Lecture 05

Project evaluation 2:
Internal rate of return and others

This lecture examines the internal rate of return (IRR) which is

one of the most widely used concepts. Choosing one of
mutually exclusive projects with the IRR method is different
from the PW/AW approach. This lecture also covers the
benefit-cost analysis and the payback period technique.

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1. Rate of return analysis

 The rate of return analysis is probably the most frequently used
approach in project evaluation.
 Consider a project whose PW is $30,000 after one year of investment.
Are you happy with this outcome?
• Not necessarily! Why?
• You might have invested $1 million or just $100,000.
• The rate of return of the former is 3% and the latter 30%!
 Why do we use the rate of return analysis?
• It is expressed as a percentage (%), readily understood and compared among
several projects.
• Unlike PW or AW, it doesn’t assume an interest rate.
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 1.1. Cost of capital
 The cost of capital is defined as the rate (%) at which money is financed.
 Suppose you want to buy a new car, but do not have enough money.
• You can obtain a bank loan for 8% of interest rate and pay for the car in cash now.
• Or, you can use your credit card and pay off the balance with 12% interest rate.
• Or, you use money from your savings account that earns 5% per year. You forgo
future returns from the account.
• The 8%, 12%, 5% rates are your cost of capital to raise money for a car.
 Corporations estimate the cost of capital from different sources.
• Equity financing: Stock sales, retained earnings, etc. sure
a Different capital
• Debt financing: Bank loan, long-term debt (bond), etc. 4
to raise

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1.1. Minimum attractive rate of return (MARR)

 Weighted average cost of capital (WACC)
• It is obtained by the combination of different sources of financing.
• To raise a total of $100 million, if a firm finances $20 million through bank loan
with 9% interest rate, $20 million bond with a return of 7%, and $60 million stock
with 11%, what is the WACC?
• WACC = (9%  0.2) + (7%  0.2) + (11%  0.6) = 9.8%
 Minimum attractive rate of return (MARR)
• It is the minimum rate that a manager is willing to accept before starting a project.
• The MARR is usually the weighted average cost of capital.
• Any projects must earn the rate of return larger than MARR.
• In practice, firms with normal risk level use the MARR of 12 – 15%.
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 1.2. Internal rate of return (IRR)
 What is the internal rate of return (IRR)?
• The rate at which a project breaks even, PW = 0 or AW = 0.
• It is expressed as a rate per period (usually one year).
• If IRR > MARR (PW > 0 or AW > 0), the project is acceptable: Any projects should
bring the rate of return larger than the cost of capital.
• The “internal” means that the return depends only on the cash flows due to a
specific investment.
 Steps of calculating IRR
• Express the benefits (B) and costs (C) of a project with unknown i*, either as PW
or AW.
• Solve for i* by setting PW(B) = PW(C) or AW(B) = AW(C).

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Ex 1-1. Rate of return

 An engineer plans to invest $5,000 at the end of every year for 40 years.
If the engineer wants to have $1 million in savings at retirement, what
interest rate (or rate of return) must the investment earn?

t t t
5000
I
5000 FIA I 407 1,000,000 FIA I 407 200
FIA 711,40 199.636 FIA81,407 259,057
7 2 is 81 i 7.00711
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 Ex 1-2. Rate of return
 Bailey Inc. is considering buying a new punch machine. The machine
has a first cost of $100,000, with $20,000 salvage value at the end of a
useful life of 15 years. Annual labor cost saving from the machine is
$10,000. What is the internal rate of return of this investment?
100000 10000 PIA i 15 20000 PIF i 15
10 PIA i 15 2 PIF i 157 0
I 31 0.01839 3 2 is 3.5.1
5 3.51 0.26556
i 3031

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Ex 1-3. University education (1)

 Why do you want to get a university education?
• One of the reasons is to earn higher future earnings in comparison to non-
university graduates.
 Suppose you estimate that university education requires a $300,000
equivalent cost at graduation (tuition and fee + lost income).
• During the first 10 years after graduation, your income will be higher than that of
a non-university graduate by $20,000 per year.
• During the subsequent 10 years, it will be higher by $30,000.
• During the last 20 years, it will be higher by $50,000. in limpidto
 What rate of return will you receive from a university education,
soif you
work for 40 years after graduation?
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 Ex 1-3. University education (2)
30k PIA i 10 PIFE lo
300000 20k PA i lol
50K PLA i 20 PIF i 207

o
iritis lil to lil lil lil 40

81 i 91 8.771

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Ex.1-3. Does education pay?

