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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 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

methods give NPVB


separate answers
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 project’s 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