Comparing Investments and

Rate of Return Analysis

Class 8-10
 Present Worth Comparisons

1.Convert future expenditures of alternatives

into equivalent rupees NOW

2.Compare the Present Worth’s

 Comparing Equal-Lived
Alternatives
• Which would you buy? i=10%
Machine A Machine B

First Cost Rs. 2500 Rs. 3500

Annual Operating 900 700

Cost
Salvage Value 200 350

Life 5 years 5 years

 Comparison
• Machine A
– PWA = 2500 + 900x(P/A,10%,5) – 200(P/F,
10%,5)
– PA = Rs. 5788
• Machine B
– PWB = 3500 + 700x(P/A,10%,5) – 350(P/F,
10%,5)
– PB = Rs. 5936
• Select Machine A
 What if Lives are different?
• Which would you buy? i=15%
Machine A Machine B

First Cost Rs. 11,000 Rs. 18,000

Annual Operating Rs. 3,500 Rs. 3,100

Cost
Salvage Value Rs. 1,000 Rs. 2,000

Life 6 years 9 years

Option 1: Least Cost Multiple of Years

• Evaluate both machines over an 18 year

period
• Machine A will be bought 3 times and
Machine B will be bought 2 times
• Find the Present Worth of both of these
strategies
 Machine A
PWA=?

1,000 1,000 1,000

1 2 6 12 18

3,500

11,000 11,000 11,000

•PWA = 11,000 + 11,000(P/F, 15%,6) + 11,000(P/F, 15%, 12) +

3500(P/A,15%,18) – 1000(P/F, 15%,6) – 1000(P/F, 15%,12) –
1000(P/F, 15%,18)

•PWA = Rs. 38,559

 Machine B
PWB=?

2,000 2,000
1 2 9 18

3,100

18,000 18,000

•PWB = 18,000 + 18,000(P/F, 15%,9) + 3100(P/A,15%,18) –

2000(P/F, 15%,9) – 2000(P/F, 15%,18)

•PWB = Rs. 41,384

 Limitations
• Will you use the same equipment for 18
years?

• Will costs be the same?

• What about technological change?

 Method 2: Planning Horizon
• Select a 5 year planning horizon (say).
Assume the salvage value will be the
same
• PWA = 11,000 + 3500(P/A,15%,5) –
1000(P/F, 15%,5)
– = Rs. 22,236
• PWB = 18,000 + 3100(P/A,15%,5) –
2000(P/F, 15%,5)
– = Rs. 27,937
 Capitalized Cost Calculations
• What if the life of the asset is very very large? What is its
present worth?
1. Draw Cash Flow diagrams for at least 2 cycles
2. Calculate Present Worth of Non-Recurring expenditures
3. For each cycle of recurring expenditures, find the
Equivalent Uniform Annual Worth (A) and add this to
other uniform amounts
4. Divide EUAW by ‘i’ to get the capitalized cost of the
EUAW
5. Add the values derived in Steps 2 and 4
 A closer look at P, i and A
• Over a long period of time, A=Pi
• How?
– Substitute n=∞ in A=Pi(1+i)n/[(1+i)n-1]
– A = Pi/[1-1/(1+i)n]
– If n=∞ then, A = Pi
– Or, the investment P earns an interest A,
given by the formula A=Pi
• After a very long time, the discounted value of the
original investment P, to be reclaimed at the end of
the period, is virtually 0. Hence we are left with the
annual returns A as the only cash stream
equivalent of P.
 Example
• Calculate the capitalized cost of a project
that has an initial cost of Rs. 1,50,000, and
an additional investment cost of Rs.
50,000 after 10 years. The annual
operating cost will be Rs. 5,000 for the first
4 years and Rs. 8,000 thereafter. In
addition, there will be a recurring rework
cost of Rs. 15,000 every 13 years.
Assume that i=15% per year.
 Step 1: Cash Flow for 2 cycles

1 2 13 18 23 26

5000
8000 8000

15,000 15,000
50,000

1,50,000
 Step 2
• Find the PW of non-recurring Expenditures

• P1 = 1,50,000 + 50,000(P/F, 15%, 10)

