CHAPTER 5

APPLICATIONS OF
MONEY-TIME
RELATIONSHIPS
 MINIMUM ATTRACTIVE RATE OF
RETURN ( MARR )
•• An
An interest
interest rate
rate used
used to
to convert
convert cash
cash flows
flows into
into equivalent
equivalent
worth
worth at
at some
some point(s)
point(s) in
in time
time
•• Usually
Usually aa policy
policy issue
issue based
based on:on:
-- amount,
amount, source
source and
and cost
cost of
of money
money available
available for
for investment
investment
-- number
number and
and purpose
purpose of
of good
good projects
projects available
available for
for investment
investment
-- amount
amount ofof perceived
perceived risk
risk of
of investment
investment opportunities
opportunities and
and
estimated
estimated cost
cost of
of administering
administering projects
projects over
over short
short and
and long
long run
run
-- type
type of
of organization
organization involved
involved
•• MARR
MARR is
is sometimes
sometimes referred
referred to
to as
as hurdle
hurdle rate
rate
 CAPITAL RATIONING
•• MARR
MARR approach
approach involving
involving opportunity
opportunity cost
cost viewpoint
viewpoint
•• Exists
Exists when
when management
management decides
decides to to restrict
restrict the
the total
total
amount
amount of of capital
capital invested,
invested, by
by desire
desire or
or limit
limit of
of
available
available capital
capital
•• Select
Select only
only those
those projects
projects which
which provide
provide annual
annual rate
rate of
of
return
return in
in excess
excess ofof MARR
MARR
•• As
As amount
amount of of investment
investment capital
capital and
and opportunities
opportunities
available
available change
change over
over time,
time, aa firm’s
firm’s MARR
MARR willwill also
also
change
change
 PRESENT WORTH METHOD ( PW )
•• Based
Based on on concept
concept of of equivalent
equivalent worth
worth of
of all
all cash
cash flows
flows
relative
relative toto the
the present
present as as aa base
base
•• All
All cash
cash inflows
inflows and
and outflows
outflows discounted
discounted to to present
present atat
interest
interest -- -- generally
generally MARRMARR
•• PW
PW is is aa measure
measure of of how
how much
much money
money can
can be be afforded
afforded
for
for investment
investment in in excess
excess ofof cost
cost
•• PW
PW is is positive
positive ifif dollar
dollar amount
amount received
received for
for investment
investment
exceeds
exceeds minimum
minimum required
required byby investors
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
–– ii == effective
effective interest
interest rate,
rate, or
or MARR
MARR per
per
compounding
compounding period period
–– kk == index
index for
for each
each compounding
compounding period
period
–– FFkk == future
future cash
cash flow
flow at
at the
the end
end of
of period
period kk
–– NN == number
number ofof 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
–– ii == effective
effective interest
interest rate,
rate, or
or MARR
MARR per
per
compounding
compounding period period
–– kk == index
index for
for each
each compounding
compounding period
period
–– FFkk == future
future cash
cash flow
flow at
at the
the end
end of
of period
period kk
–– NN == number
number ofof compounding
compounding periods
periods in
in study
study
period
period
•• interest
interest raterate is
is assumed
assumed constant
constant through
through project
project
 FINDING
•• Discount
PRESENT WORTH
Discount future
future amounts
amounts to
to the
the present
present by
by using
using the
the interest
interest
rate
rate over
over the
the appropriate
appropriate study
study period
period
N
PW == Σ
PW F
Fkk (( 11 ++ ii )) --kk
–– ii == effective k = 0 or MARR per compounding
effective interest
interest rate,
rate, or MARR per compounding
period
period
–– kk == index
index for
for each
each compounding
compounding period
period
–– FFkk == future
future cash
cash flow
flow at
at the
the end
end of
of period
period kk
–– NN == number
number of of compounding
compounding periods
periods in in study
study period
period
•• interest
interest raterate is
is assumed
assumed constant
constant through
through project
project
•• The
The higher
