Calculation of Internal Rate of

Return (IRR)
Sandeep Vyas
 Internal Rate of Return (IRR)
Internal rate of return (IRR)is the rate of return of an
individual project of a firm
The IRR of a project should be equal to or greater than the
cost of capital of a firm else the project should be rejected
It is the rate at which if the net cash inflows (PAT +
Depreciation) are discounted, they become equal to cash
outflows.
In other words, it is the rate at which NPV becomes zero.
 The IRR is calculated by trial and error method using the
following formula:
IRR = LDR + [(Q1-I.I) / (Q1-Q2)X (HDR-LDR)]
Where IRR = Internal rate of return
LDR = Lower discount rate
Q1 = Total present value of C.I at lower discount rate
I.I = Initial Investment
Q2 = Total present value of C.I at higher discount rate
HDR = Higher discount rate
 Steps to calculate IRR
Calculate PAT+ Depreciation or net annual cash inflows
Calculate present value annuity factor (or fake payback period) by:
Initial investment/ average annual PAT+ depreciation
• From the PVAF table find the rate of return of the project nearest to the PVAF
value
• Consider that rate of return as the first trial rate and then calculate fake NPV
• If NPV is positive increase the next trial rate by 2%
• And if NPV is negative decrease the next trial rate by 2%
• Calculate total present value of cash inflows at the second trial rate
• Hence both the LDR and HDR are ascertained using the last two steps
• Put the values in the formula of calculating IRR and find out the IRR of the project
 Example
A project with an initial investment of Rs. 10,000 generates
cash inflows of Rs. 5,000, Rs. 4,000 and Rs. 3,000 with life of
3 years. What will be the internal rate of return of the project?
Sol. PVAF = I.I/ Average annual cash inflows
PVAF = 10,000/(5,000+4,000+3,000/3) = 2.5
In the PVAF table, look for rate of return for 3 years nearest to
the value of 2.5.
• It is 10% ( for 3 years it 10% at a given PVAF of 2.487) in the
PVAF table.
Calculate fake NPV at this trial rate:
Year Cash infows (PAT+DEP.) P.V factor at 10% Present value

1 5,000 0.909 4545

2 4,000 0.826 3,304

3 3,000 0.751 2253

Total PV of C.I (Q1) 10,102

 Calculate fake NPV = Total PV of C.I – Initial Investment
NPV = 10,102-10,000 = 102

• NPV is positive, so increase the next trial rate by 2% i.e.

12%
Calculate total present value of cash inflows at 12%
(second trial rate) :
Year Cash infows (PAT+DEP.) P.V factor at 12% Present value
1 5,000 0.893 4,465
2 4,000 0.797 3,188
3 3,000 0.712 2,136
Total PV of C.I (Q2) 9789
 Put the values in the IRR formula:
IRR = 10% + [(10,102-10,000) / (10,102 - 9,789)X (12%-10%)]

IRR = 10% + [0.325X2%]

IRR = 10% + 0.65% = 10.65%