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INTERNAL RATE OF RETURN DESCRIBED

INTERNAL RATE OF RETURN DESCRIBED

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BACHELOR OF COMMERCE

UNIT: PROJECT MANAGEMENT (CAM 205)

ASSIGNMENT I: IRR

Date Submitted: 23/06/2014

Prepared by: Calvince Ouma

Discussed and presented by: Group Members

LECTURER :

GROUP MEMBERS:

1.

2.

3.

4.

5.

6.

KCA University-Assignment 1-Internal Rate Of Return (IRR)

INTERNAL RATE OF RETURN (IRR)

The IRR of an investment is the interest rate at which the net present value of costs (negative

cash flows) of the investment equals the net present value of the benefits (positive cash flows) of

the investment.

Internal rates of return are commonly used to evaluate the desirability of investments or projects.

The higher a project's internal rate of return, the more desirable it is to undertake the project.

Assuming all other factors are equal among the various projects, the project with the highest IRR

would probably be considered the best and undertaken first.

A firm (or individual) should, in theory, undertake all projects or investments available with

IRRs that exceed the cost of capital. Investment may be limited by availability of funds to the

firm and/or by the firm's capacity or ability to manage numerous projects.

Steps in Computing IRR

Step 1 : Calculate the NPV using the companys cost of capital

Step 2 : Calculate the NPV using the second discount rate

NB:

If the NVP is Positive Use the Second Rate that is greater than the First Rate

If the NVP is Negative Use the Second Rate that is less than the First Rate

Step 3 : Use the two NPV values to estimate the IRR. The formula to apply is as follows

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KCA University-Assignment 1-Internal Rate Of Return (IRR)

Example:

Focus High Ltd is trying to decide whether to buy a machine of Ksh. 80,000 which will save cost

of Ksh. 20,000 p.a for 5 years and which will have a resale value of Ksh. 10,000 at the end of

year 5. If it is the companys policy to undertake projects only if they expect to yield a DCF

return of 10% or more, ascertain whether this project be undertaken.

Step 1 The First NPV using the company cost of capital

Year Cash Flow PV Factor 10% PV of Cash Flow

Ksh. Ksh.

0 -80,000 1.000 -80,000

1-5 20,000 3.791 75,820

5 10,000 0.621 6,210

NPV= 2,030

Step 2

Calculate The Second NPV using a rate greater than the first rateas the first rate gave a positive NPV

Suppose we try 12%

Year Cash Flow PV Factor 10% PV of Cash Flow

Ksh. Ksh.

0 -80,000 1.000 -80,000

1-5 20,000 3.605 75,820

5 10,000 0.567 5,670

NPV= 2,230

This is fairly close to sero and negative. The IRR is therefore greater than 10% (positive NPV of Ksh.

2,030 but less than 12% (negative NPV of Ksh. 2,030

Step 3 Use the two NPV values to estimate the IRR

The interpolation method assumes that the NPV rises arises in linear fashion between the two

NPV close to 0. The IRR is therefore assumed to be a straight line between NPV= 2,030 at

10% and NPV = -2,230 at 12%

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KCA University-Assignment 1-Internal Rate Of Return (IRR)

Uses

Important: Because the internal rate of return is a rate quantity, it is an indicator of the efficiency,

quality, or yield of an investment. This is in contrast with the net present value, which is an

indicator of the value or magnitude of an investment.

An investment is considered acceptable if its internal rate of return is greater than an established

minimum acceptable rate of return or cost of capital. In a scenario where an investment is

considered by a firm that has equity holders, this minimum rate is the cost of capital of the

investment (which may be determined by the risk-adjusted cost of capital of alternative

investments). This ensures that the investment is supported by equity holders since, in general,

an investment whose IRR exceeds its cost of capital adds value for the company (i.e., it is

economically profitable).

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KCA University-Assignment 1-Internal Rate Of Return (IRR)

ADVANTAGES OF INTERNAL RATE OF RETURN

1. Perfect Use of Time Value of Money Theory

Time value of money means interest and it should high because we are sacrifice of money for specific

time. IRR is nothing but shows high interest rate which we expect from our investment. So, we can say,

IRR is the perfect use of time value of money theory.

2. All Cash Flows are Equally Important

It is good method of capital budgeting in which we give equal importance to all the cash flows not earlier

or later. We just create its relation with different rate and want to know where is present value of cash

inflow is equal to present value of cash outflow.

3. Uniform Ranking

There is no base for selecting any particular rate in internal rate of return.

4. Maximum profitability of Shareholder

If there is only project which we have to select, if we check its IRR and it is higher than its cut off rate,

then it will give maximum profitability to shareholder

5. Not Need to Calculate Cost of Capital

In this method, we need not to calculate cost of capital because without calculating cost of capital, we can

check the profitability capability of any project.

DISADVANTAGES OF INTERNAL RATE OF RETURN

1. To understand IRR is difficult

It is difficult to understand it because many student can not understand why are calculating different rate

in it and it becomes more difficult when real value of IRR will be two experimental rate because of not

equalize present value of cash inflow with present value of cash outflow.

2. Unrealistic Assumption

For calculating IRR we create one assumption. We think that if we invest out money on this IRR, after

receiving profit, we can easily reinvest our investments profit on same IRR. We seem to be unrealistic

assumption.

3. Not Helpful for comparing two mutually exclusive investment

IRR is not good for comparing two project . IRR method , as an investment decision tool, should not be

used to rate mutually exclusive projects but only to decide whether a single project is worth investing in.

In cases where one project has a higher initial investment than a second mutually exclusive project, the

first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders' wealth)

and should thus be accepted over the second project (assuming no capital constraints).

Sources

BPP Learning media c 2009

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