higher the
the interest
interest rate
rate and
and further
further into
into future
future aa cash
cash flow
flow
occurs,
occurs, the the lower
lower its
its PW
PW
 BOND AS EXAMPLE OF
•• The
PRESENT WORTH
The value
value of
of aa bond,
bond, at
at any
any time,
time, is
is the
the present
present worth
worth
of
of future
future cash
cash receipts
receipts from
from the
the bond
bond
•• The
The bond
bond owner
owner receives
receives two
two types
types of
of payments
payments from
from
the
the borrower:
borrower:
--
-- periodic
periodic interest
interest payments
payments until
until the
the bond
bond is
is retired
retired
(( based
based on on rr ););
--
-- redemption
redemption or or disposal
disposal payment
payment when
when the
the bond
bond is is
retired
retired (( based
based on on ii ););
•• The
The present
present worth
worth of
of the
the bond
bond is
is the
the sum
sum of
of the
the present
present
values
values of
of these
these two
two payments
payments atat the
the bond’s
bond’s yield
yield rate
rate
 PRESENT WORTH OF A BOND
•• For
For aa bond,
bond, let
let
ZZ == face,
face, or
or par
par value
value
CC == redemption
redemption or or disposal
disposal priceprice (usually
(usually ZZ ))
rr == bond
bond rate
rate (nominal
(nominal interest)
interest) per
per interest
interest period
period
NN == number
number of of periods
periods beforebefore redemption
redemption
ii == bond
bond yield
yield (redemption
(redemption )) rate rate per
per period
period
VVNN == value
value (price)
(price) of of thethe bond
bond N N interest
interest periods
periods prior prior to
to redemption
redemption ----
PW
PW measure
measure of of merit
merit
VN
VN == C C (( P P // F,
F, i%,
i%, N
N )) ++ rZ
rZ (( P
P // A,
A, i%,
i%, N
N ))
•• Periodic
Periodic interest
interest payments
payments to to owner
owner == rZ rZ for
for NN periods
periods ---- an
an annuity
annuity of
of N
N
payments
payments
•• When
When bond bond isis sold,
sold, receive
receive single
single payment
payment (C), (C), based
based on on the
the price
price and
and
the
the bond
bond yield
yield rate
rate (( ii ))
FUTURE WORTH METHOD (FW )
•• FW
FW isis based
based onon the
the equivalent
equivalent worth
worth ofof all
all cash
cash
inflows
inflows and
and outflows
outflows at
at the
the end
end ofof the
the planning
planning
horizon
horizon atat 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 worthworth 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 isis generally
generally MARR
MARR
•• The
The FWFW of
of aa project
project is
is equivalent
equivalent to to PW
PW
FW
FW == PW
PW (( FF // P,
P, i%,
i%, NN ))
FUTURE WORTH METHOD (FW )
•• FW
FW is is based
based on on the
the equivalent
equivalent worthworth of
of all
all cash
cash
inflows
inflows andand outflows
outflows atat the
the end
end of of the
the planning
planning
horizon
horizon at at an
an interest
interest rate
rate that
that isis generally
generally MARR
MARR
•• The
The FW FW of
of aa project
project is
is equivalent
equivalent to to PW
PW
FW
FW == PW
PW (( FF // P,
P, i%,
i%, NN ))
•• IfIf 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 worthworth of
of all
all cash
cash
inflows
inflows andand outflows
outflows atat the
the end
end of of the
the planning
planning
horizon
horizon at at an
an interest
interest rate
rate that
that isis generally
generally MARR
MARR
•• The
The FW FW of
of aa project
project is
is equivalent
equivalent to to PW
PW
FW
FW == PW
PW (( FF // P,
P, i%,
i%, NN ))
•• IfIf FW
FW >> 0,
0, itit is
is economically
economically justified
justified
N
FW ( i % ) = kΣ= 0 Fkk ( 1 + i ) NN--kk
FUTURE WORTH METHOD (FW )
•• FW
FW is is based
based on on the
the equivalent
equivalent worthworth of
of all
all cash
cash
inflows
inflows andand outflows
outflows atat the
the end
end of of the
the planning
planning
horizon
horizon at at an
an interest
interest rate
rate that
that isis generally
generally MARR
MARR
•• The
The FW FW of
of aa project
project is
is equivalent
equivalent to to PW
PW
FW
FW == PW
PW (( FF // P,
P, i%,
i%, NN ))
•• IfIf FW
FW >> 0,
0, itit is
is economically
economically justified
justified
N
