Chapter 7 Rate of Return One Project Salaheddin Abu Yahya LEARNING OUTCOMES 1. Understand meaning of ROR 2. Calculate ROR for cash flow series 3. Understand difficulties of ROR 4. Determine multiple ROR values 5. Calculate External ROR (EROR) 6. Calculate r and i for bonds 7-2 Interpretation of ROR Rate paid on unrecovered balance of borrowed money such that final payment brings balance to exactly zero with interest considered
ROR equation can be written in terms of PW, AW, or FW
Use trial and error solution by factor or spreadsheet
Numerical value can range from -100% to infinity
ROR is the unique i* rate at which a PW, FW, or AW relation equals exactly 0 ROR Calculation and Project Evaluation To determine ROR, find the i* value in the relation
PW = 0 or AW = 0 or FW = 0
Alternatively, a relation like the following finds i*
PWoutflow = PWinflow
For evaluation, a project is economically viable if
i* ≥ MARR i* Using Trial and Error The general procedure of using a PW-based equation is as follows:
1. Draw a cash flow diagram.
2. Set up the rate of return equation in the form of
Equation PW = 0
3. Select values of i by trial and error until the
equation is balanced. To select the first value (guess) of i , This may be done through the following procedure : 1. Convert all disbursements into either single amounts ( P or F ) or uniform amounts ( A ) by neglecting the time value of money. For example, if it is desired to convert an A to an F value, simply multiply the A by the number of years n . The scheme selected for movement of cash flows should be the one that minimizes the error caused by neglecting the time value of money. That is, if most of the cash fl ow is an A and a small amount is an F , convert the F to an A rather than the other way around.
2. Convert all receipts to either single or uniform values.
3. Having combined the disbursements and receipts so that a PF , PA , or
AF format applies, use the interest tables to find the approximate interest rate at which the PF , PA , or AF value is satisfied. The rate obtained is a good estimate for the first trial. EXAMPLE 7.1 An investment of $20,000 in new equipment will generate income of $7000 per year for 3 years, at which time the machine can be sold for an estimated $8000. If the company’s MARR is 15% per year, should it buy the machine?
Solution:: The ROR equation, based on a PW relation, is:
0 = -20,000 + 7000(P/A,i*,3) + 8000(P/F,i*,3)
Solve for i* by trial and error or spreadsheet: i* = 18.2% per year Since i* > MARR = 15%, the company should buy the machine EXAMPLE 7.2 Engineers with Monarch Paints have recommended to management an investment of $200,000 now in novel methods that will reduce the amount of wastewater, packaging materials, and other solid waste in their consumer paint manufacturing facility. Estimated savings are $15,000 per year for each of the next 10 years and an additional savings of $300,000 at the end of 10 years in facility and equipment upgrade costs. Determine the rate of return using hand solution. SOLUTION:
**Only for the first estimate of i ,
The roughly estimated i is between 8% and 9%. Use 9% as the
first trial because this approximate rate for the PF factor will be lower than the true value when the time value of money is considered. The result is positive, indicating that the return is more than 9%. Try i =11%. Special Considerations for ROR Multiple i* values. Depending upon the sequence of net cash inflows and outflows, there may be more than one real-number root to the ROR equation, resulting in more than one i* value. This possibility is discussed in the next section.
Reinvestment at i*. Both the PW and AW methods assume that any
net positive investment is reinvested at the MARR. However, the ROR method assumes reinvestment at the i* rate. When i* is not close to the MARR (e.g., if i* is substantially larger than MARR), this is an unrealistic assumption. In such cases, the i* value is not a good basis for decision making. This situation is discussed later. Different procedure for multiple alternative evaluations Will not be discussed. Multiple ROR Values Multiple i* values may exist when there is more than one sign change in net cash flow (CF) series. Such CF series are called non-conventional When there is more than one sign change in the net cash flows, it is possible that there will be multiple i* values in the 100% to plus infinity range
Two tests for multiple i* values:
Descarte’s rule of signs: total number of real i* values
is ≤ the number of sign changes in net cash flow series. Norstrom’s criterion: if the cumulative cash flow starts off negatively and has only one sign change, there is only one positive root . EXAMPLE 7.3 Multiple i* Values
Determine the maximum number of i* values for the cash flow shown below Year Expense Income Net cash flow Cumulative CF
(a) Determine the maximum number of i* values that may satisfy the ROR equation. (b) Write the PW equation and approximate the i* value(s) by plotting PW vs i. (c) What do the i* values mean?
