The Internal Rate

of Return Method

• This method solves for the interest rate that

equates the equivalent worth of an
alternative’s cash inflows (receipts or
savings) to the equivalent worth of cash
outflows (expenditures, including
investment costs).

24
The Internal Rate
of Return Method
IRR Decision
Rule: If IRR ≥
MARR, the
project is
economically
justified.

25
 Practice Solving
The Internal Rate of
Return Method
AMT, Inc., is considering the purchase of a digital camera for the maintenance of design specifications
by feeding digital pictures directly into an engineering workstation where computer-aided design files
can be superimposed over the digital pictures. Differences between the two images can be noted, and
corrections, as appropriate, can then be made by design engineers. The capital investment
requirement is $345,000 and the estimated market value of the system after a six-year study period is
$115,000. Annual revenues attributable to the new camera system will be $120,000, whereas
additional annual expenses will be $22,000. You have been asked by management to determine the
IRR of this project and to make a recommendation. The corporation’s MARR is 20% per year.
26
 Practice Solving
The Internal Rate of
Return Method
𝐴𝑠𝑠𝑢𝑚𝑒 𝑡ℎ𝑎𝑡: 𝑖 ′ % = 𝑀𝐴𝑅𝑅 = 20%
𝑃𝑊 20% = −$345, 000 + $115, 000 𝑃/𝐹, 20 %, 6 + $120, 000 𝑃/𝐴, 20%, 6 − $22, 000(𝑃/𝐴, 20%, 6)
𝑃𝑊 20% = −$345, 000 + $115, 000(0.3349) + $120, 000 3.3255 − $22, 000(3.325)
𝑃𝑊 20% = +$19, 412.5

𝐴𝑠𝑠𝑢𝑚𝑒 𝑡ℎ𝑎𝑡: 𝑖 ′ % = 25%

𝑃𝑊 25% = −$345, 000 + $115, 000 𝑃/𝐹, 25 %, 6 + $120, 000 𝑃/𝐴, 25%, 6 − $22, 000(𝑃/𝐴, 25%, 6)
𝑃𝑊 25% = −$345, 000 + $115, 000(0.2621) + $120, 000 2.9514 − $22, 000(2.9514)
𝑃𝑊 25% = −$25, 621.3

𝑾𝒆 𝒌𝒏𝒐𝒘 𝒕𝒉𝒂𝒕 𝟐𝟎% ≤ 𝒊′% ≤ 𝟐𝟓%

27
 Practice Solving
The Internal Rate of
Return Method
𝐼𝑛𝑡𝑒𝑟𝑝𝑜𝑙𝑎𝑡𝑒 𝑢𝑠𝑖𝑛𝑔 𝑡ℎ𝑒 𝑖𝑑𝑒𝑎 𝑜𝑓 𝑠𝑖𝑚𝑖𝑙𝑎𝑟 𝑡𝑟𝑖𝑎𝑛𝑔𝑙𝑒𝑠:
𝑃𝑜𝑖𝑛𝑡𝑠: 𝐴 = 20%, $19,412.5 ,
𝐶 = 25%, −$25,621.3 , 𝑒 = (𝑖 ′ %, 0)

𝑙𝑖𝑛𝑒 𝐵𝐴 𝑙𝑖𝑛𝑒 𝑑𝐴
=
𝑙𝑖𝑛𝑒 𝐵𝐶 𝑙𝑖𝑛𝑒 𝑑𝑒
25% − 20% 𝑖 ′ % − 20%
=
$19,412.5 − (−$25,621.3) $19,412.5 − 0
25% − 20% 𝑖 ′ % − 20%
=
$19,412.5 − (−$25,621.3) $19,412.5 − 0

𝒊′ ≈ 𝟐𝟐. 𝟏𝟔% 28
 The External Rate
of Return Method

• It directly takes into account the interest rate

(∈) external to a project at which net cash
flows generated (or required) by the project
over its life can be reinvested (or borrowed).
If this external reinvestment rate, which is
usually the firm’s MARR, happens to equal
the project’s IRR, then the ERR method
produces results identical to those of the IRR
method.
29
The External Rate
of Return Method

𝑬𝒙𝒑𝒆𝒏𝒔𝒆𝒔 = 𝑹𝒆𝒗𝒆𝒏𝒖𝒆𝒔

30
 The External Rate
of Return Method
ERR Decision
The ERR method has two basic advantages Rule: If ERR ≥
over the IRR method: MARR, the
project is
• It can usually be solved for directly, without economically
justified.
needing to resort to trial and error.
• It is not subject to the possibility of multiple
rates of return.

