Chapter 07 PDF

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park.
ISBN: 0-13-611848-8
2011 Pearson Education, Inc., Upper Saddle River, NJ. All rights reserved.
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Chapter 7 Rate-of-Return Analysis

Concept of Rate of Return
Note: Symbol convention---The symbol i* represents the break-even interest rate that
makes the PW of the project equal to zero. The symbol IRR represents the internal rate of
return of the investment. For a simple (or pure) investment, IRR = i*. For a nonsimple
investment, generally i* is not equal to IRR. In that case, we should apply the net
investment test. If the project fails the net investment test, we need to calculate the return
on invested capital (RIC) at a given MARR. We will set IRR = RIC for a mixed
investment.
7.1
7.2
7.3
7.4
$1, 245 = $1, 000(1 + i )

i = 24.5%
$24, 500 = $514.55( P / A, i, 60)
i = 0.7917% per month
r = 0.7917% 12 = 9.5%
ia = (1 + 0.007917)12 1 = 9.93% per year
$950 = $35( P / A, 4%,8) + F ( P / F , 4%,8)

0.7307 F = $714.35
F = $977.64
$10,887, 600 = $1, 650( F / P, i, 40)
6,598.55 = (1 + i ) 40
i = 24.59%
7.5
$2.5 = $1.2( P / A, i,10)

i = 46.98%
7.6
PW (i) = $50,000 + $100,000( P / F ,i,1) $40,000( P / F ,i,2) = 0

i = 44.72%
Page | 1
Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

7.7
$104, 200, 000 = $30, 000( F / P, i,54)

3, 473.33 = (1 + i )54
i = 16.30%
Investment Classification and Calculation of i*

7.8
(a) Simple investment: Project A, D
(b) Non-simple investment: Project B
(c)
Project A:
PW (i ) = $22, 000 + $30, 000( P / A, i,3) $10, 000( P / G, i,3)
=0
i* = 94.95%
Project B:
PW(i ) = $28, 000 + $32, 000( P / A, i, 2) $22, 000( P / F , i,3)

=0
i* = 55.29% and 46.46%
Project C:
PW (i) = $35, 000 $18, 000( P / A, i,3)

=0
*
i = 25.26% Borrowing rate of return
Project D:
PW (i ) = $56,500 + $2,500( P / F , i,1) + $6, 459( P / F , i, 2) + $78,345( P / F , i,3)

=0
i* = 16.47%
(d) Project B has no unique rate of return. Given that project B is nonsimple, the
true rate of return cannot be calculated until an MARR is specified.
Page | 2

7.9
The equivalent annual cash flow for the first cash flow cycle ($500, $900, $800,
$700) will be
AE (i ) = [$500( P / F , i,1) + $900( P / F , i, 2) + $800( P, F , i,3) + $700( P, F , i, 4)]( A / P, i, 4)
Then, the present worth of the infinite cash flow series is expressed as
AE(i)
PW (i) = $1,000 +
i
[$500(P / F,i,1) + + $700(P / F,i,4)]( A / P,i,4)
= $ 1,000 +
i
=0
i* = 67.9%
7.10
(a) Classification of investment projects:
Simple projects: A,B, and E
Non-simple projects: C and D
(b)
$150 +
Let X =
$60 $150
+
=0
1 + i (1 + i ) 2
1
, then,
(1 + i )
$150 + $60 X + $150 X 2 = 0

X 1 = 0.8198, X 2 = 1.2198
i* = 21.98%
(c) Find i* by plotting the NPW as a function of interest rate:

Project
i*
A
B
C
D
E
21.98%
15.99%
19.59%
0% or 79.37%
23.52%
Page | 3

7.11
(a) Classification of investment projects:
Simple projects: A, B, and D
Non-simple projects: C
(b)
Project A:
Project B:
Project C:
Project D:
i* = 5%
i* = 17.23%
i* = 18.99%
i* = 34.76%
(c) Use the PW plot command provided in Cash Flow Analyzer, or you may use
Excels Chart Wizard.
7.12
(a)
$90,000 + ($27,000 $8,000)( P / A,i,6) + $10,000( P / F ,i,6) = 0
Solving for i yields i* = 9.4208% .

(b) With the geometric expense series
$90, 000 + $27, 000( P / A, i, 6) $8, 000( P / A1 , 7%, i, 6)
+$10, 000( P / F , i, 6) = 0
Solving for i* yields i* = 7.1745% .