• P1 = Rs. 1,62,360
 Step 3
• Convert Recurring Payment of Rs. 15,000
every 13 years into EUAW over 13 years

• A1 = 15,000(A/F, 15%, 13)

• A1 = Rs. 437
 Step 4
• Divide the EUAW by the interest rate to
obtain capitalized cost
• Consider 2 series
– A series of Rs. 5000 + 437 for perpetuity
– A series of Rs. 3000 starting from year 5
• P2 = A/i = 5437/0.15 = Rs. 36,247
• P3 = A/i(P/F,i,4) = (3000/0.15)(P/F,15%,4)
– P3 = Rs. 11,436
 Step 5
• Add the various present worths

• PT = P1 + P2 + P3

• PT = Rs. 210,043 = Capitalized Cost of the

project
 Capitalized Cost Comparisons of
Two Alternatives
• There are two options for building a bridge. A
suspension bridge would cost Rs. 30.8 Million
with annual inspection costs of Rs. 15,000. The
deck would have to be re-surfaced at Rs. 50,000
every 10 years. A Truss bridge would cost Rs.
22.3 Million with annual maintenance costs of
Rs. 8000. The bridge must be painted every 3
years at a cost of Rs. 10,000, and sand-blasted
once every 10 years at a cost of Rs. 45,000.
Compare the alternatives based on their
capitalized costs, if i=6% per year.
 Suspension Bridge
• P1 = Rs. 30,800,000
• Annual Maintenance Cost = A1 = Rs. 15,000
• Recurring re-surfacing costs
– EUAW = 50,000(A/F,6%,10)
– A2 = Rs. 3794
• Capitalized cost of recurring costs = P2
– P2 = (A1+A2)/i = 18,794/0.06 = Rs. 313,233
• Total Capitalized Cost PSB = P1+P2
– PSB = Rs. 3,13,13,233
 Truss Bridge
• P1 = Rs. 22,300,000
• Annual Maintenance Cost = A1 = Rs. 8,000
• Recurring Painting costs
– EUAW = 10,000(A/F,6%,3)
– A2 = Rs. 3141
• Recurring Sandblasting costs
– EUAW = 45,000(A/F,6%,10)
– A3 = Rs. 3414
• Capitalized cost of recurring costs = P2
– P2 = (A1+A2+A3)/i = 14,555/0.06 = Rs. 2,42,583
• Total Capitalized Cost PTB = P1+P2
– PTB = Rs. 2,25,42,583
• Choose the Truss Bridge
Class Exercise: Which of the 2 earthmoving
options would you select at i=15%
PLAN A PLAN B

Mover Pad Conveyor

P (Rs.) 45,000 28,000 175,000

Annual Op 6,000 300 2,500

Cost (Rs.)
Salvage 5,000 2,000 10,000
Value (Rs.)
Life (Rs.) 8 years 12 years 24 years
 Alternative: EUAW Evaluation
• Instead of calculating the present value,
convert all cash flows into equivalent
uniform annual amounts.
• Compare these equivalent uniform annual
amounts to make a decision
• Advantage: Lives of the alternatives no
longer matter. Can easily compare over
different life spans
 Salvage Sinking-Fund Method
1. Convert the initial cost ‘P’ into an equivalent uniform
annual amount using the A/P (Capital Recovery) factor)
2. Convert the Salvage Value (SV) to an equivalent
uniform annual amount using the A/F (Sinking Fund)
factor.
3. Subtract the value from Step 2, from the value in Step 1
4. Add any other uniform annual costs to this value
obtained in Step 3
5. Convert any other cash flows into EUAWs and add this
to the value obtained in Step 4
6. EUAW = P(A/P,i%,n) – SV(A/F,i%,n) + A
 Example
• Calculate the EUAW of a machine that has
an initial cost of Rs. 8,000 and a salvage
value of Rs. 500 after 8 years. Annual
Operating Costs for the machine are
estimated to be Rs. 900, and an interest
rate of 20% per year is applicable.
 Cash Flow Diagram
500