i* values at ~8% and ~41% Since both i* values are positive, they are not of much value, because neither can be considered the true ROR of the cash flow series. This result indicates that additional information is needed to calculate a more useful project ROR EXAMPLE 7.5 P -400,000 A 75000 Phase out cost (n=10) -300,000
Perform an ROR analysis that will provide the following
information: (a) Type of cash flow series and possible number of ROR values
(b) PW graph showing all i* values
(c) Actual i* values determined using the ROR relation and
spreadsheet function
(d) Conclusions that can be drawn about the correct rate of return from this analysis (a) Type of cash flow series and possible number of ROR values
The series is nonconventional based on the sign changes
throughout the series.
Test #1: There are two sign changes in the NCF series, which indicates a possible maximum of two roots to the polynomial equation or i* values for the ROR equation.
Test #2: There is one sign change in the cumulative NCF
series, which indicates a unique positive root or one positive i* value. The ROR equation based on PW computations is:
Following the same procedure as in example 7.1. the
technique to estimate the initial i value will not work as well in this case since the majority of the cash flows do not fi t either the PF or the FP factor.
Trial-and-error solution of ROR Equation lead us to i*=
4.5% per year. This complies with the test results of one positive i* value. Removing Multiple i* Values Definition: You are the project manager and the project generates cash flows each year. Some years produce positive NCF, and you want to invest the excess money at a good rate of return. We will call this the investment rate ii . This can also be called the reinvestment rate .
Other years, the net cash flow will be negative and you must borrow funds from some source to continue. The interest rate you pay should be as small as possible; we will call this the borrowing rate ib , also referred to as the finance rate Two approaches to determine External ROR (EROR) • (1) Modified ROR (MIRR) approach • (2) Return on Invested Capital (ROIC) approach 1-Modified ROR Approach (MIRR) Four step Procedure:
Determine PW in year 0 of all negative CF at ib
Determine FW in year n of all positive CF at ii
Calculate EROR = i’ by FW = PW(F/P,i’,n)
If i’ ≥ MARR, project is economically justified
Example: EROR Using MIRR Method For the NCF shown below, find the EROR by the MIRR method if MARR = 9%, ib = 8.5%, and ii = 12%
= $9610 PW0(F/P,i’,3) + FW3 = 0 -7342(1 + i’)3 + 9610 = 0 i’ = 0.939 (9.39%) Since i’ > MARR of 9%, project is justified 2-Return on Invested Capital Approach Measure of how effectively project uses funds that remain internal to project
ROIC rate, i’’, is determined using net-investment procedure
Three step Procedure
(1) Develop series of FW relations for each year t using: (2) Set future worth relation for last year n equal to 0 (i.e., Fn= 0); solve for i’’
(3) If i’’ ≥ MARR, project is justified; otherwise, reject
ROIC Example For the NCF shown below, find the EROR by the ROIC method if MARR = 9% and ii = 12% Year 0 1 2 3 NCF +2000 -500 -8100 +6800
Solution: Year 0: F0 = $+2000 F0 > 0; invest in year 1 at ii = 12% Year 1: F1 = 2000(1.12) - 500 = $+1740 F1 > 0; invest in year 2 at ii = 12% Year 2: F2 = 1740(1.12) - 8100 = $-6151 F2 < 0; use i’’ for year 3 Year 3: F3 = -6151(1 + i’’) + 6800 Set F3 = 0 and solve for i’’
-6151(1 + i’’) + 6800 = 0
i’’= 10.55% Since i’’ > MARR of 9%, project is justified Important Points to Remember About the computation of an EROR value EROR values are dependent upon the selected investment and/or borrowing rates Commonly, multiple i* rates, i’ from MIRR and i’’ from ROIC have different values
About the method used to decide
For a definitive economic decision, set the MARR value and use the PW or AW method to determine economic viability of the project Summary of Important Points ROR equations can be written in terms of PW, FW, or AW and usually require trial and error solution
i* assumes reinvestment of positive cash flows at i* rate
More than 1 sign change in NCF may cause multiple i* values
Descarte’s rule of signs and Norstrom’s criterion useful when
multiple i* values are suspected
EROR can be calculated using MIRR or ROIC approach.
Assumptions about investment and borrowing rates is required.
