rate of Return (MARR) is also known as
minimum attractive rate of return is the rate set by an
organization to designate the lowest level of return that makes an
investment acceptable.
• Internal Rate of Return (IRR) is the rate on the unrecovered
balance of the investment in a situation where the terminal
balance is zero.
• External Rate of Return (ERR) is the rate of return that is possible
to obtain for an investment under current economic conditions.
For example, suppose that analysis of an investment shows that it
will realize an IRR of 50 percent. Rationally, it is not reasonable to
expect that we can invest in the external market and get that high
a rate. In engineering economy studies, the external interest rate
most often will be set to the MARR.
 Income Producing Proposal
A parcel of land adjacent to a proposed freeway exit is deemed likely to
increase in value. It can be purchased now for $ 80,000 and is expected
to be worth $150,000 within 5 years. During that period it can be rented
for pasture at $1500 per year. Annual taxes are presently $850 and will
likely remain constant. What rate of return will be earned on the
investment if the estimates are accurate?
 The income and disbursements can be equated according to their equivalent
present worth’s:
PWine= PW disb
$150,000(P/F, i, 5) + $1500(P/A, i, 5) = $80,000+ $850(P/A, i, 5)
Or $150,000(P/F, i, 5) - $80,000+ $1500(P/A, i, 5) - $850(P/A, i,5) = 0
$150,000(P/F, i, 5) - $80,000+ $650(P/A, i, 5) = 0
Letting i = 0%.
$150,000-$80,000+ $650(5)= $70,000+ $3250 = $73,250
Letting i 15 percent as the first trial, we have
$150,000(P/F, 15, 5)- $80,000+ $650(P/A, 15, 5) = 0
$150,000(0.49718) $80,000+ $650(3.35216)= − $3244.10 < 0
Now it is known that i lie between 0 and 15 percent.
Letting i = 14 percent gives
$150,000(P/F, 14, 5)− $80,000+ $650(P/A, 14, 5) = 0
$150,000(0.51937)−$80,000 + $650(3.43308)= $137.00 > 0
Now by linear interpolation:
i = 14.01%
 Cost Reduction Proposal
Subassemblies for a model IV scope are purchased for $71 apiece. The
annual demand is 350 units and is expected to continue for 3 years, at
which time the model V scope now under development should be ready
for manufacturing. With equipment purchased and installed for $21,000,
the production costs to internally produce the subassemblies should be
$18,500 for the first year and $12,250 in each of the last 2 years. The
equipment will have no salvage value. Should the company make or buy
the sub-assemblies?
Present annual cost = 350($71)
= $24,850
Net savings (year 1)
= $24,850 - $18,500 =$6350
Net savings (years 2, 3)
= $24,850 - $12,250
= $12,600
Now we can set up the present-worth equation in terms of the IRR,
PW=−$21,000+ $6350(P/F, i, 1) + $12,600(P/F, i, 2)
+$12,600(P/F, i, 3)=0
Trying successively higher rates of return, we find at i = 10 percent,
PW = − $21,000+ $6350(0.90909) + $12,600(0.82645)+
$12,600(0.75131) = $4652.50 >0
Similarly, we find:
i = 15 percent PW = $2333.89
i = 20 percent PW = $ 333.21
i = 25 percent PW=-$1404.80
Now we can interpolate to find the rate of return on the $21,000
investment:
IRR = 20.96%
 IRR Misconceptions
1. Ranking alternatives by individual IRR Values
2. More than one possible rate of return (Non-
simple Investment)
3. Explicit investment rate
4. Historical External Rate of Return method
5. Project balance method
6. Reinvestment question
7. Alternatives with unequal lives
 1. Ranking alternatives by individual IRR Values
Cash flows for two mutually exclusive projects with 4 year lives
and no salvage value are shown in table, the two projects are first
compared by their present worth when the minimum required
rate of return is 10 percent. Than compared at 20%, 25%, 30%,
35%, 40%, 45%, and 50%.
End of year cash flow $

