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APPLICATIONS OF

MONEY-TIME
RELATIONSHIPS
MINIMUM ATTRACTIVE RATE OF
RETURN ( MARR )
• An interest rate used to convert cash flows into
equivalent worth at some point(s) in time
• Usually a policy issue based on:
 - amount, source and cost of money available for
investment
 - number and purpose of good projects available for
investment
 - amount of perceived risk of investment
opportunities and estimated cost of administering
projects over short and long run
 - type of organization involved
• MARR is sometimes referred to as hurdle rate
CAPITAL RATIONING
• MARR approach involving opportunity cost
viewpoint
• Exists when management decides to restrict
the total amount of capital invested, by
desire or limit of available capital
• Select only those projects which provide
annual rate of return in excess of MARR
• As amount of investment capital and
opportunities available change over time, a
firm’s MARR will also change
PRESENT WORTH METHOD ( PW )
• Based on concept of equivalent worth of all
cash flows relative to the present as a base
• All cash inflows and outflows discounted to
present at interest -- generally MARR
• PW is a measure of how much money can be
afforded for investment in excess of cost
• PW is positive if dollar amount received for
investment exceeds minimum required by
investors
FINDING PRESENT WORTH
•Discount future amounts to the present by using the
•Discount future amounts to the present by using the
interest
interest rate
rate over
over the
the appropriate
appropriate study
study period
period
FINDING PRESENT WORTH
•Discount future amounts to the present by using the
•Discount future amounts to the present by using the
interest
interest rate
rate over
over the
the appropriate
appropriate study
study period
period
N
PW = Σ Fkk ( 1 + i ) --kk
k=0
–i
–i == effective
effective interest
interest rate,
rate, or
or MARR
MARR perper
compounding
compounding period period
–k
–k == index
index for
for each
each compounding
compounding period
period
––F
Fkk == future
future cash
cash flow
flow at
at the
the end
end of
of period
period kk
–N
–N == number
number of of compounding
compounding periods
periods in
in study
study
period
period
FINDING PRESENT WORTH
•Discount future amounts to the present by using the
•Discount future amounts to the present by using the
interest
interest rate
rate over
over the
the appropriate
appropriate study
study period
period
N
PW = Σ Fkk ( 1 + i ) --kk
k=0
–i
–i == effective
effective interest
interest rate,
rate, or
or MARR
MARR per per
compounding
compounding period period
–k
–k == index
index for
for each
each compounding
compounding period
period
––F
Fkk == future
future cash
cash flow
flow at
at the
the end
end of
of period
period kk
–N
–N == number
number of of compounding
compounding periods
periods in
in study
study
period
period
•interest
•interest rate
rate is
is assumed
assumed constant
constant through
through project
project
FINDING PRESENT WORTH
• Discount future amounts to the present by using the
interest rate over the appropriate study period
N

