Chapter Four

Rate of Return and Benefit-Cost Ratio

4.1. Rate of Return

The rate of return technique is one of the methods used in selecting an alternative for a project. In this
method, the interest rate per interest period is determined, which equates the equivalent worth (either
present worth, future worth or annual worth) of cash outflows (i.e. costs or expenditures) to that of
cash inflows (i.e. incomes or revenues) of an alternative. The rate of return is also known by other
names namely internal rate of return (IRR), profitability index etc. It is basically the interest rate on the
unrecovered balance of an investment which becomes zero at the end of the useful life or the study
period.

In this method of comparison, the rate of return for each alternative is computed. Then the alternative
which has the highest rate of return is selected as the best alternative. In this type of analysis, the
expenditures are always assigned with a negative sign and the revenues/inflows are assigned with a
positive sign. A generalized cash flow diagram to demonstrate the rate of return method of comparison
is presented in Fig. below

Figure 4. 1: Generalized cash flow diagram

In the above cash flow diagram, P represents an initial investment, Rj the net revenue at the end of the
jth year, and S the salvage value at the end of the nth year. The first step is to find the net present
worth of the cash flow diagram using the following expression at a given interest rate, i.

PW of cash out flow (cost or expenditure) = PW of cash inflow (income or revenue)

PW of cash inflow - PW of cash out flow = 0

PW(i) = –P + R1/(1 + i)1 + R2/(1 + i)2 + ... + Rj/(1 + i)j + ... + Rn/(1 + i)n + S/(1 + i)n

Now, the above function is to be evaluated for different values of i until the present worth function
reduces to zero, as shown in Fig. below. In the figure, the present worth goes on decreasing when the
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interest rate is increased. The value of i at which the present worth curve cuts the X-axis is the rate of
return of the given proposal/project. It will be very difficult to find the exact value of i at which the
present worth function reduces to zero.

Figure 4. 2: Present worth function graph

So, one has to start with an intuitive value of i and check whether the present worth function is
positive. If so, increase the value of i until PW(i) becomes negative. Then, the rate of return is
determined by interpolation method in the range of values of i for which the sign of the present worth
function changes from positive to negative.

Example1: A construction firm is planning to invest Rs.800000 for the purchase of construction
equipment which will generate a net profit of Rs.140000 per year after deducting the annual operating
and maintenance cost. The useful life of the equipment is 10 years and the expected salvage value of the
equipment at the end of 10 years is Rs.200000. Compute the rate of return using trial and error method
based on present worth.
Solution
The cash flow diagram of the construction equipment is shown in Fig. below

Figure 4. 3: Cash flow diagram of the construction equipment

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For determination of rate of return „ir‟ of the construction equipment, first the equation for net present
worth of cash inflows and cash outflows is equated to zero. Then using the trial and error method the
value of „ ir ‟ is determined. The net present worth of cash inflows and cash outflows of the
construction equipment is given by the following expression.

PW = -800000 + 140000(P/A, i, 10) + 200000(P/F, i, 10)

For determining the value of „ ir ‟ the net present worth is equated to zero.

Now the above equation will be solved through trial and error process to find out the value of ir.
Basically a positive value and a negative value of the net present worth will be determined at rate of
return values close to the actual one and then by linear interpolation between these two values, the
actual rate of return will be calculated. For finding out the rate of return values (close to the actual
one), those will give a positive value and a negative value of net present worth, one has to carry out a
number of trial calculations at various values of ir.

First assume a value of ir equal to 8% and compute the net present worth. Now putting the values of
different compound interest factors in the expression for net present worth at ir equal to 8% results in
the following;

PW = Rs.232054

The above calculated net present worth at ir equal to 8% is greater than zero, now assume a higher
value of ir i.e. 12% for the next trial and compute the net present worth.

PW = Rs.55428

As observed from this calculation, the net present worth is decreased at higher value of ir. Thus for
getting a negative value of net present worth, assume further higher value of ir than the previous trial
and take 14% for the next trial and determine the net present worth.

