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in knowing whether a proposed investment will earn a sufficiently high rate of return. For example, if I am considering investing in a 10-year Oregon general obligation bond, I may want to consider only those bonds that have an IRR of 4% or above. If I evaluate a bond and find its IRR to be < 3%, I dont have to do any further calculations because it clearly doesnt meet my criterion of IRR 4%. If I find a bond with an 4% < IRR < 5% then I know it would be acceptable since IRR > 4%. The minimum rate I am willing to accept for an investment is called the Minimum Attractive Rate of Return (MARR). Decision rule: When the MARR is known, you should accept the project or investment when IRR MARR. How is the MARR determined? This varies with the type of organization or individual decision-maker. MARR is usually set sufficiently high to allow for some risk of estimation errors in future costs and benefits. For example, if you would really like to guarantee a 10% return on an investment, you might set your MARR to 15%, 20% or even higher to allow for these risks. We have certainly seen a lot of variability in the price of gasoline, electricity, and natural gas in recent years. If we are estimating these costs into the future we run a risk of overestimating or underestimating these costs. Similarly, repair costs, insurance costs, and labor costs can be difficult to estimate. If we plug in our best estimates and calculate an IRR of only 10% we may find out after several years that our true rate of return was much lower if costs were higher than we had estimated. It is not unusual to find economic analyses using 30% and 40% MARRs to evaluate potential projects. Module 8: Internal Rate of Return Concept: The internal rate of return (IRR) is the interest rate paid on the unpaid balance of a loan that causes the loan principal to be fully repaid when the final payment is made.

Until this point in our course, all problems you have been asked to solve have supplied an interest rate. In this module you will be solving for the interest rate given other information about costs, benefits, and analysis period. Mathematically, this can be more difficult than the calculations you mastered in earlier modules. At times you may have to revert to a trial and error process if your calculator does not have an IRR function built in. Alternatively, you may find a spreadsheet to be helpful. (Your textbook discusses the IRR and RATE functions in Excel that can be used.) The IRR is the interest rate that balances the Present Worth of Costs (PWc) of an investment with the Present Worth of Benefits (PWb). In other words, IRR is the interest rate that, when used to calculate PWb and PWc, results in PWb = PWc (and, as a result, NPW = 0). If PWb = PWc when calculated using the IRR as the interest rate, what must also be true about the relationship of EUAB and EUAC? Reality check: If you cant answer this last question, you should re-visit the earlier discussions about the relationship of EUAB and PWb and the relationship of EUAC and PWc. IRR Calculations: IRR problems solve for i as the unknown variable. Example: You borrow $8200 and pay pack $2000 per year for each of 5 years. What interest rate have you paid? (Or, stated from the lenders perspective, you lend $8200 and receive 5 equal annual payments of $2000.) What is the rate of return on your investment? Solution: This is a uniform series problem in which we know A, P, and n. We can set up our solution in one of two forms: Solve for P given A: P = A(P/A,i,n) 8200 = 2000 (P/A,i,5) Isolate the (P/A,i,5) factor as your unknown by dividing both sides of the equation by 2000:

8200/2000 = (P/A,i,5) 4.1 = (P/A,i,5) Now its a matter of searching through the interest rate tables to find a rate for which the (P/A,i,5) factor has a value of 4.1. This is found on the 7% table. This investment has earned a 7% rate of return. The alternative form of the solution, given P,A, and n is to solve for A given P: A = P (A/P,i,5) 2000 = 8200(A/P,i,5) 2000/8200 = (A/P,i,5) 0.2439 = (A/P,i,5) The 7% table shows (A/P,7%,5) = 0.2439 so this investment is again shown to have a 7% IRR. Notice that the entire factor, whether we used (P/A,i,5) or (A/P,i,5) was the unknown in our equation. Once we determined its value through algebra, it was a matter of trial and error to find the appropriate interest rate table that contained that value for a 5-year solution. Earlier we said that the IRR was the interest rate that set PWb = PWc. Does that apply in this problem? Yes. From the borrowers perspective, PWb = $8200. This is the money you borrowed in year 0 and is a positive cash flow for you. (Presumably you used the money to buy something that has benefit to you.) Your annual costs are the $2000 repayments (cash outflows). PWc was calculated to be $8200 when i = 7%. (Thats what we found in the first solution when we found P given A.) So, the PWc of the 5 years payments of $2000 was $8200. PWb indeed equals PWc at 7%. If youre still not convinced, try solving this problem using 6% or 8% interest: At i = 8%: PWc = 2000(P/A,8%,5) PWc = 2000(3.993)