PW = Σk = 0 Fk ( 1 + i ) - k
k=0
– i = effective interest rate, or MARR per
compounding period
– k = index for each compounding period
– Fk = future cash flow at the end of period k
– N = number of compounding periods in study
period
• interest rate is assumed constant through project
• The higher the interest rate and further into future a
cash flow occurs, the lower its PW
BOND AS EXAMPLE OF
PRESENT WORTH
• The value of a bond, at any time, is the present
worth of future cash receipts from the bond
• The bond owner receives two types of
payments from the borrower:
 -- periodic interest payments until the bond is
retired ( based on r );
 -- redemption or disposal payment when the bond
is retired ( based on i );
• The present worth of the bond is the sum of the
present values of these two payments at the
bond’s yield rate
PRESENT WORTH OF A BOND
• For a bond, let
 Z = face, or par value
 C = redemption or disposal price (usually Z )
 r = bond rate (nominal interest) per interest period
 N = number of periods before redemption
 i = bond yield (redemption ) rate per period
 VN = value (price) of the bond N interest periods
prior to redemption -- PW measure of merit
 VN = C ( P / F, i%, N ) + rZ ( P / A, i%, N )
• Periodic interest payments to owner = rZ for N periods
-- an annuity of N payments
• When bond is sold, receive single payment (C), based
on the price and the bond yield rate ( i )
FUTURE WORTH METHOD (FW )
•FW
•FW isis based
based onon the
the equivalent
equivalent worth
worth of
of all
all cash
cash inflows
inflows
and
and outflows
outflows at
at the
the end
end of
of the
the planning
planning horizon
horizon at
at an
an
interest
interest rate
rate that
that is
is generally
generally MARR
MARR
FUTURE WORTH METHOD (FW )
•FW
•FW isis based
based onon the
the equivalent
equivalent worth
worth of
of all
all cash
cash inflows
inflows
and
and outflows
outflows at
at the
the end
end of
of the
the planning
planning horizon
horizon atat an
an
interest
interest rate
rate that
that is
is generally
generally MARR
MARR
•The
•The FWFW of
of aa project
project is
is equivalent
equivalent to to PW
PW
FW
FW == PWPW (( F
F // P,
P, i%,
i%, NN ))
FUTURE WORTH METHOD (FW )
•FW
•FW is is based
based on on the
the equivalent
equivalent worth
worth of
of all
all cash
cash inflows
inflows
and
and outflows
outflows at at the
the end
end of
of the
the planning
planning horizon
horizon atat an
an
interest
interest rate
rate that
that is
is generally
generally MARR
MARR
•The
•The FW FW of
of aa project
project is
is equivalent
equivalent to to PW
PW
FW
FW == PWPW (( F
F // P,
P, i%,
i%, NN ))
•If
•If FW
FW >> 0,0, itit is
is economically
economically justified
justified
FUTURE WORTH METHOD (FW )
•FW
•FW is is based
based on on the
the equivalent
equivalent worth
worth of
of all
all cash
cash inflows
inflows
and
and outflows
outflows at at the
the end
end of
of the
the planning
planning horizon
horizon atat an
an
interest
interest rate
rate that
that is
is generally
generally MARR
MARR
•The
•The FW FW of
of aa project
project is
is equivalent
equivalent to to PW
PW
FW
FW == PWPW (( F
F // P,
P, i%,
i%, NN ))
•If
•If FW
FW >> 0,0, itit is
is economically
economically justified
justified
FW ( i % ) = Σ Fkk ( 1 + i ) NN--kk
N

k=0
FUTURE WORTH METHOD (FW )
• FW is based on the equivalent worth of all cash
inflows and outflows at the end of the planning
horizon at an interest rate that is generally MARR
• The FW of a project is equivalent to PW
 FW = PW ( F / P, i%, N )
• If FW > 0, it is economically justified
 FW ( i % ) = Σ Fk ( 1 + i ) N- k
N