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PW = -Rs.15806

Since a negative value of net present worth at ir equal to 14% is obtained (as above), the actual value
of rate of return is less than 14%. The actual rate of return is now obtained by doing linear
interpolation either between 8% and 14% or between 12% and 14%. However for obtaining a more
accurate value of rate of return, the linear interpolation is carried out between 12% and 14% and is
given as follows;

PW = Rs.55428 at ir = 12%
PW = - Rs.15806 at ir = 14%

On solving the above expression, the value of ir is found to be 13.55% per year

The rate of return „ ir ‟ can also be determined by equating the net annual worth to zero. For the above
construction equipment, the net equivalent annual worth at different values of ir are calculated as
follows;

At ir = 12%

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AW = Rs.9800

At ir = 14%

AW = -Rs.3020
Now carrying out the linear interpolation between 12% and 14%;

AW = Rs.9800 at ir = 12%

AW = - Rs.3020 at ir = 14%

On solving the above expression, the value of ir is found to be 13.52% per year. The minor difference
in the values of ir from present worth and annual worth methods is due to the effect of decimal points
in the calculations. Similar to present worth and annual worth methods, the rate of return „ ir ‟ can also
be determined by equating the net future worth to zero.

From the above example, a unique value of rate of return was obtained for the construction equipment
(on the basis of its cash inflow and cash outflow). This is due to the fact that, there was only one sign
change in the cash flows i.e. minus sign at time zero for the cash outflow followed by plus sign for
cash inflows during the remaining periods. However in some cases, depending upon the cash flow it is

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possible to get multiple values of rate of return, those satisfy the rate of return equation of the
equivalent worth of cash inflows and cash out flows. This may happen due to more than one sign
change in the cash flows e.g. cash outflow (negative) at beginning (time zero) followed cash inflows
(positive) at end of year 1 and 2 and then cash outflow (negative) at end of year 3 etc. Thus while
selecting an alternative that has multiple values of rate of return (depending on the cash flow), other
method of economic evaluation may be adopted to find out the economical suitability of the
alternative.

4.2. Benefit-Cost Ratio

The benefit-cost analysis method is mainly used for economic evaluation of public projects which are
mostly funded by government organizations. In addition this method can also used for economic
evaluation of alternatives for private projects. The main objective of this method is used to find out
desirability of public projects as far as the expected benefits on the capital investment are concerned.
As the name indicates, this method involves the calculation of ratio of benefits to the costs involved in
a project.

In benefit-cost analysis method, a project is considered to be desirable, when the net benefit associated
with it exceeds its cost. Thus it becomes imperative to list out separately the costs and benefits
associated with a public project. Costs are the expenditures namely initial capital investment, annual
operating cost, annual maintenance cost etc. to be incurred by the owner of the project and salvage
value if any is subtracted from the costs. Benefits are the gains or advantages whereas dis-benefits are
the losses, both of which are experienced by the owner in the project. In case of public projects which
are funded by the government organizations, owner is the government. However this fund is generally
taxpayers’ money i.e. tax collected by government from general public, thereby the actual owners of
public projects are the general public. Thus in case of public projects, the cost is incurred by the
government whereas the benefits and dis-benefits are mostly experienced by the general public.

In order to know the costs, benefits and dis-benefits associated with a public project, consider that a
public sector organization is planning to set up a thermal power plant at a particular location. The costs
to be incurred by the public sector organization are cost of purchasing the land required for the thermal
power plant, cost of construction of various facilities, cost of purchase and installation of various
equipments, annual operating and maintenance cost, and other recurring costs etc. The benefits
associated with the project are generation of electric power that will cater to the need of the public,
generation of revenue by supplying the electricity to the customers, job opportunity for local residents,

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development other infrastructure in the nearby areas etc. The dis-benefits associated with project are
loss of land of the local residents on which the thermal power plant will come up. If it is agricultural
land, then the framers will lose their valuable land along with the annual revenue generated from
farming, even though they get money for their land from the public sector organization at the
beginning. The other dis-benefits to the local residents are greater likelihood of air pollution in the
region because of the thermal power plant, chances of contamination of water in the nearby water-
bodies etc.

In benefit-cost analysis method, the time value of money is taken in to account for calculating the
equivalent worth of the costs and benefits associated with a project. The benefit-cost ratio of a project
is calculated by taking the ratio of the equivalent worth of benefits to that of the costs associated with
that project. Either of present worth, annual worth or future worth methods can be used to find out the
equivalent worth of costs and benefits associated with the project.

