7.

RATE OF RETURN
(ROR) ANALYSIS
• This is the third of the three major analysis
techniques.
• In this case, three aspects of ROR will be
examined.
• First, the meaning of “ROR”.
• Second, the calculation of ROR.
• Third, ROR analysis problems.
 1st The meaning of ROR

Rate of return is defined as the interest

rate paid on the unpaid balance of a loan
such that the payment schedule makes
the unpaid loan balance equal to zero
when the final payment is made.
In previous chapter we examined two (actually, it was
four) plans to repay $5000 in five years with interest at
8%. In each of the plans the amount loaned ($5000)
and the loan duration (five years) was the same. Yet
the total interest paid to the lender varied from $1200
to $2000, depending on the loan repayment plan. We
saw, however, that the lender received 8% interest
each year on the amount of money actually owed, and,
at the end of five years, the principal and interest
payments exactly repaid the $5000 debt with interest
at 8%.

We say the lender received an “8% rate of return.”

TWO PLANS FOR PAYMENT OF $5000 IN FIVE YEARS WITH INTEREST AT 8%
(a) (b) (c) (d) (e) (f)
Amount Interest owed Total owed at
owed at for that year end of year Principal Total
Year beginning of {8% x (b)} {(b) + (c)} payment end-of-year
year payment
Plan 1: At end of each year pay $1000 principal plus interest due.
1 $ 5000 $ 400 $ 5400 $ 1000 $ 1400
2 4000 320 4340 1000 1320
3 3000 240 3240 1000 1240
4 2000 160 2160 1000 1160
5 1000 80 1080 1000 1080
----- ------ ------
1200 5000 6200
Plan 2: Pay interest due at end of each year and principal at end of five years.
1 $ 5000 $ 400 $ 5400 $ 0 $ 400
2 5000 400 5400 0 400
3 5000 400 5400 0 400
4 5000 400 5400 0 400
5 5000 400 5400 5000 5400
------- ------- -------
2000 5000 7000
Instead of lending money, one might invest $5000 in a
machine tool with a five-year useful life and an
equivalent uniform annual benefit of $1252.

An appropriate question is, “What rate of return would

the person receive on this investment?”

The cash flow would be as follows:

Year Cash flow ($)

0 -5000
1 +1252
2 +1252
3 +1252
4 +1252
5 +1252
 Year Cash flow ($)
0 -5000
1 +1252
2 +1252
3 +1252
4 +1252
5 +1252

It is known that five payments of $1252 are equivalent

to a present sum of $5000 when interest is 8%.
Therefore, the rate of return on this investment is 8%.
 Stated in terms of an investment, ROR
can be defined as follows:

Rate of return is the interest rate earned

on the unrecovered investment such that
the payment schedule makes the
unrecovered investment equal to zero at
the end of the life of the investment.
It must be understood that the 8% rate of return does
not mean an annual return of 8% on the $5000
investment, or $400 in each of the five years. Instead,
each $1252 payment represents an 8% return on the
unrecovered investment plus the partial return of the
investment.

This may be tabulated as follows:

It must be understood that the 8% rate of return does
not mean an annual return of 8% on the $5000
investment, or $400 in each of the five years. Instead,
each $1252 payment represents an 8% return on the
unrecovered investment plus the partial return of the
investment.

This may be tabulated as follows:

This may be tabulated as follows:
Unrecovered 8% return on Investment Unrecovered
Year Cash flow ($) investment at unrecovered repayment at investment at
beginning of investment end of year end of year
year ($) ($) ($) ($)

0 -5000 5000 400 852 4148

1 +1252 4148 331 921 3227
2 +1252 3227 258 994 2233
3 +1252 2233 178 1074 1159
4 +1252 1159 93 1159 0
5 +1252 ------ ------
1260 5000

This cash flow represents a situation where the $5000

investment has benefits that produce an 8% ROR. But, in
the five-year period, the total ROR is only $1260, far less
than $400 per year for five years. The reason is because
ROR is defined as the interest rate earned on the
unrecovered investment.
Although the two definitions of ROR are stated
differently, one in terms of a loan and the other in
terms of an investment, there is only one fundamental
concept being described.

It is that the rate of return is the interest rate at

which the benefits are equivalent to the costs.
 2nd Calculating ROR

To calculate a rate of return on an investment,

we must convert the various consequences of
the investment into a cash flow. Then we will
solve the cash flow for the unknown value of i,
which is the rate of return.
Five forms of the cash flow equation are:

PW of benefits – PW of costs = 0 (7-1)

PW of benefits
------------------- = 1 (7-2)
PW of costs
Net Present Worth = 0 (7-3)
EUAB – EUAC = 0 (7-4)
PW of costs = PW of benefits (7-5)
The five equations represent the same concept
in different forms. They can relate costs and
benefits with ROR i as the only unknown.
Example No.1
An $8200 investment returned $2000 per year over a five-year useful life.
What was the rate of return on the investment?

Solution: using Equation 7-2.

