Evaluation and Technique - Internal Rate of Return

Question 1

Internal Rate of Return

Answer 1

Time adjusted rate of return - evaluates a project by determining discount rate that equate the PV of the project’s future cash inflows with PV of cash outflows;

Directly related to the net present value method; both always result in same accept or reject outcome; Once IRR is determined, it is compared with firm’s cost of capital or other measure of desired rate of return. If IRR = or is greater it would be financially acceptable

It does so by determining the present value factor implicit in the project and “backs into” the related interest or discount rate.

Question 2

Calculation of IRR

Answer 2

Equation for NPV = 0

Future annual cash inflows x PV factor = Investment Cost

Question 3

IRR VS NPV

Answer 3

IRR determines what rate of return makes the net present value of net cash flows = zero

Both the net present value method and the internal rate of return method of evaluating capital projects assume that all cash inflows (or savings) that result from the project are immediately reinvested to earn a return for the company.
The earnings from these investments constitute part of the benefit derived by the company from its investment in a project. There is, however, a difference in the rate of return of the reinvestment implicitly assumed under the two methods:

1) The net present value method implicitly assumes that reinvestment of cash inflows earns the hurdle rate of return, the same rate used to discount future cash flows to get present value.
2) The internal rate of return method implicitly assumes that reinvestment of cash inflows earns a rate of return equal to the internal rate of return.