Rate of Return Analysis

Week 11

Internal Rate of Return Lenders Viewpoint

The interest rate on the balance of a loan such that the unpaid loan balance equals zero when the final payment is made.
Year 0 1 2 3 4 5 Cash flow -5000 +1252 +1252 +1252 +1252 +1252 2. At the end of 5 years, the payments exactly repaid the $5000 debt with interest rate 8%. We say the lender received 8% rate of return. 1. We know that the PW of five payments of $1252 are equivalent to $5000 when interest rate is 8%.

Internal Rate of Return Investors Viewpoint

The interest rate earned on the unrecovered investment such that the unrecovered investment equals zero at the end of the life of the investment.
Year 0 1 2 Cash flow -5000 +1252 +1252 1. Investment $5000 in a machine with lift time 5 years and an EUAB of $1252, what is the interest rate we receive on this investment? 2. The cash flow stream is with 8% rate of return.

3
4 5

+1252
+1252 +1252

Internal Rate of Return (IRR)

By definition: Given a cash flow stream, IRR is the interest rate i at which the benefits are equivalent to the costs or the NPW=0

NPW=0 PW of benefits - PW of costs =0 PW of benefits = PW of costs PW of benefits / PW of costs=1 EUAB-EUAC=0

Internal Rate of Return (IRR)

Suppose you have the following cash flow stream. You invest $700, and then receive $100, $175, $250, and $325 at the end of years 1, 2, 3 and 4 respectively. What is the IRR for your investment?
$325 $250 $100 $175

time

$700

700 = 100/(1+i) + 175/(1+i)2 + 250/(1+i)3 + 325/(1+i)4.

It turns out that i = 6.91 %. How to calculate IRR?

Calculating Rate of Return

$100 Ways to find the IRR Compound Interest Tables 3 0 1 2 Interest Tables and Interpolation $700 Graphically (see the graph of f(c)) Numerically (Excels IRR, or other root finding methods). $250 $175

$325

4 time

NPW = -700 + 100/(1+i) + 175/(1+i)2 + 250/(1+i)3 + 325/(1+i)4. If you have a CFS with an investment (-P) followed by benefits (non negative) from the investment. The graph of NPW versus i will have the same general form. It will decrease at a decreasing rate and have a value 0 at some unique value i*. Where the graph has a value 0 defines the IRR.
NPW 50 40 30 20 10 0 NPW

1.00%

2.80%

4.60%

6.40%

8.20%

10.00%

11.80%

13.60%

15.40%

17.20%

-10 -20

i in %

19.00%

Example 1
$1252 $1252 $1252 $1252 $1252

time

$5000

From Compound Interest Tables

PWB/PWC = 1 1252(P/A,i,5)/5000 = 1

Interest rate

(P/A,i,5)

(P/A,i,5) = 5000/1252 = 3.993

i=8%

7% 8% 9%

4.100 3.993 3.890

Example2 :Graphic solution

Year Cash flow

Year 0 1 2 3 4 IRR 5
Trial IRR 0 1 2 3 4 5

Cash flow
($100.00) $20.00 ($100.00) $30.00 $20.00 $20.00 $40.00 $30.00 $40.00

Unrecovered Return on Investment Unrecovered investment at Unrecovered unrecovered repayment at investment at Return on Investment Unrecovered beginning of at investment investment end of year end of year unrecovered repayment at investment at year

PW of

beginning of investment end of end costs = PW of benefits$6.53 year $93.47 of year year $100.00 $13.47

$20.00 $40.00 13.47% $40.00

$93.47 $12.59 $17.41 $76.07 $76.07 $10.25 $9.75 $6.53 $66.32 $93.47 $100.00 $13.47 100=20/(1+i)+30/(1+i)2+20/(1+i)3+40/(1+i)4+40/(1+i)5 $66.32 $8.93 $93.47 $12.59 $31.07$17.41 $35.25 $76.07 $35.25 $4.75 $35.25 ($0.00)

