The internal rate of return (IRR) ACCA F9
- 1. The internal rate of return (IRR) By Shawn Bourne
- 2. What is the Internal Rate of Return (IRR)? The internal rate of return (IRR) is the discount rate where the NPV of a given set of cash flows is equal to zero. The IRR is the rate of return the project achieved-the rate of return refers to the speed that money comes back to you. You is comparing the IRR with the rate used to discount the project. Rule If IRR rate is greater than discount rate, accept project, if not reject project.
- 3. How to calculate the IRR rate The IRR rate is found by error and trial. How to calculate the IRR rate 1. Calculate the NPV using the company's cost of capital. 2. Calculate the NPV using a second discount rate. (a) If the NPV is positive, use a second rate that is greater than the first rate. (b) If the NPV is negative, use a second rate that is less than the first rate. 3. Use the two NPV values to estimate the IRR. The formula to apply is as follows: IRR = a + NPVa x (b-a)% NPVa-NPVb a= lower of two interest rates used b= higher of two interest rates used NPVa=positive NPV NPVb=negative NPV NB-you add together NPVa and NPVb.
- 4. Example Example A company bought a machine for $80,000 and it will last for 5 years and will have a scrap value of $10,000 at the end of year 5. It will have cash inflows of $20,000 per annum. It is company policy to undertake projects which exceed the return of 10%.
- 5. Solution Solution First calculate the NPV, using the cost of capital of 10% Year Cash flow D.F 10% PV 0 -80,000 1 -80000 1 to 5 20000 3.791 75820 5 10000 0.621 6210 NPV 2030
- 6. Solution-Continue Calculate the second NPV, using a rate that is greater than the first rate, as the first rate gave a positive answer. Suppose we try 12%. Year Cash flow D.F 12% PV 0 -80,000 1 -80000 1 to 5 20000 3.605 72100 5 10000 0.567 5670 NPV -2230 This fairly close to zero and negative. Use the two NPV values to estimate the IRR. 10 + 2030 X (12-10)% 0.11 11% 2030+2230
- 7. Advantages and Disadvantages of the Internal Rate of Return Advantages 1. It considers the time value of money. 2. It takes into account the total cash inflows and cash outflows. 3. The profitability of the project is consider over the life of the project. Disadvantages 1. It involves tediuos calculations. 2. may lead to poor decision making (mutually exclusive projects). 3. It may be difficult to understand, why you have to calculate more than one rate.