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Internal Rate of Return for Capital Budgeting

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Ravi (IBA)

IRR

Definition:

The internal rate of return on an investment or

project is the "annualized effective compounded

return rate" or rate of return that makes the

net present value (NPV as NET*1/(1+IRR)^year)

of all cash flows (both positive and negative)

from a particular investment equal to zero.

It can also be defined as the discount rate at

which the present value of all future cash flow is

equal to the initial investment or in other words

the rate at which an investment breaks even.

investment is the discount rate at

which the net present value of costs

(negative cash flows) of the

investment equals the

net present value of the benefits

(positive cash flows) of the

investment.

Uses of IRR

IRR calculations are commonly used to

evaluate the desirability of investments or

projects.

The higher a project's IRR, the more

desirable it is to undertake the project.

Assuming all projects require the same

amount of up-front investment, the

project with the highest IRR would be

considered the best and undertaken first.

theory, undertake all projects or

investments available with IRRs that

exceed the cost of capital.

Investment may be limited by

availability of funds to the firm

and/or by the firm's capacity or

ability to manage numerous projects.

a rate quantity, it is an indicator of

the efficiency, quality, or yield of an

investment.

This is in contrast with the net

present value, which is an indicator

of the value or magnitude of an

investment.

to compare capital projects.

For example, a corporation will evaluate an

investment in a new plant versus an extension of

an existing plant based on the IRR of each project.

In such a case, each new capital project must

produce an IRR that is higher than the company's

cost of capital. Once this hurdle is surpassed, the

project with the highest IRR would be the wiser

investment, all other things being equal (including

risk).

Calculation

out r

Internal Rate of Return (IRR) or Discounted

Cash Flow Rate of Return measures the

expected rate of returns on an investment

or project based on internal factors.

It finds widespread application to compare

and rank the attractiveness of different

projects. Read on for some IRR examples.

Internal Rate of Return Examples

Assume a new bottling plant costs $25,000, including

installation cost, operating at 100 percent capacity for

five years, with uniform operating costs and profits:

cost of raw materials: $750

overheads such as rent, salary, energy costs and others:

$1000

costs to maintain the machinery: $250

expected sales revenue per annum: $7500

effective tax rate: 10 percent

The IRR of the project can help in determining the

attractiveness of the project relative to the cost of capital.

of the project every year

Annual cash inflow: $7500

Less: cash outflows: ($750+$1000+$250) =

$2000

Gross Profit = $7500-$2000 = $5000

Less: Tax @10 percent of gross profit =

$500

Net annual Cash Flow =$5000-$500=$4500

future cash flows

The formula to determine future cash flows= (Cash

Flow)*(1 + Interest Rate)^number of years

Assuming the cost of capital is 5 percent for this

project.

Present Value for first year = 4500*(1+5 percent) =

4500*1.05 = 4725

The cash flow can vary every year or period of

calculation, but for the sake of convenience, assume

that the cash flow remains same for the entire period

of the machinerys lifecycle, that is 5 years.

percent)^2 = 4500*1.1025 = 4961.25

Present value for the third year = 4500*(1+5

percent)^3 = 4500*1.1576 = 5209.20

Present value for the fourth year = 4500*(1+5

percent)^4 = 4500*1.2150 = 5467.5

Present value for the fifth year = 4500*(1+5

percent)^5 = 4500*1.2763 = 5743.35

Net present value of the project = -25,000 (initial

investment) + 4725 + 4961.25 + 5209.20 +

5467.5 + 5743.35 = 1106.30

value of the investment becomes zero.

At 5 percent, the net present value is

greater than the investment, meaning

that IRR is less than 5 percent, and if

the project delivers a return of 5

percent, it becomes profitable.

In a similar manner, IRR ranks two

projects of similar nature.

IRR Calculation

We will use one example in order to illustrate how the internal rate of

return can be calculated and the approach is. Lets say that company A

uses the internal rate of return to evaluate investment opportunities and

make a decision regarding the profitability and viability of a project.

There is one potential project that Company A wishes to appraise with the

following characteristics:

-An initial investment of $50,000 is required during the first year.

-The project will last for four years and the cash inflows during these four

years will be:

Year 1 : $15,000

Year 2: $20,000

Year 3: $25,000

Year 4: $18,000

The company has a cost of capital of 15% and wishes to appraise this

project and decide whether to proceed or not.

IRR is the discount rate that makes the

present value of the cash flows become

$nil.

We can therefore use a trial and error

approach and start increasing the

discount rates until we get to a present

value that is $nil.

discount rate of 19% gives around

$500 NPV while a 20% discount rate

gives a $-462 NPV. We can therefore

understand that the IRR is

somewhere in the middle or around

19.5%.

IRR= Ra + (NPVa/(NPVa-NPVb))*(Rb-Ra)

where

Ra is the discount rate that gives the

positive net present value,

NPVa is the positive NPV,

NPVb is the negative NPV and Rb is the

discount rate that gives the negative

NPV.

see that a 10% discount rate gives a positive

NPV and a 20% gives a negative NPV. We can

therefore use the formula above and calculate

IRR as:

IRR= 10+(11,242/(11,242+462))*(2010)=19.6%

As you can see both methods will give the

same IRR (more or less) but most people prefer

to calculate IRR by using the second approach

since it involves less calculations.

Advantages

There are however certain advantages that IRR has

which make it one of the most preferred capital

appraisal methods.

Its an easy way to decide to accept or reject

projects.

Its a robust method that can be used to monitor

how a project is performing based on the actuals vs

the budgets and how that compares to the cost of

capital.

It takes into account the time value of money

compared to other methods (payback period for

example) that do not.

appraisal method but there are certain limitations.

For example: When a project has positive cash flows,

followed by negative and then followed by positive cash

flows again, there will be more than one IRR (more than

solution).

IRR is not very reliable when comparing projects that

have significantly different time horizons (i.e project A

will last for 5 years while project B will last for 15 years).

Due to the limitations explained above, IRR is mostly

used a decision tool (accept or reject) and not as a

comparison tool (project A vs project B).

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