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 Ex 1-4. Choice of inheritance
 Frank’s grandfather has given Frank the choice between two
alternatives in his will.
• Alternative 1: $20,000 cash
• Alternative 2: $1,500 cash now plus $1,000 per month for 20 months beginning
the first day of next month
 What rate of return makes the two alternatives equivalent?

20000 1500 t 1000 PIA i 20

Pl.A i 207 18.5
4770 75 201 18.5
ie 1 to F
IAnnual't
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1.3. Note: Finding i using Excel

 Uniform return: “RATE(n, –A, P, F)”
 Irregular return: “IRR(all range)”
Date Project A Project B
0 - 50,000 - 50,000
1 8,000 7,000
2 8,000 7,500
3 8,000 8,500
4 8,000 10,000
5 8,000 8,500
6 8,000 6,000
7 8,000 9,000
8 8,000 9,000
9 8,000 9,500
10 8,000 11,000
i= RATE(10,8000,-50000) IRR(A1:A11)
9.6% 10.7%

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 2. Incremental analysis of IRR
 Previous examples of choosing one of two alternatives can be formally
examined by the incremental analysis of IRR.
 Choice of a project
• In mutually exclusive projects, should you choose the project with the highest
IRR?
• No. Unlike the case of PW/AW approach, simple comparison of IRRs of each
project is not a correct approach.
 Incremental analysis
• When there are two or more alternatives, you should perform the IRR analysis by
computing the incremental IRR.
• This is the trickiest aspect of the IRR analysis in project evaluation.

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Ex 2-1. Why incremental analysis? (1)

 You need to choose one of the two mutually exclusive projects.
• Project 1: Invests $1,000 today and returns $1,500 a year later.
• Project 2: Invests $2,000 today and returns $2,800 a year later.
 Any money not invested here is invested elsewhere at a MARR of 6%.
Which project should you choose?

PW I 1000 1500 PIF 6 1 415 do

PW 2 2000 2800 PIF61,17 642 whichone
you
do
IRR i 1000 i 5
15,9g µ
IRR z 2000 2997 i 401
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 2.1. Steps of incremental analysis
 For mutually exclusive projects, you should choose project 2. Why?
• Remember that you only have a single chance of investment.
• For money not invested here, you should check whether the IRR of the
incremental investment earns larger than MARR.
 Steps of incremental analysis
• Order the projects from the lowest to the highest initial cost.
• Start with the lowest cost project, and check whether IRR > MARR. If so, it is the
current best.
• Check whether IRR of the ‘incremental investment’ between the current best and
challenger exceeds MARR.
• If so, the challenger becomes the current best. This process continues.

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Ex 2-1. Why incremental analysis? (2)

 Let’s use the incremental investment approach of IRR in example 2-1.
• Project 1 has a lowest initial investment cost ($1,000), so its IRR should first be
checked (against “do-nothing” alternative).
1,000 = 1,500/(1 + i)  i = 0.5 (50%)
Earth
• Since IRR (50%) > MARR (6%), project 1 is the current best.
• Now, we calculate the IRR of incremental investment from project 1 to project 2.
price (2,000 – 1,000) = (2,800 – 1,500)/(1 + i)  i = 0.3 (30%)
• Since IRR (30%) > MARR (6%), project 2 should be chosen.
 The additional $1,000 should be invested in project 2 with 30% return,
instead of investing elsewhere with 6% of MARR.
• The critical assumptions are $2,000 is available and we choose only one project.
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 Ex 2-2. Multiple alternatives
 WatAir plans to buy a new metal cutter, out of 3 options, each of which
has a life of 10 years with no salvage value. Given a MARR of 15%,
which option should be chosen?
Option 1 Option 2 Option 3
Initial cost $100,000 $150,000

I QEIIenace
$200,000

OP
Annual savings

100000 25000 PIA i 10

$25,000 $34,000 $46,000

joyLizzy's
dad
ANTEATER
1072 0711 1150k100k 134k 254 PIA I 101 124 LIL 154
10103 OP 200k10014 46k2514 PA i lo is Lic 181 d Betterthan
MARR

21.44
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IRR17 18.5
IRR21 10.91
IRR37

Ex 2-3. Incremental analysis (1)

 The five alternatives with 20-year service life are considered. Given an
MARR of 10%, which one is best?
A B C D 0 E
First cost $4,000 $2,000 $6,000 $1,000 $9,000
Annual benefits $639 $410 $761 $117 $785