PWc = $7986. At i = 8%, PWb = $8200 and PWc = $7986 so PWb > PWc. At i = 6%: PWc = 2000(P/A,6%,5) PWc = 2000(4.212) PWc = $8424. At i = 6%, PWb = $8200 and PWc = $8424 so PWb < PWc. We know from our solution above that at i = 7%, PWc = 2000(4.100) = $8200 so PWb = PWc when i = 7%. This does not tell us whether 7% is a good rate of return on our investment or a reasonable interest rate for our borrowing. It simply tells us that 7% is the rate of return. Example: You spend $700 to upgrade your heating system. You save the following in heating costs each year as a result:

Year 1 2 3 4 Savings $100 175 250 325

What is the IRR of this project? Solution: Find the interest rate that sets EUAB = EUAC or sets PWb = PWc. It doesnt matter whether you solve for present worth or the uniform amount because the correct interest rate will work for both. Sometimes the nature of the cash flows can make one approach easier than the other. Well solve it both ways. Solution method 1: Set PWb = PWc.

PWc = $700 (spent on the system) PWb = 100(P/A,i,4) + 75(P/G,i,4) (notice how we constructed a uniform series + a gradient) 100(P/A,i,4) + 75(P/G,i,4) = 700 Since this is a single equation with two unknowns ((P/A,i,4) and (P/G,i,4) are both unknown), this can only be approached by trial and error: guess an interest rate find the values of the factors from the interest rate table evaluate the resulting expression

Lets guess 5%: (P/A,5%,4) = 3.546 (P/G,5%,4) = 5.013 100(3.546) +75(5.013) = $730.58 so PWb > PWc at i = 5% In our earlier example, we found that when PWb > PWc, our IRR was greater than the interest rate we had tried. We can conclude here that the IRR > 5%. Go ahead and try a higher rate and re-evaluate PWb. Well give you the answer after showing you the second way to solve this problem, namely setting EUAB = EUAC. Solution method 2: Set EUAB = EUAC. EUAC = 700(A/P,i,4) (Remember, we need to annualize the initial purchase price) EUAB = 100 + 75(A/G,i,4) (This is annualizing the benefits of 100 plus the gradient of 75) 100 + 75(A/G,i,4) = 700(A/P,i,4) Again, we have 2 unknowns in a single equation so we must resort to trial and error as we did with the PWb = PWc equation in Solution method 1.

Guess 8% (since we know 5% is too low from our first trial and error attempt): EUAB = 100 + 75(1.404) = $205.30 EUAC = 700(.3087) = $216.09 At i = 8%, EUAB < EUAC. This tells us that IRR < 8%. So far we have determined that 5% < IRR < 8% so were narrowing in our chase. Lets try i = 7%: EUAB = 100 + 75(1.416) = $206.20 EUAC = 700(.2952) = $206.64 Within rounding, EUAB = EUAC when i = 7% so IRR = 7%. Further comment on the estimation procedure: The two problems above had solutions found on the interest rate tables. However, most real world problems end up with IRRs that are not found on the tables, such as 2.6% or 17.4%. What do you do if youve evaluated PWb and PWc (or EUAB and EUAC) and discover that one tables rate is too low and the next tables rate is too high? Depending on the problem you would consider one of the following options: State that the IRR is between x% and y% and do not try to estimate any more precisely. For example, you may find that 9% < IRR < 10%. That may be close enough for the nature of the problem, especially if alternative investments have IRRs significantly below or significantly above this range. Estimate a new interest rate within the range youve identified, say 9.5%, and use the calculator-based formulas or a spreadsheet to continue to evaluate PWb and PWc (or EUAB and EUAC) using this more precise rate. Continue to narrow down the rate in this manner until you find, to the number of decimal places you or your boss finds appropriate, the IRR. Use linear interpolation to estimate the IRR within the range youve identified. This is a cruder, less precise estimation method than the