31
 Practice Solving
The External Rate of
Return Method
A piece of new equipment has been proposed by engineers to increase the productivity of a certain
manual welding operation. The investment cost is $25,000, and the equipment will have a market
(salvage) value of $5,000 at the end of its expected life of five years. Increased productivity attributable
to the equipment will amount to $8,000 per year after extra operating costs have been subtracted from
the value of the additional production. Recall that the MARR is 20% per year and suppose that ∈ =
MARR. What is the project’s ERR, and is the project acceptable?

32
 Practice Solving
The External Rate of
Return Method
𝑼𝒔𝒊𝒏𝒈 𝒇𝒖𝒕𝒖𝒓𝒆 𝒄𝒐𝒎𝒑𝒐𝒖𝒅𝒊𝒏𝒈:

𝐸 𝐹/𝑃, 𝑖 ′ %, 𝑁 = 𝑅 𝐹/𝐴, ∈ %, 𝑁 + 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

$25, 000 𝐹/𝑃, 𝑖 ′ %, 5 = $8, 000 𝐹/𝐴, 20%, 5 + $5, 000

$25, 000 𝐹/𝑃, 𝑖 ′ %, 5 = $8, 000 (7.4416) + $5, 000

𝒊′ = 𝟐𝟎. 𝟖𝟖%

𝑺𝒊𝒏𝒄𝒆 𝒊′ > 𝑴𝑨𝑹𝑹, the project is justified, but just barely.

33
 The Payback
Method

• The payback method, which is often called

the simple payout method, mainly indicates a
project’s liquidity rather than its profitability.

34
 The Payback
Method
Historically, the payback method has been
used as a measure of a project’s riskiness,
since liquidity deals with how fast an
investment can be recovered.

The payback method calculates the number of

years required for cash inflows to just equal
cash outflows.
35
The Payback
Method
The simple payback
period is the smallest value of θ(θ
≤ N).

The discounted payback period, θ

‘(θ’ ≤ N), is calculated so that the
time value of money is
considered.

36
 Practice Solving

The Payback Method

A public school is being renovated for $13.5 million. The building has geothermal heating and cooling,
high-efficiency windows, and a solar array that permits the school to sell electricity back to the local
electric utility. The annual value of these benefits is estimated to be $2.7 million. In addition, the
residual value of the school at the end of its 40-year life is negligible. What is the simple payback period
and internal rate of return for the renovated school?

37
 Practice Solving

The Payback Method

𝐶𝑜𝑠𝑡 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝑥 𝑁 𝑃𝑊 = (𝑅𝑒𝑣𝑒𝑛𝑢𝑒 + 𝑆𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒) − 𝐶𝑜𝑠𝑡

𝐶𝑜𝑠𝑡 0 = $2,700,000 𝑃/𝐴, 𝑖%, 40 − $13, 500,000
𝑁= $13, 500,000 = $2,700,000 𝑃/𝐴, 𝑖%, 40
𝑅𝑒𝑣𝑒𝑛𝑢𝑒
$13, 500, 000 𝒊 = 𝟏𝟗. 𝟗𝟗% ≈ 𝟐𝟎%
𝑁=
$2, 700,000
𝑁 = 5 𝑦𝑒𝑎𝑟𝑠

38
Basic Concepts for Comparing Alternatives
 Comparison and Selection
among Alternatives

Principle 2 (focus on the differences)

𝑅𝑎𝑡𝑒 𝑜𝑓 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛
• The alternative that requires the minimum 𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
investment of capital and produces satisfactory =
𝐴𝑛𝑛𝑢𝑎𝑙 𝑛𝑒𝑡 𝑠𝑎𝑣𝑖𝑛𝑔𝑠
𝑎𝑑𝑑𝑖𝑡𝑖𝑜𝑛𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
functional results will be chosen unless the
incremental capital associated with an alternative
having a larger investment can be justified with
respect to its incremental benefits.

40
 Comparison and Selection
among Alternatives

Rule 1: When revenues and other economic benefits are

present and vary among the alternatives, choose the
alternative that maximizes overall profitability.

