Business Finance

( ACC 501)

Internal Rate of Return (IRR)

Prepared
~ by ~
Instructor
ACC501

Virtual University of Pakistan

 IRR
Internal Rate of Return
Prepared
~ by ~
Instructor
ACC501

Virtual University of Pakistan

 What is IRR ?
 The discount rate often used in capital budgeting that makes
the net present value of all cash flows from a particular
project equal to zero.

 Generally speaking, the higher a project's internal rate of

return, the more desirable it is to undertake the project.

 As such, IRR can be used to rank several prospective projects

Prepared a firm is considering. Assuming all other factors are equal
among the various projects, the project with the highest IRR
~ by ~ would probably be considered the best and undertaken first.
Instructor
ACC501  IRR is sometimes referred to as “Economic Rate of Return
(ERR)".

Virtual University of Pakistan

 FINDING IRR
(Trial & Error Method with Interpolation Formula)
 A project involves an initial Cash Flows
outlay of Rs. 240,000. The Years (Rs.)
estimated net cash flows
for the project are as
given: 1. 140,000

 The company’s required

2. 80,000
rate of return is 13 percent.
Prepared 3. 60,000
~ by ~
 Calculate the IRR for the
4. 20,000
Instructor project. Is the project
ACC501 feasible assuming all other
factors are equal ? 5. 20,000

Virtual University of Pakistan

 Trial & Error Method
(By applying different discount rates)
At 13 % discount rate:
NPV = - 240,000+[140,000/(1.13)]+[80,000/(1.13)2]+[60,000/(1.13)3]+[20,000/(1.13)4]+[20,000/(1.13)5]
= - 240,000 + 123,894 + 62,652 + 41,583 + 12,266 + 10,855
= - 240,000 + 251,250
= Rs. 11,250

At 15 % discount rate:
NPV = - 240,000+[140,000/(1.15)]+[80,000/(1.15)2]+[60,000/(1.15)3]+[20,000/(1.15)4]+[20,000/(1.15)5]
= - 240,000 + 121,739 + 60,491 + 39,450 + 11,435 + 9,944
= - 240,000 + 243,059
= Rs. 3,059

Prepared At 17 % discount rate:

NPV = - 240,000+[140,000/(1.17)]+[80,000/(1.17)2]+[60,000/(1.17)3]+[20,000/(1.17)4]+[20,000/(1.17)5]
~ by ~ = - 240,000 + 119,658 + 58,441 + 37,463 + 10,673 + 9,122
= - 240,000 + 235,357
Instructor = Rs. - 4643

ACC501

Virtual University of Pakistan

 INTERPOLATION FORMULA
By using 15% rate we have a positive figure that is greater than zero
whereas by using 17% rate we have a negative figure that is lesser
than zero. NPV appears to be zero between 15% and 17%, so IRR is
somewhere in that range. By using INTERPOLATION Formula, we can
find that the IRR is about 15.79 %

IRR = Lower discount Rate + Difference between the two discount

rates x (NPV at lower discounted rate / absolute difference between
the NPVs of the two discount rates)

= 15 + ( 17 – 15 ) x ( 3,059 / (3,059 – ( - 4643 ))

Prepared
= 15 + 2 x ( 3,059 / 7,702 )
~ by ~ = 15 + 2 x 0.3972
Instructor = 15 + 0.7944
ACC501
IRR = 15.79 % Approx.

Virtual University of Pakistan

 Now Applying 15.79%, We have NPV nearer to Zero

NPV = -240,000+[140,000/(1.1579)]+[80,000/(1.1579)2]
+[60,000/(1.1579)3]+[20,000/(1.1579)4]+[20,000/(1.1579)5]

= - 240,000 + 120,909 + 59,669 + 38,649 + 11,126 + 9,609

= - 240,000 + 239,962

Prepared NPV = Rs. 38  Nearer to Zero

~ by ~
Instructor
ACC501

Virtual University of Pakistan

 Project Feasibility

The project is feasible as its Internal Rate of Return

(IRR) is greater than the company’s required rate of
return, assuming all other factors are equal*.

*( If there are two mutually exclusive projects and

both have IRR greater than the company’s required
Prepared
rate of return then the project with higher NPV will
~ by ~
be preferred. In other words, other capital budgeting
Instructor
techniques will be employed. )
ACC501

Virtual University of Pakistan

 Dear Students !

It is hoped that…..
You’d be now able to find out IRR easily.

. . . GOOD LUCK . . .
Prepared
~ by ~
Instructor
Instructor ACC501
ACC501
Virtual University of Pakistan

Virtual University of Pakistan