Internal Rate of

Return
SUDARSAN PALANI
From
Ideatiger.com
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.
Using the Financial Calulator

BA II Plus
Go to the Cash Flow worksheet, plug in CFo, CF1, and so
on
Go to the IRR button and click CPT (compute) and you
will get your IRR!
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
Is IRR always a good choice?

IRR is useful in deciding whether or

not to invest in a single project
When multiple projects are being
considered, IRR is not a good
investment tool to use to evaluate
which project to choose.
The IRR calculation automatically
assumes that all cash outflows are
reinvested at the IRR, but doesnt
evaluate what the investor does with
cash inflows, which would have an
effect on the true IRR.
Multiple IRRs

When projects have non-normal cash flows,

multiple IRRs may occur
A non-normal cash flow occurs when a project calls
for a large cash outflow sometime during or at the
end of its life
There is no way to know which IRR is correct
Sign changes in the Cash
Flows
IRR evaluates a project correctly when
there is an initial negative cash flow,
followed by a series of positive ones (-
+++).
If the signs are reversed (+---), that will
change the accurateness of the IRR
calculation.
If there are multiple sign changes in the
cash flows (+-+-+) or (-+-+-), your
calculation would result in multiple IRRs,
also making the project very difficult to
evaluate.
NPV vs. IRR

NPV and IRR methods will always lead to the same

accept/reject decisions for independent projects
NPV and IRR can give conflicting rankings for mutually
exclusive projects (you must pick one project, you
cannot accept both)
NPV vs. IRR

NPV profiles of projects can cross when project size

differences exist (the cost of one project is larger than
that of the other) or when timing differences exist
(most of the cash flows from one project come in the
early years, while most of the cash flows from the other
project come in the later years)
NPV vs. IRR
NPV
If the cost of
capital is greater
than this crossover
rate, the two
methods give same
answer Crossover rate
If the cost of
capital less than Cost of capital
crossover rate, two NPVA
methods give
separate answers NPVB
NPV vs. IRR?

The NPV calculation will usually always provide a more

accurate indication of whether or not a project should
be undertaken or not.
However, since IRR is a percentage, and NPV is shown in
$$, it is more appealing for a manager to show someone
a particular rate of return, as opposed to $$ amounts.
Why do we use IRR?

IRR is necessary from a capital budgeting standpoint.

Just as NPV is a way to evaluate an investment, IRR
provides more insight into whether or not a
project/investment should be undertaken.
More useful for long term investments, with multiple
cash flows
Modified Internal Rate of
Return
Another capital budgeting tool for investments
Assumes that the projects cash flows are reinvested at
the cost of capital, not at the IRR.
This slight difference, makes the MIRR more accurate
than the IRR.
Any Questions?