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Internal Rate of Return (Irr) : Made By:-Niharika Tandon Mba Ms-3 Sem

The document discusses internal rate of return (IRR), which is the discount rate that makes the net present value of an investment equal to zero. It provides formulas to calculate IRR for projects with annuity and mixed cash flows. IRR is used to evaluate projects by comparing it to the required rate of return - projects with an IRR higher than the required rate are accepted. The document also discusses other capital budgeting techniques like profitability index and compares IRR and NPV methods.

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298 views25 pages

Internal Rate of Return (Irr) : Made By:-Niharika Tandon Mba Ms-3 Sem

The document discusses internal rate of return (IRR), which is the discount rate that makes the net present value of an investment equal to zero. It provides formulas to calculate IRR for projects with annuity and mixed cash flows. IRR is used to evaluate projects by comparing it to the required rate of return - projects with an IRR higher than the required rate are accepted. The document also discusses other capital budgeting techniques like profitability index and compares IRR and NPV methods.

Uploaded by

saniveta
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPT, PDF, TXT or read online on Scribd
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INTERNAL RATE OF

RETURN(IRR)
Made By:-
NIHARIKA TANDON
MBA MS-3rd Sem
IRR – WHAT IT IS?
 Rate of a return a project earns
 The discount rate r which equates
the aggregate present value of the
net cash inflows (CFAT) with the net
aggregate present value of cash
outflows of a project
 NPV=0
IRR – ACCEPT / REJECT
DECISION

 Compare actual IRR with required


rate of return (cut-off rate, hurdle
rate)
 IRR > k
IRR COMPUTATION
 Determine the payback period for the proposed
investment
 In the table look for the pay back period that is
equal to or closest to the life of the project
 In the year row look for PV values closes to PB
period one bigger than and another smaller
than it.
 Note the interest rate corresponding to the PV
values
 Determine actual IRR by interpolation (Using
equation or indirectly by finding present values
of annuity)
IRR EQUATION
 IRR = r – ( Payback period – Discount
factor for interest rate r) / (Discount
factor for lower interest rate – Discount
factor for higher interest rate
 r is either of the two interest rates used
in the formula
 If the lowest r is used the following
expression must be added, if higher r is
used deduct the following expression
IRR EQUATION -
ALTERNATIVE

 IRR = r – [(Present value of cash


outlay – Present value of cash
inflows) / (Difference in the
calculated present values of the
inflows)] * Difference in interest
rates
IRR – ANNUITY CASH FLOWS
 Model Problem 1:
 A project costs Rs. 36,000 and is
expected to generate cash inflows of
Rs. 11,200 annually for 5 years.
Calculate IRR of the project.
IRR – ANNUITY CASH FLOWS
 Solution:
 The pay back period is 3.214 (Rs.36000/
Rs.11,200)
 From Table discount factors closest to
3.214 for 5 years are 3.274 (16 percent
rate of interest) and 3.199 (17 percent of
interest rate)
 Using the values in equations
 IRR = 16+ [(3.274 – 3.214) / (3.274 –
3.199)] = 16.8 per cent
IRR – ANNUITY CASH FLOWS
 The pay back period is 3.214
(Rs.36000/ Rs.11,200)
 From Table discount factors closest
to 3.214 for 5 years are 3.274 (16
percent rate of interest) and 3.199
(17 percent of interest rate)
 Using the values in equations
 IRR = 17 - [(3.214 – 3.199) / (3.274
– 3.199)] = 16.8 per cent
IRR – ANNUITY CASH INFLOWS
 PV (CFAT) (0.16) = 11200* 3.274 =
Rs. 36,668.8
 PV(CFAT) (0.170) = 11200*3.199 =
Rs. 35.828
 IRR = 16 + [ ( 36,668.8 – 36,000) /
(36,668.8 – 35,828.8) ] * 1 = 16.8
per cent or
 IRR = 17 - [ ( 36, 000 – 35, 828.8) /
(840) ] * 1 = 16.8 per cent or
IRR – MIXED STREAM OF CASH
INFLOWS
 Calculate the average annual cash inflow
to get the fake annuity
 Determine the fake pay back period
dividing the initial outlay by the average
annual CFAT determined by step 1
 Look for the factor in Table closest to the
fake pay back value in the same manner
as in the case of annuity. The result is
the rough approximation of IRR, based
on the assumption that the mixed stream
is an annuity
IRR – MIXED STREAM OF CASH
INFLOWS
 Adjust subjectively the IRR obtained by comparing with
the pattern of the cash flow. (If cash flow is more than
the calculated annuity raise the percentage few points
and vice versa)
 Find out the PV (Using table) of mixed cash flows
taking IRR as the discount rate as estimated in the
previous step
 Calculate PV using the discount rate. If NPV = 0 that is
the IRR.
 If not repeat and stop when two consecutive IRRs
causing one NPV positive and another NPV negative are
calculated
 The actual value can be ascertained by the method of
interpolation too
CALCULATE THE IRR –
MIXED STREAM
Initial outlay Rs. 56,125