1 2 8

900

8000 =
0 1 2 8

EUAW=?
 Calculations
• A1 = Annual cost of Investment
– A1 = 8000(A/P,20%,8) = Rs. 2084.88
• A2 = Annual Value of Salvage
– A2 = 500(A/F,20%,8) = Rs. 30.31
• A3 = AOC = Rs. 900
• EUAW = A1-A2+A3 = Rs. 2955 (approx)
 Compare the following using
EUAW. i=15%
Eqpt A Eqpt B
First Cost (Rs.) 26,000 36,000
Annual Maintenance Cost 800 300
(Rs.)
Annual Labour Cost (Rs.) 11,000 7,000
Extra Income Taxes (Rs.) - 2,600
Salvage Value (Rs.) 2,000 3,000
Life (years) 6 10
 Calculations
• EUAWA = 26,000(A/P,15%,6) –
2,000(A/F,15%,6) + 800 + 11,000
– EUAWA = Rs. 18,442
• EUAWB = 36,000(A/P,15%,10) –
3,000(A/F,15%,10) + 300 + 7,000 + 2600
– EUAWB = Rs. 16,925

• Choose Eqpt B since EUAWB < EUAWA

EUAW for perpetual Investments –
which will you choose? ‘I’=5%
• Two proposals for increasing the capacity of canals are
being considered. Proposal A involves dredging.
Dredging equipment and accessories cost Rs. 65,000.
The equipment will have a 10 year life with a salvage
value of Rs. 7000. Annual Operating Costs (AOC) will be
Rs. 22,000. Weed control is also to be done and the
annual cost of weed control is Rs. 12,000.
• Proposal B involves lining the canal with concrete. The
initial cost is Rs. 6,50,000. The lining is permanent but
yearly maintenance of Rs. 1000 will be required. In
addition, repairs will need to be made every 5 years at a
cost of Rs. 10,000.
 Calculations
• EUAWA = 65,000(A/P,5%,10) –
7,000(A/F,5%,10) + 22,000 + 12,000
– EUAWA = Rs. 41,861
• EUAWB
– Remember A=Pi
– EUAWB = 650,000x0.05 + 10,000(A/F,5%,5) + 1000
– EUAWB = Rs. 35,310

• Choose Eqpt B since EUAWB < EUAWA

 Class Exercise: What would you choose if you
were only looking at a 4 year horizon? i=15%

Eqpt A Eqpt B
First Cost (Rs.) 26,000 36,000
Annual Maintenance Cost 800 300
(Rs.)
Annual Labour Cost (Rs.) 11,000 7,000
Extra Income Taxes (Rs.) - 2,600
Salvage Value after 4 12,000 15,000
years (Rs.)
Life (years) 6 10
 Internal Rate of Return
• The internal rate of return (IRR) is the rate
of return paid on unpaid balance of a loan
or borrowing such that the equivalent sum
of all the cash flows becomes zero.

• IRR is always positive.

 Computing IRR
• IRR is the rate of interest at which the
present worth of disbursements is equal to
the present worth of receipts
• Compute the present worth of
disbursements PD
• Compute the present worth of receipts PR
• Set PD = PR
• Solve for ‘i’
 Alternative – use Equivalent
Uniform Annual Worth
• Compute the EUAW of disbursements
EUAWD
• Compute the EUAW of receipts EUAWR
• Set EUAWD = EUAWR
• Solve for ‘i’
• Note: Solving for ‘i’ is an iterative
procedure
 Formulating the solution
• You invest Rs. 1000 now and will get Rs.
500 back 3 years from now and Rs. 1500
five years from now. What is your IRR?
• PD=1000
• PR=500(P/F,i,3) + 1500(P/F,i,5)
• 1000=500(P/F,i,3) + 1500(P/F,i,5)
• 0 = 500(P/F,i,3) + 1500(P/F,i,5) – 1000
• Solve for i
 Tip for solving for IRR
• Convert all disbursements and receipts
into either a P, F or A value by neglecting
time value of money
• Use this figure to solve for i
• Use this value of ‘i’ as a ball park IRR to
start your iterations
 Example
• You invest Rs. 5000 now in common stock
that is expected to yield Rs. 100 per year
for 10 years and Rs. 7000 at the end of 10
years. What is the IRR?
7000
100
1 2
10

