INTERNAL RATE OF

RETURN (IRR)
 Internal Rate of Return (IRR)
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 IRR is a very commonly used criterion for capital

budgeting.
 It is popular with the managers because it gives a
very simple answer in the form of annual
percentage and you can compare it to the inflation,
cost of capital or financing.
 The formula uses trial and error method.
 Internal Rate of Return (IRR)
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 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.
 Rationale for the IRR Method
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1. The IRR on a project is its expected rate of return.

2. If the internal rate of return exceeds the cost of funds
used to finance the project, a surplus will remain after
paying for the capital, and this surplus will accrute to
the firm’s stockholder.
3. Therefore, taking on a project whose IRR exceeds its
cost of capital increases shareholders’ wealth.
4. On the other hand, if the internal rate of return is less
than the cost of capital, then taking on a project will
impose a cost on current shareholders.
5. It is this “break even” characteristic that makes the IRR
useful in evaluating capital projects.
 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
7
8
9
 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.
 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