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You are on page 1of 5

Hello Class, we are moving right along. We have only 3 chapters to go. While the last

one was relatively easy, this chapter requires a little work. You are finally getting to the

point where you know enough to start analyzing projects. The Rate of Return (ROR) is

sometimes called the Internal Rate of Return (IRR), Return on Investment (ROI) and

Profitability Index (PI). Rate of Return is the rate paid on the unpaid balance of an

investment so that the final payment brings the balance exactly to zero with interest

considered. The rate of return is expressed as a percentage per period. (-100% < i <

.

A return of -100% means the entire investment is lost. The definition above does not

state that the rate of return is on the initial amount of the investment, but rather it is on

the unrecovered balance and varies from period to period. Review example on page

144 145 to understand this concept. Table 6.2 if the 10% return is always figured on

the initial investment of $1000. Column six in year 4 shows a remaining unrecovered

amount of $138.12 is recovered in the 4th year.

ROR Calculation

The Rate of Return and Present Worth are set up exactly the same. The only

differences are what is given and what is sought. The PW based ROR equation is

generalized by:

0 = PWD + PWR

(10,10000-50000,700000) to get i = 5.16% rate required. However, be careful there are

some shortcomings with the use of spreadsheet it does not offer same level of

understanding as the calculator or by hand (PW, AW, and FW relations).

Multiple alternatives have a different solution. They are explained 6.5. I will also

covered later in this lecture

You may also obtain one or more i values. This is covered in 6.6 and 6.7 in your book.

Please read and know what reinvestment of i * for ROR on page 148. Be careful,

remember to reinvest any leftover capital at the MARR rate. The write up on Page 139

140 Proves that the project with the highest interest rate is not always the best choice.

This is because we have to use any leftover capital and invest it at the MARR.

When considering ROR analysis for more than one alternative, you need to understand

the following:

Alternatives must have equal lives. Select the one that has the longest life. (make sure

that you go to at least one cycle then restructure the cash flow of the second so that it

emulates the same n. If they are unequal adjust using the LCM (Least Common

Multiple)

When doing incremental Analysis for two projects set up a table as shown below. Table

6.4 in your book

Year Used Press New Press New - Used

0 -15,000 -21,000 -6,000

1-25 -8,200 -7,000 -1,200

25 +750 +1050 +300

Total -219,250 -194,950 +24,300

Notice that if you take the difference used press total and subtract the new press total,

the will equal the increments total. This will always be and will act as a check for you.

Once the cash flows are tabulated determine the incremental rate of return on the extra

amount by the larger investment amount (when there is cash left over) required by the

larger investment alternative, (See table 6.5). noticed how the cash flow for A goes to 3

years twice so that it can equal the 6 year period of B. t* represents the return over n

years.

Otherwise select the lower investment alternative

2. An incremental Analysis must be used

3. The incremental ROR value between two alternatives (B and A) is correctly

identified as t* BA or simply t*

2. Has a t* MARR indicating theat that the extra initial investment is justified.

using a PW based equivalence relation can now be applied:

add DN as the first alternative

2. Determine the incremental cash flow between the first two alternatives. (B A)

over the least common multiple (LCM) of lives. (for revenue alternatives, the first

ordered alternative is DN

3. Set up a PW-based relation of this incremental rate of return.

4. If t* MARR eliminate A. B is the survivor. Otherwise A is the survivor.

5. Compare the survivor to the next alternative. Continue to compare alternatives

using steps 2 4 until only one alternative remains

This will make problems long and arduous. Make sure that you list all values. It is easy

to make mistakes in this type of calculation. Pay attention to signs.

There is a unique, real number, i* value for a conventional series. A non conventional

series ( table 6-10) has more than one sign change and multiple roots may exist.

the cash flow series.

When applying this rule zero cash flow values are disregarded. Problem 6,8 is a good

example to know and understand.

Read the section on using spreadsheet and calculator functions. They will make your

life a lot easier.

Good summary on this chapter on page 170. Do yourself a favor and read it.

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