(c) To maintain i* = 9.4208%
PW (i) = $90,000 + $27,000(P / A1 , g,9.4208%,6)
$8,000( P / A1 ,7%,9.4208%,6) + $10,000( P / F,9.4208%,6)
=0
Solving for g yields
g = 2.20%
7.13
(a) Rate of return calculation:
Project A: i* = 23.75%
Project B: i* = 16.19%
Page | 4

(b)
PW Plot
$50,000
$40,000
PW ($)
$30,000
$20,000
$10,000
$0
($10,000) 0
10
15
20
25
30
35
40
45
50
($20,000)
($30,000)
Interest Rate (%)
The interest rate that makes two projects equivalent is 37.93%.

7.14
(a) Cash flow sign rules:
Projects
A
B
C
D
E
F
Number of Sign Changes

1
2
1
1
2
3
Possible Number of i*
0, 1
0, 1, 2
0, 1
0, 1
0, 1, 2
0, 1, 2, 3
By the accumulated sign test, there is only one positive i* for B, E, and F.
(b) Use the PW plot command provided in Cash Flow Analyzer, or you may use
(c)
Project A: i* = 100%
Project B: i* = 482.92% and 59.69%
Project C: i* = 20.04%
Project D: i* = 40.57%
Project E: i* = 265.42% and -86.18%
Project F: i* = 209.46%
7.15
(a) From the Cash Flow Analyzer IRR = 20%
Page | 5

(b) Use the PW plot command provided in Cash Flow Analyzer, or you may use
(c) Since MARR(15%) < IRR = 20%, accept the project!
Mixed Investments
7.16
(a)
Project 1: i*1 = 110%, i*2 = 60%
Project 2: i* = 136.22%
Project 3: i*1 = 23.85%, i*2 = 83.85%
(b) Investment classification:

Project 1: nonsimple and mixed investment, IRR = 75%
PB(75%,12%)0 = $1, 000
PB(75%,12%)1 = $1, 000(1 + 0.75) + $2,500 = $750
PB(75%,12%) 2 = $750(1 + 0.12) 840 = $0
Project 2: simple and pure investment, IRR = 136.22%

Project 3: nonsimple and mixed investment, IRR = 22.14%
PB(22.14%,12%)0 = $1, 000
PB(22.14%,12%)1 = $1, 000(1 + 0.2214) + $1, 400 = $178.6
PB(22.14%,12%) 2 = $178.6(1 + 0.12) 200 = $0
(c) If MARR = 12%, all the projects are acceptable.
7.17
(a)
$150 +
Let X =
$150
$36
+
=0
1 + i (1 + i ) 2
1
, then,
(1 + i )
Page | 6

$150 + $150 X + $36 X 2 = 0

X 1 = 0.8333, X 2 = 5
i* = 20%
(b)
Simple projects: A, B, and D
Non-simple projects: C and E
(c) Apply the cash flow sign rule:

Projects
A
B
C
D
E
Number of Sign Changes

1
1
2
1
2
Possible Number of i*
0, 1
0, 1
0, 1, 2
0, 1
0, 1, 2
Actual i*
20%
15.32%
No return
17.70%
12.63%,41.42%
(d)
Project B: IRRB = 15.32%
Project C: IRRC = None
Project D: IRRD = 17.70%
Project E: IRRE = 12.29%
Note that, since project E is a mixed investment, we need to find the IRRs for E
by using external interest rate of 12%.
(e) Apply the net investment test for project E.
0
1
2
3
4
5
Project Balances
Project E (i*=12.63%)
$200
$325
-$134
-$651
-$533
$0
So, project E fails the net investment test. Projects A, B, and D pass the net
investment test, indicating that they are pure investment. Project C has no
meaningful rate of return.
7.18
IRR = 9.69% .
Page | 7

7.19
(a)
Project 1: i* = 82.21%
Project 2: i*1 = 14.64%, i*2 = 210.28%
Project 3: i* = 100%
(b) Apply the net investment test:

Project 1:
PB(82.21%)0 = $8,500
PB (82.21%)1 = $8,500(1 + 0.8221) + $10, 000 = $5, 487.85
PB(82.21%) 2 = $5, 487.85(1 + 0.8221) + $10, 000 = 0
(-,-,0), pure investment
Project 2:
PB(14.64%)0 = $5, 000
PB(14.64%)1 = $5, 000(1 + 0.1464) + $10, 000 = $4, 268
PB(14.64%)2 = $4, 268(1 + 0.1464) + $30, 000 = $34,892.80
PB(14.64%)3 = $34,892.8(1 + 0.1464) $40, 000 = 0

(-,+,0), mixed investment
Project 3:
PB(100%)0 = $1,500
PB(100%)1 = $1,500(1 + 1) + $6, 000 = $3, 000
PB(100%) 2 = $3,000(1 + 1) $6,000 = 0
(c)
Project 1: IRR1 = 82.21%
(d) Only project 1 is acceptable.

