W3_HWB_IRR and Payback Period


1. Problem Definition

Using the description of the problem on my W2 last week’s blog, this time I will try to analyze economies with other methods. Capital of Rp. 350 million (15% bank interest rate per year) and operating costs Rp. 1 million per month or Rp. 12 million per year with a value of MARR (Minimum Attractive Rate of Return) that I set for myself at 25% per year, and assumption of CNG tubes will worth Rp 25 million if sold (extreme assumption). Is the investment worth with contracts Rp. 15 million per month or Rp. 180 million per year for 3 years.

2. Development of Feasible Alternatives

Methods of analysis that will be used this time are:

– Internal Rate of Return (IRR), and
– Discounted Payback Period

3. Development Outcomes for alternative

IRR is value of interest rate in percentage when NPV is equal to zero, or the value of the interest rate percentage which the total number of cash inflows and cash outflows equal to zero.
The payback period is the time required to restore the capital value or cash out, of the profit or cash inflows generated.

4. Selection of Criteria

IRR value is greater than the value of MARR, then the investment is acceptable, if the IRR is worth less than the MARR, the investment is rejected or not feasible.
Time resulting from the payback period method is as an indicator for assessing an investment is acceptable or not in terms of risk.

5. Analysis of the Alternatives

IRR of an investment illustration above is (linear interpolation):

PW = 0 = – Rp 350,000,000 + (Rp 180,000,000 – Rp 12,000,000)(P/A, i %, 3) + Rp 25,000,000 (P/F, i %, 3), i % = ?

At i = 25% (MARR) : PW = – Rp 350,000,000 + Rp 168,000,000(1.952) + Rp 25,000,000 (0.512)
= – Rp 9,264,000

At i = 20% : PW = – Rp 350,000,000 + Rp 168,000,000(2.1065) + Rp 25,000,000 (0.5787)
= Rp 18,359,500

(20%-25%)/(- Rp 9,264,000 – Rp 18,359,500) = ( i % – 25%)/(- Rp 9,264,000), i = 23.32 % (IRR)

The payback period is:

Year (n) Cash Flow PV factor Discounted Cash Flow Cumulative Discounted Cash Flow

0 (350,000,000) 1.0000 (350,000,000) (350,000,000)
1 168,000,000 0.8696 146,092,800 (203,907,200)
2 168,000,000 0.7561 127,024,800 (76,882,400)
3 193,000,000 0.6575 126,897,500 50,015,100

The discounted payback period is 2 + (76,882,400 / 126.897) = 2,606 years

6. Selection of Preferred Alternatives

IRR is a 23.32% which means below the value of MARR (25%) so the investment is not worth it to run. The payback period is 2.606 years, which means in the time of 2.606 years will able to return on investment.

7. Performance Monitoring and Post-Evaluation of Result
Although the payback period indicates that the payback period is shorter than the term of the contract, but still not satisfactory investor who wants IRR above 25%. IRR and payback period method is very good to be used as indicators in investment decisions.

References:
1. Sullivan W.G., Wicks E.M., Koelling C.P, (2012), Engineering Economics, pp. 194, 15th edition, Prentice Hall.
2. what-is-irr-and-how-is-it-calculated, Retrieved from http://www.onemint.com/2010/11/23/what-is-irr-and-how-is-it-calculated/
3. discounted-payback-period, Retrieved from http://accountingexplained.com/managerial/capital-budgeting/discounted-payback-period

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2 Responses to W3_HWB_IRR and Payback Period

  1. drpdg says:

    GREAT case study Pak Heru and you’ve done a nice job following our step by step process and with your citations.

    My question to you still is where are you coming up with the MARR of 25%? I think that is a VERY important question because with a calculated MARR of 23.6%, this may very well be a very attractive investment to make…. BUT until you know what elements went into determining the MARR, you may very well have set a criteria which is unrealistic, given the risk and investment involved…..???

    I really urge you to focus on pages 310 and 529-534 and explain to us FIRST how you calculated your MARR. Only when you know your MARR and have picked a value which truly reflects the risk can you make any of the other calculations.

    For your W4 blog posting, demonstrate what you know about WACC and MARR and show us clearly what components went into calculating your 25% and whether 23,6% is still within reason, given the risks being assumed? (And the answer may be yes or no)

    Keep up the good work, Pak Heri!!

    BR,
    Dr. PDG, Jakarta

  2. drpdg says:

    Whoops, Pak Hari!!! Sorry…… Maaf!!!

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