Internal Rate of Return(IRR)
Method
Internal Rate of Return method is also a
modern technique of capital budgeting that
takes into account the time value of money.
It is also known as time adjusted rate of
return, discounted cash flow, discounted rate
of return, yield method, and trial and error
method.
It is that rate at which present value of cash
inflows is equal to present value of cash
outflow (means NPV is 0)
Steps involved in IRR Method
1. Determine future cash inflows
2. Determine the rate of discount at which present
value of cash inflows is equal to present value of
cash outflows
3. Accept the proposal ,if IRR is higher than or equal
to cut off rate (Cost of Capital) and reject the
proposal if IRR is lower than cut off rate
4. In case of alternative Proposals , the proposal having
highest IRR will accepted
When the annual net cash flows are equal over the life of the asset
Firstly, find out present value factor by dividing
initial outlay (cost of the investment) by annual cash
flow, i.e.
Present Value Factor =
Then refer to present value annuity table of year given
where Present value factor equal with calculated
present value factor , that rate is IRR
Example 1
Initial Outlay Rs.50,000
Life of the asset 5 years
Estimated Annual Cash inflows Rs. 12,500
Calculate Internal Rate of Return
Solution
Present Value Factor =
=
By referring to Present Value annuity table of 5
years , at 8 % the value is 3.9927 , which is
nearly to 4. So IRR is 8% approx
When annual cash flows are unequal over
life of the asset
If annual cash inflows are unequal following steps will be
followed:
(1) Prepare cash flow table by using an arbitrary discount rate
(2) Find out the NPV
(3) If NPV is positive ,then apply higher discount rate
(4) Apply the higher discount rate till the NPV is negative
(5) If the NPV is negative at higher rate , the IRR must be
between two rates
Example 2
Initial Investment Rs.60,000
Life of the Asset 4 years
Estimated annual cash inflows :
1st Year Rs. 15,000
2nd Year Rs. 20,000
3rd Year Rs. 30,000
4th Year Rs. 20,000
Solution
Cash flow table at various assumed discount rate 10% and 12%
Year Annual cash Discount rate 10% Discount rate 12%
inflows P.V.F P. V P.V.F P. V
1 15,000 .909 13,635 .892 13,380
2 20,000 .826 16,520 .797 15,940
3 30,000 .751 22,530 .711 21,330
4 20,000 .683 13,660 .635 12,700
Total Present Value = 66,345 = 63,350
NPV at 10% discount rate is = 66,345- 60,000= Rs.6,345
NPV at 12% discount rate is = 63,350-60,000= Rs,3,350
Cont…d
Cash flow table at various assumed discount rate 14% and 15%
Year Annual cash Discount rate 14% Discount rate 15%
inflows P.V.F P. V P.V.F P. V
1 15,000 .877 13,155 .869 13,035
2 20,000 .769 15,380 .756 15,120
3 30,000 .674 20,220 .657 19,710
4 20,000 .592 11,840 .571 11,420
Total Present Value = 60,595 = 59,285
NPV at 14% discount rate is = 60,595- 60,000= Rs.595
NPV at 15% discount rate is = 59,285-60,000= - 715
Cont..d
Now at 14% discount rate NPV is 595 and 15% discount rate
NPV is – 715, So NPV lies between 14% to 15%. To calculate
IRR following formula will be applied:
IRR = 14% + .45% = 14.5 % approx