7.20
(a) Pure investment: B
(b) Mixed investments: A and C
Page | 8

(c) Project A: IRRA = 140.56% , Project B: IRRB = 21.86% , Project C:

IRRC = 12.24% at an external rate of 12%
(d) All three projects are acceptable.
7.21
(a) There are two sign changes in cash flow, indicating the possibility of multiple
i* s.
i*1 = 10%, i*2 = 20
Apply the net investment test:
PB(10%)0 = $1, 000, 000
PB(10%)1 = $1, 000, 000(1.1) + $2,300, 000 = $1, 200, 000
PB(10%) 2 = $1, 200, 000(1.1) $1,320, 000 = 0
(b) At an external interest rate of 12%, IRR = 12.14%.

(c) The project is acceptable.
7.22
(a) i*1 = 6%, i*2 = 0%
Project A
PB(6%)0 = $1, 000
PB(6%)1 = $1, 000(1.06) + $2, 060 = $1, 000
PB(6%) 2 = $1, 000(1.06) $1, 060 = 0
(-,+,0), a mixed investment
Project B
A simple and pure investment
Project C
Page | 9

PB(17.66%)0 = $1,500
PB(17.66%)1 = $1,500(1.1766) + $1, 000 = $764.90
PB(17.66%) 2 = 764.90(1.1766) $800 = $1, 700
PB(17.66%)3 = $1, 700(1.1766) + $2, 000 = 0
(-,-,-,0), a pure investment
Project A is the only mixed investment.
(c) Projects B & C are acceptable.
7.23
(a) Project A: i*1 = 10%, i*2 = 100% , Project B: i*1 = 350.34%, i*2 = 80.83%
(b) Pure investment: C, mixed investments: A, B, D and E
(c) Project A: IRRA = 13.57% , Project B: IRRB = 342.16% , Project C:
IRRC = 18% , Project D: IRRD = 31.07% , Project E: IRRE = 19.67%
(d) All projects are acceptable.
7.24
(a) Use the PW plot command provided in Cash Flow Analyzer.
From the plot, we get i*1 = 43.47%, i*2 = 77.67%
PB(43.47%)0 = $8,000
PB(43.47%)1 = $8,000(1 + 0.4347) + $10,000 = $1,477.98
PB(43.47%) 2 = $1,477.98(1 + 0.4347) + $30,000 = $27,879.5
PB(43.47%)3 = $27,879.5(1 + 0.4347) $40,000 = 0
(c) Since IRR = -16.30 % < 18%, the project is not acceptable.
7.25
(a) Apply the net investment test using i* = 10% :
PB(10%)0 = $150, 000
PB(10%)1 = $150, 000(1.1) + $465, 000 = $300, 000
PB(10%)2 = $300, 000(1.1) $330, 000 = 0
Page | 10

(b) By cash flow analyzer IRR = 6.30%. So the project is not acceptable.
7.26 (d)
IRR Analysis
7.27
PW (10%) = $2,000 + $1,000(P / F,10%,1)

+$1,200(P / F,10%,2) + $ X ( P / F,10%,3)
=0
X = $132
7.28 The present worth of the project cash flow is

PW (i ) = $10 M + $1.8M ( P / A, i,8) + $1M ( P / F , i,8) = 0
Since IRR = 10.18% > MARR, accept the project.
7.29 The present worth of the project cash flow is

PW (i ) = $15, 000 + $14, 520( P / F , i, 2) + $3,993( P / F , i,3) = 0
Since IRR = 10% = MARR, the project breaks even.
7.30
(a) Since IRR = 10% and PW(10%) = 0, we have,
PW (10%) = $2,500 + $700( P / F ,10%,1) + $900( P / F ,10%, 2)
+ X ( P / F ,10%,3) = 0
X = $1,490.5
(b) Since IRR > 8%, the project is acceptable.

