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Rate of return
3 definitions:
1) Based on a typical loan transaction
2) Based on the mathematical expression of the PW function
3) Based on the project cash-flow series
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Definition 1: Interest Earned on Loan
Balance
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Loan Balance Calculation:
A = $10,000 (A/P, 10%, 3) = $4,021
Unpaid Return on Unpaid
balance unpaid balance
at beg. balance Payment at the end
Year of year (10%) received of year
-$10,000
-$10,000 -$1,000 +$4,021 -$6,979
0 -$6,979 -$698 +$4,021 -$3,656
1 -$3,656 -$366 +$4,021 0
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A return of 10% on the amount still outstanding
at the beginning of each year
Mathematical Relation:
PW (i * ) PW (i * )cash inflows PW (i * )cash outflows
0
Of course: PW (i * ) FW (i * ) AE (i * ) 0
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Definition 3: Return on Invested Capital
Internal Rate of Return
The internal rate of return (IRR) is the interest rate earned on the
unrecovered project balance of the investment such that, when
the project terminates, the unrecovered project balance will be
zero.
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Return on Invested Capital
The firm earns a 10% rate of return on funds that remain internally
invested in the project. Since the return is internal to the project, we
call it internal rate of return.
The project brings in enough cash to pay for itself in 3 years and also
to provide the firm with a return of 10% on its invested capital. 7
7.2- Methods of finding the rate of return
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Example 7.1 Investment Classification
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7.2 - Predicting Multiple i*s
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Net Cash-Flow Rule of Signs
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Accumulated Cash-Flow Sign Test
0 -$100 -$100 0
1 -$20 -$120 0
2 $50 -$70 0
3 $0 -$70 0
4 $60 -$10 0
5 -$30 -$40 0
6 $100 $60 1
Predict the number of real positive rates of return for each of the following
cash flow series.
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No sign 2 sign 1 sign
change changes change
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(b) Find the number of possible i*.
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7.2.3 - Computational Methods
3. Graphical Method
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1 - Direct solution method
Example 7.3:
n Project A Project B
0 -$2,000 -$2,000
1 0 1,300
2 0 1,500
3 0
4 3,500
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2 - Trial and error method
(works only for simple investment)
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Figure 7.3 Cash flow diagram for a simple investment (Example 7.4).
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3 - Graphical method
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Example 7.5
Period Cash
flow
0 -10.000
1 20.000
2 20.000
3 -25.000
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Figure 7.4 Graphical solution to rate-of-return problem for a typical nonsimple
investment (Example 7.5).
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7.3 Internal-rate-of-return criterion
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Accept the project in regions: A, C
Reject the project in regions: B, D
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In simple projects: i* can serve as an appropriate index
for accepting/rejecting the investment.
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7.3.2 Net-investment test: pure vs. mixed investments
PURE BORROWING:
the project balances computed at the projects i* values are 0
throughout the life of the investment [PB(i*) n 0 ]
the first cash flow is negative [A0>0]
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NET INVESTMENT (pure investment):
PB(i*) n 0
A0<0
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Example 7.6
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A B C D
n
Cash flow PB (i*) Cash flow PB (i*) Cash flow PB (i*) Cash flow PB (i*)
0 -1000 -1000 -1000 -1000 -1000 -1000 -1000 -1000
1 -1000 -2336,41 1600 380,4743 500 -799,531 3900 2800
2 2000 -1122,41 -300 163,9982 -500 -1539,02 -5030 -1950
3 1500 0 -200 0 2000 0 2145 0
i* 0,3364 0,2195 0,2995 0,1 / 0,3 / 0,5
Example : Proyect A
PB(33, 64%)0 1000
PB(33, 64%)1 1000(1 0,3364) (1000) 2336
PB(33, 64%) 2 2336(1 0,3364) 2000 1122,36
PB(33, 64%)3 1122,36(1 0,3364) 1500 0
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7.3.3 Decision rule for pure investments
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Projected annual net savings = $ 871.500
Projected after-tax salvage value at the end of year 15 = $ 80.000
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7.3.3 Decision rule for mixed investments
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7.4 Mutually exclusive alternatives
The project with the highest IRR may NOT be the preferred
alternative.
Example:
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7.4.2 The incremental investment analysis
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Example 7.10
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Example 7.11
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Example 7.12
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7.4.3 Handling unequal service lives
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n Project A Project B
Problem 1
0 -1000 -1000
1 400 0
2 600 0
3 800 1500
Consider the investment project given in Table P7.20. Assume that MARR
= 12% for the following questions.
a) Identify the pure investment(s).
b) Identify the mixed investment(s).
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Problem 7.27
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Problem 7.40
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