Internal Rate of Return (IRR)

Finding IRR is no more difficult now . . .

What is IRR ?

• The discount rate often used in capital budgeting that

makes the net present value of all cash flows from a
particular project equal to zero.
• Generally speaking, the higher a project's internal rate of
return, the more desirable it is to undertake the project.
• As such, IRR can be used to rank several prospective
projects a firm is considering. Assuming all other factors
are equal among the various projects, the project with
the highest IRR would probably be considered the best
and undertaken first.
• IRR is sometimes referred to as “Economic Rate of
Return (ERR)".
 FINDING IRR
(Trial & Error Method with Interpolation Formula)

• A project involves an initial Cash Flows

outlay of Rs. 240,000. The Years (Rs.)
estimated net cash flows for the
project are as given: 1. 140,000

• The company’s required rate of 2. 80,000

return is 13 percent.
3. 60,000
• Calculate the IRR for the 4. 20,000
project. Is the project feasible
assuming all other factors are 5. 20,000
equal ?
IRR can be calculated by Trial & Error Method:
(By applying different discount rates)
At 13 % discount rate:
NPV = - 240,000+[140,000/(1.13)]+[80,000/(1.13)2]+[60,000/(1.13)3]+[20,000/(1.13)4]+[20,000/(1.13)5]
= - 240,000 + 123,894 + 62,652 + 41,583 + 12,266 + 10,855
= - 240,000 + 251,250
= Rs. 11,250

At 15 % discount rate:
NPV = - 240,000+[140,000/(1.15)]+[80,000/(1.15)2]+[60,000/(1.15)3]+[20,000/(1.15)4]+[20,000/(1.15)5]
= - 240,000 + 121,739 + 60,491 + 39,450 + 11,435 + 9,944
= - 240,000 + 243,059
= Rs. 3,059

At 17 % discount rate:
NPV = - 240,000+[140,000/(1.17)]+[80,000/(1.17)2]+[60,000/(1.17)3]+[20,000/(1.17)4]+[20,000/(1.17)5]
= - 240,000 + 119,658 + 58,441 + 37,463 + 10,673 + 9,122
= - 240,000 + 235,357
= Rs. - 4643
 INTERPOLATION FORMULA :
By using 15% rate we have a positive figure that is greater
than zero whereas by using 17% rate we have a negative
figure that is lesser than zero. NPV appears to be zero
between 15% and 17%, so IRR is somewhere in that range.
By using INTERPOLATION Formula, we can find that the
IRR is about 15.79 %

IRR = Lower discount Rate + Difference between the two discount rates x
(NPV at lower discounted rate / absolute difference between the NPVs of
the two discount rates)

= 15 + ( 17 – 15 ) x ( 3,059 / (3,059 – ( - 4643 ))

= 15 + 2 x ( 3,059 / 7,702 )
= 15 + 2 x 0.3972
= 15 + 0.7944
IRR = 15.79 % Approx.
Now Applying 15.79%, We have NPV nearer to Zero :

NPV = -240,000+[140,000/(1.1579)]+[80,000/(1.1579)2]
+[60,000/(1.1579)3]+[20,000/(1.1579)4]+[20,000/(1.1579)5]
= - 240,000 + 120,909 + 59,669 + 38,649 + 11,126 + 9,609
= - 240,000 + 239,962
NPV = Rs. 38  Nearer to Zero
Project Feasibility :

The project is feasible as its Internal Rate of

Return (IRR) is greater than the company’s
required rate of return, assuming all other factors
are equal*.

*( If there are two mutually exclusive projects and

both have IRR greater than the company’s required
rate of return then the project with higher NPV will
be preferred. In other words, other capital
budgeting techniques will be employed. )
 Dear Students !

It is hoped that…..
You’d be now able to find out IRR easily.

. . . GOOD LUCK . . .

Instructor . . . FIN622 (Corporate Finance)

Virtual University of Pakistan, Lahore.