Rule 2: When revenues and other economic benefits are

not present or are constant among the alternatives,
consider only the costs and select the alternative that
minimizes total cost.

41
 1. The Study (Analysis)
Period

The repeatability assumption involves two main

conditions:
1. The study period over which the alternatives are
being compared is either indefinitely long or equal to a
common multiple of the lives of the alternatives.
2. The economic consequences that are estimated to
happen in an alternative’s initial useful life span will also
happen in all succeeding life spans (replacements).

42
 1. The Study (Analysis)
Period

The coterminated assumption uses a finite and

identical study period for all alternatives. This
planning horizon, combined with appropriate
adjustments to the estimated cash flows, puts the
alternatives on a common and comparable basis.

43
 1. The Study (Analysis)
Period

The study (analysis) period, sometimes called the

planning horizon, is the selected time period over
which mutually exclusive alternatives are
compared. The key point is that the selected study
period must be appropriate for the decision
situation under investigation.

44
 2. Useful Lives Are Equal
to the Study Period

The most straightforward technique for comparing mutually

exclusive alternatives when all useful lives are equal to the
study period is to determine the equivalent worth of each
alternative based on total investment at i = MARR. Then, for
investment alternatives, the one with the greatest positive
equivalent worth is selected. And, in the case of cost
alternatives, the one with the least negative equivalent worth
is selected.

45
 Practice Solving
Useful Lives Are Equal to
the Study Period
Best Flight, Inc., is considering three mutually
exclusive alternatives for implementing an automated
passenger check-in counter at its hub airport. Each
alternative meets the same service requirements, but
differences in capital investment amounts and
benefits (cost savings) exist among them. The study
period is 10 years, and the useful lives of all three
alternatives are also 10 years. Market values of all
alternatives are assumed to be zero at the end of
their useful lives. If the airline’s MARR is 10% per
year, which alternative should be selected in view of
the cash-flow diagrams shown?
46
 Practice Solving
Useful Lives Are Equal
to the Study Period
𝑆𝑜𝑙𝑢𝑡𝑖𝑜𝑛 𝑢𝑠𝑖𝑛𝑔 𝑃𝑟𝑒𝑠𝑒𝑛𝑡 𝑊𝑜𝑟𝑡ℎ:
𝑃𝑊 (𝑖%) = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒𝑠 − 𝐶𝑜𝑠𝑡𝑠

𝑃𝑊 (10%)𝐴 = $69, 000 𝑃/𝐴, 10%, 10 − $390,000 = $33, 977.40

𝑃𝑊 (10%)𝐵 = $167, 000 𝑃/𝐴, 10%, 10 − $920,000 = $106, 149.20
𝑃𝑊 (10%)𝐶 = $133, 500 𝑃/𝐴, 10%, 10 − $660,000 = $160, 304.10

𝑩𝒂𝒔𝒆𝒅 𝒐𝒏 𝒕𝒉𝒆 𝑷𝑾 𝒎𝒆𝒕𝒉𝒐𝒅, 𝑨𝒍𝒕𝒆𝒓𝒏𝒂𝒕𝒊𝒗𝒆 𝑪 𝒘𝒐𝒖𝒍𝒅 𝒃𝒆 𝒔𝒆𝒍𝒆𝒄𝒕𝒆𝒅

𝒃𝒆𝒄𝒂𝒖𝒔𝒆 𝒊𝒕 𝒉𝒂𝒔 𝒕𝒉𝒆 𝒍𝒂𝒓𝒈𝒆𝒔𝒕 𝑷𝑾.
47
 3. Useful Lives Are
Unequal among the
Alternatives

This assumes that the economic estimates for an alternative’s

initial useful life cycle will be repeated in all subsequent
replacement cycles. If the repeatability assumption is not
applicable to a decision situation, then an appropriate study
period needs to be selected (coterminated assumption).

