Question

What will be most cost effective? When looking for ways to save money, while getting the best product available, we look at the best outcome of costs vs. benefits. or in the terms of what we are studying in this module, the highest rate of return (ROR). Simply stated, the definition of ROR is the discount rate that makes the net present value of an investment zero. Therefore, the greater the discount rate, the greater the return on the investment. Is ROR the same as receiving the “biggest bang for your buck?” If present worth and annual worth are easier to calculate then the ROR, why is ROR a more popular analysis tool for determining investments? If a company does not have the money to invest in all positive discount rate projects as per ROR, will ROR calculations provide a reliable priority of investment projects? Why or why not? Sometimes ROR can give multiple results. How would you explain these multiple results to management?

Answer 1

When you say that ROR is the discount rate that makes the net present value of an investment zero, you are talking about IRR (Internal rate of return) i.e. the rate at which present value of inflow equals the present value of outflow (resulting in NPV becoming zero).

'Biggest bang for your buck' is in a way talking about the return on your investment (ROI). It implies highest value for the amount spent by you. It is to be noted that sometimes even ROI is referred to as ROR. Both ROI and IRR are used to measure the performance of one's investment. ROI calculates the return by considering the difference between current value and original value in percentage terms. ROI gives the return % right from the beginning i.e. calculates return right from the time you invested till date whereas IRR is an annualised percentage. For both these measures of ROR, the rule is the same - Higher the better i.e. getting biggest bang for your buck.

ROR is more popular analysis tool than present worth and annual worth because the computers these days have made ROR calculation easy. It serves as an easy measure i.e. it can be compared to the cost of capital of the company, if the IRR is higher than the cost of capital, the project should be undertaken. If it is lower than the cost of capital, the project is not worthwhile. It serves as a easy to compare yardstick making the accept-reject decisions simple to take.

The projects can be divisible or indivisible. If the projects are divisible, the project should be undertaken in the order of highest to lowest ROR. The projects with ROR below the cost of capital should be rejected outright. So yes it gives a reliable priority of investment project selection. For projects that are indivisible, it is better to calculate profitability index i.e. return per $. The project with highest return per dollar of investment must be undertaken. The projects undertaken should have an overall highest ROR for the company.

It is possible that ROR might give multiple results. It happens when there are >1 IRRs for a particular project. Usually projects with normal distribution of cash flows have a single IRR but non-normal distribution of cash flows result in more than 1 IRR (i.e. ROR) i.e. the is negative cash flow followed by positive followed by negative and so on. This reason can be explained to the management. Also, the management can be explained the solution for the same - i.e. instead of going for IRR as the ROR , go for Modified IRR or net present value method of selecting projects.