k=0
–i = effective interest rate
–k = index for each compounding period
–Fk = future cash flow at the end of period k
–N = number of compounding periods in study period
ANNUAL WORTH METHOD ( AW )
• AW is an equal annual series of dollar amounts, over
a stated period ( N ), equivalent to the cash inflows
and outflows at interest rate that is generally MARR
• AW is annual equivalent revenues ( R ) minus annual
equivalent expenses ( E ), less the annual
equivalent capital recovery (CR)
 AW ( i % ) = R - E - CR ( i % )
• AW = PW ( A / P, i %, N )
• AW = FW ( A / F, i %, N )
• If AW > 0, project is economically attractive
• AW = 0 : annual return = MARR earned
CAPITAL RECOVERY ( CR )
• CR is the equivalent uniform annual cost of the
capital invested
• CR is an annual amount that covers:
– Loss in value of the asset
– Interest on invested capital ( i.e., at the MARR )
 CR ( i % ) = I ( A / P, i %, N ) - S ( A / F, i %, N )
 I = initial investment for the project
 S = salvage ( market ) value at the end of the
study period
 N = project study period
INTERNAL RATE OF RETURN METHOD ( IRR )
• IRR solves for the interest rate that equates the
equivalent worth of an alternative’s cash
inflows (receipts or savings) to the equivalent
worth of cash outflows (expenditures)
• Also referred to as:
– investor’s method
– discounted cash flow method
– profitability index
• IRR is positive for a single alternative only if:
– both receipts and expenses are present in the
cash flow pattern
– the sum of receipts exceeds sum of cash
outflows
INTERNAL RATE OF RETURN METHOD ( IRR )
•IRR is i’ %, using the following PW formula:
N N
Σ R kk ( P / F, i’ %, k ) = Σ E kk ( P / F, i’ %, k )
k=0 k=0
INTERNAL RATE OF RETURN METHOD ( IRR )
•IRR is i’ %, using the following PW formula:
N N
Σ R kk ( P / F, i’ %, k ) = Σ E kk ( P / F, i’ %, k )
k=0 k=0
R kk = net revenues or savings for the kth year
INTERNAL RATE OF RETURN METHOD ( IRR )
•IRR is i’ %, using the following PW formula:
N N
Σ R kk ( P / F, i’ %, k ) = Σ E kk ( P / F, i’ %, k )
k=0 k=0
R kk = net revenues or savings for the kth year
E kk = net expenditures including investment
costs for the kth year
INTERNAL RATE OF RETURN METHOD ( IRR )
•IRR is i’ %, using the following PW formula:
N N
Σ R kk ( P / F, i’ %, k ) = Σ E kk ( P / F, i’ %, k )
k=0 k=0
R kk = net revenues or savings for the kth year
E kk = net expenditures including investment
costs for the kth year
N = project life ( or study period )
INTERNAL RATE OF RETURN METHOD ( IRR )
•IRR is i’ %, using the following PW formula:
N N
Σ R kk ( P / F, i’ %, k ) = Σ E kk ( P / F, i’ %, k )
k=0 k=0
R kk = net revenues or savings for the kth year
E kk = net expenditures including investment
costs for the kth year
N = project life ( or study period )
•If i’ > MARR, the alternative is acceptable
INTERNAL RATE OF RETURN METHOD ( IRR )
• IRR is i’ %, using the following PW formula:
N N
Σ R
k ( P / F, i’ %, k ) = Σ E k ( P / F, i’ %, k )
k=0 k=0
 R k = net revenues or savings for the kth
year
 E k = net expenditures including investment
costs for the kth year
 N = project life ( or study period )
• If i’ > MARR, the alternative is acceptable
N N
• To compute IRR for alternative, set net PW = 0
 PW = Σ R k ( P / F, i’ %, k ) - Σ E k ( P / F, i’ %, k )
k=0 k=0

=0
INTERNAL RATE OF RETURN PROBLEMS

• The IRR method assumes recovered funds, if


not consumed each time period, are
reinvested at i ‘ %, rather than at MARR
• The computation of IRR may be
unmanageable
• Multiple IRR’s may be calculated for the same
problem
• The IRR method must be carefully applied and
interpreted in the analysis of two or more
alternatives, where only one is acceptable
THE EXTERNAL RATE OF RETURN METHOD
( ERR )
• ERR directly takes into account the
interest rate ( ε ) external to a project at
which net cash flows generated over the
project life can be reinvested (or
borrowed ).
• If the external reinvestment rate, usually
the firm’s MARR, equals the IRR, then
ERR method produces same results as
IRR method
CALCULATING EXTERNAL RATE OF
RETURN ( ERR )
1. All net cash outflows are discounted to the present
(time 0) at ε % per compounding period.
2. All net cash inflows are discounted to period N at ε

%.
3. ERR -- the equivalence between the discounted cash

inflows and cash outflows -- is determined.


