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INTERNAL RATE OF RETURN

NPV (Net Present Value)


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!

Net Present Value


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

4627 3719 3005 9000


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

The NPV Decision Rules


If NPV>0, accept the Project
If NPV=0, accept or reject the Project.
If NPV<0, reject the Project.

Internal Rate of Return (IRR)


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).

If IRR > k, the project should be accepted.


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Calculation of Internal Rate of


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

Calculation of Internal Rate of


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 %

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Why IRR matters

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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Problems with the IRR


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.

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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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Multiple and Indeterminate


Internal Rates of Return
Conventional projects have a unique rate of return.

Multiple or no internal rates of return can occur for


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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Choosing Between the Discounted


Cash Flow Methods
Independent investments:

Projects that can be considered and evaluated in isolation from


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.

For example, a piece of land is used to build a factory, which


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.

In such cases, it doesnt matter whether we use NPV or IRR.


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.
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Link to Project Management


NPV and IRR in the decision taking process

Methods to evaluate a project


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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