$76.07 $10.25 $9.75 $66.32 NPW=-100+20/(1+i)+30/(1+i)2+20/(1+i)3+40/(1+i)4+40/(1+i)5 $8.93 $100.00$31.07 $35.25 Total$66.32 $50.00 $35.25 $4.75 $35.25 ($0.00) Total $50.00 $100.00

Net Present Value Present Value

interest rates 0 Trial5 10 interest 15 rates 20 0 25 5 30 10 35 15 40 20 45 50

NPW

13.47%

$60.00 $50.00 $40.00 $30.00 $20.00 $60.00 $10.00

25

$50.00 $26.46 $9.24 NPW ($3.49) ($12.97) $50.00 ($20.06) $26.46 ($25.37) ($29.36) $9.24 ($32.34) ($3.49) ($34.54) ($12.97) ($36.16)

i=13.5%
5 10 15 20 25 30 35 40 45 50

$50.00 $40.00
$0.00

($10.00) 0

$30.00 ($20.00) $20.00 ($30.00)

($40.00) $10.00 ($50.00)

$0.00 5 10 15 20 25 30 35 40 45 50

($20.06)

($10.00) 0

Calculating Rate of Return

NPW 50 40 30 20 10 0
1.00% 2.80% 4.60% 6.40% 8.20% 10.00% 11.80% 13.60% 15.40% 17.20% 19.00%

NPW
i*

NPW

-10 -20

i in %

If we have a CFS with borrowed money involved, e.g., (P,-A,-A,A), the NPW plot would be flipped around and would look something like the following one:

Some concept about Interest

Interest Convention. If a lender says she is receiving 11% interest, it might seem reasonable to you to say that the borrower is faced with 11% interest. This is not the way interest is discussed. Interest is referred to in absolute terms without associating a positive or negative sign with it. A banker might say she pays 5% interest on savings accounts, and charges 11% on personal loans no sign is associated with the rates. We implicitly recognize interest as a charge for the use of someone elses money and as a receipt for letting others use our money. In determining the interest rate in a particular situation, we solve for a single unsigned value of it. We then view this value in the customary way, either as a charge for borrowing money, or as a receipt for lending money.

Internal Rate of Return (IRR)

One can make up cash flow streams where no positive real root exists, or even where roots are complex numbers. To do so you must violate the hypotheses of the IRR Main Result.
Note. Some entries in a CFS can be 0. Example. Buy a Merrill Lynch Ready Assets Trust for $5,000. Sell it two years later for $5926. Then CFS = (-5000,0,5926), and IRR = 8.8669%.

Rate of Return Analysis

Example statements about a project: 1. The net present worth of the project is $32,000. 2. The equivalent uniform annual benefit is $2,800. 3. The project will produce a 23% rate of return

The third statement is perhaps most widely understood.

Rate of return analysis is probably the most frequently used analysis technique in industry. Its major advantage is that it provides a figure of merit that is readily understood.

Rate of Return Analysis

Rate of return analysis has another advantage. With NPW or EUAB one must choose an interest rate for using in the calculations. This choice may possibly be difficult or controversial. With ROR analysis no (exterior) interest rate is introduced into the calculations. Instead, we compute a ROR from the CFS. Warning. Relying only on ROR is not always a good idea.

Rate of Return Analysis

Motivating Example. Banks 1 and 2 offer you the following Deals 1 and 2 respectively:

Deal 1. Invest $2,000 today. At the end of years 1, 2, and 3 get $100, $100, and $500 in interest; at the end of year 4, get $2,200 in principal and interest. Deal 2: Invest $2,000 today. At the end of years 1, 2, and 3 get $100, $100, and $100 in interest; at the end of year 4, get $2,000 in principal only. Question. Which deal is the best?

Rate of Return Analysis

Deal 1: Find out the implicit interest rate you would be receiving; that is, solve for the interest rate in which the PW of benefits are equal to your payments $2,000. 2000 = 100/(1+i)1 + 100/(1+i)2 + 500/(1+i)3 + 2200/(1+i)4 IRR: i = 10.78%.

