Internal Rate of Return (IRR) for Investing Project

Internal Rate of Return (IRR) for Investing Project

Internal rate of return (IRR) is the discount rate that makes Net Present Value (NPV) of investment zero.

NPV =sum of present value of each cash inflow – initial                investment when NPV=0, so sum of present value of each cash inflow =initial investment

Investing project has only one IRR.

To determine IRR, we can use the following way:

IRR= r1 + [(r2-r1)/(NPVr1-NPVr2)] x NPVr1, so normally discount rate 2( r2) > discount rate 1 (r1)

Project Decision:

         – if IRR>cost of capital => accept the project

          – if IRR<cost of capital => Reject the project

Advantages for Internal Rate of Return (IRR):

• Closely related to NPV, often leading to identical decisions.
• Easy to understand and communicate.

Disadvantages for Internal Rate of Return (IRR):

• May result in multiple answers or not deal with unconventional cash flows.
• May lead to incorrect decisions in comparisons of mutually exclusive investment

Example:

Capital investment of $10,000 for three years has cash flows below:

Required:

1. Calculate internal rate of return (IRR)
2. Make decision, and required rate of return of 15%

Solution:

1. Internal Rate of Return (IRR)

NPV=5,000/(1+r)^1 +5,000/(1+r)^2+2,000/(1+r)^3 – 10,000

NPV at 10% = $177

NPV at 12% = ($126)

IRR=10%+[(12%-10%)/(177+126)] x 177 = 11.17%

2. Decision

IRR=11.17%

Required rate of return = 15%

15%>11.17%, so the project should be rejected.

Source:

1. Phnom Penh HR
2. Mcgraw-Hill – Fundamentals Of Corporate Finance