Internal Rate of Return (IRR)

 A project's internal rate of return (IRR) is the discount rate

that makes the net present value (NPV) of the project equal to
zero. Or
 The discount rate that equates the present value of a project’s
expected cash inflows to the present value of the project’s
cost. Or
 The IRR is the rate that forces the NPV to equal zero.
 A project should be accepted if its IRR is higher than its cost
of capital and rejected if it is lower
 If a project’s IRR is lower than its cost of capital, the project
does not earn its cost of capital and should be rejected.
 Internal Rate of Return (IRR) (Cont…)
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 The equation for the IRR as follows:

 Internal Rate of Return (IRR) (Cont…)
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 For example
 Internal Rate of Return (IRR) (Cont…)
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Advantages of Internal Rate of Return

1. Perfect Use of Time Value of Money Theory
 Time value of money means interest and it should high because we
are sacrifice of money for specific time. IRR is nothing but shows
high interest rate which we expect from our investment. So, we can
say, IRR is the perfect use of time value of money theory.
2. All Cash Flows are Equally Important
 It is good method of capital budgeting in which we give equal

importance to all the cash flows not earlier or later. We just create its
relation with different rate and want to know where is present value
of cash inflow is equal to present value of cash outflow.
3. Uniform Ranking
 There is no base for selecting any particular rate in internal rate of

return.
 Internal Rate of Return (IRR) (Cont…)
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Advantages of Internal Rate of Return (Cont…)

4. Maximum profitability of Shareholder
 If there is only project which we have to select, if we

check its IRR and it is higher than its cut off rate, then
it will give maximum profitability to shareholder
5. Not Need to Calculate Cost of Capital
 In this method, we need not to calculate cost of

capital because without calculating cost of capital, we

can check the profitability capability of any project.
 Internal Rate of Return (IRR) (Cont…)
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Disadvantages of Internal Rate of Return

1. To understand IRR is difficult
 It is difficult to understand it because many student can not
understand why are calculating different rate in it and it becomes
more difficult when real value of IRR will be two experimental rate
because of not equalize present value of cash inflow with present
value of cash outflow.
2. Unrealistic Assumption
 For calculating IRR we create one assumption. We think that if we

invest out money on this IRR, after receiving profit, we can easily
reinvest our investments profit on same IRR. We seem to be
unrealistic assumption.
3. Not Helpful for comparing two mutually exclusive investment
 IRR is not good for comparing two project