Financial Management

( MGT201)

An easy way to calculate Internal

Rate of Return (IRR)
 What is IRR ?
• The discount rate often used in capital budgeting that makes the
net present value of all cash flows from a particular
project equal to zero.
• Generally speaking, the higher a project's internal rate of return,
the more desirable it is to undertake the project.
• As such, IRR can be used to rank several prospective projects
that a firm is considering. Assuming all other factors equal
among various projects, the project with the highest IRR would
probably be considered the best and undertaken first.
 EXAMPLE: FINDING IRR
(Trial & Error Method with Interpolation Formula)

• A project involves an initial

outlay of Rs. 240,000. The Years Cash Flows (Rs.)
estimated net cash flows for the
project are given in the table.
1. 140,000

• The company’s required rate of

2. 80,000
return is 13 percent.
3. 60,000
• Calculate the IRR for the project.
Is the project feasible, assuming 4. 20,000
all other factors are equal ?
5. 20,000
 Trial & Error Method
(After applying different discount rates)

At 15 % discount rate:
NPV = - 240,000+[140,000/(1.15)]+[80,000/(1.15)2]+[60,000/(1.15)3]+[20,000/(1.15)4]+[20,000/(1.15)5]

= - 240,000 + 121,739 + 60,491 + 39,450 + 11,435 + 9,944

= - 240,000 + 243,059

= Rs. 3,059

At 17 % discount rate:
NPV = - 240,000+[140,000/(1.17)]+[80,000/(1.17)2]+[60,000/(1.17)3]+[20,000/(1.17)4]+[20,000/(1.17)5]

= - 240,000 + 119,658 + 58,441 + 37,463 + 10,673 + 9,122

= – 240,000 + 235,357

= – Rs. 4,643
 Findings
• By using 15% discount rate, a positive figure is
achieved which is greater than zero;
• Whereas by using 17% discount rate, a negative
figure is achieved which is less than zero.
• It seems that NPV will be zero between 15% and
17%, so IRR is somewhere in between 15% and 17%.
By using INTERPOLATION Technique or Formula, we
can find that the IRR is about 15.79%, which is
illustrated in next slides.
Interpolation Technique
(For Finding IRR)
Interpolation Technique
(For Finding IRR)

•  

IRR = Lower Rate + X

IRR = 0.15 + 0.0079
IRR = 0.1579 or 15.79%
OR
 Interpolation Formula
(For Finding IRR)

IRR = Lower discount Rate + Difference between the two discount rates * (NPV
at lower discounted rate / absolute difference between the NPVs of the two
discount rates)
= 15 + ( 17 – 15 ) x ( 3,059 / (3,059 – ( - 4643 ))
= 15 + 2 x ( 3,059 / 7,702 )
= 15 + 2 x 0.3972
= 15 + 0.7944

IRR = 15.79 % Approx.

CHECK: Now Applying 15.79%, We have NPV nearer to
Zero

NPV = -240,000+[140,000/(1.1579)]+[80,000/(1.1579)2]
+[60,000/(1.1579)3]+[20,000/(1.1579)4]+[20,000/(1.1579)5]

= - 240,000 + 120,909 + 59,669 + 38,649 + 11,126 + 9,609

= - 240,000 + 239,962

NPV = Rs. 38  Nearer to Zero

 Project Feasibility
The project is feasible as its Internal Rate of Return
(IRR) is greater than the company’s required rate of
return, assuming all other factors equal*.

*( If there are two mutually exclusive projects and both have

IRR greater than the company’s required rate of return, then
the project with higher NPV will be preferred. In other words,
other capital budgeting techniques will be employed. )