Objective:

Introducing the Internal Rate of Return (IRR) method for

comparing projects and selecting the method to use in
Lecture 10 project comparisons.
Topics to be Covered:
- The Internal Rate of Return (IRR)
- Internal Rate of Return Comparisons
- IRR for Independent Projects
Comparison Methods Part - IRR for Mutually Exclusive Projects
- Multiple IRRs
2 - External Rate of Return (ERR) Methods
- When to Use the ERR
- Rate of Return and Present/Annual Worth Methods
Compared
- Equivalence of Rate of Return and Present/Annual Worth
Methods
1 - Why Choose One Method Over the Other? 2

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Internal Rate of Return (IRR) Internal Rate of Return (IRR), cont’d.

The IRR is that interest rate at which a project just breaks even. How to calculate the IRR for complex cash flows:

Example 5.1 (p. 127): PW(disbursements) = PW(receipts)

Suppose $100 is invested today in a project that returns $110 in
one year. FW(disbursements) = FW(receipts)

$110 AW(disbursements) = AW(receipts)

1 year
- Solve equation for i* using trial-and-error and linear
interpolation.
$100
P = F(P/F,i*,1) or 100 = 110/(1+ i*) The value of i* could be positive or negative. A negative IRR
means that the project is losing money rather than earning it.
i* = 0.1 = 10%
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 Internal Rate of Return Comparisons
Example 5.2 (p. 128): 1- IRR for Independent Projects
Clem is considering buying a tuxedo. It would cost $500, but
would save him $160 per year in rental charges over its five-year
- The project is accepted if its IRR > the MARR value
life. What is the IRR for this investment.
PW(disbursements) = $500 - The project is considered marginally accepted if its
IRR = MARR
PW(receipts) = $160(P/A,i*,5)
$500 = $160(P/A,i*,5) or (P/A,i*,5) = 3.125
Using interest rate tables, trial -and-error, and linear interpolation
i* = 18.14

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Example 5.3 (p. 130):

Example 5.3 (p. 130):

MARR = 12%
AW(receipts) - AW(disbursements) = 0
5000(A/F, i*, 10) + 15000 + 5000(A/G, i*,10)
-120000(A/P, i*,10) - 10000 = 0
OR (A/F, i*, 10) + 1 + (A/G, i*,10) - 24(A/P , i*,10) = 0
i* (or IRR) can be obtained using:
- Trial-and-error alone or with linear interpolation, or
- Spreadsheet
i* = 13.6% > MARR, the company should buy the new canner
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 Internal Rate of Return Comparisons Example 5.4 (p. 132):
Consider two investments. The first costs $1 today and
2- IRR for Mutually exclusive projects returns $2 in one year. The second costs $1000 and returns
$1900 in one year. Which is the preferred investment. Your
The projects must have equal lives if they are compared MARR is 70%.
using the IRR method
The first project has i* = 100%
Algorithm:
1. Sort the projects from the lowest first cost to the highest. The second project has i* = 90%
Start with the least first cost project. Call this the current
best. - Do not choose the project with the highest IRR
2. Challenge the current best with the next most expensive - Observe that the least cost investment provides a rate of return
project. If the challenger is successful, i.e., if the incremental (IRR) that exceeds MARR.
investment has an IRR ≥ MARR, then make the challenger -Use the incremental investment analysis!
the current best.
3. Repeat Step 2 until there are no further challengers.
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Example 5.5 (p. 133):

Incremental Investment: Monster Meats can buy a new meat slicer system for
$50,000. They estimate it will save them $11,000 per year in
-(1000 - 1) + (1900 - 2)(P/F, i*,1) = 0 labour and operating costs. The same system with an
automatic loader is $68,000 and will save approximately
Or (P/F, i*,1) = 0.52634 $14,000 per year. The life of either system is thought to be
i* = 89.98% eight years.
The incremental investment has IRR > MARR, Monster Meats has three feasible alternatives:
Thus the second investment should be chosen Alternative First cost Annual
Savings
1-DN $0 $0
2-Meat slicer alone $50,000 $11,000
3-Meat slicer with
automatic loader $68,000 $14,000
Monster Meats uses a MARR of 12% for this type of project.
Which alternative is better?
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 Step1: Consider the Meat slicer alone
Example 5.6 (p. 135):
-50000+11000(P/A, i*, 8) = 0
MARR = 15%. Which alternative should be chosen?
solve for i*: i* = 14.5% > MARR Lathe 1 2 3 4
Meat slicer alone is better than the DN alternative First Cost $100 000 $150 000 $200 000 $255000
Annual Savings 25 000 34 000 46 000 55 000
Step2: Consider the Meat slicer with automatic loader
-68000+14000(P/A, i*, 8) = 0
Solution:
solve for i*: i* = 12.5% > MARR
Lathe1:
Step3: Consider the incremental investment -100000+25000(P/A, i* ,10) = 0
-(68000-50000)+(14000-11000)(P/A, i*, 8) = 0 Solve for i*: i* = 21.4% > MARR
solve for i*: i* = 7% < MARR
Monster meat should not buy the automatic loader Lathe1 is considered current best
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Cont. of Example 5.6

Lathe2 is “challenger” of the “current best”
-(150000-100000)+(34000-25000) (P/A, i* ,10) = 0 Cont. of Example 5.6

Solve for i*: i* = 12.4% < MARR Lathe4 is “challenger” of the “current best”

Lathe2 fails the challenge. Lathe1 is still the current best -(255000-200000)+(55000-46000) (P/A, i* ,10) = 0
Solve for i*: i* = 10.1% < MARR

Lathe3 is “challenger” of the “current best” Lathe4 fails the challenge. Lathe3 is still the current best

-(200000-100000)+(46000-25000) (P/A, i* ,10) = 0

Solve for i*: i* = 16.4% > MARR The best alternative is Lathe3

Lathe3 becomes the current best

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 Flowchart for Comparing Mutually
Exclusive Alternatives Some Helpful Hints
z Is it necessary to check the IRR for each project?
z No, but it may be helpful
z Can we use IRR for “cost only” problems?
z Yes: pairwise comparison answers “which is better?”
z What happens if we must do one project, but none
of the projects have an IRR greater than the
MARR?
z e.g. several cost-only plans
z follow the algorithm: pairwise comparison answers “is
Challenger better than Current Best?”
z Must we calculate each incremental IRR
accurately?
17 z Not if you want only to pick the best 18

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