5000
 Solution
1. 5000 = 100(P/A,i,10) + 7000(P/F,i,10)
2. For a start, add up all the receipts
1. 10x100 + 7000 = 8000
3. Try 5000 = 8000(P/F,i,10)
1. (P/F,i,10) = 0.625
2. i is between 4% and 5%
3. Use i=5% in equation 1
4. Test -5000+ 100(P/A,5%,10) + 7000(P/F,5%,10)
1. = Rs. 70 (approx)
2. Too high – use a higher discount rate of 6%
5. Test -5000+ 100(P/A,6%,10) + 7000(P/F,6%,10)
1. = Rs. -355 (approx)
2. Too low
6. Interpolating between 70 and -355, we get i=5.16%
Solving the Same Using EUAW
• EUAWD=5000(A/P,i,10)
• EUAWR=100 + 7000(A/F,i,10)
• 5000(A/P,i,10)=100 + 7000(A/F,i,10)
• 0 = 100 + 7000(A/F,i,10) - 5000(A/P,i,10)
• Iteratively solving for i yields IRR=5.16%
 Points to Note
1. If there are fluctuating positive and negative
cash flows over time, there could be multiple
solutions for IRR. Pick the most reasonable
2. Organizations usually set a Minimum Attractive
Rate of Return (MARR) that they compare
IRRs to
1. Hopefully IRR>MARR
3. IRR assumes that any receipts are reinvested
at the IRR. This may not be true and receipts
may be invested at other rates. A composite
rate of return can then be calculated
 What can I do with IRR?

• Use it to evaluate multiple

alternatives!
 Why IRR? Why not PW?
1. If you are comparing 2 alternatives, one with
high investment and one without, it is likely that
the high investment alternative will always end
up with the higher PW.
2. IRR is useful in evaluating mutually
independent or unconnected alternatives
3. IRR is a good benchmark to independently
evaluate a project with to see if a project
matches of exceeds your ‘hurdle’ rate
So can we just pick the project with
the higher IRR?
• You have a bank balance of Rs. 100, a MARR of 10%
and have two options. Option A requires a Rs. 100
investment, and yields a 40% return. Option B requires a
Rs. 50 investment and yields a 50% return.
• Option B is better than A purely based on IRR
• However, what will happen to the other Rs. 50 that you
do not invest if you choose Option B?
• If you invest this at the MARR, then the overall Rate of
Return for B is
– (50x40%+50x10%)/100 = 25%
• I would rather invest in A.
 What should I do then?
• Conduct an incremental investment rate of return
analysis
• Tabulate the NET CASH FLOWS
– Differences in cash flows between two investment options (e.g.
Option 2 – Option 1)
– Do this for the least common multiple of the working lives of
each option
– This represents the “extra investment/savings” that is required
for the costlier option
• Find the IRR that would set these Net Cash Flows to
zero and compare with MARR
– If IRR>MARR, select Option 2
– If IRR<MARR, select Option 1
 Example
• Your MARR is 15% per year. Which of the
following alternatives would you select using an
IRR analysis?

Eqpt A Eqpt B
First Cost (Rs.) 8000 13,000
Annual Op Cost 3500 1600
Salvage Value 0 2000
Life (Years) 10 5
 Procedure
1. Let the option requiring the larger initial
investment be Option 2
2. Prepare a Net Cash Flow Tabulation for
Option 2 – Option 1
3. Draw a Net Cash Flow Diagram
4. Find the IRR that sets these Net Cash
Flows to 0
5. Compare this IRR with MARR = 15%
Net Cash Flow Table
Year Eqpt A Eqpt B Difference (B-
A)
0 -8000 -13000 -5000
1 -3500 -1600 1900
2 -3500 -1600 1900
3 -3500 -1600 1900
4 -3500 -1600 1900
5 -3500 -1600+2000- 1900-11000
13000
6 -3500 -1600 1900
7 -3500 -1600 1900
8 -3500 -1600 1900
9 -3500 -1600 1900
10 -3500 -1600+2000 1900+2000
 Net Cash Flow Diagram

