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FIN 321
Erin Kelso & Jen Wroblewski
Thursday, February 1st
What is IRR?
The discounted rate that equates the present
value of a project’s expected cash inflows to
the present value of the project’s 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 you’ve calculated IRR
If IRR is greater than the cost of capital, then you’ve
got a GOOD project on your hands (go for it!).
If IRR is less than the cost of capital, then you’ve got
a BAD project on your hands (don’t 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 friend’s 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 friend’s got another business
scheme…see 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
doesn’t 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
Crossover rate
answer
If the cost of Cost of capital
capital less than
crossover rate, two
NPVA