 The absolute value of the present equivalent worth of
the net cash outflows at ε % is used in step 3.
• A project is acceptable when i ‘ % of the ERR
method is greater than or equal to the firm’s MARR
CALCULATING EXTERNAL RATE OF
N
RETURN ( ERR )
Σ Ekk ( P / F, ε %, k )( F / P, i ‘ %, N )
k=0
=
N
Σ Rkk ( F / P, ε %, N - k )
k=
0
CALCULATING EXTERNAL RATE OF
N
RETURN ( ERR )
Σ Ekk ( P / F, ε %, k )( F / P, i ‘ %, N )
k=0
=
N
Σ Rkk ( F / P, ε %, N - k )
k=
R
Rkk== excess
excess of
0 receipts
of receipts over
over expenses
expenses in
in period
period kk
CALCULATING EXTERNAL RATE OF
N
RETURN ( ERR )
Σ Ekk ( P / F, ε %, k )( F / P, i ‘ %, N )
k=0
=
N
Σ Rkk ( F / P, ε %, N - k )
k=
R
Rkk==excess
excess of
0 receipts
of receipts over
over expenses
expenses in
in period
period kk
E
Ekk == excess
excess of
of expenses
expenses over
over receipts
receipts in
in period
period kk
CALCULATING EXTERNAL RATE OF
N
RETURN ( ERR )
Σ Ekk ( P / F, ε %, k )( F / P, i ‘ %, N )
k=0
=
N
Σ Rkk ( F / P, ε %, N - k )
k=
R
Rkk==excess
excess of
0 receipts
of receipts over
over expenses
expenses in
in period
period kk
E
Ekk == excess
excess of
of expenses
expenses over
over receipts
receipts in
in period
period kk
N
N == project
project life
life or
or period
period of
of study
study
CALCULATING EXTERNAL RATE OF
N
RETURN ( ERR )
Σ Ekk ( P / F, ε %, k )( F / P, i ‘ %, N )
k=0
=
N
Σ Rkk ( F / P, ε %, N - k )
k=
R
Rkk==excess
excess of
0 receipts
of receipts over
over expenses
expenses in
in period
period kk
E
Ekk == excess
excess of
of expenses
expenses over
over receipts
receipts in
in period
period kk
N
N == project
project life
life or
or period
period of
of study
study
ε == external
external reinvestment
reinvestment rate
rate per
per period
period
CALCULATING EXTERNAL RATE OF
N
RETURN ( ERR )
 Σ E ( P / F, ε %, k )( F / P, i ‘ %, N )
k
k=0
= 

N
 Σ Rk ( F / P, ε %, N - k )
k=
Rk= excess
 of
0 receipts over expenses in period k
Ek = excess of expenses over receipts in period k

N = project life or period of study


ε = external reinvestment rate per periodN
Σ Rk ( F / P, ε %, N - k )
k=0
0 i ‘ %= ?
Time N
N
Σ Ek ( P / F, ε %, k )( F / P, i ‘ %, N )
k=0
ERR ADVANTAGES
• ERR has two advantages over
IRR:
1. It can usually be solved for

