Rates of Return Construction Engineering 221 Economic Analysis

Rates of Return ROR stand for Rate of return- it is the effective annual interest rate earned on an investment ROI is Return on Investment is NOT stated as a dollar amount in financial analysis. The book is wrong on this. They are using ROI as a substitute for net present value (NPV) The key is to know what you are comparing- present value or interest rate earned

Rates of Return Minimum attractive rate of return (MARR) is the lowest ROR at which a company will consider investing MARR is not usually used in calculating, only in comparing. It is the “do nothing” option

Rates of Return Example –Option 1 ROR = 12.5% –Option 2 ROR = % –Option 3 = 10.5% –MARR = 15% –The company would choose not to invest

Rates of Return MARR is not usually stated as an option, it is a constraint or decision criteria that applies to all investment considerations Typical decision conditions for X alternatives: –Interest rate is given (a developer’s borrowing rate or MARR or risk adjusted rate for each alternative) –Cash flows are predicted pro forma for each alternative –Durations are given (lease periods or equipment life) for each alternative

Rates of Return Calculate NPV for each option and choose the best (highest value) Example- three options for acquiring a piece of heavy equipment

Rates of Return Option 1- balloon lease pay $50,000 now and then $50 per hour for each hour used (pay lump sum at end of the lease period) Option 2 - net lease- pay $20,000 up front and then $10,000 per month for three years, lessee pays all maintenance Option 3- triple net- pay $10,000 up front and the $8,000 per month to the lessee and pay maintenance costs which are estimated at $1000 per month to begin, increasing $100 per month

Rates of Return Assume you will need the equipment on the project for three years, and you estimate 1500 hours per year in usage. MARR is 8% Option 1 NPV = 50,000 + {50 X 1500 X 3}[P/F, 8, 3) Option 1 NPV= 50,000 + {225,000 X.7938}, OR $228, 605

Rates of Return Option 2 NPV = 20, ,000 (P/A, 8, 3), or 20,000 + {120,000 X } Option 2 NPV = 329,252 Option 3 NPV = 10, ,000 (P/A, 8,3) + 12,000(P/A, 8,3) (P/G, 8, 3) OR 10, ,000 X ,000 X X = 291,265

Rates of Return Since these are all disbursements, choose the lowest NPV, or option 1. If the project goes slow and the equipment will be needed for more than 1500 hours per year, the risk is higher for overruns From the lessee’s standpoint, they are taking the least risk on option 1 and the most risk on option 2, so the NPV’s reflect that risk/ return tradeoff