Internal Rate of Return (IRR)

The internal Rate of Return is the rate of return that equates the present value of all cash
inflows to the initial investment. In other words, it is the interest rate that causes the net present
value to be zero. The rule in decision-making is that projects with the highest internal rates of
return are accepted. This method is very tedious because there is no exact formula.

Computing the internal rate of return presents two complications. First, the actual internal rate of
return will most likely not coincide with the rates available in the present value tables. In other
words, it is unlikely that the actual rate of return will exactly be 15% or 20%. The actual rate of
return will probably lie somewhere between two rates of return included in the table. A fair
estimation of the internal rate of return can be determined by means of trial and error and the
mathematical process known as interpolation. Second, the cash flows may be unequal.
Computing the internal rate of return then becomes a “hit-or-miss” proposition.

Detailed computer routines ease the computational drudgery. Manually, the process is
burdensome, i.e., one simply tries a rate, and then tries another, until the applicable rate is
finally determined.

Decision Rule:

If IRR < required rate of return ------> reject the project

If IRR > required rate of return ------> accept the project

Advantages
The advantages of using the internal rate of return method are as follows:
1. It acknowledges the time value of money. Cash inflow and cash outflow are translated
into their present values using the computed IRR before arriving at a decision.
2. It is more exact and realistic than the ARR.
3. If not constantly changing, the streams of cash flows can provide a rate of return that is
useful in making a decision.
4. It provides a decision similar to the NPV if the project is independent.

Disadvantages
The disadvantages of using the internal rate of return method are as follows:
1. It requires a lot of time to compute especially when the cash inflows are not even.
2. It provides multiple IRRs in situations where the movement of cash flows is erratic.
3. Under manually exclusive projects, the IRR may provide results conflicting the NPV.

Example:
Assume that:
Initial investment Php 12,950
Estimated life 10 years
Annual cash inflows Php 3,000
Cost of capital 12.0%

Answer: Trial and error

 At 18%

= Php3,000 x PV of Ordinary Annuity

= Php3,000 x 4.4941
= Php13,482

At 20%

= Php3,000 x PV of Ordinary Annuity

= Php3,000 x 4.1925
= Php12,578

By interpolation

Php13,482 Php13,482
12,950 Initial investment
12,578 at 20%
---------------------------------------------
Php 532 Php 904
==========================

IRR = 18% + 532/904(2%)

= 18% + 1.18%
= 19.18%

If the cash inflows are unequal, firstly, complete the sum of the present value of all cash inflows;
secondly, proceed to the trial-and-error procedure; lastly, interpolate.