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Introduction
Capital projects should consider return on the capital that is sufficiently attractive in view of the risks involved and potential alternative uses. We will discuss 5 methods for evaluating the economic profitability of a project:
Present worth (PW) Future worth (FW) Annual worth (AW) Internal Rate of Return (IRR) External Rate of Return (ERR)
1. 2. 3. 4. 5.
Convert cash flows into equivalent worth at some point (s) in time using an interest rate known as Minimum Attractive rate of Return (MARR)
The basic question to be addressed: is the proposed capital investment and its associated expenditures (cash out flow) can be recovered by revenue (savings) over time (cash in flow) in addition to a return on the capital (rate of return ~ MARR) that is sufficiently attractive in view of the risk involved.
An interest rate used to convert cash flows into equivalent worth at some point(s) in time Usually a policy issue based on:
- amount, source and cost of money available for investment - number and purpose of good projects available for investment - amount of perceived risk of investment opportunities and estimated cost of administering projects over short and long run - type of organization involved
CAPITAL RATIONING
Establishing MARR involves opportunity cost viewpoint results from phenomena of CAPITAL
RATIONING
Exists when management decides to restrict the total amount of capital invested, by desire or limit of available capital Select only those projects which provide annual rate of return in excess of MARR As amount of investment capital and opportunities available change over time, a firms MARR will also change
See slide
Discount future amounts to the present by using the interest rate over the appropriate study period
-k PW = k F ( 1 + i ) =0 k
N
i = effective interest rate, or MARR per compounding period k = index for each compounding period Fk = future cash flow at the end of period k N = number of compounding periods in study period interest rate is assumed constant through project The higher the interest rate and further into future a cash flow occurs, the lower its PW
i = effective interest rate k = index for each compounding period Fk = future cash flow at the end of period k N = number of compounding periods in study period
A piece of new equipment has been proposed by engineers to increase the productivity of a certain manual welding operation. The investment cost $25,000, and the equipment will have a salvage value $5,000 at the end of a five year study period. Increased productivity attributable to this equipment will amount to $8,000 per year after extra operating costs have been subtracted from the revenue generated by the additional production. The firm MARR is 20% per year.
a) Draw the cash flow diagram b) Determine the equivalent present worth (PW)
CAPITAL RECOVERY ( CR )
CR is the equivalent uniform annual cost of the capital invested CR is an annual amount that covers:
Loss in value of the asset Interest on invested capital ( i.e., at the MARR )
CR ( i % ) = I ( A / P, i %, N ) - S ( A / F, i %, N ) I = initial investment for the project S = salvage ( market ) value at the end of the study period N = project study period
Consider a machine that cost $10,000, last for five years, and have a salvage (market) value $2,000. Thus, the loss in value of this asset over five years is $8,000. Additionally, the MARR is 10% per year. Thus
CR (i%)=I(A/P,i%,N) S(A/F,i%,N)
Solution:
CR (10%) = $10,000(A/P,10%,5) - $2,000(A/F,10%,5) = $10,000 (0.2638) - $2,000 (0.1638) = $2,310.40
Problem 4.19a
A certain service can be performed satisfactorily by process X, which has a capital investment cost of $8,000, an estimated life of 10 years, no salvage value, an annual net receipts (revenue expenses) of $2,400. Assuming a MARR of 18% before income taxes, find the AW of this process and specify whether you would recommend it.
Solution: AW (i%) = R - E CR (i%) AW (18%) = $2,400 [$8,000(A/P,18%,10) - $0(A/F,18%,10)] = $2,400 [$1,780 - $0] = $620 Conclusion: because AW (18%) is positive, the process X is recommended.
