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INTERNAL RATE OF RETURN

What is internal rate of return?
• IRR is the discount rate that equates the present value of cash inflow to the present value of cash outflows.
• IRR is the true rate of return associated with a project or yield on an investment or marginal efficiency of capital.

.Basic principle in IRR 0 Interest is compounded annually 4 100 100 (1+r)4 = 146 100 = 146 (1+r)4 = 146 X 1 146 (1+r)4 Assume r is 10 % =146 x 1/ (1.10)4 100 = 100 True rate of return is 10 %.

At 10 % discount rate the present Value of cash inflow is equal to the present value of cash outflow. Now you can understand that the discount rate that equates the Present value of cash inflow to the present value of cash outflow Is the internal rate of return. IRR is the annualized rate of return on investment .Basic principle in IRR 0 1 2 3 4 146 -100 110 121 133 @ 10 % interest rate compounded annually If you deposit Rs 100 now and get Rs 146 after 4 years the rate of Return associated with your investment is 10 % ( yield on your Investment or true rate of return).

10)4 161 (1.Empirical testing of IRR 0 1 2 3 4 5 .10)1 121 133 146 161 100 100 121 (1.10)3 146 (1.10)2 133 (1.10)5 100 100 .100 100 110 110 (1.

10)2 133 (1.100 121 133 146 161 100 100 121 (1.10)4 161 (1.Empirical testing of IRR 0 2 3 4 5 .10)3 146 (1.10)5 100 100 .

10)4 161 (1.10)5 .100 133 146 161 100 133 (1.Empirical testing of IRR 0 3 4 5 .10)3 100 100 146 (1.

100 146 161 100 100 146 (1.10)5 .10)4 161 (1.Empirical testing of IRR 0 1 2 3 4 5 .

1 CO CI = 1+r CO CO = CI (1+ r) .000 = 10.08 – 1 = 0.800 after one year.Concept and equation of IRR Assume that you deposit Rs 10.08 or 8 % r = C1 – CO CO r = CI .000 with a bank and would get back Rs 10.000 = 1.800 – 10.800 .10.000 10. The true rate of return on your investment would be: Rate of return = 10.000 10.

000 10.800 10.800 10.000 = 10.000( 1 + 8 % ) 10.08) = 10.08 C0 = C1 (1+r)1 .800 1.Concept and equation of IRR 0 @8% 1 10.800 10.000 + 10.000 (1.000 x 8 % = 10.

NPV must be equal to zero .Formula for IRR IRR = C1 + C2 + C3 + ……. + Cn (1+k)n - Co =0 (1+k)1 (1+k)2 (1+k)3 IRR = n Ct .C0 t = 1 (1+K)t =0 At Internal rate of return.

Calculation of IRR Uneven Cash Flows Even Cash Flows .

000 and is expected to generate cash inflows of Rs 8.com/IRR.asp .datadynamica.000 at the end of each year for next 3 years. Calculate the Internal rate of return.000 and Rs 6.000.Uneven Cash flows: Calculating IRR by Trial and Error Method A project costs Rs 10. Rs 7. http://www.

0 5. 0 (Net Present Value) NPV: 0 3. enter a discount rate. To calculate NPV.(Internal Rate of Return) IRR: 1. 0 7. Discount Rate: 0 % . 0 N/A 2. 0 Calculate 4. 0 IRR is independent of the Discount Rate. 0 6.

756 + 6000 x 0.862 + 7000 x 0.r1) .658 6960 + 5292 + 3948 = 16200 = 16.PVCI2 x (r2 .641 6896+ 5201 + 3846 = 15943 = 16.000 Trial @ 16 % 8000 x 0.CALCULATION OF IRR – TRIAL AND ERROR Trial @ 15 % 8000 x 0.870 + 7000 x 0.PVCO PVCI1 .000 15 % ( r1) 16200 PVCI1 16 % (r2) 15943 PVCI2 IRR = ( r1) + PVCI1 .743 + 6000 x 0.

000 = 5430 (PVAF 6.000 + 5430 (PVAF 6.r ) = 0 20.Equal Cash Flows : Calculation of IRR Cost of investment = Rs 20.000 5430 (PVAF 6.683 .000 Annual cash flow = Rs 5430 for 6 years Calculate the Internal Rate of Return NPV = -20.r ) = 3.r ) (PVAF 6.683 r = 16 % = 3.r ) = 20.

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000 .000 25 5430 (PVAF 6.000 10 5430 (PVAF 6.20.000 1 5430 2 5430 3 5430 4 5430 5 5430 NPV 12580 7.000 20 5430 (PVAF 6.000 15 5430 (PVAF 6.000 16 5430 (PVAF 6.20) – 20.15) – 20.974 6 5430 Discount rate % 0 32580 – 20000 5 5430 (PVAF 6.561 3.16) – 20.648 550 0 -1.Decision Making Criteria – Accept / Reject Rule Using IRR 0 .25) – 20.942 -3.10) – 20.5) – 20.

Decision Making Criteria – Accept / Reject Rule Using IRR 12 10 8 6 x x If r > k accept If r < k reject If r = k may accept 4 x 2 0 -2 IRR xx 5 10 15 x 20 NPV + 25 x NPV - .

It is consistent with the share holders wealth maximization objective • 4. Value additive principle does not hold when IRR method is used .It takes into consideration of all cash flows generated through out the life of the project • 3.Evaluation of IRR • 1.It considers the time value of money • 2.

8 IRR % 20.1 2.7 = 11.0 15.7 11.1 + 2.0 12.8 IRR (A) + IRR (B) = IRR (A+B) .2 NPV (A) + NPV (B) = NPV (A+B) = 9.Value Additive Principle Project A B A+B CO -100 -100 -200 CI 120 168 288 NPV@10 % 9.

Evaluation of IRR • It fails to indicate a correct choice between mutually exclusive projects under certain situations • NPV and IRR rules will give conflicting ranking to the projects under the following conditions – The cash flow pattern of the projects may differ – The cash outlays of the projects may differ – The projects may have different expected lives .

4 -106 -257 -388 .6 276 -3.Project M N CO -1.680 C1 1.510 NPV@9% 301 321 IRR 23 % 17 % NPV PROFILES OF PROJECT M AND N Discount rate % 0 5 10 15 20 25 30 M (Rs) % change 560 409 -2.680 -1.400 140 C2 700 840 C3 140 1.2 53 -40 -125 N (Rs) % change 810 520 -3.6 70 -7.2 159 -4.5 276 -4.

Evaluation of IRR 1200 1000 800 600 IRR 17 % (Project N) IRR 23 % (Project M) x Fisher’s Intersection 400 200 0 -200 -400 5 10 15 20 25 30 .