Internal Rate of Return IRR

The internal rate of return is simply the rate of return on an investment. IRR is similar to the net present value calculation. The NPV calculation finds the net present value using a predefined discount rate. IRR finds the discount rate that makes the NPV equal to zero. The discount rate is the cost of borrowing or using money for investments. The decision to accept or reject the purchase depends on the whether the internal rate of return is higher than the discount rate. The decision criteria for these projects is simple, accept the project if the IRR is higher than the discount rate or the cost of borrowing. There are also financing decisions, where there are cash inflows followed by cash outflows. For example, magazine publishers recieve subscription payments in the beginning and then incur delivery costs later. In the case of financing projects the decision criteria is opposite to that of the investing projects, accept the financing project if the IRR is less than the discount rate or cost of borrowing. In the magazine example accept the project if it is cheaper to finance or borrow the money from the subscribers than the bank. This example involves the decision to purchase a new machine to replace an old one. JonesCo needs to purchase a new machine and has a choice of two machines that will provide the same function. Machine A cost $100,000 and would provide savings of $25,000 for the next five years. Machine B cost $75,000 and would provide savings of $20,000 for the next 5 years. The company's discount rate is 10%. Machine A 0 Cash flows -$100,000 1 $25,000 Time 2 3 $25,000 $25,000

4 $25,000

5 $25,000

Machine B Cash flows 0 -$75,000 1 $20,000

Time 2 3 $20,000 $20,000

4 $20,000

5 $20,000

Machine A costs more than machine B but also provides higher savings than machine B in the future. Both machines have total savings of $25,000 over the cost of the machine. IRR analysis can be used to find out which machine will provide the highest return on investment. Machine A IRR Machine B IRR 10.4248%

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The IRR for machine A is less than the discount rate of 10%, in other words it cost more to borrow the money than the machine will return. In contrast machine B has an IRR of 10.42%, this means that the machine will return more than the cost of borrowing the money and is therefore a good investment.

Internal Rate of Return Function
The internal rate of return can be easily calculated using the IRR function in Excel. The IRR function can be found under the financial category. To illustrate this we will use machine B from the previous example. Machine B Cash flows 0 -$75,000 1 $20,000 Time 2 3 $20,000 $20,000 4 $20,000 5 $20,000

Values- cash flows Guess- this is where you can guess the rate of return and Excel will use it as a starting point. This is optional.

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