IRR Flashcards
What is IRR
IRR is the discount rate at which the NPV of a project is zero.
When do you accept or reject projects
Accept projects where the IRR is higher than the cost of capital and reject projects where the IRR is lower than the cost of capital.
how is the IRR Determined
determined by calculating the NPV of a project at two different discount rates and then using the following formula to find the rate at which the NPV = 0
what is the formula for IRR (It’s not given in AFM)
Look up the formula
in excel how do you calculate IRR
= IRR (B20 ….. F20) or with a guess
where B20 … F20 is the series of cash flows starting at time 0 (NOT T1 LIKE NPV).
Note though, that this functionality only works if the cash flows are for consecutive years with the first cash flow at time 0.
Like NPV, doesn’t work for annuity and perpetuity
IN CBE
=IRR (Values T0 :values Tn, [Guess])
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MODIFIED IRR (New in AFM)
This was developed to overcome 3 main difficulties with the use of IRR .
What are they
1) Re-investment assumption
2) Multiple IRR’s
3) Choosing between two mutually exclusive projects
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1) Re-investment assumption
When referring to the IRR as a return, it is assumed that any net cash inflows that arise can be re-invested at the IRR itself. This is often an unrealistically high rate.
The MIRR assumes that any net cash inflows that arise are reinvested at the firm’s cost of capital and not the IRR. This is far more realistic.
2) Multiple IRR’s
If a project has unusual cash flows (for example, an outflow then a series of inflows then a further outflow) there could be more than one IRR or no IRR at all! This makes the decision-making rule more complex.
There is only ever one MIRR! It doesn’t matter whether the cash flow pattern is normal or unusual.
3) Choosing between two mutually exclusive projects
If there is a need to choose between two mutually exclusive projects (for example, two alternative sites for a new factory) then the project with the highest IRR might not have the highest NPV at the company’s cost of capital.
The NPV approach and IRR approach therefore may give conflicting results. In this situation the project with the highest NPV should be chosen in preference to the project with the highest IRR.
The NPV rule is consistent with the MIRR rule when choosing between two mutually exclusive projects. The project with the highest NPV at the cost of capital of the company will always have the highest MIRR.
Modified IRR Formula names
𝑃𝑉𝑅=𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑟𝑒𝑡𝑢𝑟𝑛 𝑝ℎ𝑎𝑠𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 (inflows) i,e, t1-tx where there is a return
𝑃𝑉𝐼=𝑝𝑟𝑒𝑠𝑒𝑛𝑡 𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝑝ℎ𝑎𝑠𝑒 𝑜𝑓 𝑡ℎ𝑒 𝑝𝑟𝑜𝑗𝑒𝑐𝑡 (outflows in a sense)
𝑟𝑒 = cost of capital
n = life of the project
MIRR Can be used in excel also
what is the formula
= MIRR (B20 ….. F20,cost of capital, cost of capital)
B20 … F20 is the series of cash flows starting at time 0.
this functionality only works if the cash flows are for consecutive years with the first cash flow at time 0.
the 2 cost of capital will be the same in MIRR Calc. One is COC of financing and another of reinvestment rate which we assume is the same as COC