B/C = PW of Benefit = AW of Benefit = FW of Benefit

PW of Cost AW of Cost FW of Cost
The decision guideline is simple:
If B/C >1.0, accept the project as economically justified for the estimates and discount rate applied.
If the B/C value is exactly or very near 1.0, noneconomic factors will help make the decision.
If B/C < 1.0, the project is not economically acceptable

Example2: A firm is trying to decide which of two devices to install to reduce costs in a
particular situation. Both devices cost $1000 and have useful lives of five years and no salvage
value. Device A can be expected to result in $300 savings annually. Device B will provide
savings of $400 annually. With interest 7%, which device should the firm purchase?
Solution

Device A:
PW cost = $1000
PW benefit = 300(P/A, 7%, 5) = $1230
BCR = 1230 / 1000
= 1.23

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Device B:
PW cost = $1000
PW benefit = 400(P/A,7%,5) = $1640
BCR = 1640 / 1000
= 1.64
To maximize Benefit-Cost Ratio, the firm should buy device B.

4.3. Payback Periods

Payback period is the period of time required for the profit or other benefits of an investment to equal
the cost of the investment

Payback analysis is another use of the present worth technique. It is used to determine the amount of
time, usually expressed in years, required to recover the first cost of an asset or project. The payback
period, also called payback or payout period, has the following definition and types.

The payback period np is an estimated time for the revenues, savings, and any other monetary benefits
to completely recover the initial investment plus a stated rate of return i.

There are two types of payback analysis as determined by the required return.
No return; i=0%: Also called simple payback, this is the recovery of only the initial investment.
Discounted payback; i > 0%: The time value of money is considered in that some return, for example,
10% per year, must be realized in addition to recovering the initial investment.

Example3: The cash flows for two alternatives are as follows:

Year Alternative A Alternative B
0 -$1000 -$2783
1 +200 +1200
2 +200 +1200
3 +1200 +1200
4 +1200 +1200
5 +1200 +1200

You may assume the benefits occur throughout the year rather than just at the end of the year. Based
on payback period, which alternative should be selected?

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Solution
Alternative A
Payback period is the period of time required for the profit or other benefits of an investment to equal
the cost of the investment. In the first 2 years, only $400 of the $1000 cost is recovered. The remaining
$600cost is recovered in the first half of Year3.
Thus, the payback period for Alternative A is 2.5 years.

Alternative B
Since the annual benefits are uniform, the payback period is simply
$2783/$1200 per year = 2.3 years
To minimize the payback period, choose Alternative B.

4.4. Breakeven Analysis

It is performed to determine the value of the variable or a parameter of a project or alternative that
makes two elements equal. Break Even Analysis in economics, business, and cost accounting refers to
the point in which total cost and total revenue are equal.

 When is Break even analysis used?

Starting a new business: If you wish to start a new business, a break-even analysis is a must. Not only
it helps you in deciding, whether the idea of starting a new business is viable, but it will force you to
be realistic about the costs, as well as guide you about the pricing strategy.

Creating a new product: In the case of an existing business, you should still do a break-even analysis
before launching a new product—particularly if such a product is going to add a significant
expenditure.

Changing the business model: If you want to change your business model, like, switching from
wholesale business to retail business, you should do a break-even analysis. The costs could change
considerably and this will help you to figure out the selling prices need to change too.

Break even quantity (QBE) = Fixed costs

(Sales price per unit – Variable cost per unit)

Where:
Fixed costs are costs that do not change with varying output (i.e. salary, rent, building, machinery).
These costs are directly related to the level of production, but not the quantity of production.

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Sales price per unit is the selling price (unit selling price) per unit.

Variable cost per unit is the variable costs incurred to create a unit. Variable costs are costs that will
increase or decrease in direct relation to the production volume. (E.g. materials costs, packaging cost,
fuel and other cost that are directly related to the production).

 Breakeven Point:-
 Determined using relations of revenue and cost at different values of the variable, Q
 It may happen by designing the element to minimize the cost, or the production level to realize
the revenue
 Can be measured using units/year, percentage of capacity, hours per month and many other
dimensions
Example: Mr. X is the managerial accountant in charge of Company A, which sells water bottles. He
previously determined that the fixed costs of Company A consist of property taxes, a lease, and
executive salaries, which add up to $100,000. The variable cost associated with producing one water
bottle is $2 per unit. The water bottle is sold at a premium price of $12. Determine the break-even
quantity.

Solution
Break even quantity = $100,000 / ($12 – $2) = 10,000

Therefore, given the fixed costs, variable costs, and selling price of the water bottles, Company A
would need to sell 10,000 units of water bottles to break even.

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