7.31 PW (13%) = $2, 000 + $500( P / A,13%, 3) + $ X ( P / F ,13%,5) = 0
X = $1, 509.74
Page | 11

7.32
z Let X be the annual rent per apartment unit. Then the net cash flow table is:
N
Capital
Investment
-14,500,000
Revenue
Maintenance
Manager
Net Cash Flow

-14,500,000
50 X
-350,000
-85,000
50X - 435,000
50 X
-400,000
-85,000
50X - 485,000
50 X
-450,000
-85,000
50X - 535,000
50 X
-500,000
-85,000
50X - 585,000
50 X
-550,000
-85,000
50X +15,365,000
16,000,000
Through the Excel Solver function by setting PW(15%) = 0,

X = $49,473.35.
7.33
z Let X be the annual savings in labor.
PW (12%) = $35, 000 + ( X $4, 000)( P / A,12%, 6) + $5, 000( P / F ,12%, 6) = 0
X = $11,896.82
7.34
z Net cash flow table:
n Land Building Equipment Revenue Expenses Net Cash Flow
0 -$1.50
-$3
-$4.50
1
-$4
-$4.00
2
$3.50
-$1.40
$2.10
3
$3.68
-$1.47
$2.21
4
$3.86
-$1.54
$2.32
5
$4.05
-$1.62
$2.43
6
$4.25
-$1.70
$2.55
7
$4.47
-$1.79
$2.68
8
$4.69
-$1.88
$2.81
9
$4.92
-$1.97
$2.95
10
$5.17
-$2.07
$3.10
11
$5.43
-$2.17
$3.26
12
$5.43
-$2.17
$3.26
13
$5.43
-$2.17
$3.26
14
$2
$1.40
$0.50
$5.43
-$2.17
$7.16
Page | 12

z Rate of return calculation:

PW (i ) = $4.5 $4( P / F , i,1) + $2.1( P / F , i, 2) + "
+ $7.16( P / F , i,14) = 0
i* = 24.85%
z Since this is a simple investment, IRR = 24.85%. At MARR = 15%, the
project is economically attractive.
7.35
PW (18%) = $150, 000 + ( X 50, 000)( P / A,18%,10)
+15, 000( P / F ,18%,10)
=0
X = $82, 739.26
7.36
(a)
PW (i ) = $30 $9( P / F , i,1) + $18( P / F , i, 2) + $20( P / F , i,3)

+ $18( P / F , i, 4) + $10( P / F , i,5) + $5( P / F , i, 6)
=0
This is a simple investment. Therefore, IRR = i* = 40.20% .
Since IRR is higher than MARR, the project is acceptable.
(b) IRR = 45.47%

(c) IRR = 27.30%
Comparing Alternatives
Notes to Instructors: To apply the IRR decision rule in comparing mutually exclusive
investments, we need to conduct an incremental analysis. If the incremental cash flow
series represents a mixed investment, we should apply the net investment test and make
the selection by calculating the return on invested capital (or true internal rate of return).
Computational procedure for finding the RIC is not shown in this presentation. Excel or
Cash Flow Analyzer could be used.
Page | 13

7.37
(a) Project A: IRR = 16.01%
Project B: IRR = 18.18%
(b) Project A and B are acceptable.
(c) Since the incremental cash flow displays a nonsimple investment, we may
abandon the IRR analysis and make a selection based on the NPW criterion.
PW (15%) A = $2, 673.21
PW (15%) B = $7,991.29
PW(15%) A-B = $5,318.07 < 0

Select project B.
7.38 Option 1: Buy a certificate.

Option 2: Purchase a bond, and assume that MARR = 5% .
n
0
1
2
3
4
5
Option 1
-$10,000
0
0
0
0
15,386.24
Net Cash Flow

Option 2
Option 1 Option 2
-$10,000
$0
-650
650
-650
650
-650
650
-650
650
4736.24
10,650
The rate of return on incremental investment is

i*1 2 = 25.49% > 5%
Option 1 is a better choice.
7.39 Determine the cash flow on incremental investment:

Net Cash Flow
Project A
Project B
B-A
-$2,500
-$3,600
-$1,100
1,600
2,600
1,000
1,840
2,200
360
i*B A = 18.52% > 15% , select project B.
Page | 14

7.40
(a) IRR on the incremental investment:
Net Cash Flow
Project A1
Project A2
-11,000
-13,000
5,000
6,200
5,000
6,200
5,000
6,200
n
0
1
2
3
A2 A1
-$2,000
1,200
1,200
1,200
i* A 2 A1 = 36.31%
(b) Since it is an incremental simple investment, IRR A2-A1 = 36.31% > 10% .
Therefore, select project A2.
7.41
(a) IRR on the incremental investment:
n
0
1
2
3
A1
-$15,000
7,500
7,500
7,500
Net Cash Flow

