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mple Based On Internal Rate Of Return

An investment of $ 1,36,000 yields the following cash inflows (profits before depreciation but after tax ! "etermine internal rate of return!

Year 1 # 3 $ % &otal Solution

$ 30,000 $0,000 60,000 30,000 #0,000 1,'0,000

(et us first discount the various cash inflows at ') to see whether this is the internal rate of return!

Year 1 # 3 $ %

Amount ($) 30,000 $0,000 60,000 30,000 #0,000

8% factor 0!*#6 0!'%+ 0!+*$ 0!+3% 0!6'1 &otal

Discounted value ($) #+,+'0!00 3$,#'0!00 $+,6$0!00 ##,0%0!00 13,6#0!00 1,$%,3+0!00

,ince our cash outflow is $ 1,36,000 and out total discounted cash inflows is much higher than that, it is apparent that the internal rate of return should be higher than ')! (et us try 1#) as the discounting rate!

Year 1 # 3 $

Amount ($) 30,000 $0,000 60,000 30,000

1 % factor 0!'*3 0!+*+ 0!+1# 0!636

Discounted value ($) #6,*+0 31,''0 $#,+#0 1*,0'0

#0,000

0!%6+ &otal

11,3$0 1,31,'10

&his time the total discounted cash inflow ($ 1,31,'10 is lower than the cash outflow of $ 1,36,000! -ence a lower rate than 1#) is the internal rate of return! (et us try 10)!

Year 1 # 3 $ %

Amount ($) 30,000 $0,000 60,000 30,000 #0,000

1!% factor 0!*0* 0!'#6 0!+%1 0!6'3 0!6#1 &otal

Discounted value ($) #+,#+0 33,0$0 $%,060 #0,$*0 1#,$#0 1,3',#'0

At discount rate of 10) the sum of the present value of cash inflows is more than the cash outflow! -ence the internal rate of return is between 10) and 1#)! &he exact rate can be obtained by interpolation as follows.

/!0!0! 1 2here 3450 1 3resent value of cash outlay

3456A& 1 3resent value of cash inflows ("6r 7 annuity

r 1 8ither of two interest rates used in the formula

9r 1 "ifference in interest rates

934 1 "ifference in present values of inflows! &herefore,

1 10) : 0!+) 1 10!+) ;ote. ,tudents must have seen that as we used a higher discounting rate (i!e! 1#) instead of ') the total of the present value of inflows went down! ,imilarly, if we use a lower discounting rate the present value of cash inflows will increase! <y trial and error we can reach = rate, at which the discounted cash inflows and outflows will be e>ual! &his would be the internal rate of return!

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