❖ Useful life < Study period

• Cost alternatives
• Investment alternatives
❖ Useful life > Study period
48
 Practice Solving
Useful Lives Are Unequal
among the Alternatives
The following data have been estimated for two mutually
exclusive investment alternatives, A and B, associated
with a small engineering project for which revenues as
well as expenses are involved. They have useful lives of
four and six years, respectively. If MARR = 10% per year,
show which alternative is more desirable by using
equivalent-worth methods and use the repeatability
assumption.
49
 Practice Solving
Useful Lives Are Unequal
among the Alternatives

50
 Practice Solving
Useful Lives Are Unequal
among the Alternatives
LCM of 4 and 6 is 12 years. It will be used as the study period

Alternative A will have 3 cycles: 1 investment cycle and 2 reinvestment cycles

Using PW Method:
𝑃𝑊 (10%)𝐴 = $1,225 𝑃/𝐴, 10%, 12 − $3,500 − $3,500 𝑃/𝐹, 10%, 4 − $3,500(𝑃/𝐹, 10%, 8)

𝑃𝑊 (10%)𝐴 = $1,225(6.1836) − $3,500 − $3,500(0.6830) − $3,500(0.4665)

𝑃𝑊 (10%)𝐴 = $1,027.82

51
 Practice Solving
Useful Lives Are Unequal
among the Alternatives
LCM of 4 and 6 is 12 years. It will be used as the study period

Alternative B will have 2 cycles: 1 investment cycle and 1 reinvestment cycle

𝑃𝑊 (10%)𝐵 = $1,480 𝑃/𝐴, 10%, 12 − $5,000 − $5000 𝑃/𝐹, 10%, 6
𝑃𝑊 (10%)𝐵 = $1,480(6.1836) − $5,000 − $5,000(0.5645)
𝑃𝑊 (10%)𝐵 = $2, 261.63

𝑩𝒂𝒔𝒆𝒅 𝒐𝒏 𝒕𝒉𝒆 𝑷𝑾 𝒎𝒆𝒕𝒉𝒐𝒅, 𝒘𝒆 𝒘𝒐𝒖𝒍𝒅 𝒔𝒆𝒍𝒆𝒄𝒕 𝑨𝒍𝒕𝒆𝒓𝒏𝒂𝒕𝒊𝒗𝒆 𝑩.

𝑻𝒓𝒚 𝒔𝒐𝒍𝒗𝒊𝒏𝒈 𝒕𝒉𝒆 𝒔𝒂𝒎𝒆 𝒑𝒓𝒐𝒃𝒍𝒆𝒏 𝒔𝒖𝒊𝒏𝒈 𝑨𝑾 𝒂𝒏𝒅 𝑭𝑾.
52
 Practice Solving
Useful Lives Are Unequal
among the Alternatives
Suppose that the previous example is modified such that
an analysis period of six years is used (coterminated
assumption) instead of 12 years, which was based on
repeatability and the least common multiple of the useful
lives. Perhaps the responsible manager did not agree
with the repeatability assumption and wanted a six-year
analysis period because it is the planning horizon used in
the company for small investment projects.

53
 Practice Solving
Useful Lives Are Unequal
among the Alternatives

54
 Practice Solving
Useful Lives Are Unequal
among the Alternatives
Suppose that the previous example is modified such that
an analysis period of six years is used (coterminated
assumption) instead of 12 years, which was based on
repeatability and the least common multiple of the useful
lives. Perhaps the responsible manager did not agree
with the repeatability assumption and wanted a six-year
analysis period because it is the planning horizon used in
the company for small investment projects.

55
 Practice Solving
Useful Lives Are Unequal
among the Alternatives

Using FW Method:

𝐹𝑊 (10%)𝐴 = $1255 𝐹/𝐴, 10%, 4 𝐹/𝑃, 10%, 2 − $3,500(𝐹/𝑃, 10%, 4)

𝐹𝑊 (10%)𝐴 = $1255(4.641) 1.21 − $3,500(1.7716)
𝐹𝑊 (10%)𝐴 = $847.13

𝐹𝑊 (10%)𝐵 = $1480 𝐹/𝐴, 10%, 6 − $5,000(𝐹/𝑃, 10%, 6)

𝐹𝑊 (10%)𝐵 = $1480(7.7156) − $5,000(1.7716)
𝑭𝑾 (𝟏𝟎%)𝑩 = $𝟐, 𝟓𝟔𝟏. 𝟎𝟏 − 𝑪𝒉𝒐𝒐𝒔𝒆 𝒕𝒉𝒊𝒔 𝒂𝒍𝒕𝒆𝒓𝒏𝒂𝒕𝒊𝒗𝒆
56
End.
ANY OTHER QUESTIONS?

57