INTERNAL RATE OF RETURN METHOD ( IRR ) IRR solves for the interest rate that equates the equivalent worth of an alternatives cash inflows (receipts or savings) to the equivalent worth of cash outflows (expenditures) Also referred to as:
investors method discounted cash flow method profitability index
INTERNAL RATE OF RETURN METHOD ( IRR ) IRR is i %, using the following PW formula:
k=0
R k ( P / F, i %, k ) = E k ( P / F, i %, k )
k=0
R k = net revenues or savings for the kth year E k = net expenditures including investment costs for the kth year N = project life ( or study period ) If i > MARR, the alternative is acceptable To compute IRR for alternative, set net PW = 0
PW = R k ( P / F, i %, k ) - E k ( P / F, i %, k ) = 0 k=0 k=0 i is calculated on the beginning-of-year unrecovered investment through the life of a project (slide)
N N
DISADVANTAGES OF IRR
The IRR method assumes recovered funds, if not consumed each time period, are reinvested at i %, rather than at MARR The computation of IRR may be unmanageable Multiple IRRs may be calculated for the same problem The IRR method must be carefully applied and interpreted in the analysis of two or more alternatives, where only one is acceptable Basic IRR method cannot rank mutually exclusive projects, the project with higher IRR potentially having lower net present value . . . inconsistent ranking.
ADVANTAGES OF IRR
IRR can be calculated without having to estimate cost of capital or MARR IRR, in the form of rate of return is more appealing to evaluate investment IRR is more appealing to communicate profitability When unique (not multiple IRRs), it provides valuable information about the return on the investment and is often viewed as a measure of efficiency
50
rate of return (%)
0
0 8 16 26 36 45 54 64 74 84 94 104 114 124 134 144
-50
PW ($)
154
If the number of real IRRs which is greater than the MARR is: Even (including zero), reject the project; Odd, accept the project.
Referring to the earlier chart of PW vs. rate of return
If 30% < MARR < 60%, there is one real IRR (60%) that is greater than MARR; therefore the project should be accepted. Then we identify the relevant IRR as 60%. If MARR < 30%, there are two real IRRs (both 30% and 60%) that are greater than MARR. Hence, the project should be rejected.
If MARR > 60%, there is no real IRR that is greater than MARR; therefore the project should be rejected.
D Zhang (2005), Engineering Economist, Vol. 50, Issue 4, pp 237-335
Problem 4.4 b
Determine the IRR of the following engineering project when the MARR is 15% per year.
Investment cost Expected life Salvage value Annual receipts Annual expenses $10,000 5 years -$ 1,000 $ 8,000 $ 4,000
Solution: PW = 0 = -$10,000 $1,000(P/F,i%,5) + (8,000-$4,000)(P/A,i%,5) By trial and error process, at i = 20%, PW = $1560.50 at i = 25%, PW = $ 429.50
B linear extrapolation, i = 27%, hence the project is acceptable; > MARR
A piece of new equipment has been proposed by engineers to increase the productivity of a certain manual welding operation. The investment cost $25,000, and the equipment will have a market value $5,000 at the end of a study period of five years. Increased productivity attributable to this equipment will amount to $8,000 per year after extra operating costs have been subtracted from the revenue generated by the additional production. If the firm MARR is 20% per year, is this proposal a sound one? Use the IRR method. Solution: PW = 0 = -$25,000 + $8,000(P/A,i%,5) + $5,000(P/F,i%,5) By trial and error process, at i = 20%, PW = $ 934.30 at i = 25%, PW = -$1847.10 By linear interpolation, i = 22 %.
Therefore, the project is acceptable (i% > MARR)
Solution: Set FW = 0 FW = 0 = -$126,000 (F/P,i%,8) + ($88,000 - 49,000) (F/A,i%,8) + $33,000 By trial and error process, at i = 25%, FW = -$55,811 at i = 30%, FW = $64,370 By linear interpolation, i = 27.3%
ERR directly takes into account the interest rate ( ) external to a project at which net cash flows generated over the project life can be reinvested (or borrowed ). If the external reinvestment rate, usually the firms MARR, equals the IRR, then ERR method produces same results as IRR method
Rk ( F / P, %, N - k ) k=
0 receipts over expenses in period k Rk = excess of Ek = excess of expenses over receipts in period k N = project life or period of study
i %= ? Time
k = 0k
R ( F / P, %, N - k )
k=0
Ek ( P / F, %, k )( F / P, i %, N )
ERR ADVANTAGES
ERR has two advantages over IRR: 1. It can usually be solved for directly, rather than by trial and error. 2. It is not subject to multiple rates of return.
