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IRR Calculation:
where:
○ n = time period and is a positive integer
○ N = total number of time periods
○ r = IRR
○ Cn = Cash flow at time period n
Simple Summary:
Solutions Page 1
Simple Summary:
The above definitions can seem overly technical and complex so to simplify the
definition, IRR can be considered as the average interest rate on an investment that
have all cash flows breakeven.
The higher the IRR the better because it means that an investment can be profitable
even at very high interest rates.
Year 1 $12,000
Year 2 $15,000
Year 3 $18,000
Year 4 $21,000
Year 5 $26,000
From the given info what is the IRR? Also derive and explain the formula for NPV.
Solution:
To understand the IRR, we first look at what the PV's are for each cash flow in
each year.
Year 0: This is the initial start of the year in which we have to lower or discount all
other cash flows to. This is also when we get our loan. Thus we have:
Year 1: At the end of the first year we have a cash flow of $12,000. Since this is the at
the end of the year we have to find out how much the $12,000 is worth at the very
start of our investment. This is because, as stated earlier, the time value of money and
its ability to increase in value due to interest/inflation, etc. Thus we assume that the
PV of the cash flow increases year by year by the IRR:
Year 2: As with year 1 we need to go backwards in time and figure out what the PV is
at the start of our investment but this time we need to go back 2 years. After year 2
Solutions Page 2
Year 2: As with year 1 we need to go backwards in time and figure out what the PV is
at the start of our investment but this time we need to go back 2 years. After year 2
the cash flow is $15,000 thus the PV is derived as shown below:
Thus putting this all together we get our net present value:
Solutions Page 3
IRR and NPV
Solutions Page 4