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    Chap. 7

    Uploaded by

    Khuram Maqsood

    Copyright:

    © All Rights Reserved
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    Chap. 7

    Uploaded by

    Khuram Maqsood
    40 views15 pages

    Copyright

    © © All Rights Reserved

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    Copyright:

    © All Rights Reserved
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    Download as pptx, pdf, or txt
    40 views15 pages

    Chap. 7

    Uploaded by

    Khuram Maqsood

    Copyright:

    © All Rights Reserved
    Download as PPTX, PDF, TXT or read online from Scribd
    Download as pptx, pdf, or txt
    of 15

    Chapter 7 : Rate of Return Analysis

    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 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
    ROR Calculation Using PW, FW or AW Relation
    Example: 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?

    PW = 0 $ 8000
    Solution:: The ROR equation, based on a PW
    A = $ 7000 relation, is:
    0 1 2 3
    PW = -20,000 + 7000(P/A,i*,3) + 8000(P/F,i*,3) = 0

    i=? Solve for i* by trial and error or spreadsheet


    $ 20000
    Try i* = 10% $3418.5 > 0
    Try i* = 20% $ - 642.05 < 0
    Interpolation:
    10% 3418.5 Solve for i*
    i* 0 i* = 18.4% per year
    20% - 642.05
    Since i* > MARR = 15%, the company should buy the machine
    i1 = 10% P1 = 3418.5
    i* P=0
    i2 = 20% P2 = - 642.05

    i*  i1 
     i2  i1 
      P  P1 
     P2  P1 
    i*  10 
     20  10 
      0  3418.5 
     642.05  3418.5 

    4
    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

    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 .

    7-5
    Plot of PW for CF Series with Multiple ROR Values

    i* values at ~8%
    and ~41%

    7-6
    Example: Multiple i* Values
    Determine the maximum number of i* values for the cash flow shown below
    Year Expense Income Net cash flow Cumulative CF
    0 -12,000 - -12,000 -12,000
    1 -5,000 + 3,000 -2,000 -14,000
    2 -6,000 +9,000 +3,000 -11,000
    3 -7,000 +15,000 +8,000 -3,000
    4 -8,000 +16,000 +8,000 +5,000
    5 -9,000 +8,000 -1,000 +4,000

    Solution:
    The sign on the net cash flow changes The cumulative cash flow begins
    twice, indicating two possible i* values negatively with one sign change
    Therefore, there is only one i* value ( i* = 8.7%)
    7-7
    Removing Multiple i* Values
    Two new interest rates to consider:
    Investment rate ii – rate at which extra funds
    are invested external to the project

    Borrowing rate ib – rate at which funds are


    borrowed from an external source to provide
    funds to the project

    Two approaches to determine External ROR (EROR)


    • (1) Modified ROR (MIRR)
    • (2) Return on Invested Capital (ROIC)
    7-8
    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) = 0

    If i’ ≥ MARR, project is economically justified

    7-9
    Example: EROR Using MIRR Method
    For the nonconventional cash flow ,NCF, shown below, find the EROR by the MIRR
    method if MARR = 9%, ib = 8.5%, and ii = 12%
    Year 0 1 2 3
    NCF +2000 -500 -8100 +6800

    Solution: PW0 = -500(P/F,8.5%,1) - 8100(P/F,8.5%,2)


    = $-7342
    FW3 = 2000(F/P,12%,3) + 6800
    = $9610

    PW0(F/P,i’,3) + FW3 = 0

    -7342(1 + i’)3 + 9610 = 0 , i’ = 0.0939 (9.39%)


    Since i’ > MARR of 9%, project is justified
    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:
    Ft = Ft-1(1 + k) + NCFt

    where: k = ii if Ft-1 > 0 and k = i’’ if Ft-1 < 0

    (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


    7-11
    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
    Ft = Ft-1(1 + k) + NCFt
    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

    7-12
    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
    ROR of Bond Investment
    Bond is IOU with face value (V), coupon rate (b), no. of payment periods/year (c),
    dividend (I), and maturity date (n). Amount paid for the bond is P.
    I = Vb/c
    General equation for i*: 0 = - P + I(P/A,i*,nxc) + V(P/F,i*,nxc)

    A $10,000 bond with 6% interest payable quarterly is purchased for $8000.


    If the bond matures in 5 years, what is the ROR (a) per quarter, (b) per year?

    Solution: (a) I = 10,000(0.06)/4 = $150 per quarter


    ROR equation is: 0 = -8000 + 150(P/A,i*,20) + 10,000(P/F,i*,20)
    By trial and error or spreadsheet: i* = 2.8% per quarter
    (b) Nominal i* per year = 2.8(4) = 11.2% per year
    Effective i* per year = (1 + 0.028)4 – 1 = 11.7% per year
    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.

    General ROR equation for bonds is


    0 = - P + I(P/A,i*,nxc) + V(P/F,i*,nxc)
    © 2012 by McGraw-Hill All Rights Reserved
    7-15

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