(see slide Problem 4.38)
A piece of new equipment has been proposed by engineers to increase the productivity of a certain manual welding operation. The investment cost $25,000, and the equipment will have a market value $5,000 at the end of a study period of five years. Increased productivity attributable to this equipment will amount to $8,000 per year after extra operating costs have been subtracted from the revenue generated by the additional production. If the external investment rate = MARR = 20% per year, what is the alternatives ERR, and is this proposal a sound one?
Solution:
$25,000(F/P,i%,5) = $8,000(F/A,20%,5) + $5,000 (F/P,i%,5) = $64,532.80/$25,000 = 2.5813 i = 20.88% Since i > MARR, the alternative is minimally justified.
Problem 4.32
Summary of the projected costs and annual receipts for a new product line is presented as follows: End of Year Net Cash Flow 0 - $450,000 1 - 42,500 2 92,800 3 386,000 4 614,600 5 - 202,200 The companys external reinvestment rate per year = MARR = 10% per year Solution: [$450,000 + $42,500(P/F,10%,1) + $202,200(P/F,10%,5)](F/P,i%,5) = $92,800(F/P,10%,3) + $386,000(F/P,10%,2) + $614,600(F/P,10%,1) $614,182.73(F/P,i%,5) = $1,265,544 (F/P,i%,5) = 2.0622 By interpolation, i% , ERR = 15.6%
Problem 4.34
Given a cash flow as stated below: End of Year Net Cash Flow 0 - $10,000 17 1,400 7 10,000 The external rate of reinvestment for the company = 8% per year. Solution: $10,000(F/P.i%,7) = $1,400(F/A,8%,7) + $10,000 (F/P,i%,7) = $22,491.92 / 10,000 = 2.2492 By interpolation, ERR = i% = 12.3%
Problem 4.48:
A certain project has a net receipts equaling $1,000 now, has costs of $5,000 at the end of the first year, and earns $6,000 at the end of the second year. If the external reinvestment rate of 10% is available, what is the rate of return for this project using the ERR method ? Solution:
$5,000(P/F,10%,1)(F/P,i%,2) = $1,000(F/P,10%,2) + $6,000 (F/P,i%,2) = $7,210 / $4,545.50 = 1.5862 By interpolation, ERR = i% = 25.9%
Sometimes referred to as simple payout method Indicates liquidity (riskiness) rather than profitability Calculates smallest number of years ( ) needed for cash inflows to equal cash outflows -- break-even life ignores the time value of money and all cash flows which occur after If is calculated to include some fraction of a year, it is rounded to the next highest year
k=1
( Rk -Ek) - I > 0
EOY 0 1 2 3 4 5
The payback period is at 4th years, because the cumulative balance turns positive at EOY 4
[time value of money is not considered]
The payback period is at 5th year, because the cumulative discounted balance turns positive at EOY 5
[time value of money is considered]
INVESTMENT-BALANCE DIAGRAM
Describes how much money is tied up in a project and how the recovery of funds behaves over its estimated life.
Initial investment =P 0 1 2 3
1 + i
(RN - EN)
$0
downward arrows represent annual returns (Rk - Ek) : 1 < k < N dashed lines represent opportunity cost of interest, or interest on BOY investment balance IRR is value i that causes unrecovered investment balance to equal 0 at the end of the investment period.
Investment Balance, $
5,000
MARR = 5%
$2,001 ( = FW )
Years
0 1 2 3 4 - $2,199 - $2,310 - $2,310 - $2,310 - $6,604 - $8,600 - $4,509 5
+ $4,310
- 5,000
- $2,310
- $2,310
- 10,000 -$10,500
Investment Balance, $
MARR = 10%
+$550
$3505 ( = FW )
+ $500
-$1,000
+ $4,000 3 -$495
0 1 2
-$450
End of year
+$6,000
1.10
- $5,000 -$5,500