Although the most commonly quoted measure of economic worth for a project
or alternative is the rate of return (ROR), its meaning is easily misinterpreted,
and the methods to determine ROR are often applied incorrectly. In
this chapter, the procedures to correctly interpret and calculate the ROR of a
cash flow series are explained, based on a PW or AW equation. The ROR is
known by several other names: internal rate of return (IRR), return on investment
(ROI), and profitability index (PI), to name three. The determination of
ROR is accomplished using a manual trial-and-error process or, more rapidly,
using spreadsheet functions.
In some cases, more than one ROR value may satisfy the PW or AW equation.
This chapter describes how to recognize this possibility and an approach
to find the multiple values. Alternatively, one unique ROR value can
be obtained by using a reinvestment rate that is established independently
of the project cash flows.
Only one alternative is considered here; the next chapter applies these
same principles to multiple alternatives. Finally, the rate of return for a bond
investment is discussed here.
The case study focuses on a cash flow series that has multiple rates of
return.
