INTERNAL RATE OF RETURN

What is internal rate of return?

IRR is the discount rate that equates the present value of cash inflow to the present value of cash outflows.
IRR is the true rate of return associated with a project or yield on an investment or marginal efficiency of capital.

Basic principle in IRR

0 Interest is compounded annually 4

100 100 (1+r)4 = 146 100 = 146 (1+r)4 = 146 X 1

146

(1+r)4 Assume r is 10 % =146 x 1/ (1.10)4 100 = 100 True rate of return is 10 %.

Basic principle in IRR

0 1 2

4 146

-100

110 121 133 @ 10 % interest rate compounded annually

If you deposit Rs 100 now and get Rs 146 after 4 years the rate of Return associated with your investment is 10 % ( yield on your Investment or true rate of return). At 10 % discount rate the present Value of cash inflow is equal to the present value of cash outflow. Now you can understand that the discount rate that equates the Present value of cash inflow to the present value of cash outflow Is the internal rate of return. IRR is the annualized rate of return on investment

Empirical testing of IRR 0 1 2 3 4 5

- 100
100

110
110 (1.10)1

121

133

146

161

100
100

121 (1.10)2
133 (1.10)3 146 (1.10)4 161 (1.10)5

100
100

Empirical testing of IRR 0 2 3 4 5

- 100

121

133

146

161

100
100

121 (1.10)2
133 (1.10)3 146 (1.10)4 161 (1.10)5

100
100

Empirical testing of IRR 0 3 4 5

- 100

133

146

161

100

133 (1.10)3

100
100

146 (1.10)4 161 (1.10)5

Empirical testing of IRR 0 1 2 3 4 5

- 100

146

161

100
100

146 (1.10)4 161 (1.10)5

Concept and equation of IRR

Assume that you deposit Rs 10,000 with a bank and would get back Rs 10,800 after one year. The true rate of return on your investment would be: Rate of return = 10,800 10,000 = 10,800 - 10,000 10,000 10,000
= 1.08 1 = 0.08 or 8 % r = C1 CO CO r = CI - 1 CO

CI = 1+r CO

CO =

CI (1+ r)

Concept and equation of IRR

0 @8% 1

10,000

10,800

10,000 + 10,000 x 8 % = 10,800 10,000( 1 + 8 % ) 10,000 (1.08) = 10,800 10,000 = 10,800 1.08 C0 = C1 (1+r)1

Formula for IRR

IRR =

C1

C2 +

C3 + . + Cn (1+k)n

Co

=0

(1+k)1

(1+k)2 (1+k)3

IRR =

Ct - C0 t = 1 (1+K)t

=0

At Internal rate of return, NPV must be equal to zero

Calculation of IRR

Uneven Cash Flows

Even Cash Flows

Uneven Cash flows: Calculating IRR by Trial and Error Method

A project costs Rs 10,000 and is expected to generate cash inflows of Rs 8,000, Rs 7,000 and Rs 6,000 at the end of each year for next 3 years. Calculate the Internal rate of return.

http://www.datadynamica.com/IRR.asp

(Internal Rate of Return) IRR:

1.

N/A
2.
0
(Net Present Value) NPV:

0
3.
0

Calculate

4.

5.

6.

7.

IRR is independent of the Discount Rate. To calculate NPV, enter a discount rate.

Discount Rate:
0

CALCULATION OF IRR TRIAL AND ERROR

Trial @ 15 % 8000 x 0.870 + 7000 x 0.756 + 6000 x 0.658 6960 + 5292 + 3948 = 16200 = 16,000 Trial @ 16 % 8000 x 0.862 + 7000 x 0.743 + 6000 x 0.641 6896+ 5201 + 3846 = 15943 = 16,000 15 % ( r1) 16200 PVCI1 16 % (r2) 15943 PVCI2

IRR = ( r1) + PVCI1 - PVCO PVCI1 - PVCI2

(r2 - r1)

Equal Cash Flows : Calculation of IRR

Cost of investment = Rs 20,000 Annual cash flow = Rs 5430 for 6 years Calculate the Internal Rate of Return

NPV = -20,000 + 5430 (PVAF 6,r ) = 0 20,000 = 5430 (PVAF 6,r ) (PVAF 6,r ) = 20,000 5430 (PVAF 6,r ) = 3.683 r = 16 % = 3.683

Decision Making Criteria Accept / Reject Rule Using IRR

0
- 20,000

1 5430

2 5430

3 5430

4 5430

5 5430 NPV 12580 7,561 3,648 550 0 -1,942 -3.974

6 5430

Discount rate % 0 32580 20000 5 5430 (PVAF 6,5) 20,000 10 5430 (PVAF 6,10) 20,000 15 5430 (PVAF 6,15) 20,000 16 5430 (PVAF 6,16) 20,000 20 5430 (PVAF 6,20) 20,000 25 5430 (PVAF 6,25) 20,000

Decision Making Criteria Accept / Reject Rule Using IRR 12 10 8 6 x x If r > k accept If r < k reject If r = k may accept

4
x 2 0 -2

IRR xx 5 10 15
x 20

NPV +

25 x NPV -

Evaluation of IRR

1.It considers the time value of money 2.It takes into consideration of all cash flows generated through out the life of the project 3.It is consistent with the share holders wealth maximization objective 4. Value additive principle does not hold when IRR method is used

Value Additive Principle Project A B A+B CO -100 -100 -200 CI 120 168 288 NPV@10 % 9.1 2.7 11.8 IRR % 20.0 12.0 15.2

NPV (A) + NPV (B) = NPV (A+B) = 9.1 + 2.7 = 11.8 IRR (A) + IRR (B) = IRR (A+B)

Evaluation of IRR
It fails to indicate a correct choice between mutually exclusive projects under certain situations NPV and IRR rules will give conflicting ranking to the projects under the following conditions
The cash flow pattern of the projects may differ The cash outlays of the projects may differ The projects may have different expected lives

Project M N

CO -1,680 -1,680

C1 1,400 140

C2 700 840

C3 140 1,510

NPV@9% 301 321

IRR 23 % 17 %

NPV PROFILES OF PROJECT M AND N Discount rate % 0 5 10 15 20 25 30 M (Rs) % change 560 409 -2.6 276 -3.2 159 -4.2 53 -40 -125 N (Rs) % change 810 520 -3.5 276 -4.6 70 -7.4 -106 -257 -388

Evaluation of IRR
1200 1000 800 600 IRR 17 % (Project N)

IRR 23 % (Project M)
x Fishers Intersection

400
200 0

-200
-400

10

15

20

25

30