A2
-$20,000
8,000
15,000
5,000
A2 A1
-$5,000
500
7,500
-2,500
Since the incremental cash flow displays a mixed investment with i*1 = 64.50% and i*2 = 6.67%, we need to find the return on invested capital (RIC).
The true rate of return on incremental investment (A2-A1) at a MARR of 10%
is 7.36%, which is smaller than MARR, so we select A1.
(b)
PW (10%) A1 = 15, 000 + $7,500( P / A,10%,3) = $3, 651
PW (10%) A 2 = 20, 000 + $8, 000( P / F ,10%,1) + $15, 000( P / F ,10%2)
+ $5, 000( P / F ,10%,3) = $3, 426
Select project A1.
7.42 (c)
Page | 15

7.43
(a) IRR for incremental investment:
n
0
1
2
Project A
-$300
0
690
Net Cash Flow

Project B
-$800
1,150
40
B-A
-$500
1,150
-650
i* B A = 0% or 30%
Since this is a mixed incremental investment, we need to find the IRR using an
external interest rate of 15%.
IRRB A = 16.96% >15%
Project B is preferred.
(b) Use the PW plot command provided in Cash Flow Analyzer.
7.44 Incremental cash flows (Model A Model B):
n
0
1
2
3
4
AB
-$2,376
0
0
0
2,500
IRR A B = 1.28%
If MARR < 1.28%, Model A is preferred.
7.45
PW (i) A = $8,000 + ($900 $150)( P / A,i,20) + $500( P / F,i,20) = 0
PW (i) B = $12,000 + ($1,100 $100)(P / A,i,20) + $600(P / F,i,20) = 0
With MARR at 12%, IRR for Model A: 7.12%, IRR for Model B: 5.65%.
Neither model is attractive.
Page | 16

7.46
(a) The least common multiple project lives = 6 years Analysis period 6 years
n
0
1
2
3
4
5
6
Project A
-$100
60
50
50-100
60
50
50
Net Cash Flow

Project B
-$200
120
150-200
120
150-200
120
150
BA
-$100
60
-100
170
-110
70
100
By the net investment test, the incremental investment is a pure investment, so

IRR = 15.98%.
Since IRRB A = 15.98% > 15% , select project B.
(b) Incremental analysis between C and D:
n
0
1
2
Project C
-$4,000
2,410
2,930
Net Cash Flow

Project D
-$2,000
1,400
1,720
CD
-$2,000
1,010
1,210
IRR C D = 7.03% < 15% , Project D is preferred.
(c) Incremental analysis between E and F:
n
0
1
2
Project E
-$2,000
3,700
1,640
Net Cash Flow

Project F
-$3,000
2,500
1,500
F E
-$1,000
-1,200
-140
No IRR, indicating E dominates F, so select E.
Page | 17

7.47 Let A0 = current practice, A1 = just-in-time system, A2 = stock-less supply

system.
z Comparison between A0 and A1:
n
0
1-8
A0
0
-9,000,000
A1
-$3,000,000
-3,800,000
A1 A0
-$3,000,000
5,200,000
i* A1 A 0 = IRR A1 A 0 = 173.28% > 10%
A1 is a better choice.
z Comparison between A1 and A2:
n
0
1-8
A2
-$6,000,000
-1,900,000
A1
-$3,000,000
-3,800,000
A2 A1
-$3,000,000
1,900,000
i* A 2 A1 = IRR A 2 A1 = 62% > 10%
A2 is a better choice. That means that the stockless supply system is

the final choice.
7.48
(a)
Project A vs. Project B
n
0
1
2
3
4
Project A
-$1,000
900
500
100
50
Net Cash Flow

Project B
-$1,000
600
500
500
100
BA
$0
-300
0
400
50
i* B A = IRR B A = 21.27% > 12% , select B.
Project B vs. Project C
n
0
1
2
Project B
-$1,000
600
500
Net Cash Flow

Project C
-$2,000
900
900
CB
-$1,000
300
400
Page | 18

3
4
500
100
900
900
400
800
i*C B = IRR C B = 26.36% > 12% , select C.
(b)
$1, 000 = $300( P / A, i, 4)

i = 7.71%
BRR = 7.71% .
(c) Since BRR is less than MARR, project D is acceptable.