directly, rather than by trial and


error.
2. It is not subject to multiple rates

of return.
PAYBACK PERIOD METHOD
•Sometimes
•Sometimes referred
referred to
to as
as simple
simple payout
payout method
method
PAYBACK PERIOD METHOD
•Sometimes
•Sometimes referred
referred toto as
as simple
simple payout
payout method
method
•Indicates
•Indicates liquidity
liquidity (riskiness)
(riskiness) rather
rather than
than profitability
profitability
PAYBACK PERIOD METHOD
•Sometimes
•Sometimes referred
referred toto as
as simple
simple payout
payout method
method
•Indicates
•Indicates liquidity
liquidity (riskiness)
(riskiness) rather
rather than
than profitability
profitability
•Calculates
•Calculates smallest
smallest number
number of years (( Θ
of years Θ )) needed
needed forfor
cash
cash inflows
inflows to
to equal
equal cash
cash outflows
outflows --
-- break-even
break-even lifelife
PAYBACK PERIOD METHOD
•Sometimes
•Sometimes referred
referred toto as
as simple
simple payout
payout method
method
•Indicates
•Indicates liquidity
liquidity (riskiness)
(riskiness) rather
rather than
than profitability
profitability
•Calculates
•Calculates smallest
smallest number
number of years (( Θ
of years Θ )) needed
needed forfor
cash
cash inflows
inflows to
to equal
equal cash
cash outflows
outflows --
-- break-even
break-even lifelife
•Θ
•Θ ignores
ignores the
the time
time value
value of
of money
money andand all
all cash
cash flows
flows
which
which occur after Θ
occur after Θ
PAYBACK PERIOD METHOD
•Sometimes
•Sometimes referred
referred toto as
as simple
simple payout
payout method
method
•Indicates
•Indicates liquidity
liquidity (riskiness)
(riskiness) rather
rather than
than profitability
profitability
•Calculates
•Calculates smallest
smallest number
number of years (( Θ
of years Θ )) needed
needed forfor
cash
cash inflows
inflows to
to equal
equal cash
cash outflows
outflows --
-- break-even
break-even lifelife
•Θ
•Θ ignores
ignores the
the time
time value
value of
of money
money andand all
all cash
cash flows
flows
which
which occur after Θ
occur after Θ
Θ
Σ ( Rkk -Ekk) - I > 0
k=1
PAYBACK PERIOD METHOD
• Sometimes referred to as simple payout method
• Indicates liquidity (riskiness) rather than profitability
• Calculates smallest number of years ( Θ ) needed for
cash inflows to equal cash outflows -- break-even
life
• Θ ignores the time value of money and all cash flows
Θ Θ
which occur after
 Σ ( Rk -Ek) - I > 0
k=1
• If Θ is calculated to include some fraction of a year, it
is rounded to the next highest year
PAYBACK PERIOD METHOD
•The
•The payback
payback period
period can
can produce
produce misleading
misleading results,
results,
and
and should
should only
only be
be used
used with
with one
one of
of the
the other
other
methods
methods of
of determining
determining profitability
profitability
PAYBACK PERIOD METHOD
•The
•The payback
payback period
period can
can produce
produce misleading
misleading results,
results,
and
and should
should only
only be
be used
used with
with one
one of of the
the other
other
methods
methods of
of determining
determining profitability
profitability
••A
A discounted
discounted payback period Θ
payback period where Θ
Θ ‘‘ (( where Θ ‘‘ << N
N ))
may
may be
be calculated
calculated so
so that
that the
the time
time value
value of
of money
money is is
considered
considered
PAYBACK PERIOD METHOD
•The
•The payback
payback period
period can
can produce
produce misleading
misleading results,
results,
and
and should
should only
only be
be used
used with
with one
one of of the
the other
other
methods
methods of
of determining
determining profitability
profitability
••A
A discounted
discounted payback period Θ
payback period where Θ
Θ ‘‘ (( where Θ ‘‘ << N
N ))
may
may be
be calculated
calculated so
so that
that the
the time
time value
value of
of money
money is is
considered
considered
Θ
Σ ( Rk - Ek) ( P / F, i %, k ) - I > 0
k=1
PAYBACK PERIOD METHOD
•The
•The payback
payback period
period can
can produce
produce misleading
misleading results,
results,
and
and should
should only
only be
be used
used with
with one
one of of the
the other
other
methods
methods of
of determining
determining profitability
profitability
••A
A discounted
discounted payback period Θ
payback period where Θ
Θ ‘‘ (( where Θ ‘‘ << N
N ))
may
may be
be calculated
calculated so
so that
that the
the time
time value
value of
of money
money is is
considered
considered
Θ
Σ ( Rk - Ek) ( P / F, i %, k ) - I > 0
k=1
i‘
i‘ is
is the
the MARR
MARR
PAYBACK PERIOD METHOD
•The
•The payback
payback period
period can
can produce
produce misleading
misleading results,
results,
and
and should
should only
only be
be used
used with
with one
one of of the
the other
other
methods
methods of
of determining
determining profitability
profitability
••A
A discounted
discounted payback period Θ
payback period where Θ
Θ ‘‘ (( where Θ ‘‘ << N
N ))
may
may be
be calculated
calculated so
so that
that the
the time
time value
value of
of money
money is is
considered
considered
Θ
Σ ( Rk - Ek) ( P / F, i %, k ) - I > 0
k=1
i‘
i‘ is
is the
the MARR
MARR
II is
is the
the capital
capital investment
investment made
made at
at the
the present
present time
time
PAYBACK PERIOD METHOD
•The
•The payback
payback period
period can
can produce
produce misleading
misleading results,
results,
and
and should
should only
only be
be used
used with
with one
one of of the
the other
other
methods
methods of
of determining
determining profitability
profitability
••A
A discounted
discounted payback period Θ
payback period where Θ
Θ ‘‘ (( where Θ ‘‘ << N
N ))
may
may be
be calculated
calculated so
so that
that the
the time
time value
value of
of money
money is is
considered
considered
Θ
Σ ( Rk - Ek) ( P / F, i %, k ) - I > 0
k=1
i‘
i‘ is
is the
the MARR
MARR
II is
is the
the capital
capital investment
investment made
made at
at the
the present
present time
time
(( kk == 00 )) is
is the
the present
present time
time
PAYBACK PERIOD METHOD
• The payback period can produce misleading results,
and should only be used with one of the other
methods of determining profitability
• A discounted payback period Θ ‘ ( where Θ ‘ < N )
may be calculated so that the time value of money
is considered
 Θ’
 Σ ( Rk - Ek) ( P / F, i %, k ) - I > 0
k=1
 i‘ is the MARR
 I is the capital investment made at the present time
 ( k = 0 ) is the present time
 Θ ‘ is the smallest value that satisfies the equation