Machine A Machine B
Year CFAT CFAT
1 14000 22000
2 16000 20000
3 18000 18000
4 20000 16000
5 25000 17000
Machine Machine
A B
PV Factor Total PV Factor Total
Year CFAT (0.18) PV CFAT (0.18) PV
1 14000 0.847 11858 22000 0.847 18172
2 16000 0.718 11488 20000 0.718 13660
3 18000 0.609 10962 18000 0.609 10152
4 20000 0.516 10320 16000 0.516 7472
5 25000 0.437 10925 17000 0.437 6562

55553 56018
Less: In.
Inv 56125 56125

-572 -107
SOLUTION
Machine Machine
A B
PV Factor PV Factor
Year CFAT (0.17) Total PV CFAT (.20) Total PV
1 14000 0.855 11970 22000 0.833 18326
2 16000 0.731 11696 20000 0.694 13880
3 18000 0.624 11232 18000 0.579 10422
4 20000 0.534 10680 16000 0.484 7712
5 25000 0.456 11400 17000 0.442 6834

56978 57174
Less:
In.Inv 56125 56125

853 1049
SOLUTION
 Machine A: Both 17 and 18 percent
are giving positive and negative
NPVs, interpolation method can be
applied to find actual CRR
 Machine B: Both 20 and 21 percent
give negative and positive NPVs
interpolation method can be used
PROFITABILITY INDEX METHOD/
BENEFIT COST RATIO (B/C RATIO)
 Measures the present value of
returns per rupee invested
 PI = Present value cash inflows/
Present value of cash outflows
 Accept/ Reject rule:
 PI > 1 accept the project
 PI = 1 Be indifferent
CALCULATE PI

Machine A Machine B
Rs.56,125 Rs.56,125

3375 11375
5375 9375
7375 7375
9375 5375
11375 3375
5 5
3000 3000
STRENGTHS
• It provides a simple hurdle rate for
investment decision-making.
•Considers the time value of money.
•Considers all cash flows of the project.
•Considers the risk of future cash
flows.
•Tells whether an investment increases
the firm's value.
•No use of required rate of return (No
controversial calculation).
•Maximising shareholder wealth.
•Better in times of capital rationing.
•Superior to NPV.
WEAKNESSES

• It's not as easy to understand as


some measures and not as easy to
compute (even Excel uses
approximations).
• Computational anomalies can
produce misleading results,
particularly with regard to
reinvestments.
•Requires an estimate of the cost of capital
in order to make a decision.
•May not give the value-maximizing
decision when used to compare mutually
exclusive projects.
•May not give the value-maximizing
decision when used to choose projects
when there is Capital Rationing.
•Cannot be used in situations in which the
sign of the cash flows of a project change
more than once during the project's life.
•Produces multiple rates difficult to
handle.
•Mutually exclusive proposals, highest
IRR project selected leaving others.
•Assumption: All cash inflows are
reinvested.
NPV vs IRR METHODS
NPV (NET PRESENT IRR (INTERNAL RATE
VALUE) METHOD OF RETURN) METHOD

 NPV is calculated in  IRR is expressed in


terms of currency. terms of the
percentage return a
firm expects the
capital project to
return.
 NPV Method is
preferred over other
methods since it  IRR Method does not.
calculates additional
wealth.
 Applying NPV using  IRR method always
different discount gives the same
rates will result in recommendation.
different
recommendations.

 NPV Method can be  The IRR Method


used to evaluate cannot be used to
projects where there evaluate projects
are changing cash where there are
flows (e.g., an initial changing cash flows
outflow followed by
in-flows and a later
out-flow)

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