IRR D 1000 177 PIA 5,20 PA i 207 8.54 9.941

19.961 10 U
IRR B 2000 410 PIA i 24 I
IRR A B 40002000 639410 PIA i20 I 5 9.63 2101X
IRR C B 60002000 761410 PA i 207 401 X
i 6.081
IRR E B 90002000 785410 PA i 207 5 0.6714101 X
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Final Answer is B
If different service like youhere to use the AnnualWorth
9
 Ex 2-3. Incremental analysis (2)

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2.3. Problems of IRR analysis

 The main difficulty (or shortcoming) of the IRR analysis is that there
may be multiple IRRs.
 Suppose a project pays $1,000 today, costs $5,000 a year from now,
and pays $6,000 in two years. What is the IRR? your
plow
1,000 + 6,000(P/F, i, 2) = 5,000(P/F, i, 1)
1 – 5/(1 + i) + 6/(1 + i)2 = 0 sooo
(i – 1)(i – 2) = 0  i = 100% or 200%
 Which one to choose?
• There is no easy criterion of choice.
• We can use several alternative IRR methods, but they have some limitations.

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 Ex 2-4. Multiple IRRs
 Consider the following cash flows. 60
19 20
10

0 1 2 3 4 5

50 50
2 I RR Rn
th
canter
Y up

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Ex 2-5. One positive IRR

 Consider the following cash flow. How many IRRs exist?

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 Ex 2-6. Two positive IRRs
 Consider the following cash flow. How many IRRs exist?

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2.3. Why multiple solutions?

 Multiple IRRs may exist if there are multiple changes in signs of the cash
flow.
• Simple investment (one change in sign) leads to a single IRR.
• Non-simple investment (multiple changes in sign) may produce multiple IRRs.
• Non-simple investment implies that there are both loans and investments.
 How to handle multiple IRRs?
• Different approaches exist which guarantees a single rate of return.
• External rate of return (ERR): “Excess” cash is assumed to earn a certain interest.
• Modified IRR (MIRR): Consider two interest rates for investment and financing.
 For non-simple investments, you better use PW or AW approach.

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 3. Benefit-cost ratio analysis
 For the PW/AW approach, an option is acceptable at a given MARR,
provided that
PW(B) – PW(C)  0 or AW(B) – AW(C)  0
 These conditions could be stated as a ratio of benefits to costs.
Benefit-cost ratio (B/C) = PW(B)/PW(C) = AW(B)/AW(C)
• B/C of a project should be at least larger than 1 to be acceptable.
• The fundamental idea of the benefit-cost ratio is the same as PW or AW.
• This approach is commonly used by the public sector.
 For mutually exclusive projects, we should also use the incremental
approach of the B/C ratio.
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Ex 3-1. Benefit cost ratio (1)

 A firm is trying to decide which of the two devices to install. Both
devices have useful lives of 5 years and no salvage value.
• Device A costs $1,000 and can be expected to result in $300 savings annually.
• Device B costs $1,350 and will provide cost savings of $300 the first year, with an
annual increase of $50 from the 2nd year.
 With interest at 7%, which device should the firm purchase? Use the
benefit-cost ratio approach.

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 Ex 3-1. Benefit cost ratio (2)

YuscTTemental
analysis cometJet
L we the highest
one
BIC A 300 PIA71,571000 1.23
BK B 300 PIA 7 5 so PIG71,5 1350 1 19

BK B A 50 PIG71,5 350 1.092 I

FinalAne
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Ex 3-2. Benefit cost ratio (1)

 The six mutually exclusive alternatives have 20-year useful lives and no
salvage value. If MARR is 6%, which alternative should be selected?
A B C D E F
Cost $4,000 $2,000 $6,000 $1,000 $9,000 $10,000

x
PW(benefit) 7,330 4,700 8,730 1,340 9,000 9,500

beg
B/C 1.83 2.35 1.46 1.34 1.00 0.95

B D 4700 13407 2000 1000 3 36 7 1

a a
C A 730 7330 6000 4000 0.7 I the final answer
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 Ex 3-2. Benefit cost ratio (2)

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Ex 3-2. Benefit cost ratio (3)

• The shaded area is where B/C < 1 (for example, option F).
• Starting with D, the slope of each increment is considered.