Project 0 1 2 3 4
X -1000 100 350 600 850
Y -1000 1000 200 200 200
 PW(X)= − $1000+ [$100+ $250(A/G, 10, 4)] (P/A, 10, 4)
= −$1000+ [$100+$250 (1.38117)] (3.16987)
=$411.52
PW(Y) =−$1000+ [$1000+ $200(P/A, 10, 3)] (P/F, 10, 1)
=− $1000+ [$1000+ $200(2.48685)](0.90909)
= $361.24
This ranks project X higher than project Y
When a comparison is made that uses individual IRRs, the
rankings are reversed:
For project X:
PW =−$1000+ [$100+ $250(A/G, i, 4)] (P/A, i, 4)=0
At i 20 percent,
PW =−$1000+ [$100+ $250(1.27422)] (2.58873) = $83.53
and at i=25 percent,
PW =−$1000+ [$100+ $250(1.22493)] (2.36160)
=−$40.64
Interpolating for PW = 0, we get IRR(X) = 23.4 percent.
For project Y:
PW =−$1000 + [$1000+ $200(P/A, i, 3)] [P/F, i, 1]=0
IRR = 34.26 percent that ranks project Y ahead of project X
2. More than one possible rate of return (Non-simple Investment)
Consider a rather contrived single project situation. One of the alternatives for
improving an operation is to do nothing to it for 2 years and then spend $10,000
on improvements. If this course of action is followed, the immediate gain is
$3000 (income) followed by 2 years of break-even operations. Thereafter,
annual income should be $2000 per year for 4 years. What rate of return can be
expected from following this course of delayed action? (7% to 55%)

End of year Cash flow$

0 +3000
1 0
2 -10000
3 2000
4 2000
5 2000
6 2000
PW = $3000 - $10,000(P/F, i, 2) + $2000(P/A, i, 4)(P/F, i, 2) = 0
 3. Explicit investment rate
An explicit reinvestment rate is a designated interest percentage
appropriate for a specific application. The explicit reinvestment rate
may be the minimum attractive rate of return employed by the
organization or a rate suggested by the PW profile.

4. Historical External Rate of Return method

The occurrence of multiple i* roots with the non-simple investment
return can be avoided by using the historical external rate-of-return
(HERR) method where the main appeal is its pragmatic
assumption that receipts are actually reinvested at a generally
available interest rate. This rate is typically taken to be the MARR.
The flaw is that this method does not base the reinvestment on
project cash flow balances; it is based solely on project receipts.
 5. Project balance method

6. Reinvestment question

7. Alternatives with unequal lives

Problem :1
A person is planning a new business. The initial outlay and cash
flow pattern for the new business are as listed below. The
expected life of the business is five years. Find the rate of return
for the new business.
PW = –1,00,000 + 30,000(P/A, i, 5)
When i = 10%,
PW(10%) = –1,00,000 + 30,000(P/A, 10%, 5)
= –1,00,000 + 30,000(3.7908)
= Rs. 13,724.
PW(15%) = Rs. 566.
PW(18%) = Rs. – 6,184
Problem :2
A company is trying to diversify its business in a new product line.
The life of the project is 10 years with no salvage value at the end of
its life. The initial outlay of the project is Rs. 20,00,000. The annual
net profit is Rs. 3,50,000. Find the rate of return for the new
business.

PW(i) = –20,00,000 + 3,50,000(P/A, i, 10)

When i = 10%,
PW(10%) = –20,00,000 + 3,50,000(P/A, 10%, 10)
= –20,00,000 + 3,50,000(6.1446)
= Rs. 1,50,610.
PW(12%) = Rs. –22,430.
i = 11.74 %
Problem :3
For the cash flow diagram shown in Fig. compute the rate of return.
The amounts are in rupees

PW = –1,275 + [150 + 150(A/G, i, 5)] (P/A, i, 5)

PW(10%) = –1,275 + [150 + 150(A/G, 10%, 5)] (P/A, 10%, 5)
= –1,275 + [150 + 150(1.8101)] (3.7908)
= Rs. 322.88
PW(15%) = Rs. 94.11
PW(18%) = Rs. –21.24
i = 17.45%
Problem :4
A company is planning to expand its present business activity. It
has two alternatives for the expansion programme and the
corresponding cash flows are tabulated below. Each alternative has
a life of five years and a negligible salvage value. The minimum
attractive rate of return for the company is 12%. Suggest the best
alternative to the company.
 PW1 = –5,00,000 + 1,70,000(P/A, i, 5)
PW1(15%) = –5,00,000 + 1,70,000(P/A, 15%, 5)
= –5,00,000 + 1,70,000(3.3522)
= Rs. 69,874
PW1(20%) = Rs. 8,402
PW1(22%) = Rs. –13,188
i = 20.78%
 PW2 = – 8,00,000 + 2,70,000(P/A, i, 5)
PW2(20%) = – 8,00,000 + 2,70,000(P/A, 20%, 5)
= – 8,00,000 + 2,70,000(2.9906)
= Rs. 7,462
PW2(22%) = Rs. –26,828

i = 20.435%
Thank you