FW ( i % ) =k =Σ0 Fkk ( 1 + i ) NN--kk
–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
AW is is an
an equal
equal annual
annual series
series of of dollar
dollar amounts,
amounts, over
over aa
stated
stated period
period (( N N ),), equivalent
equivalent to to the
the cash
cash inflows
inflows and
and
outflows
outflows at at interest
interest raterate that
that isis generally
generally MARR
MARR
•• AW
AW is is annual
annual equivalent
equivalent revenues
revenues (( R R )) minus
minus annual
annual
equivalent
equivalent expenses
expenses (( E E ),), less
less the
the annual
annual equivalent
equivalent
capital
capital recovery
recovery (CR)
(CR)
AW
AW (( ii % % )) == R
R -- EE -- CR
CR (( ii %
% ))
•• AW
AW == PW PW (( AA // P,
P, ii %,
%, N
N ))
•• AW
AW == FW FW (( AA // F,
F, ii %,
%, NN ))
•• IfIf AW
AW >> 0,
0, project
project is is economically
economically attractive
attractive
•• AW
AW == 00 :: annual
annual return
return == MARRMARR earned
earned
 CAPITAL RECOVERY ( CR )
•• CR
CR is
is the
the equivalent
equivalent uniform
uniform annual
annual cost
cost of
of the
the
capital
capital invested
invested
•• CR
CR is
is an
an annual
annual amount
amount that
that covers:
covers:
–– Loss
Loss in
in value
value ofof the
the asset
asset
–– Interest
Interest on
on invested
invested capital
capital (( i.e.,
i.e., at
at the
the MARR
MARR ))
CR
CR (( ii %
% )) == II (( A
A // P,
P, ii %,
%, NN )) -- S
S (( A
A // F,
F, ii %,
%, NN ))
II == initial
initial investment
investment for for the
the project
project
SS == salvage
salvage (( market
market )) valuevalue at
at the
the end
end ofof the
the
study
study period
period
NN == project
project study
study period
period
INTERNAL RATE OF RETURN METHOD ( IRR )
• IRR solves for
for the
the interest
interest rate
rate that
that equates
equates the
the
equivalent worth of an alternative’s cash inflows
(receipts or savings)
savings) to
to the equivalent worth of
cash outflows
outflows (expenditures)
(expenditures)
• Also referred to as:
–– investor’s
investor’s method
method
–– discounted
discounted cashcash flow
flow method
method
–– profitability
profitability index
index
• IRR is positive for a single alternative only if:
–– both
both receipts
receipts and
and expenses
expenses are
are present
present in
in the
the cash
cash
flow
flow pattern
pattern
–– the
the sum
sum of
of receipts
receipts exceeds
exceeds sum
sum ofof cash
cash outflows
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 kk ( P / F, i’ %, k ) = Σ E kk ( P / F, i’
i’ %, k )
k=0 k=0
R kk = net
net revenues or savings for the kth year
E kk = net expenditures including investment
costs for the kth year
N = project life
life ( or study period )
• If i’ >> MARR, the alternative isis acceptable
acceptable
• To compute
compute IRR for alternative, set net PW = 0
N N
PW == Σ R
PW R kk (( P
P // F,
F, i’ %, kk )) -- Σ E
i’ %, E kk (( P
P // F,
F, i’
i’ %,
%, kk )) == 00
k=0 k=0
•• i’
i’ is
is calculated
calculated on on the
the beginning-of-year
beginning-of-year unrecovered
unrecovered
investment
investment through
through the the life
life of
of aa project
project
 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.
1. All
All net
net cash
cash outflows
outflows are
are discounted
discounted to
to the
the present
present
(time
(time 0) at ε %
0) at % per
per compounding
compounding period.
period.
2.
2. All
All net
net cash
cash inflows
inflows are
are discounted
discounted to to period
period N at ε
N at
%.
%.
3.
3. ERR
ERR ---- the
the equivalence
equivalence between
between the the discounted
discounted cash
cash
inflows
inflows and
and cash
cash outflows
outflows --
-- is
is determined.
determined.
The
The absolute
absolute value
value of
of the
the present
present equivalent
equivalent worth
worth ofof
the
the net
net cash
cash outflows at ε %
outflows at % isis used
used in in step
step 3.
3.
•• AA project
project isis acceptable
acceptable when
when ii ‘‘ %% ofof the
the ERR
ERR
method
method is is greater
greater than
than or
or equal
equal toto the
the firm’s
firm’s MARR
MARR
CALCULATING EXTERNAL RATE OF
N
RETURN ( ERR )
Σk = E
0 k
k
( P / F, ε %, k )( F / P, i ‘ %, N )

