Rates of Return

1
Rates of Return

• Construction Engineering 221
• Economic Analysis

2
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

3
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

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Rates of Return

• Example
• Option 1 ROR 12.5
• Option 2 ROR 11.875
• Option 3 10.5
• MARR 15
• The company would choose not to invest

5
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 developers 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

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Rates of Return

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

7
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

8
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 3P/F, 8,
  3)
• Option 1 NPV 50,000 225,000 X .7938, OR
  228, 605

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Rates of Return

• Option 2 NPV 20,000 120,000 (P/A, 8, 3), or
  20,000 120,000 X 2.5771
• Option 2 NPV 329,252
• Option 3 NPV 10,000 96,000 (P/A, 8,3)
  12,000(P/A, 8,3) 1200 (P/G, 8, 3) OR
• 10,000 96,000 X 2.5771 12,000 X 2.5771 1200
  X 2.4450 291,265

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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 lessees standpoint, they are taking the
  least risk on option 1 and the most risk on
  option 2, so the NPVs reflect that risk/ return
  tradeoff