INVESTMENT-BALANCE
DIAGRAM

 Describes how much money is


tied up in a project and how the
recovery of funds behaves over
its estimated life.
INTERPRETING IRR USING
INVESTMENT-BALANCE
P (1 + i‘)
DIAGRAM
Unrecovered [ P (1 + i‘) - (R1 - E1) ] (1 +i‘)
1 + i‘
Investment 1 + i‘
Balance, $ (R1 - E1) 1 + i‘
(R2 - E2)
(R3 - E3)
Initial investment
(RN-1 - EN-1 ) 1 + i‘
=P
(RN - EN)
$0
0 1 2 3 N
• downward arrows represent annual returns (Rk - Ek) : 1 < k < N
• dashed lines represent opportunity cost of interest, or interest
on BOY investment balance
• IRR is value i ‘ that causes unrecovered investment balance to
equal 0 at the end of the investment period.
INVESTMENT-BALANCE
DIAGRAM EXAMPLE
• Capital Investment ( I ) = $10,000
• Uniform annual revenue = $5,310
• Annual expenses = $3,000
• Salvage value = $2,000
• MARR = 5% per year
Investment
Balance, $ 5,000 MARR = 5%
$2,001 ( = FW )

Θ’
+ $4,310
Years
0
5
1 2 3 4
Area of Negative - $2,199 - $2,310
Investment - $2,310
- 5,000 Balance - $4,294
- $6,290 - $4,509
- $2,310
- $8,190 - $2,310 - $6,604
- $2,310
- $8,600
- 10,000
-$10,500
WHAT INVESTMENT-BALANCE
DIAGRAM PROVIDES
• Discounted payback period ( Θ ‘) is 5 years
• FW is $2,001
• Investment has negative investment balance
until the fifth year
 Investment-balance diagram provides
additional insight into worthiness of proposed
capital investment opportunity and helps
communicate important economic information