calculator-based method but it will be closer than simply stating the range of x% < IRR < y%. We will present an example of using linear interpolation when we discuss bond yields later in this module. Module 8: Bond Analysis This section discusses the relationship between the rate of return on a bond and the price of the bond. What is a bond? A bond is a legal debt instrument. It obligates the bond issuer to repay the bond holder a particular amount called the Face Value at a known time in the future (the maturity date). It may also obligate the bond issuer to repay the bond holder a specific amount of money, either annually or semi-annually (twice a year) until the bond reaches its maturity date. Bonds are issued by corporations or different branches of government. Bonds issued by state or local governments are known as municipal bonds and the interest payments received by the bond holder over the life of the bond are exempt from federal income tax (and state and local income tax if the bond holder resides in the city or state that issued the bond). Interest payments received on corporate bonds are fully taxable on federal and state tax returns. You are probably familiar with US Savings Bonds, issued by the federal government. US Savings Bonds do not pay any periodic interest but hold all payment until maturity. Bonds that pay no periodic interest are known as zero coupon bonds. Here are the key components of a bond: Purchase price: The price the bond holder pays for the bond when buying it from the original issuer or in the bond market from another seller. Maturity: The date when the bond will be paid in full by the bond issuer to the current bond holder. At the time of maturity, the bond holder will receive the final interest payment plus the face value amount of the bond and the bond will be retired (fully paid off). Maturities may be as short as several months or as long as 30 years.

Face value (or denomination): The amount the bond holder will receive at maturity. Interest rate (or coupon rate): The percent of the face value that will be paid as interest to the bond holder each year until maturity. For example, if the bond has a $5000 face value and pays 5% interest, the bond holder will receive .05*$5000 = $250 interest every year until maturity. If the bond pays interest semi-annually, the bond holder will receive half this amount ($125) every six months. Current yield (or yield to maturity): The rate of return the bond holder receives on this bond. If the purchase price paid by the bond holder equals the face value of the bond, the current yield will be the same as the coupon rate. However, it is possible to pay more or less than the face value when buying the bond so the current yield is usually different from the coupon rate. (As you will see in this section, if the bond holder pays less than the face value, the current yield will be greater than the coupon rate. If the bond holder pays more than the face value, the current yield will be less than the coupon rate. Bond price and current yield are, therefore, inversely related.) Example:

A bond is issued that will mature in 10 years. It has a $1000 face value and a 4% interest rate, interest to be paid semi-annually. If the bond sells for $1000, what is its yield (rate of return)? Here is the time-line for this problem: Payment made orreceived by bondholder -$1000 20 20 20 etc. 20 1020

Period 0 1 2 3 19 20

bought the bond interest received at end of 6 months = .5 * .04 * 1000 interest received at end of 1 year interest received at end of 1.5 years interest received at end of 9.5 years interest for final 6 months plus return of face value

To find the rate of return on this bond, set PWb = PWc PWc = $1000 (the purchase price of the bond)

PWb = 20(P/A,i,20) + 1000(P/F,i,20) Notice that PWb consists of a uniform series of the $20 semi-annual interest payments for 10 years (20 periods) plus the one-time final payment of $1000 at the end of period 20. The 10-year horizon is a 20-period problem because interest payments are made semi-annually. Caution: When you solve this problem as stated, you are solving for the nominal semi-annual (6-month) interest rate. To find the nominal annual rate of return, you must multiply this value by 2 to convert from semi-annual to annual. Try guessing 2% for the semi-annual rate of return (half of the 4% annual interest rate): at i = 2%: PWb = 20(P/A,2%,20) + 1000(P/F,2%,20) PWb = 20(16.351) + 1000(.6730) PWb = 327.02 + 673 = $1000.02 Within rounding, PWb = PWc at i = 2% so the semi-annual rate of return is 2% and the annual rate of return (yield) is 4%. Example: Now suppose the same bond is bought for $880 instead of $1000. What is the rate of return (yield) on the bond? PWc = $880 PWb = 20(P/A,i,20) + 1000(P/F,i,20) Note that PWb doesnt change in format. The bond holder will still receive $20 interest every 6 months plus the $1000 face value at maturity. The only thing that changes is the price of the bond which is PWc.

