ENGR 3360U Winter 2014

Unit 7
Internal Rate of Return Analysis
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-II-01

Unit 7 Rate of Return

Change Record
2014-I-01 Initial Creation

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Unit 7 Rate of Return

Course Outline
1.
2.

3.
4.
5.
6.
7.
8.
9.
7-3

Engineering Economics
General Economics
1.
Microeconomics
2.
Macroeconomics
3.
Money and the Bank of
Canada
Engineering Estimation
Interest and Equivalence
Present Worth Analysis
Annual Cash Flow
Rate of Return Analysis
Picking the Best Choice
Other Choosing Techniques
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10. Uncertainty and Risk

11. Income and Depreciation
12. After-tax Cash Flows
13. Replacement Analysis
14. Inflation
15. MARR Selection
16. Public Sector Issues
17. What Engineering should know
about Accounting
18. Personal Economics for the
Engineer

Dr. M. Bennett, P.Eng., PMP

Unit 7 Rate of Return

LEARNING OBJECTIVES
ROR = Rate of Return

1.
2.
3.
4.
5.

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Definition of ROR/IRR
IRR using PW and AW
Calculations about IRR
Multiple IRRs
ROR of bonds

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Unit 7 Rate of Return

7. 1 Rate of Return - Introduction

Referred to as ROR or IRR (Internal Rate of Return) method
It is one of the popular measures of investment worth
DEFINITION -- ROR is either the interest rate paid on the unpaid
balance of a loan, or the interest rate earned on the unrecovered
investment balance of an investment such that the final payment or
receipt brings the terminal value to exactly equal 0
The ROR of found using a PW or AW relation. The rate
determined is called i*

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Unit 7 Rate of Return

Unrecovered Investment Balance

ROR is the interest rate earned/charged on the
unrecovered balance of a loan or investment project
ROR is not the interest rate earned on the original
loan amount or investment amount (P)

The i* value is compared to the MARR -If i* > MARR, investment is justified
If i* = MARR, investment is justified (indifferent
decision)

If i* < MARR, investment is not justified

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Unit 7 Rate of Return

Valid Ranges for usable i* rates

Mathematically, i* rates must be:

100% i
*

1. An i* = -100% signals total and complete loss

of capital
2. One can have a negative i* value (feasible)
but not less than 100%
3. All values above i* = 0 indicate a positive
return on the investment

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Unit 7 Rate of Return

Internal Rate of Return (IRR)

Is the interest rate at which the PW or AW
= 0.

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Unit 7 Rate of Return

7.2 Calculation of i* using PW or AW

Relations
Set up an IRR equation using either PW or AW
relations and equate to zero

0 = - PW of disbursements + PW receipts
= - PWD + PWR
0 = - AW of disbursements + AW receipts
= - AWD + AWR
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Unit 7 Rate of Return

i* by Trial and Error by Hand Using a PW Relation

1. Draw a cash flow diagram
2. Set up the appropriate PW equivalence equation

and set equal to 0

3. Select values of i* and solve the PW equation
4. Repeat for values of i until 0 is bracketed, i.e.,
the equation is balanced
5. May have to interpolate to find the approximate
i* value

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Unit 7 Rate of Return

ROR using Present Worth

+$1,500

+$500

Assume you invest $1,000 at t = 0; receive $500 @ t = 3

and $1500 at t = 5. What is the IRR of this project?
$1,000

1000 = 500(P/F, i*,3) +1500(P/F, i*,5)

The above PW expression

must be solved by trial and
error

Guess at a rate and try it

Adjust accordingly
Bracket
Interpolate
i* approximately 16.9% per year on the unrecovered
investment
balances

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Unit 7 Rate of Return

Trial and Error

1000 = 500(P/F, i*,3) +1500(P/F, i*,5)
2 = (P/F, i*,3) +3(P/F, i*,5)
Try 15% 2= .6575 + 3(.4972) = 2.149
Try 18% 2 = .6086 + 3(4371) = 1.919
i* = (2.149-2)/(2.149-1.919)*3 +15 = 16.9

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Unit 7 Rate of Return

Spreadsheet Methods
Excel supports ROR analysis with 2 functions:
=RATE(n,A,P,F)

when A series is present

=IRR(first_cell:last_cell, guess)
when cash flows vary

RATE is used when an investment (P) is made

followed by n equal, end of period cash
flows

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Unit 7 Rate of Return

The IRR Excel Function

When cash flows vary from period to period
Entries: Enter the cash flow values into
contiguous cells (including any $0 amounts)
Enter the IRR function
=IRR(first_cell:last_cell,guess)
guess is an optional starting value the user feels
is in the vicinity of the true i* value
If omitted, Excel assumes a starting value of 10%
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Unit 7 Rate of Return

Example 7.2
The Moscow City Tower was expected to have been
the worlds tallest building when finished in 2010.
The HVAC engineer for a company involved in its
construction has requested that $500,000 be spent
now during construction on software and hardware
to improve the efficiency of the environmental
control systems. This is expected to save $10,000
per year for 10 years in energy costs and $700,000
at the end of 10 years in equipment refurbishment
costs. Find the internal rate of return by hand.