N
=
Σ
k=
Rkk ( F / P, ε %, N - k )
0
 CALCULATING EXTERNAL RATE OF
N
RETURN ( ERR )
Σk = E
0 k
k
( P / F, ε %, k )( F / P, i ‘ %, N )

N
=
Σ
k=
Rkk ( F / P, ε %, N - k )
0
R
Rkk = excess of receipts
= excess of receipts over
over expenses
expenses in
in period
period kk
 CALCULATING EXTERNAL RATE OF
N
RETURN ( ERR )
Σk = E
0 k
k
( P / F, ε %, k )( F / P, i ‘ %, N )

N
=
Σ
k=
Rkk ( F / P, ε %, N - k )
0
R
Rkk = excess of receipts
= excess 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 )
Σk = E
0 k
k
( P / F, ε %, k )( F / P, i ‘ %, N )

N
=
Σ
k=
Rkk ( F / P, ε %, N - k )
0
R
Rkk = excess of receipts
= excess 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 )
Σk = E
0 k
k
( P / F, ε %, k )( F / P, i ‘ %, N )

N
=
Σ
k=
Rkk ( F / P, ε %, N - k )
0
R
Rkk = excess of receipts
= excess 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 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 ΣN R ( F / P, ε %, N - k )
k = 0k
0 i ‘ %= ?

N
Time 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 for for
cash
cash inflows
inflows to
to equal
equal cash
cash outflows
outflows --
-- break-even
break-even life
life
 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 for for
cash
cash inflows
inflows toto equal
equal cash
cash outflows
outflows --
-- break-even
break-even life
life
•• ΘΘ ignores
ignores the
the time
time value
value of
of money
money and
and all
all cash
cash flows
flows
which
which occur after Θ
occur after Θ
 PAYBACK PERIOD METHOD
•• Sometimes
Sometimes referred
referred to to 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 for for
cash
cash inflows
inflows toto equal
equal cash
cash outflows
outflows --
-- break-even
break-even life
life
•• ΘΘ ignores
ignores the
the time
time value
value of
of money
money and
and all
all cash
cash flows
flows
which
which occur afterΘ Θ
occur after Θ
Σ ( Rkk -Ekk) - I > 0
k=1
 PAYBACK PERIOD METHOD
•• Sometimes
Sometimes referred
referred to to 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 for for
cash
cash inflows
inflows toto equal
equal cash
cash outflows
outflows --
-- break-even
break-even life
life
•• ΘΘ ignores
ignores the
the time
time value
value of
of money
money and
and all
all cash
cash flows
flows
which
which occur afterΘ Θ
occur after Θ
Σ ( Rkk -Ekk) - I > 0
k=1
•• IfIf Θ
Θ is
is calculated
calculated to
to include
include some
some fraction
fraction of
of aa year,
year, itit
is
is rounded
rounded to
to the
the next
next highest
highest year
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 ofof 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 ofof 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 ofof 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
k=1
( Rk - Ek) ( P / F, i %, k ) - I > 0
 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 ofof 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
k=1
( Rk - Ek) ( P / F, i %, k ) - I > 0
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 ofof 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
k=1
( Rk - Ek) ( P / F, i %, k ) - I > 0
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 ofof 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
k=1
( Rk - Ek) ( P / F, i %, k ) - I > 0
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
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 isis considered
considered

Θ’
i‘
i‘ isis the
the MARR
MARRΣ
k=1
( Rk - Ek) ( P / F, i %, k ) - I > 0
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
Θ
Θ ‘‘ is is the
the smallest
smallest value
value that
that satisfies
satisfies the
the equation
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 1 + i‘ [ P (1 + i‘) - (R1 - E1) ] (1 +i‘)
Investment 1 + i‘
Balance, $ (R1 - E1) 1 + i‘
(R2 - E2)
(R3 - E3)
Initial investment 1 + i‘
(RN-1 - EN-1 )
=P
(RN - EN)
$0
0 1 2 3 N
•• downward
downward arrows
arrows represent
represent annual
annual returns
returns (R
(Rkk -- E
Ekk)) :: 11 << kk << N
N
•• dashed
dashed lines
lines represent
represent opportunity
opportunity cost
cost of
of interest,
interest, or or interest
interest on on
BOY
BOY investment
investment balance
balance
•• IRR
IRR is
is value
value ii ‘‘ that
that causes
causes unrecovered
unrecovered investment
investment balance balance to to
equal
equal 00 at
at the
the end
end ofof the
the investment
investment period.
period.
 INVESTMENT-BALANCE
DIAGRAM EXAMPLE
•• Capital
Capital Investment
Investment (( II )) == $10,000
$10,000
•• Uniform
Uniform annual
annual revenue
revenue == $5,310
$5,310
•• Annual
Annual expenses
expenses == $3,000
$3,000
•• Salvage
Salvage value
value == $2,000
$2,000
•• MARR
MARR == 5%5% per
per year
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 - $4,294
Balance
- $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