Engineering Economic Analysis

212 RATEOF RETURNANALYSIS

The valUeof the IRR is between 4 and 5%. By interpolation,

(

999.96 -950.00

)

... 4.43%

IRR 4%t (1%) 999.96 -883.10

!he nominal interestrate is 2 x 4.43 % ' 8.86%. Tbe ef(ective interestra.te is (1+ 0.0443)L.,. 1.

9.05%.

RATEOF RETURN ANALYSIS

Rate of return analysis is probably the most frequently used exact analysis technique'

in industry. Although problems in computing rate of return sometimes occur, its major

advantageoutweighs the occasional difficulty.The major advantageis that we can compute

a single figure of merit that is readily understood.

Consider these statements:

·The net present worth on the project is $32,000.

·The equivalent uniform annual net benefit is $2800.

·The project will produce a 23% rate of return.

While none of these statements tells ~e complete story, the third one gives a measure

of desirability of the project in terms that are wide.1yunderstood. It is this acceptance by

engineers and business leaders alike of rate of return that has promoted its more frequent

use than present worth or annual cash flow methods.

There is another advantage to rate of return analysis. In both present worth and annual

cash flow calculations, one must select an interest rate for use in the calculations-and

this may be a difficult and controversial item. In rate of return analysis, no interest rate is

introducedinto the calculations(exceptas describedin Appendix7A). Instead,we compute a

rate of return (more accurately calledinternal rate of return)from the cash flow.To decide

how,to proceed, the calculated rate of return is compared with a preselected minimum

attractive rate of return, or simply MARR. This is the same value ofiused for present

worth and annual cash flow analysis.

When there are two alternatives, rate of return analysis is performed by computing

theincremental rate of return-~IRR-on the difference between the alternatives. Since

we want to look at increments of investment, the cash flow for the difference between the

alternativesis computed by taking the higher initial-cost alternativeminusthe lower initial-

cost alternative. If ~IRR is the same or greater than the MARR, choose the higher-cost

alternative. If .6.IRRis less than the MARR, choose the lower-cost alternative.

Two-Alternative Situation

.6.IRR~ MARR

~IRR < MARR

Decision

Choose the higher-cost alternative

Choose the lower-cost alternative

Rate of return and incremental rate of return analysis are illustrated by Examples 7-5

through 7-8.'