W10_SSG_Investment Decision by Internal Rate of Return


PROBLEM DEFINITION

Considering traffic Jam in Jakarta, many of the worker who live at suburb of Jakarta using motorcycle as mean of transportation to office. This situation gives opportunities to develop a business motorcycle rental. I want to see whether this motorcycle rental is economically justified.

DEVELOPMENT OF FEASIBLE ALTERNATIVES

There are several methodologies used to justify whether the investment is justifiable or not. One of them is by measuring the Internal Rate of Return (IRR) and Minimum Acceptance Rate of Return (MACC).

DEVELOPMENT OF OUTCOMES FOR EACH ALTERNATIVE

The rule is if IRR ≥ MARR, the investment is economically justified. In this case, MARR is determined 17.88% per month. The duration of the investment is 1 year.

SELECTION OF CRITERIA

MARR (Minimum Acceptance Rate of Return).

Considering that “ I can invest the total cost for Investment below to Bank” as an options. So The MARR will be based on this assumption.

Investment Expected Return can be calculated based on below equation.

RS-RF = β (RM-RF),

where         

RS =  Expected Return

RF = Risk Free Rate of Investment

RM = Return of Marker as a whole

RM – RF = Market Premium

Β  = Beta of Stock

Equation 1. Expected Return

This exercise considering below assumption:

Risk Free (RF) = fixed interest deposits rate (Bank Mandiri) = 5.13 % / year

Market Premium (RM-RF) = 8.5% ()

Beta of Stock = 1.5

RS = RF+ β (RM-RF)

RS = 5.13% +1.5 (8.5%) = 17.88%

MARR = RS = 17.88%

IRR (Internal Rate of Return).

Figure 1. Cost of Investment for an a year

                                Figure 2. Revenue of One year + Salvage Value

Figure 3. Cashflow for one year considering the IRR

ANALYSIS FOR THE ALTERNATIVES

IRR is reached when Total NPV = 0.

Figure 4.  IRR = NPV=zero

NPV = PV1 + PV2 + PV3 + PVn…Equation 1. Net Present Value PV = C / (1 + i)^nEquation 2. Present Value
IRR = NPV = 0,Equation 3. Interest Rate of Retun WherePV = Present ValueNPV = Net Present ValueIRR = Interest Rate of ReturnI = interest rateN = number of time

Folllowing the equation above, it’s clear that NPV is function of interest rate (i) and number (n) inversely. This also represented in the graphic when interest rate increase, NPV is decrease. In one point where NPV = 0, it’s interest rate is the IRR.

According to IRR 30,01% > MARR 17.88%, this investment is economically justified.

SELECTION ON THE PREFERRED ALTERNATIVES

The investement is economically justified for investment according to IRR 30.01 % > MARR 17.88%. The margin of IRR – MARR =  IDR 4,324K.

PERFORMANCE MONITORING AND POST EVALUATION RESULT

IRR determination is based on cash flow. Higher income, lower cost would result higger IRR.

REFERENCES

Investovedia.(2013).Internal Rate of Return.Access September 27, 2013 from

http://www.investopedia.com/terms/i/irr.asp

Princeton University.(2013).Internal Rate of Return.Access September 27, 2013 from

http://www.princeton.edu/~achaney/tmve/wiki100k/docs/Internal_rate_of_return.html

Investodia.(2013).How to calculate Required Rate of Return.Access October 1, 2013 from

http://www.investopedia.com/articles/fundamental-analysis/11/calculating-required-rate-of-return.asp

Kontan.(2013).Suku Bunga Keuangan.Access.October1,2013 from.

http://pusatdata.kontan.co.id/bungadeposito/

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1 Comment

Filed under Sutoyo S, Week 10

One response to “W10_SSG_Investment Decision by Internal Rate of Return

  1. AWESOME Pak Sutoyo!!! This is the quality posting I am looking for!! Now I feel comfortable that you at least understand how to calculate MARR and what a “reasonable” MARR should look like for a reasonably risky project here in Indonesia.

    What I expect you to do is focus less on the NPV and more on the WACC and MARR numbers. What I think you will find is that MOST Indonesian companies are using MARR which are way, way way too low, given the riskiness of their projects.

    ESPECIALLY the Government of Indonesia which unless they have changed, were using 10%?

    Bottom line- IF you get the MARR wrong then the whole NPV/IRR/ERR analysis is WRONG……

    Looking forward to seeing you apply this lesson learned in your real life, day to day project analysis.

    BR,
    Dr. PDG, Jakarta

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