2000
1900

1 2 5
10

5000
11000
 Calculating IRR
• Using PW analysis
– 0 = -5000 + 1900(P/A,i,10) – 11000(P/F,i,5) +
2000(P/F,i,10)
• Solve for i
– Start with 5000 = 10000(P/F,i,5)
– i is between 14% and 15%
– Iterating we find i=12.65%
• IRR<MARR
– Hence Select Option A
• Excel can calculate IRR quite easily
• You can also do this using EUAW
 Selecting from more than 2
alternatives
1. Order the alternatives in increasing order of initial investment
costs
2. For alternatives with positive cash flows, select the first alternative
and calculate the IRR and compare it with MARR
1. If IRR>MARR, set this option as the defender and the next
option as the challenger
2. If IRR<MARR eliminate this alternative and go back to Step 2
above
3. At the end of this exercise, if only one option exists, then this
must be selected. If no options exist, then no option is selected
3. Determine Net Incremental Cash Flow between Challenger and
Defender
4. Calculate the IRR
1. If IRR>MARR, then challenger becomes defender. The next
available option is the challenger
2. If IRR<MARR, challenger is eliminated and next available
option is the challenger
5. Repeat until only one option remains
 Example:
• 4 building locations have been suggested below.
If the MARR is 10%, use an incremental rate of
return analysis to select a building location
A B C D

Building Rs. Rs. Rs. Rs.

Cost 2,00,000 2,75,000 1,90,000 3,50,000
Income 22000 35000 19500 42000

Life (yrs) 30 30 30 30
 Solution
• Arranging in Increasing order of Initial
Costs, we get C-A-B-D
• Since they have revenues, first calculate
IRR of C
– 1,90,000 = 19,500(P/A,i,30)
– (P/A,i,30)= 9.74
– i = 9.63%
• Since IRR<MARR, eliminate C
 Solution
• Next Consider IRR of A
– 2,00,000 = 22000(P/A,i,30)
– (P/A,i,30)= 9.09
– i = 10.49%
• Since IRR>MARR, A is the Defender
– B is the Challenger
• Compare A and B (B minus A)
 B Minus A
• Looking at the Net Cash Flows
– Incremental Building Cost = Rs. 75,000
– Incremental Income = Rs. 13,000
• Formulating IRR Equation
– 75,000 = 13000(P/A,i,30)
– (P/A,i,30) = 5.77
– i = 17.28%
• Since IRR>MARR, B is now the Defender
– D is the Challenger
• Compare B and D (D minus B)
 D Minus B
• Looking at the Net Cash Flows
– Incremental Building Cost = Rs. 75,000
– Incremental Income = Rs. 7,000
• Formulating IRR Equation
– 75,000 = 7000(P/A,i,30)
– (P/A,i,30) = 10.71
– i = 8.55%
• Since IRR<MARR, B remains the Defender
– D is eliminated and no more options are available
• Select Option B
• Can also do this using EUAW method
 Miscellaneous
• You can use either method – NPV or IRR, there are no
hard and fast rules
• IRR assumes only one constant rate of return
throughout the project. That is a limitation when
compared with NPV
• If there are only disbursements and no revenues (i.e.
only an investment), then do not compare an
alternative with MARR. Start comparing them
straightaway with one another as challenger and
defender
– At least one must be selected, even if all are poor
– If Revenues exist, then you may end up with a situation where
you do not select any of the alternatives
• If the lives are not the same, use the LCM of the lives
of the options
 Class Exercise: MARR is 13.5%
per year. Which will you choose?
Eqpt 1 Eqpt 2 Eqpt 3 Eqpt 4

First 5000 6500 10000 15000

Cost
AOC 3500 3200 3000 1400

Salvage 500 900 700 1000

Value
Life (yrs) 8 8 8 8
Thank You