Internal Rate of Return

FIN 321 Erin Kelso & Jen Wroblewski Thursday, February 1st

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

Example IRR Problem

You are debating whether or not to invest in your best friends business idea, so use IRR to evaluate the project: Cost of Capital: 10% Initial Investment: -$200 Cash Flows over the past 5 years:

Years 1 & 2: $50 Years 3 & 4: $100 Year 5: $125

Compute IRR!

A. 15.36% B. 31.20% C. -17.29% D. 26.04% E. none of the above

And the Answer is.

In your calculator: CFo=-200 Enter C01=50 Enter F01=2 Enter C02=100 Enter F02=2 Enter C03=125 Enter F03=1 Enter IRR CPT IRR =

Try another one

Your friends got another business schemesee if you want to help him out! Cost of Capital: 5% Initial Investment: -$1500 Cash Flows over the past 5 years:

Years 1,2 & 3: $100 Year 4: $200 Year 5: $500

Compute IRR again!

A. 2.61% B. -9.66% C. 10.65% D. -21.79% E. none of the above

And the answer is

In your calculator: CFo=-1500 Enter C01=100 Enter F01=3 Enter C02=200 Enter F02=1 Enter C03=500 Enter F03=1 Enter IRR CPT IRR =

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

If the cost of capital is greater than this crossover rate, the two methods give same answer If the cost of capital less than crossover rate, two methods give separate answers

NPV

Crossover rate Cost of capital NPVA 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?

Sources

Internal Rate of Return. Wikipedia.org.

http://en.wikipedia.org/wiki/Internal_rate_of_return

Internal Rate of Return IRR. Investopedia.com.

http://www.investopedia.com/terms/i/irr.asp