(d)
Project C
-$2,000
900
900
900
900
0
1
2
3
4
Net Cash Flow

Project E
-$1,200
400
400
400
400
CE
-$800
500
500
500
500
i*C E = IRR C E = 50.23% > 12% , select C.
7.49
(a)
i1* = 54.52%,
i2* = 57.61%, and i3* = 38.41%
(b)
Project 1 versus Project 2:
n
0
1
2
Project 1
-$1,500
700
2,500
Project 2
-$5,000
7,500
600
21
-$3,500
6,800
-1,900
The incremental cash flow represents a mixed investment, we calculate the

RIC at MARR of 15%:
IRR2-1 = 47.08% > 15%, so select project 2.
Page | 19

Project 2 versus Project 3:
n
0
1
2
Project 2
-$5,000
7,500
600
Project 3
-$2,200
1,600
2,000
23
-$2,800
5,900
-1,400
This incremental cash flow (2 - 3) is another mixed investment; we need to

calculate the RIC at 15% which is 67.24% > 15%, so we choose project 2.
Select Project 2.
7.50
(a) IRRB = 25.99%
(b) PW (15%) A = $10, 000 + $5,500( P / A,15%,3) = $2,558
(c) Incremental analysis:
n
0
1
2
3
Net Cash Flow

Project A
Project B
-$10,000
-$20,000
5,500
0
5,500
0
5,500
40,000
BA
-$10,000
-5,500
-5,500
34,500
Since IRR B A = 24.24% > 15%, select project B.
7.51 Project B
7.52 Model C
7.53 All projects would be acceptable because individual ROR exceed the MARR.
Based on the incremental analysis, we observe the following relationships:
IRR A 2 A1 = 10% < 15% (Select A1)
IRR A3 A1 = 18% > 15% (Select A3)
IRR A3 A 2 = 23% > 15% (Select A3)
Therefore, A3 is the best alternative.
Page | 20

7.54 From the incremental rate of return table, we can deduce the following
relationships:
IRR A2 A1 = 8.9% < 15% (Select A1)
IRR A3 A2 = 42.7% > 15% (Select A3)
IRR A 4 A3 = 0% < 15% (Select A3)

IRR A5 A 4 = 20.2% > 15% (Select A5)
IRR A6 A5 = 36.3% > 15% (Select A6)
It is necessary to determine the preference relationship among A1, A3, and A6.
IRR A3 A1 = 16.66% > 15% (Select A3)
IRR A6 A3 = 20.18% > 15% (Select A6)
A6 is the best alternative.
7.55 For each power saw model, we need to determine the incremental cash flows
over the by-hand operation that will result over a 20-year service life.
Category
Investment cost
Salvage value
Annual labor savings
Annual power cost
Net annual savings
Power Saw
Model A
Model B
$6,000
$4,000
400
600
1,296
1,725
400
420
896
1,305
Net Cash Flow

Model A
Model B
-$4,000
-$6,000
896
1,305
896
1,305
n
0
1
2
#
20
IRR
PW(10%)
400+896
22.02%
$3,688
600+1,305
21.34%
$5,199
Model C
$7,000
700
1,944
480
1,464
Model C
-$7,000
1,464
1,464
700+1,464
20.46%
$5,568
z Model A versus Model B:

PW (i ) B A = $2, 000 + $409( P / A, i, 20) + $200( P / F , i, 20)
=0
IRR B A = 19.97% > 10%
Select Model B.
Page | 21

z Model B versus Model C:

PW (i)C B = $1,000 + $159( P / A,i,20) + $100( P / F,i,20)
IRR C B
=0
= 15.02% > 10%
Select Model C.
The PW rule also selects Model C, as indicated in the table above.
Unequal Service Lives

7.56 With the least common multiple of 6 project years,
n
0
1
2
3
4
5
6
Project A
-$5,000
3,000
4,000
4,000-5,000
3,000
3,000
3,000
Net Cash Flow

Project B
-$10,000
8,000
8,000 10,000
8,000
8,000 10,000
8,000
8,000
BA
-$5,000
5,000
-6,000
9,000
-5,000
4,000
4,000
Since the incremental cash flow series is a mixed investment, we calculate the
RIC at 15%.
IRRB-A = 25.67% > 15%, so choose project B.
We can easily verify the result by using the NPW:
PW(15%) B A = $5, 000 + $5, 000( P / F ,15%,1)
+ " + $4, 000( P / F ,15%, 6)
= $1,587.86
7.57
(a) Since there is not much information given regarding the future replacement
options and required service period, we may assume that the required service
period is 3 years and project A2 can be repeated at the same cost in the future.
(b) The analysis period may be chosen as the least common multiple of project
lives, which is 3 years.
Page | 22

n
0
1
2
3
A2 A1
-$5,000
0
0
15,000
IRR A2 A1 = 44.22%
The MARR must be less than 44.22% for Project A1 to be preferred.
Short Case Studies