PW of benefits 2000(P/A,i,5)
------------------ = 1 ----------------- = 1
PW of costs 8200

Rewriting the equation, we see that

(P/A, i,5) = 8200/2000 = 4.1

Then look at the Compound Interest Tables for the value of i where (P/A,i,5) –
4.1; if no tabulated value of i gives the value, we will then find values on
either side of the desired value (4.1) and interpolate to find the ROR i.
From the tables, we find: i (P/A,i,5)
6% 4.212
7% 4.100
8% 3.993
In this example, no interpolation is needed as the ROR. For this investment is
exactly 7%.
Example No. 2
An investment resulted in the following cash flow. Compute the rate of return.

Year Cash flow ($)

0 -700
1 +100
2 +175
3 +250
4 +325

Solution:

EUAB – EUAC = 0
100 + 75(A/G,i,4) – 700(A/P,i,4) = 0

In this situation, there are two different interest factors in the equation. Thus,
the problem will not be able to be solved easily as Example 1. Since there is
no convenient direct method of solution, the equation will be solved by trial
and error.
Try i = 5%. EUAB – EUAC = 0
100 + 75(A/G,5%,4) – 700(A/P,5%,4) = 0
100 + 75(1.439) – 700(0.2820) = 0
At i = 5%, EUAB – EUAC = 208 – 197 = +11
Example No. 2

The EUAC is too low, if the interest rate is increased, EUAC will increase.
Try i = 8%. EUAB – EUAC = 0
100 + 75(A/G,8%,4) – 700(A/P,8%,4) = 0
100 + 75(1.404) – 700(0.3019) = 0
At i = 8%, EUAB – EUAC = 205 – 211 = -6

This time the EUAC is too large. We see that the true ROR is between 5% and
8%. Try i = 7%.
EUAB – EUAC = 0
100 + 75(A/G,7%,4) – 700(A/P,7%,4) = 0
100 + 75(1.416) – 700(0.2952) = 0
At i = 8%, EUAB – EUAC = 206 – 206 = 0

The ROR is 7%.

Example No. 3
Given the cash flow below, calculate the rate of return on the investment.

Year Cash flow ($)

0 -100
1 +20
2 +30
3 +20
4 +40
5 +40

Solution: using NPW = 0, try i = 10%

NPW = - 100 + 20(P/F,10%,1) + 30(P/F,10%,2) + 20(P/F,10%,3) +

40(P/F,10%,4) + 40(P/F,10%,5)
= -100 + 20(0.9091) + 30(0.8264) + 20(0.7513) + 40(0.6830) +
40(0.6209)
= -100 + 18.18 + 24.79 + 15.03 + 27.32 + 24.84
= -100 + 110.16 = +10.16

The trial interest rate i is too low. Select a second trial, i = 15%.
Example No. 3
For i = 15%
NPW = -100 + 20(0.8696) + 30(0.7561) + 20(0.6575) + 40(0.5718) +
40(0.4972)
= -100 + 17.39 + 22.68 + 13.15 + 22.87 + 19.89
= -100 + 95.98 = -4.02
Net Present Worth

+10

+5
0 i
5% 10% 13.5% 15%
-5

Figure 1. Plot of NPW vs. interest rate i

Example No. 3

These two points are plotted in Figure 1. By linear interpolation, the ROR can
be computed as follows:
10.16
i = 10% + (15% - 10%) ------------------ = 13½%
10.16 + 4.02

It can be proved that the ROR is very close to 13½% by showing that the
unrecovered investment is very close to zero at the end of the life of the
investment.
Example No. 3

Unrecovered 13½% return Investment Unrecovered

Year Cash flow ($) investment at on repayment at investment at
beginning of unrecovered end of year end of year
year ($) investment ($) ($)
($)

0 -100
1 +20 100.0 13.5 6.5 93.5
2 +30 93.5 12.6 17.4 76.1
3 +20 76.1 10.3 9.7 66.4
4 +40 66.4 8.9 31.1 35.3
5 +40 35.3 4.8 35.2 0.1*
*This small unrecovered investment indicates that the ROR is slightly less than
13½%.
 Plot of NPW vs. Interest Rate i
A cash flow representing an investment followed by
benefits from the investment would have an NPW vs. i
plot (it will be called an NPW plot for convenience) in
the form of Figure 2.

Year Cash flow NPW

0 -P +
1 +Benefit A
0 i
2 +A
3 +A -
4 +A
. .
. . Figure 2. Typical NPW plot for an
investment.
. .
 Plot of NPW vs. Interest Rate i
If, on the other hand, borrowed money was involved,
the NPW plot would appear as in Figure 3. This form of
cash flow typically results when one is a borrower of
money. In all cases where interest is charged, the NPW
at 0% will be negative.

Year Cash flow

0 +P NPW
1 -Repayment A +
2 -A
0 i
3 -A
4 -A -
. .
. . Figure 3. Typical NPW plot for borrowed
. . money.
Example No. 4

A new corporate bond was initially sold by a stockbroker

to an investor for $1000. The issuing corporation
promised to pay the bondholder $40 interest on the $1000
face value of the bond every six months, and to repay the
$1000 at the end of ten years. After one year the bond
was sold by the original buyer for $950.
a. What rate of return did the original buyer receive on
his investment?
b. What rate of return can the new buyer (paying $950)
expect to receive if he keeps the bond for its
remaining nine-year life?
Example No. 4
Solution to Example 4a:
950

40 40

1000

Since $40 is received each six months, the problem will be solved
using a six-month interest period.

