Internal Rate of Return

If a firm is to make a profit it must earn a higher rate of return on an investment than
its cost of capital/investment. Management needs to know what rate of return on an
investment will yield. The expected yield can be compared with the rate of return
earned on its other capital. This rate is found by calculating the I.R.R.

Decision Rule:
The I.R.R is the discounting rate which equates the discounted net receipts from a
project to its costs (i.e the rate which produces a nil (zero) NPV. The IRR is likened
unto the breakeven point).
The IRR is found by:

1.Discounting the cash flows using 2 different rates sufficiently far apart to give one positive and
one negative NPV.
2.Interpolating the NPVs to arrive at the IRR.
3.IRR can also be found by extrapolation (done by drawing a graph).

Interpolation Method

The linear relationship of the IRR is calculated by the

formula: IRR =X+ (pq x ac/ad)

Where
X = the rate giving the positive NPV
pq = the distance between the 2 rates used to give the NPVs
ac = the positive NPV
ad = the positive NPV plus the negative NPV (this gives the
total distance)

Steps:
1. Find the NPVs for the 2 values
2. Place values of the NPV in the equation
3. Calculate the equation
4. Value arrived at is the IRR (it is a percentage)

Ex.#l
A project involves an initial outlay of $100,000. The annual net receipts for 5 years are
$28,000 yearly.
Required: Use rates of 10% and 14% to calculate the IRR.
 Ex. #2
Abednego can borrow $20,000 at 12% p.a. He is considering a venture which has an
initial outlay of $20,000. The venture will produce net receipts of $6,000 yearly.

Required:
i. Calculate the IRR.

The managers of Absic Co. are considering investing in one of three projects. The projects are
mutually exclusive. Each project will entail an initial outlay of $500 000.
All profits are received on the last day of the relevant
year. Forecast profits are:
Project A Project B Project C
Year I $70 000 $70 000 $60 000
Year 2 72 000 75 000 75 000
Year 3 75 000 80 000 85 000
Year 4 80 000 85 000 75 000
Year 5 82 000 90 000 65 000

As stated earlier this method of capital budgeting is used to calculate the discount rate (RRR) at
which the Net Present Values (NPV) of Cash Flows equals to zero. I.e. it is used to estimate what
rate of return (discount rate) should be used to ensure the initial investment is recovered.
What discount rate will cause your NPV to be equal to 0.

Two different methods are used for ANNUITIES and UNEVEN CASH flows.

Annuities

From previous knowledge we know:

NPV = -Initial Investment + (annuity * PV Factor)

Set NPV to zero
0 = - Initial Investment + (annuity * PV Factor)
+ Initial Investment = (annuity * PV Factor)
+ Initial Investment = PV Factor
Annuity

E.g.
Douglas Comp. Invests $45,000 in Project XYZ. RRR 12 %

Project XYZ
Yr. 1 21000
Yr. 2 21000
Yr. 3 21000

NPV is:
5,442 = -45,000 + (2.402 * 21000)
With IRR we want to know what discount Factor would cause our NPV to be zero. Therefore we
set NPV to zero.

0 = -45,000 + (a*21000)
45,000 = a * 21000
45000 = 2.14
21000

a = 2.14 (this is the annuity factor)

We then turn to the present value of the annuities table Exhibit 14C-4.
Look for period/year 3 row
Search across that row until we find the PV factor which comes closest to 2.14 in that
row.
Whichever column it is located gives you your IRR.

In this case the PV factor is 19%. Therefore if the RRR of aforementioned project was 19%
the NPV would be 0. This means taking into consideration the time value of money it is
ESTIMATED, that at a RRR of 19% this project would, at least, recover initial investment.

Question 2.
A new machine costing 114, 000 could be purchased so as to save manual operations costing
27,000 per annum. The machine would last 8 years and have no residual value at the end of
its useful life.
I. Calculate IRR.
II. Calculate the level of annual savings required in order to provide a 12% IRR.