Internal Rate of Return IRR Internal Rate of
- Slides: 15
Internal Rate of Return (IRR)
Internal Rate of Return (IRR) • Is the rate of interest at which – The present value of expected cash inflows from a project • Equals – The present value of expected cash outflows of the project.
Calculating the Internal Rate of Return
Computing the IRR. . . • The IRR can be calculated by dividing the net investment by the annual cash flow to find the investments present value factor. • Then, refer to the Present Value of an Annuity of $1 table to find the corresponding rate.
Whoa! I never thought I would say this - but could I see that in equation form? I surely must be losing it!
Calculating the IRR Net Investment in Project ----------------- = PV Factor Annual Cash Flows 379, 100 ------- = 3. 791 $100, 000 Present Value Factor
Calculating the IRR. . . • To determine the IRR, refer to the Present Value of an Annuity of $1 table for 5 periods; • Scan across the line until you find a factor approximating 3. 791; • The rate at the top of the column is the Internal Rate of Return.
This is the IRR
Wow! Is it always that easy? Surely there must be a fly in the ointment.
Calculating the IRR. . . • Use computer • Use financial calculator • Use trial and error
Trial and Error. . . Try a discount rate and calculate the NPV of the project using that rate.
Trial and Error. . . • If the NPV is less than zero, try a lower rate. – A lower rate will increase the NPV. We are looking for the rate that will result in zero NPV.
Trial and Error. . . • If the NPV is greater than zero, try a higher discount rate. – Higher rate equals lower NPV.
Using the IRR. . . • A project is accepted if the internal rate of return exceeds the required rate of return. – If IRR > RRR ==>Accept – If IRR = RRR ==>Accept – If IRR < RRR ==>Reject
Using the IRR. . . • Projects with higher IRRs are preferred to projects with lower IRRs, all other things being equal.
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