Internal Rate of Return (IRR)

Another Investment Decision Rule

Review: The NPV rule states to accept all projects with NPV > 0, where
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝟑 𝑪𝑭𝟒
𝑵𝑷𝑽 = −𝑰𝑵𝑽𝟎 + + + + + ⋯ … ..
(𝟏 + 𝒓) (𝟏 + 𝒓)𝟐 (𝟏 + 𝒓)𝟑 (𝟏 + 𝒓)𝒓

* Need to solve for NPV!

Internal Rate of Return (IRR): Calculate the IRR and accept all projects
with IRR “high enough”.
𝑪𝑭𝟏 𝑪𝑭𝟐 𝑪𝑭𝟑 𝑪𝑭𝟒
𝟎 = −𝑰𝑵𝑽𝟎 + + + + + ⋯ … ..
(𝟏 + 𝑰𝑹𝑹) (𝟏 + 𝑰𝑹𝑹)𝟐 (𝟏 + 𝑰𝑹𝑹)𝟑 (𝟏 + 𝑰𝑹𝑹)𝒓

* Need to solve for IRR!

 How High is “High Enough”?
The IRR will be compared to…

The Risk-Adjusted Discount Rate (RADR)

The Required Rate of Return (RRR)

The Weighted Average Cost of Capital (WACC)

The Discount Rate (r)

(all of which are different names for the same thing!)

 Calculating the IRR

The Iterative Method (i.e. trial and error)

A financial calculator (using IRR function)

MS Excel
• Use solver
• Use IRR function
Example: Using the Iterative Method (i.e. trial and error)
 IRR solved on MS Excel using both the IRR function and solver

IRR= 0.285982
(1+IRR)= 1.285982
Year 0 1 2 3 4 5 6 SUM()
CF -100 20 40 60 60 20 20
PV -100 15.55231 24.18744 28.21279 21.93871 5.686627 4.42201 -0.00011

Use IRR function: 28.6%

Using Solver: 28.6%

Example calculated and graphed using MS Excel

NPV
140

120

100

80

60

40

20

0
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0%
-20
 IRR solved on MS Excel using both the IRR function and solver

IRR= 0.094997
(1+IRR)= 1.094997
Year 0 1 2 3 4 5 6 SUM()
CF -150 30 30 30 30 30 60
PV -150 27.40 25.02 22.85 20.87 19.06 34.81 0.00

Use IRR function: 9.5%

Using Solver: 9.5%

Example: Chaotic Industries using MS Excel

NPV
r NPV 80
0.0% 60 60
5.0% 25
40
10.0% -2
15.0% -24 20
20.0% -40 0
25.0% -54 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0% 35.0% 40.0%
-20
30.0% -65
35.0% -73 -40

-60

-80
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Problems with the IRR Rule
 Homework: Solve for the NPV and IRR for the following projects

(1) For NPV, use r = 14%

Year 0 1 2 3 4 5 6
CF -1,245 315 155 200 87 100 955

(2) For NPV, use r = 9%

Year 0 1 2 3 4 5 6
CF -14,550 3,090 3,588 4,300 3,200 4,111 4,220

(3) For NPV, use r = 15%

Year 0 1 2 3 4 5 6
CF -10,000 2,000 2,600 2,850 3,200 3,400 3,550