Internal Rate of Return

and Profitability Index

1-04-2010
 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 – Annuity Cash Flows
 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

Year CFAT PV Factor Total PV CFAT PV Factor Total PV

(0.18) (0.18)

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. 56125 56125

Inv

-572 -107
 Solution
Machine Machine
A B

Year CFAT PV Factor Total PV CFAT PV Factor Total PV

(0.17) (.20)
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
 Evaluation of IRR
 Positive:
 Considers time value of money
 Takes total cash inflows into account
 Easy to understand
 No use of required rate of return (No
controversial calculation)
 Maximising shareholder wealth
 Evaluation of IRR
 Drawback:
 Tedious calculation
 Produces multiple rates difficult to
handle
 Mutually exclusive proposals, highest
IRR project selected leaving others
 Assumption: All cash inflows are
reinvested
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
 Evaluation
 Better in times of capital rationing
 Superior to NPV
 Calculate PI

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

3375 11375
5
5375 9375
7375 7375
9375 5375
11375 3375
5