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 3.1. Public sector benefit-cost ratio
 The benefit-cost analysis is commonly used by public sectors.
• The public sector takes a broad viewpoint and considers who pay the costs and
who receive the benefits (of, say, highways, power plants, water management).
• Numerator (benefit): All consequences to the users or the public (benefit as
positive and cost as negative).
• Denominator (cost): All consequences to the sponsor or government (cost as
positive and benefit as negative).
 Is “congestion in traffic” cost or benefit?
• The public suffers from congestion, so it is a negative benefit to the public.
 What about “reduced maintenance cost” of a bridge?
• It is a negative cost to the government.
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Ex 3-3. Government B/C ratio

 A government official recommended a new traffic system to reduce
congestion.
• The traffic system is estimated to cost $1.5 million.
• The annual maintenance cost of the system is $8,000.
• Citizen will save $50,000 per year due to reduced travel time.
• Additional annual saving from reduced accidents is $175,000.
• The expected life of the system is 10 years, and MARR is 5%.
 What is the benefit-cost ratio of this new system?

175000 50000 Proceed

BC 1.11 1 2
1 5M AIP51,107 8000
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 Ex 3-4. Government B/C ratio (1)
 The City of Waterloo plans to increase its airport capacity. It can build a
new airport in the suburb, or upgrade the current one. Assuming 10%
MARR and a 10-year time horizon for this project, which option should
be accepted? Use the benefit-cost ratio approach.
Belt13107
BCB A (new airport) B (upgrading)
27PIA10
201911,101 MImproved service/year $55 million $28 million
1010
151pA
Increased travel cost/year $15 million 0
0115 Cost of highway improvements $50 million $10 million Buidatfort

271 Construction costs $150 million $115 million

1.31
Reduced value of houses 0 $25 million
noise
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nowhere

Ex 3-4. Government B/C ratio (2)

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 4.1. Sensitivity analysis
 Sensitivity analysis
• Sometimes, one or more parameters are undetermined, and we can compute
the effect of different parameter values.
• For undetermined MARR, we calculate the project’s PW as a function of the
unknown MARR.
 Example: Consider the following alternatives.
Brass Steel Titanium
Initial cost $100,000 $175,000 $300,000
Service life 4 10 25
• The firm is uncertain about the interest rate (or MARR). Determine the best
alternative at each interest rate with a graph.

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Ex. 4-1. Sensitivity analysis

• 0%  MARR  6.3%  Choose Titanium

• 6.3%  MARR  15.3%  Choose Steel
• 15.3%  MARR  Choose Brass

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 4.2. Breakeven analysis
 The process of varying a parameter and determining the values that
achieves a certain “threshold” or “break-even” value.
• If you invest in a new project, how high the sales must be so that you break even?
• Or, at what level of MARR does the PW or AW become zero?
 Example: Consider a project that may be constructed to full capacity
now with a cost of $140,000, or may be constructed in two stages (with
$100,000 now and $120,000 n years from now).
• All facilities will last for 40 years with zero salvage value.
• The annual operation and maintenance cost is the same.
• Assume an 8% interest rate.
 Mark the breakeven point on the sensitivity graph.
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Ex. 4-2. Breakeven analysis

• Construction of full capacity now: PW (cost) = 140,000
• Two-stage construction: PW (cost) = 100,000 + 120,000(P/F, 8%, n)
n=5 PW = 100,000 + 120,000(0.6806) = $181,700
n = 10 PW = 100,000 + 120,000(0.4632) = $155,600
n = 20 PW = 100,000 + 120,000(0.2145) = $125,700

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 it
4.3. Payback period
 Payback period: It measures the speed of the return
• Payback period = Cost/Annual benefit
• However, it is not a suitable approach, because it ignores the effect of timing
(i.e., interest rate) and other information.
 Ex 4-1. A firm is trying to decide which of two scales it should install. If
both scales have a 6-year life, which one should be selected given an
8% interest rate. Use the payback period approach.
Alternative Cost Annual benefit Salvage value

Atlas scale $2,000 $450 $100

Tom Thumb scale $3,000 $600 $700

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Ex 4-3. Payback period

 Payback period
• Atlas scale = 2,000/450 = 4.4 years
• Tom Thumb scale = 3,000/600 = 5 years

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 Summary of Lecture 05
 Definition and calculation of IRR
• Incremental analysis
• Multiple IRRs
 Benefit cost ratio
 Payback period

 Selective end-of-chapter problems

• Newnan Ch7: 5, 9, 13, 15, 20, 21, 36(a), 42, 43, 57, 60, 109
• Newnan Ch8: 4, 9, 13, 20, 29, 36

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