Deal 2: We find i for which

2000 = 100/(1+i)1 + 100/(1+i)2 + 100/(1+i)3 + 2000/(1+i)4 IRR: i = 3.82%. Which deal would you prefer?

CFS Analysis
We have two CFSs. 1. Number them CFS1 and CFS2, with CFS1 having the largest year 0 cost (in absolute value). 2. Compute CFS = CFS1 CFS2. (Its year 0 entry must be negative.) 3. Find the IRR for CFS, say IRR . 4. If IRR MARR, choose CFS1. If not, choose CFS2. Example: there are two cash flows: (-20,28) and (-10,15). MARR = 6%. 1. CFS1= (-20,28), CFS2= (-10,15) 2. CFS = CFS1-CFS2 =(-10,13) 3. IRR = 30%.

4. IRR > MARR => we choose CFS1 = (-20,28).

CFS Analysis
More generally, suppose you must choose between projects A or B. We can rewrite the CFS for B as B = A + (B A). In this representation B has two CFS components: (1) the same CFS as A, and (2) the incremental component (B A). B is preferred to A when the IRR on (BA) exceeds the MARR.

Thus, to choose one between B and A, IRR analysis is done by computing the IRR on the incremental investment (BA) between the projects.

CFS Analysis
In summary, we compute the CFS for the difference between the projects by subtracting the cash flow for the lower investment-cost project (A) from that of the higher investment-cost project (B). Then, the decision rule is as follows: IF IRRB-A > MARR, select B IF IRRB-A = MARR, select either A or B IF IRRB-A < MARR, select A.

Here, B-A is an investment increment.

Why we use IRR in IRR analysis

Years 0 1 IRR A -10 15 B -20 28 B-A -10 13 MARR=6%

50% 40% 30%

Select A MARR < IRRB-A Select B Select B

IRRB-A

NPV

3.92 6.05

Although the rate of return of A is higher than B, B got $8 return from the $20 investment and A only got $5 return from $10 investment. Project B: you put $20 in project B to get a return $8. Project A: you put $10 in project A (and $10 in your pocket) to get a return $5.

Why we use IRR in IRR analysis

Years 0 1 IRR

A -10 15

B -20 28

B-A -10 13

MARR=6%

50% 40% 30%

Select A MARR < IRRB-A Select B Select B

IRRB-A NPV 3.92 6.05

From this example, we know that we cant evaluate two projects by comparing the IRRs of the projects. Instead, we use IRR and MARR to make the decision.

Project Balance

Menunjukan posisi saldo nilai proyek pada suatu waktu tertentu, jika proyek terpaksa dihentikan pada waktu tersebut. Contoh proyek dengan i = 20%

Contoh Project Balance

Periode (t) 0 1 2 3 4 5 Aliran kas -10.000 +1.000 +5.000 +8.000 +6.000 +3.000 Project Balance -10.000 -10.000 (1,2) + 1.000 = -11.000 -11.000(1,2) + 5.000 = -8.200 -8.200 (1.2) + 8.000 = -1.840 -1.840 (1.2) + 6.000 = +3.792 +3.792 (1.2) + 3.000 = +7.550

Project Balance

Profil project Balance memperllihatkan 4 karakteristik penting dari proyek:

Net Future Worth yaitu PB terakhir Payback kapan PB berubah dari negatif ke positif Exposure to loss luas area negatif Profit potential luas area positif

Latihan

Hitung Project balance pada i = 25% dan gambarkan grafiknya untuk proyek-proyek berikut ini:
t 0 1 2 3
4

A -1000 +912 +684 +456

+228

B -1000 +631 +631 +631

+631

C -1000 +284 +568 +852

+1136

D -1000

+3641

Profitability Index

Ratio antara nilai sekarang dari aliran kas pendapatan dengan nilai sekarang aliran kas biaya. PW Revenue PI = PW Cost Ratio antara nilai ekuivalen tahunan dari aliran kas pendapatab dengan nilai ekuivalen tahunan aliran kas biaya.