Using ROR analysis to evaluate a single project
The rate of return method is commonly used in engineering and business settings to evaluate one project, as discussed in this chapter, and to select one alternative from two or more, as explained in the next chapter. As mentioned earlier, an ROR analysis is performed using a different basis than PW and AW analyses. The cash flows themselves determine the (internal) rate of return. As a result, there are some assumptions and special considerations with ROR analysis that must be made when calculating i* and in interpreting its real-world meaning. A summary is provided below.
§ Multiple i* values. Depending upon the sequence of net cash inflows and outflows, there may be more than one real-number root to the ROR equation, resulting in more than one i* value.
§ Reinvestment at i*. Both the PW and AW methods assume that any net positive investment (i.e., net positive cash flows once the time value of money is considered) is reinvested at the MARR. However, the ROR method assumes reinvestment at the i* rate. When i* is not close to the MARR (e.g., if i* is substantially larger than MARR), this is an unrealistic assumption. In such cases, the i * value is not a good basis for decision making.
§ Different procedure for multiple alternative evaluations. To correctly use the ROR method to choose from two or more mutually exclusive alternatives requires an incremental analysis procedure that is significantly more involved than PW and AW analysis.
If possible, from an engineering economic study perspective, the AW or PW method at a stated MARR should be used in lieu of the ROR method . However, there is a strong appeal for the ROR method because rate of return values are very commonly quoted. And it is easy to compare a proposed project’s return with that of in-place projects.
When it is important to know the exact value of i*, a good approach is to determine PW or AW at the MARR, then determine the specific i* for the selected alternative.
As an illustration, if a project is evaluated at MARR =15% and has PW< 0, there is no need to calculate i*, because i*<15%. However, if PW is positive, but close to 0, calculate the exact i* and report it along with the conclusion that the project is financially justified.