Internal Rate of Return

Meaning of Capital Budgeting

Capital budgeting can be defined as the process

of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. Capital budgeting addresses the issue of strategic long-term investment decisions. Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization.

Why Capital Budgeting is so Important?

Involve massive investment of resources

Are not easily reversible Have long-term implications for the firm Involve uncertainty and risk for the firm

Capital Budget Techniques

Net PresentValue

Discounted

BenefitCost/Profitability Index Ratio

Capital Budget Techniques

IRR

Accounting Rate of Return Non Discounted Payback Period

Internal Rate of Return

The rate at which the net present value of cash

flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investment

Projects promised rate of return given initial

investment and cash flows. Consistent with wealth maximization Accept a project if IRR Cost of Capital

Question
The management is considering to acquire an equipment costing $1,00,000 . It is expected that the equipment will provide equal annual cash flows of $30,000 for a period of 4 years. Should management accept this investment proposal?

Solution By Present value factor for an annuity of $1

1.Determine a present value factor for an annuity of $1 using the following formula:

Present value factor for an annuity of $1 = Amount to be invested / Equal annual cash inflows
2. Locate the present value factor (determined in step 1) in the present value of an annuity of $1 table. First locate the number of years of expected useful life of the investment and then proceed horizontally across the table until you find the present value factor determined in step 1. 3.Identify the internal rate of return by the heading of the column in which the present value factor is located. 4.Accpet the project if the IRR > Cost of Capital

 Present value factor for an annuity of $1

=$1,00,000 / $30,000=3.33 From the Table check for the present value factor for an annuity of $1 IRR is in between 7% and 8%
IRR=r-(PB-DF
r= Either of the two rate of PB= Payback Period DFr =Discounted factor for the interest rate r. DFrL= Discounted factor for the lower interest rate . DFrH= Discounted factor for the higher interest rate r. IRR= 8-(3.333-3.312/3.387-3.312)=7.78%

DFrL-DFrH

IRR with Liner Interpolation

One basis to this method is the NPV come on decreasing as

the rate of return increased. 1.Calculat the NVP at a discounted rate of x%(let take 5%). Discounted Net Cash Flows at 5% DCF1 = 30000/(1+5%)1 = 30000/1.05 = 28571.43 DCF2 = 30000/(1+5%)2 = 30000/1.1025 = 27210.88 DCF3 = 30000/(1+5%)3 = 30000/1.15763 = 25915.13 DCF4 = 30000/(1+5%)4 = 30000/1.21551 = 24681.07

NPV = 28571.43 + 27210.88 + 25915.13 + 24681.07 -100000 =6378.51

2.Now as the NPV is positive with a rate of return of 5 %.Take a higher a rate of return i.e y%(10%)
Discounted Net Cash Flows at 10%

DCF1 = 30000/(1+10%)1 = 30000/1.1 = 27272.73 DCF2 = 30000/(1+10%)2 = 30000/1.21 = 24793.39 DCF3 = 30000/(1+10%)3 = 30000/1.331 = 22539.44 DCF4 = 30000/(1+10%)4 = 30000/1.4641 = 20490.4 NPV Calculation at 10% NPV = 27272.73 + 24793.39 + 22539.44 + 20490.4 100000= -4904.04

3.IRR with Linear Interpolation

IRR = iL + [(iU-iL)(NPVL)] / [NPVL-NPVU]

iL = 5%;iU = 10%;NPVL = 6378.51;NPVU = -4904.04 IRR = 0.05 + [(0.1-0.05)(6378.51)] / [6378.51--4904.04] = 7.80%

Advantage of IRR
It takes into account the time value of money
It considers the profitability of the project for its

entire economic life It provides for uniform ranking of various proposals due to the percentage rate of return This method is compatible with the maximum profitability.

Disadvantage of IRR
As an investment decision tool, the calculated IRR should not be used to rate

mutually exclusive projects, but only to decide whether a single project is worth investing in. In cases where one project has a higher initial investment than a second mutually exclusive project, the first project may have a lower IRR (expected return), but a higher NPV (increase in shareholders wealth) and should thus be accepted over the second project. A method called marginal IRR can be used to adapt the IRR methodology to this case. Another problem with the IRR method is that it may give different rates of return. Suppose there are two discount rates (two IRRs) that make the present value equal to the initial investment. In this case, which rate should be used for comparison with the cutoff rate? The purpose of this question is not to resolve the cases where there are different IRRs. Under IRR it is assumed that all the intermediate cash flows are reinvested at the IRR which always not hold true.

Which approach is better

Both NPV and IRR methods yield better decision-making data based

off them being sophisticated capital budgeting techniques and consider time value of money and life time of the project. NPV and IRR methods yield better decision-making data based off them being sophisticated capital budgeting techniques as NPV implicitly assumes that any intermediate cash inflows generated by an investment are reinvested at the firms cost of capital. Financial managers prefer to use IRR the preference for IRR is due to the general disposition of businesspeople toward rates of return rather than actual dollar returns. The payback method is a quick and easy way to filter a project to see if the time should be spent to further analyze whether the project should move forward