ST 7.1
We assume monthly service fee = $40, the number of monthly transactions
per scanner = 1,000, and a service period of 5 years with no salvage value.
Here we assume an effective annual return on investment is 20%. This
means the required monthly return would be 1.53%.
Let R be the required monthly revenue per scanner.
PW(1.53%) = $50 + [ R ($40 + $100)]( P / A,1.53%, 60)
=0
R = $141.28
It is interesting that mere $1.28 additional revenue over its O&M brings
1.53% monthly return on investment.
ST 7.2
(a) Analysis period of 40 years(unit: thousand $):
Without mothballing cost:
PW (i) = $1,500,000 + $138,000(P / A1 ,0.05%,i,40)
=0
i = 8.95%
*
With mothballing cost of $0.75 billion:

PW(i ) = $1,500, 000 + $138, 000( P / A1 , 0.05%, i, 40)
$750, 000( P / F , i, 40)
=0
i* = 8.77% and -18.60%
Page | 23

Now this is a mixed investment, so we need to find out the true rate of return
(RIC), which requires an MARR. If we assume a MARR of 7%, the RIC will
be about 8.70%. For a 40-year analysis period, the drop in IRR with the
mothballing cost is about 2.79%, which is relatively insignificant.
(b) Analysis period of 25 years (unit: thousand $):
Without mothballing cost:
PW (i) = $1,500,000 + $138,000(P / A1 ,0.05%,i,25)
=0
i = 7.84%
*
With mothballing cost of $0.75 billion:

PW(i ) = $1,500, 000 + ($207, 000 $69, 000)( P / A1 , 0.05%, i, 25)
$750, 000( P / F , i, 25)
=0
i* = 6.80% and -18.17%
Once again this is a mixed investment, so we need to assume a MARR. At

MARR = 7%, the RIC is about 6.78%. Clearly, the project is no longer
profitable. For a 25-year analysis period, the drop of IRR with the mothballing
cost is about 13.52%, which is relatively significant.
ST 7.3
(a)
Assumptions required
We need to assume there are no cash flows for the first three years if
B&E Cooling decides to defer the decision.
Assume the firm will be in business for an indefinite period.
We assume that the best cooling technology will be the absorption
technology that will be introduced 3 years from now. Therefore, if
B&E Cooling decides to select Option 1 now, Option 2 will be
adopted for an indefinite period at the end of 8 years.
(b) Investment decision:

Rate of return analysis:
We need incremental analysis for these two options and then we find
that the incremental cash flow is a mixed investment case over a
period of 40 years.
Page | 24

Period
Option1
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
Option2
6000
9000
9000
9000
9000
9000
9000
9000
5000
4000
4000
4000
4000
4000
4000
4000
1000
4000
4000
4000
4000
4000
4000
4000
1000
4000
4000
4000
4000
4000
4000
4000
1000
4000
4000
4000
4000
Option1Option2
5000
4000
4000
4000
4000
4000
4000
4000
1000
4000
4000
4000
4000
4000
4000
4000
1000
4000
4000
4000
4000
4000
4000
4000
1000
4000
4000
4000
4000
4000
4000
4000
1000
4000
6000
9000
9000
14000
5000
5000
5000
5000
1000
0
0
3000
0
0
0
0
3000
0
0
3000
0
0
0
0
3000
0
0
3000
0
0
0
0
3000
0
0
3000
0
Page | 25

37
38
39
40
4000
4000
4000
1000
unit:$1,000
4000
4000
4000
4000
0
0
0
3000
We use Cash Flow Analyzer with MARR=15% and calculate

RIC1 2 = 154% > 15% , so option 1 is a better choice.
.
ST 7.4
n
0
1
2
Current Pump(A) Larger Pump(B)

$0
-$1,600,000
$10,000,000 $20,000,000
$10,000,000
$0
IRR =
B-A
-$1,600,000
$10,000,000
-$10,000,000
25%
400%
The incremental cash flows result in multiple rates of return (25% and 400%), so
we need to find the RIC. At MARR = 20%, the RIC is 4.17%, which is less than
20%, so we stick with the smaller pump. With the NPW analysis, we reach the
same conclusion.
PW (20%) B-A = $1.6 M + $10 M (P / F,20%,1) $10 M ( P / F,20%,2)

