The *return on invested capital*, RIC,
is used by the add-in to find a single interest measure that
depends only on the cash flow and what we call the external investment
rate. The external investment rate is the
rate that the organization can earn on money external to the
project. A reasonable value to use for this is the MARR. One
definition of the MARR is
"the rate that you could earn if the money were not invested
in the project".
The difficulty with the example cash flow is that
the project is mixed in that at some time in its life it uses
cash from the organization (an investment), while at others
it is loaning cash to the organization (a loan). All
three measures, NPW, NAW and IRR, compound the current balance
with the same interest rate whether the balance is positive
or negative.
Let's say you have an arrangement with a bank that
allows you to borrow money and deposit money in the same account.
When the account is negative, that is the bank is investing in
you, you must pay interest to the bank. When the account is positive,
you are loaning money to the bank and they will pay interest
to your account. If your bank is like mine, they will not charge
the same interest rate in the two cases. The bank will charge
a higher rate when you owe them money, and pay a lower interest
rate when it owes you money.
This is the same as the RIC computation. The computation
produces a cumulative balance as the right-most column
in the figure above. Here we call the balance the *Net
Investment*.
When the balance is negative, the project is an investment and
the balance grows (becomes more negative)
with interest rate *i*.
When the balance is positive, the project is loaning money to
the sponsor, so the balance grows (becomes more positive)
with interest rate equal to the *MARR*.
The RIC is the value of *i* that
makes the cumulative value at the last period equal to zero.
This brief discussion is only an introduction to a complicated
concept. The important point here is that RIC gives
one value when the IRR may give more than one.
The value of the RIC is unique and it leads to
the same conclusion as the NPW method. The add-in assumes that
the external rate of return is equal to the MARR. For the example
when the MARR is 10%, the RIC is 9.65%. Both the NPW and the
RIC reject the investment.
A number of other measures have been suggested that yield a
single rate for evaluating a project. One is the *modified
internal rate of return*, MIRR. This is discussed at several
sites on the web, and is implemented in the MIRR Excel function. |