ME 291
Engineering
Economy
ME-291 Engineering
Economy
Lecture 19
Chapter 7
Rate of Return Analysis: Single alternative
Faculty of Mechanical Engineering
Ghulam Ishaq Khan Institute, Topi, Swabi
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Rate of Return
• Rate of return (ROR) is the rate paid on the
unpaid balance of borrowed money, or the
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rate earned on the un-recovered balance of
an investment so that the final payment or
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receipts brings the balance to exactly zero
with interest considered.
• Interest can be -100% < i < ∞
• i = - 100% means the entire amount is lost.
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Example 7.1
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Solution Using the 10% ROR on Un-
recovered Balance
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Using 10% ROR on Initial Amount
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c) A total of $ 400 in interest must be earned if
10% return each year is based on the intial
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amount of $1000. However, only $ 261.88 in
interest must be earned if a 10% return on
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un-recovered balance is used. See figure on
next slide.
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Rate of Return Calculation Using the
PW or AW equation
• 0 = - PWD + PWR
• 0 = - AWD + AWR
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• Then “i ” is the value that makes these equations
numerically correct and is called i*.
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• It is the root of the ROR relation.
• To determine if the alternative’s cash flow series is
viable, compare i* with the established MARR
– If i* ≥ MARR, accept the alternative as
economically viable
– If i* < MARR, the alternative is not viable
economically.
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Example
• If we deposit $1000 now and are promised payments
of $500 three years from now and $1500 five years
from now, the rate of return relation using the PW
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factors is
1000 = 500(P/F,i*,3) + 1500(P/F,i*,5)
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• The value of i* to make the equality correct is to be
computed. If the $1000 is moved to the right side of
equation, we have
0 = - 1000 + 500(P/F,i*,3) + 1500 (P/F,i*,5)
• The equation gives i* = 16.9%, by using Trial and
error method.
• The rate of return will always be greater than zero if
the total amount of receipts is greater than the
amount of disbursements, when the time value of
money is considered.
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i* calculation by Trial and Error
• Draw a cash flow diagram
• Setup the rate of return equation
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• Select values of i by trial and error until the
equation is balanced.
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