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

NPV

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

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