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Chapter 6 Rate of Return Analysis

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

Where P W D = Present Worth of Disbursements or cash outflows

P W R = Present Worth of Receipts or cash inflows.

Annual Worth or Future Worth can also be used in these equations.

For Example 6.2 it is simpler to use the Spreadsheet function (RATE


(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.

Incremental cash flow = Cash flow B - cash flow

Understanding Incremental Analysis for ROR

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

Cash Flow Increments


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.

If t* MARR, select the larger investment alternative (labeled B)


Otherwise select the lower investment alternative

ROR Evaluation of Two or More Mutually Exclusive Alternatives

1. Equal service comparisons required


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*

The guideline for selection to select the alternative:

1. Requires the largest investment


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

The following procedure for comparing multiple, mutually exclusive alternatives,


using a PW based equivalence relation can now be applied:

1. Order the alternatives by increasing initial investment. For revenue alternatives


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.

Multiple ROR Values

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 maximum number i* values is equal to the number of sign changes in


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.