Let PW of cost = PW of benefits

1000 = 40(P/A,i,2) + 950(P/F,i,2)
Try i = 1½%  1000 = 40(1.956) + 950(0.9707)
= 78.24 + 922.17 = 1000.41
The interest rate per six months is very close to 1½%. This means
the nominal (annual) interest rate is 2 x 1.5% = 3%. The effective
(annual) interest rate = (1 + 0.015)2 – 1 = 3.02%.
 Example No. 4 1000

Solution to Example 4b: A = 40

n=18

950
There is the same $40 semi-annual interest payment. For six-month
interest periods:

950 = 40(P/A,i,18) + 1000(P/F,1,18)

Try i = 5%  950 = 40(11.690) + 1000(0.4155) = 467.60 + 415.50
= 883.10
The PW of benefits is too low. Try a lower interest rate, say, i = 4%.
950 = 40(12.659 + 1000(0.4936) = 506.36 + 493.60 = 999.96
The value of i is between 4% and 5%. By interpolation,
999.96 – 950.00
i = 4% + (1%) -------------------- = 4.43%
999.96 – 883.10
The nominal interest rate is 2 x 4.43% = 8.86%. The effective interest
rate is (1 + 0.0443)2 – 1 = 9.05%.
 3rd ROR Analysis

• ROR analysis is probably the most frequently used

exact analysis technique industry.
• Although problems in computing ROR sometimes
occur, its major advantage outweighs the occasional
difficulty.
• The major advantage that can be computed as a
single figure of merit that is readily understood.
 Consider these statements:

• The net present worth on the project is $32,000.

• The equivalent uniform annual net benefit is $2800.
• The project will produce a 23% rate of return.

While none of these statements tells the complete

story, the third one gives a measure of desirability of
the project in terms that are widely understood. It is
this acceptance by engineers and businessmen alike
of rate of return that has promoted its more frequent
use than present worth or annual cash flow methods.
• In both present worth and annual cash flow
calculations, one must select an interest rate for use
in the calculations—and this may be a difficult and
controversial item.
• In ROR analysis, no interest rate is introduced into
the calculations.
• Instead, a rate of return (more accurately called
internal rate of return) is computed from the cash
flow.
• To decide how to proceed, the calculated ROR is
compared with a preselected minimum attractive
rate of return, or simply MARR.
• This is the same value of i used for present worth
and annual cash flow analysis.
• When there are two alternatives, ROR analysis is
performed by computing the incremental rate of
return—DROR—on the difference between the
alternatives.

Two-alternative
situation Decision
DROR > MARR Choose the higher-cost alternative
DROR < MARR Choose the lower-cost alternative
Example No. 5

If an electromagnet is installed on the input conveyor of a

coal processing plant, it will pick up scrap metal in the
coal. The removal of this metal will save an estimated
$1200 per year in machinery damage being caused by
metal. The electromagnetic equipment has an estimated
useful life of five years and no salvage value. Two
suppliers have been contacted: Leaseco will provide the
equipment in return for three beginning-of-year annual
payments of $1000 each; Saleco will provide the
equipment for $2783. If the MARR is 10%, which supplier
should be selected?
Example No. 5
Solution: Since both suppliers will provide equipment with
the same useful life and benefits, this is a fixed-output
situation. In ROR analysis, the method of solution is to
examine the differences between the alternatives. By
taking (Saleco-Leaseco) an increment of investment will
be obtained.

Year Leaseco Saleco Difference between alternatives

Saleco – Leaseco
0 -1000 -2783 -1783
1 -1000
+1200 +1200 +1000
2 -1000
+1200 +1200 +1000
3 +1200 +1200 0
4 +1200 +1200 0
5 +1200 +1200 0
Example No. 5
Compute the NPW at various interest rates on the
increment of investment represented by the difference
between the alternatives.
Year Cash flow ($) PW* at 0% PW* at 8% PW* at 20% PW at ∞%
n Saleco- ($) ($) ($) ($)
Leaseco

0 -1783 -1783 -1783 -1783 -1783

1 +1000 +1000 +926 +833 0
2 +1000 +1000 +857 +694 0
3 0 0 0 0 0
4 0 0 0 0 0
5 0 0 0 0 0
-------- --------- -------- --------
NPW = +217 0 -256 -1783

*Each year the cash flow is multiplied by (P/F,i,n).

At 0%: (P/F,0%,n) = 1 for all values of n
At ∞%: (P/F,∞%,0) = 1
(P/F,∞%,n) = 0 for all other values of n
Example No. 5
These data are plotted in Figure 4. From the figure it can
be seen that NPW = 0 at i = 8%.

NPW

+217

0
0 8 20 ∞% Interest Rate
-256

-1783

Figure 4. NPW plot for Example 5.

Thus, the incremental rate of return—DROR—of

selecting Saleco rather than Leaseco is 8%. This is less
than the 10% MARR. Select Leaseco.