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IRR (Internal Rate of Return)

in Project Management

The two most-used measures for evaluating projects are

the net present value and the internal rate of return!

The difference between the present value of the future cash flows from

an investment and the amount of investment. Present value of the

expected cash flows is computed by discounting them at the required rate

of return.

Where,

N=total number of periods

T= the time of the cash flow

i= the discount rate (the rate of return that could be earned on an

investment)

Rt = the net cash flow i.e. cash inflow cash outflow at time t (R0: it is

subtracted from the whole as any initial investments during first year is

not discounted for NPV purpose)

NPV EXAMPLE

Example :

Investment of $9000.

Net cash flows of $5090, $4500 and $4000 at the

end of years 1, 2 and 3 respectively.

Assume required rate of return is 10% p.a.

What is the NPV of the project?

Solution:

Apply the NPV formula given.

n

NPV

Ct

t 1 1 k

C0

5090

4500

4000

9000

2

3

1.10 1.10 1.10

2351

Thus, using a discount rate of 10%, the projects NPV = +$2351 > 0, and is therefore

acceptable.

If NPV>0, accept the Project

If NPV=0, accept or reject the Project.

If NPV<0, reject the Project.

The internal rate of return (IRR) is the discount

rate that equates the PV of a projects net cash

flows with its initial cash outlay.

IRR is the discount rate (or rate of return) at

which the net present value is zero.

The IRR is compared to the required rate of

return (k).

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Return

By setting the NPV formula to zero and treating the rate of return as the

unknown, the IRR is given by:

1 k

t 1

Ct

C0 0

where:

C0 = initial cash outlay on project

Ct = net cash flow generated by project at time t

n = life of the project

r = internal rate of return

Return (cont.)

Using the cash flows of Example of NPV, the

IRR is:

5090

4500

4000

9000

2

3

1 IRR (1 IRR )

(1 IRR )

IRR 25 %

10

IRR allows managers to rank projects by their overall rates of return rather than their net

present values, and the investment with the highest IRR is usually preferred.

Ease of comparison makes IRR attractive, but there are limits to its usefulness.

For Example, IRR works only for investments that have an initial cash outflow (the purchase of

the investment) followed by one or more cash inflows.

Also, IRR does not measure the absolute size of the investment or the return. This means that

IRR can favor investments with high rates of return even if the dollar amount of the return is

very small.

For Example, a $1 investment returning $3 will have a higher IRR than a $1 million investment

returning $2 million. Another short-coming is that IRR cant be used if the investment

generates interim cash flows. Finally, IRR does not consider cost of capital and cant compare

projects with different durations.

IRR is best-suited for analyzing venture capital and private equity investments, which typically

entail multiple cash investments over the life of the business, and a single cash outflow at the

end via IPO or sale.

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Under normal circumstances, the IRR Rule will lead to the correct

decision (do or dont do) regarding a single investment project. However,

there are problems:

o Risk has to be appropriately accounted for in the hurdle rate.

o If there are multiple positive and negative future cash flows, there may be multiple

IRRs.

o Undoing a project generates the same IRR as doing the project.

o The IRR rule cannot compare two competing projects. One project could have a higher

IRR but a lower NPV.

12

Advantages of IRR

The IRR method is easily understood, it recognizes the time value of money,

and compared to the NPV method is an indicator of efficiency.

KEY POINTS

The IRR method is very clear and easy to understand. 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.

The IRR method also uses cash flows and recognizes the time value of

money.

The internal rate of return is a rate quantity, an indicator of the efficiency,

quality, or yield of an investment.

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Disadvantages of IRR

IRR can't be used for exclusive projects or those of different durations; IRR may

overstate the rate of return.

KEY POINTS

The first disadvantage of IRR method is that IRR, 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.

IRR overstates the annual equivalent rate of return for a project whose interim

cash flows are reinvested at a rate lower than the calculated IRR.

IRR does not consider cost of capital; it should not be used to compare projects of

different duration.

In the case of positive cash flows followed by negative ones and then by positive

ones, the IRR may have multiple values.

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Internal Rates of Return

Conventional projects have a unique rate of return.

non-conventional projects with more than one sign

change in the projects series of cash flows.

Thus, care must be taken when using the IRR

evaluation technique.

Under IRR: Accept the project if it has a unique IRR >

the required rate of return.

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Cash Flow Methods

Independent investments:

other projects.

This means that the decision on one project will not affect the

outcomes of another project.

Mutually exclusive investments:

Alternative investment projects, only one of which can be

accepted.

rules out an alternative project of building a warehouse on the

same land.

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Cont

Independent investments:

For independent investments, both the IRR and NPV methods lead to

the same accept/reject decision, except for those investments where

the cash flow patterns result in either multiple or no internal rate(s) of

return.

Evaluating mutually exclusive projects:

NPV and IRR methods can provide a different

ranking order.

The NPV method is the superior method for mutually exclusive

projects.

Ranking should be based on the magnitude of NPV.

17

NPV and IRR in the decision taking process

estimate the value of the project

choosing which project gets priority

By applying

NPV as time value of money (money figure)

IRR calculate the investments profitability as an interest rate

(percentage figure)

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