Beruflich Dokumente
Kultur Dokumente
Analysis
Suppose that a bank lends $10,000 and it is repaid
$4021 at the end of each year for 3 years.
How can be the interest rate determined that the
bank charges on this transaction?
P = A (P/A, i, 3)
$10,000 = $4021 (P/A, i, 3)
i = 10%
The bank will earn 10% return on its investment of
$10,000.
The bank calculates the loan balances over the life of loan
as follows.
It indicates that,
The bank can break even at a 10% rate of
interest.
Rate of return becomes the rate of interest
that equates the present value of future cash
repayments to the amount of loan.
Investment Balance Diagram
11,000
4021
project balance
7677
Un recovered
4021
10,000
4021
6979
4021
3656
years
0 1 2 3
Rate of Return is the break even interest rate (i*) which
equates the present worth of Projects cash outflows
to the present worth of its cash inflows.
PW (i*) =0
PWcash inflow PWcash outflow = 0
i*
0 i
PW outflow
What is IRR?
The discounted rate that equates the present
value of a projects expected cash inflows to
the present value of the projects costs
What is IRR?
The discount rate
which sets the
NPV of all cash
flows equal to 0.
Helps to
determine the
YIELD on an
investment.
How do we calculate IRR?
NPV = Net Present Value of the project
Initial Investment
Ct=Cash flow at time t
IRR = Internal Rate of Return
Calculating IRR
Set the NPV = 0
Plug in your Cash Flows & Initial
Investment
Solve for IRR!
This is the same equation used for NPV,
except you know your interest rate, i.
So now what?
Once youve calculated IRR
If IRR is greater than the cost of capital, then youve
got a GOOD project on your hands (go for it!).
If IRR is less than the cost of capital, then youve got
a BAD project on your hands (dont undertake the
project).
If the IRR and cost of capital are equal, then you
should use another method to evaluate the project!
Basically, the higher the IRR, the better the project
Simple vs. non Simple investment
4 $1500
Solution
PROJECT 1
FW (i*) =0
FWinflow FWoutflow =0
$1500 - $1,000(F/P,i*,4) = 0
1.5 = (1+i*)4
Solving for i*,
i* =
4
1.5 1
i* = 0.1067 = 10.67%
PROJECT 2
PW (i*) =0
-$2000 + $1300 + $1500 = 0
(1+i*) (1+i*)2
Let, 1/ (1+i*) =X
$1
0 1 2 3 4 5 6 7 8
PW (i*) = 0
PW inflow PW outflow = 0
1.8 (P/A, i*%, 8) + 1 (P/F, i*%, 8) -10 = 0
Lets select interest rate = 8%
PW (8%) = 1.8 (P/A, 8%, 8) + 1 (P/F, 8%, 8) 10 = $ 0.88
Since PW is positive, the value of i is raised,
Lets suppose interest rate =12%
PW (12%) = 1.8 (P/A, 12%, 8) 1 (P/F, 12%, 8) 10 = - $ 0.65
1.8 10.156
9.207
1.8
8.161
1.8
9.218
$ 10
8.356 7.008
1.8
7.407 5.738
1.8
6.361 4.339
1.8
5.208
2.8
1.8
3.938
2.539
2.8
0 1 2 3 4 5 6 7 8
Years
i Rk (F/P, %, N-k)
k o
Rk
0 k N
Ek
k o
Ek (P/F, %, k)
Ek (P/F, %, k) (F/P, i, N) = Rk (F/P, %, N-k)
Where,
Rk = receipts in period k
Ek = expenditures in period k
N = project life or number of study period
% = external reinvestment rate per period.
Accept /Reject Decision Rule
0 1 2 3 4 5 6
RS 1000 RS 1000
RS 5000