If you pay less than the face value for the bond, your rate of return will be higher than the stated interest rate. So, we know that annual i > 4% and semiannual i > 2%. Lets try 2.5% to evaluate PWb. at i = 2.5%: PWb = 20(P/A,2.5%, 20) + 1000(P/F,2.5%,20) PWb = 20(15.589) + 1000(.6103) = $922.08 This is closer to $880 than PWb when i = 2% but it may not be close enough. Try at i = 3%: at i = 3%: PWb = 20(P/A,3%,20) + 1000(P/F,3%,20) = $851.24 The semi-annual interest rate that sets PWb = PWc is between 2.5% and 3%, meaning the annual rate of return is between 5% and 6%. This is a pretty large spread. To be more precise, we can use linear interpolation to refine our estimate. Linear interpolation assumes our answer lies on a straight line between i = 2.5% and i = 3%. This is not exactly correct since interest rates are compounding (hence growing geometrically, not linearly) but it will give us a close enough approximation when the boundaries of the known rates are fairly close as in this example (where the difference between 2.5% and 3% is only 1/2%). Here is a formula for linear interpolation:

Notice that the denominator of the above equation calculates the difference in value between PWb when i = 2.5% (which was $922.08) and PWb when i = (2.5% + 0.5%) which was $851.24. The numerator determines the difference between PWb when i = 2.5% and the actual PWc that was paid for the bond. Since the denominator spans the effect of adding a full 0.5% interest rate to our base of 2.5%, the numerator effectively tells us what fraction of that distance (or what fraction of 0.5%) we actually covered.

= 2.797%

The semi-annual rate of return is 2.8% the annual rate of return (current yield) = 5.6%. Why does a bond sell at a price below its face value?

A bond that sells below its face value is said to sell at a discount. As the market rate of interest rises (often for very complex reasons that go beyond the scope of this course), a potential seller of a bond must price the bond to be competitive with other similar bonds in the market. This means that corporate bonds with similar risk characteristics should be priced similarly to each other. Municipal bonds should be priced similar to other municipal bonds with similar risk characteristics. (Bond risk is also a complicated part of financial analysis and beyond the scope of this course.) Since the face value and semi-annual interest amounts cannot change over the life of the bond (F and A are constant), the only way to make the bond competitive is to lower its price. As long as an investor is able to earn 5.6% on a bond, he or she would not care if the bond is priced at $880 as in this example or if it were priced at $1000 but paid $28 interest every six months (instead of the $20 in our example) for 10 years. The second bond would also yield 5.6% with the following PWb and PWc:

PWc = $1000 PWb = 28(P/A,i,20) + 1000(P/F,i,20) If you solve the PWb equation using the calculator-based formulas where you can use interest rates not on the tables, the semi-annual interest rate will be 2.8%. Try it and see for yourself. Why does a bond sell at a price above its face value?

If market interest rates fall, a bonds price could rise above its face value. That bond would be said to be selling at a premium. Again, this would happen to keep the yield on this bond competitive with the yield on similar bonds in the market. The higher price increases PWc. Since F and A (the face value and periodic interest amounts) are constant, i must fall to let PWc = PWb. Example: The same 10 year $1000 bond paying 4% interest semi-annually is sold for $1042. What is the bonds current yield? PWc = $1042 PWb = 20(P/A,i,20)+ 1000(P/F,i,20) Try i = 1.75 % semi-annually (you know i < 2% because PWc > face value) and 20/1000 = 2%) PWb = 20(P/A,1.75%,20) + 1000(P/F,1.75%,20) PWb = 20(16.753) + 1000(.7068) PWb = 335.06 + 706.80 = $1041.86 The bonds semi-annual yield = 1.75% the annual rate of return (current yield) = 3.5%.

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