= $0.21 < 0
Reject the larger pump.
ST 7.5
(a)
Clearly the fellow engineers advice seems genuine, but the scale of
investment as well as of timing of cash flows will affect the true rate of return.
To determine whether or not the higher cost investment (project 2) can be
justified, we need to perform an incremental analysis.
(b)
n
0
1
2
Project 2 Project 1
-$10,000
+$23,000
-$13,200
Page | 26

This incremental cash flow series represents a nonsimple investment with two
rates of return at
i*2 1 = 10% or 20%
It is also a mixed investment. We may develop the RIC as a function of
MARR..
Let i = RIC (or true IRR) and assume i < 1.3
PB (i, MARR)0 = $10, 000
PB (i, MARR)1 = $10, 000(1 + i ) + $23, 000
= $13, 000 10, 000i
PB (i, MARR) 2 = ($13, 000 10, 000i)(1 + MARR)
$13, 200
=0
(Note that if i > 1.3, there will be no feasible solution.) Rearranging the terms
in PB (i, MARR) 2 gives an expression of IRR as a function of MARR.
1.32
IRR = 1.3
1 + MARR
For example, at MARR = 15%
IRR B A = 15.2% > 15%
Select project 2.
Page | 27

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Contemporary Engineering Economics, Fifth Edition, by Chan S. Park.

Chapter 7 Rate-of-Return Analysis

$1, 245 = $1, 000(1 + i )

$950 = $35( P / A, 4%,8) + F ( P / F , 4%,8)

$2.5 = $1.2( P / A, i,10)

PW (i) = $50,000 + $100,000( P / F ,i,1) $40,000( P / F ,i,2) = 0

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

$104, 200, 000 = $30, 000( F / P, i,54)

Investment Classification and Calculation of i*

PW(i ) = $28, 000 + $32, 000( P / A, i, 2) $22, 000( P / F , i,3)

PW (i) = $35, 000 $18, 000( P / A, i,3)

PW (i ) = $56,500 + $2,500( P / F , i,1) + $6, 459( P / F , i, 2) + $78,345( P / F , i,3)

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

$150 + $60 X + $150 X 2 = 0

(c) Find i* by plotting the NPW as a function of interest rate:

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

$90,000 + ($27,000 $8,000)( P / A,i,6) + $10,000( P / F ,i,6) = 0

Solving for i yields i* = 9.4208% .

Solving for i* yields i* = 7.1745% .

Solving for g yields

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

The interest rate that makes two projects equivalent is 37.93%.

Number of Sign Changes

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

(b) Investment classification:

Project 2: simple and pure investment, IRR = 136.22%

(c) If MARR = 12%, all the projects are acceptable.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

$150 + $150 X + $36 X 2 = 0

(c) Apply the cash flow sign rule:

Number of Sign Changes

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

(b) Apply the net investment test:

PB(14.64%)3 = $34,892.8(1 + 0.1464) $40, 000 = 0

(d) Only project 1 is acceptable.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

(c) Project A: IRRA = 140.56% , Project B: IRRB = 21.86% , Project C:

(b) At an external interest rate of 12%, IRR = 12.14%.

(-,+,0), a mixed investment

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

PW (10%) = $2,000 + $1,000(P / F,10%,1)

7.28 The present worth of the project cash flow is

Since IRR = 10.18% > MARR, accept the project.

7.29 The present worth of the project cash flow is

Since IRR = 10% = MARR, the project breaks even.

(b) Since IRR > 8%, the project is acceptable.

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

Net Cash Flow

Through the Excel Solver function by setting PW(15%) = 0,

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

z Rate of return calculation:

PW (i ) = $30 $9( P / F , i,1) + $18( P / F , i, 2) + $20( P / F , i,3)

Since IRR is higher than MARR, the project is acceptable.

(b) IRR = 45.47%

Contemporary Engineering Economics, Fifth Edition, by Chan S. Park. ISBN: 0-13-611848-8

PW(15%) A-B = $5,318.07 < 0

7.38 Option 1: Buy a certificate.

Net Cash Flow

The rate of return on incremental investment is

Option 1 is a better choice.

7.39 Determine the cash flow on incremental investment:

i*B A = 18.52% > 15% , select project B.