You are on page 1of 28

# Internal Rate of Return

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.

## In more specific terms, the IRR of an

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.

## A firm (or individual) should, in

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.

## Because the internal rate of return is

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.

## One of the uses of IRR is by corporations that wish

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 Examples

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.

## Example 1: Manual Method

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.

## The first step is to determine the cash flow

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

## The second step is to determine the present value of

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.

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

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

## IRR is the rate at which the net present

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
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.

## From the IRR definition, we know that the

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.

## As we can see from this table, a

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%.

## Internal Rate of Return Formula

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.

## The table is part of the first table and we can

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.

## Internal Rate of Return

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.

## The internal rate of return is a very robust capital

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).