Rate of Return Analysis Lecture No. - PowerPoint Presentation

Slide1

Rate of Return Analysis

Lecture No.

23

Chapter 7

Contemporary Engineering Economics

Copyright ©

2016

Chapter Opening Story - Investing in Wal-Mart Stock

In October 1,1970, when Wal-Mart Stores, Inc. went public, an investment of 100 shares cost $1,650.

That investment would have been worth $15,384,576 on September 30, 2014, after nine times stock splits for 2 for 1. What would be the

rate of return on this investment?

WMT Split History Table

Date

Ratio

08/25/1975

2

for 1

12/17/1980

2

for 1

07/12/1982

2

for 1

07/11/1983

2

for 1

10/07/1985

2

for 1

07/13/1987

2

for 1

07/09/1990

2

for 1

02/26/1993

2

for 1

04/20/1999

2

for 1

Rate

of Return

Investopedia

® says: IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings in the market.

What it is

: Interest earned on your invested capital, or commonly known as internal rate of return (IRR)

ASimple Example

: The interest earned on your savings account is the rate of return on your deposits.

Wal-Mart Investment Problem

Given

:

P = $1,650F = $15,384576

N

= 44 years

Find

: iFormula to UseF

=

P

(1 + i)N$15,384,576 = $1,650(1 + i)44i = 23.09%

Cash Flow Diagram

$15,384,576

$1,650

1970

2014

How Good Was the Wal-Mart Investment and What Can It Be Compared with?

If you took out $1,650 from your savings account and invested in Wal-Mart stock, you could have

$15,384,576

Or the equivalent to earning

23.09%

interest each year on your savings account over 44 years.

If you did not invest $1,650 in Wal-Mart stock, what could you use your money for?

If the best you could do was to leave the money in a savings account to earn 6% interest over 44 years, you would have

$21,426

.

What is the meaning of 6% interest? This will be your opportunity cost rate or minimum return required for any investment.

Is This a Good

Investment

?

In 1970, as long as you could earn

more than a 6% interest in another

investment opportunity,

you would take that investment

. Therefore

, that 6% is viewed as a

minimum attractive rate of return

(or required rate of return). This is the interest rate commonly used in NPW analysis. So to see if the proposed investment is a good one, you adopt the following decision rule:ROR (23.09%) > MARR(6%)

Why

is ROR measure

so popular?

This project will bring in a 15% rate of return on the investment

.

This project will result in a

net surplus of $10,000

in NPW.

Which statement is easier to understand?

Definition 1: Interest Earned on Loan Balance

Rate of return

(ROR) is defined as the interest rate earned on the

unpaid (outstanding) balance

of an installment loan.

Example

: A bank lends $10,000 and receives

an annual repayment of $4,021 over 3 years.

The

bank is said to earn a

return of 10%on its loan of $10,000.

Loan Balance Calculation:

A

= $10,000 (

A

/

P

, 10%, 3)

= $4,021

0

1

23$0-$10,000-$6,979-$3,656

-$1,000 -$698 -$366

+$4,021

+$4,021+$4,021

-$10,000

-$6,979-$3,656$0

A return of 10% on the amount still outstanding at the beginning of each year

Unpaid Loan

Balance at

Beginning of Year

Return on

Unpaid

Balance (10%)

Payment

Received

from Borrower

Unpaid Loan

Balance at

End of Year

$0

-$10,000

n

Definition 2: Break-Even Interest Rate

Rate of return

(ROR) is the break-even interest rate,

i

*

, which equates the present worth of a project’s cash outflows to the present worth of its cash inflows.

Mathematical Relation

:

Example

:

Definition 3: Return on Invested

Capital: Internal

Rate of Return

The internal rate of return (IRR) is the interest rate earned on the

unrecovered

project

balance

of the investment such that when the project terminates, the unrecovered project balance will be zero.

Example

: A company invests $10,000 in a

computer system, which results in equivalent annual labor savings of $4,021 over 3 years. The company is said to earn a return of 10% on its investment of $10,000.

Return on Invested Capital

The firm earns a 10% rate of return on funds that remain

internally

invested in the project. Since the return is internal to the project, we call it

internal rate of return

.