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Unit 7 Rate of Return

Cash Flow

$700K
$10K

9 10

$500K

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Unit 7 Rate of Return

Use the trial-and-error procedure based on a PW equation.

1. Previous figure shows the cash flow diagram.
2. Set up the PW=0 equation.
0 = -500,000 + 10,000(P/A, i*,10) + 700,000(P/F, i*,10)
3. Use the estimation procedure to determine i* for the first trial.
All income will be regarded as a single F in year 10 so that the
P/F factor can be used. The P/F factor is selected because
most of the cash flow ($700,000) already fits this factor and
errors created by neglecting the time value of the remaining
money will be minimized. Only for the first estimate of i*
define
P = $500,000, n = 10, and F = 10(10,000) + 700,000 =
$800,000. Now we can state that
500,000 = 800,000(P/F,i,10)
(P/F,i,10) = 0.625
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Unit 7 Rate of Return

The roughly estimated i* is between 4% and 5%. Use 5% as the first trial
because this approximate rate for the P/F factor is lower than the true value
when the time value of money is considered. At i* = 5%, the IRR equation is
0 = -500,000 + 10,000(P/A,5%,10) + 700,000(P/F,5%,10)
0 < $6946
The result is positive, indicating that the return is more than 5%. Try i* = 6%.
0 = -500,000 + 10,000(P/A,6%,10) + 700,000(P/F,6%,10)
0 > $-35,519
Since the interest rate of 6% is too high, linearly interpolate between 5% and
6%.
i* = 5.00 + 6946/(6946 + 35519) = 5.16%

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Unit 7 Rate of Return

Example 3
An engineer invests $5,000 at the end of
every year during a 40-year career. If she
wants $1 million in savings at retirement,
what interest must the investment earn?
PW = 0 = -5000(F/A, i, 40)+ 1000000
(F/A, i, 40) = 200
(F/A, 7, 40) = 199.636 so 7%.

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Unit 7 Rate of Return

Example 4
A bond is sold to an investor for $1,000
paying $40/6 months for 10 years. He sells
the bond a year later for $950.
a) what rate of return did the first buyer get?
b) what ror can the new buyer expect if she
holds it to maturiy?

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Unit 7 Rate of Return

Solution

950
40
1

40
2

Six-month

1000
PWc = PWb; 1000= 40(P/A,i,2) + 950(P/F,i,2)
At 1.5%, 1000 = 1000.41
NIR = 3%; EIR = (1+0.015)2 -1 = 3.02%

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Unit 7 Rate of Return

Solution B
950 = 40(P/A, i, 18) + 1000(P/F, i, 18)
4% = 999.96 too high
5% = 883.10 too low
IRR 4% + 1%(999.66-950)/(999.96-883.10)
IRR = 4.43% NIR = 8.86% EIR = 9.05%

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Unit 7 Rate of Return

Example 7.7
An engineering student is deciding whether
to buy two one-term parking permits or a
single annual one. The annual one costs
$180 and the semi-annual ones, $130
(assume Aug 2012 and Jan 2013). What is
the ROR for buying the annual one?

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Unit 7 Rate of Return

solution
-180 = -130(1+(P/F,imon, 5))
(P/F,imon, 5) = -50/-130 = 0.3846
[using the formula]
1/(1+imon )5 = 0.3846
(1+imon )5 = 2.6
1+imon = 1.2106
imon = 21.06%
Annual (1.2106 12 -1) = 891%
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Unit 7 Rate of Return

Example 7-8
An engineering firm can buy liability
insurance either quarterly or annually. The
quarterly cost is $10,000 and the annual,
$35,000. What is the ROR for buying
annually?

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Unit 7 Rate of Return

Solution
35000 =10000(1+(P/A, iqrt,3))
(P/A, iqrt,3) = 2.5
(P/A, 9%,3) = 2.531
(P/A, 10%,3) = 2.487
iqrt = 0.09 + (0.10 0.09)(2.531-2.5)/(2.5312.487)
= 9.7%

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