ENGINEERING

ECONOMY
2024 FALL SEMESTER
Lecturer: Research Assistant Dr. İsmail ÖZTANIR
WEEK 14/LECTURE 14
3rd October 2025
LECTURE 14
EVALUATING A SINGLE PROJECT:
INTERNAL RATE OF RETURN (IRR)
The Internal Rate of Return (IRR) Method
■ The internal rate of return (IRR) method, the investor’s method, the discounted cash
flow method, and the profitability index are all different names for the same method
which we call IRR here. This method is used to find the interest rate that equates the
equivalent worth of an alternative’s cash inflows (receipts or savings) to the equivalent
worth of cash outflows (expenditures, including investment costs). Equivalent worth
might be computed using any of the PW, FW, or AW methods. The resultant interest
rate is termed the Internal Rate of Return (IRR).
■ The IRR is sometimes referred to as the breakeven interest rate. For a single
alternative, from the lender’s viewpoint, the IRR is not positive unless
– 1) both receipts and expenses are present in the cashflow pattern, and
– 2) the sum of receipts exceeds the sum of all cash outflows.
■ Using a PW formula, we see that the IRR is the i’% at which,
𝑁 𝑁

෍ 𝑅𝑘 (𝑃/𝐹 , 𝑖 ′ %, 𝑘) = ෍ 𝐸𝑘 (𝑃/𝐹 , 𝑖 ′ %, 𝑘)
𝑘=0 𝑘=0
where 𝑅𝑘 : net revenues or savings for the kth year
𝐸𝑘 : net expenditures, including any investment costs for the kth year
N: project life (or study period)
i’: the interest rate that is to be determined →
1 1 1 1
𝑅0 × + ⋯ + 𝑅𝑁 × = 𝐸0 × + ⋯ + 𝐸𝑁 ×
1 + 𝑖′ 0 1 + 𝑖′ 𝑁 1 + 𝑖′ 0 1 + 𝑖′ 𝑁
𝑁 𝑁
1 1
෍ 𝑅𝑘 × ′ 𝑘
= ෍ 𝐸𝑘 ×
1+𝑖 1 + 𝑖′ 𝑘
𝑘=0 𝑘=0

■ Once the i’ has been calculated, it is compared with the MARR to assess whether the
alternative in question is acceptable. If 𝑖′ ≥ 𝑀𝐴𝑅𝑅, the alternative is acceptable; otherwise
not.
IRR Decision Rule: If 𝐼𝑅𝑅 ≥ 𝑀𝐴𝑅𝑅, the
project is economically justified.
■ An alternative way of computing the IRR is to determine the i’ at which its net PW is
zero. Thus, IRR is the value of i’ at which,

𝑁 𝑁
1 1
𝑃𝑊 = ෍ 𝑅𝑘 × − ෍ 𝐸𝑘 × =0
1 + 𝑖′ 𝑘 1 + 𝑖′ 𝑘
𝑘=0 𝑘=0

■ The point at which PW=0 defines i’%, which is the project’s IRR. The value of i’% can
also be determined as the interest rate at which FW=0 pr AW=0.
■ Example (Sullivan et al., pages 204-205) Economic Desirability of a Project Using the
IRR Method: AMT Inc. is considering the purchase of a digital camera for the
maintenance of design specifications by feeding digital pictures directly into an
engineering Workstation where computer-aided design files can be superimposed over
the digital pictures. The capital investment required is $345,000, and the estimated
market value of the system after a six-year study period is $115,000. Annual revenues
attributable to the new camera system will be $120,000, whereas additional expenses
annually will be $22,000. You have been asked to determine this project’s IRR and
make a recommendation. The corporation’s MARR is 20% per year.

$115,000

$120,000 $120,000
$120,000 $120,000 $120,000
$120,000
0 1 2 3 4 5 6

$22,000 $22,000 $22,000 $22,000 $22,000 $22,000

$345,000
■ 𝑃𝑊 = 0 → 𝐼𝑅𝑅 =? →

1 1 + 𝑖′ 6 − 1 1
115,000 × + 120,000 − 22,000 × ′ + −345,000 × =0
1 + 𝑖′ 6 𝑖 × 1 + 𝑖′ 6 1 + 𝑖′ 0

■ Because this is a complex function, we can use an excel spreadsheet to solve it. Excel has a
function for IRR.
■ IRR(range, guess) function requires the net cash flows for the study period and an initial guess for
the IRR value (here using the MARR as guess value is a good idea).
→= −𝐵2
→= 𝐵4 − 𝐵5
→= 𝐵4 − 𝐵5
→= 𝐵4 − 𝐵5
→= 𝐵4 − 𝐵5
→= 𝐵4 − 𝐵5
→= 𝐵4 − 𝐵5 + 𝐵3
■ If we want to solve it by hand, we can use the linear interpolation method.
■ We first need to try a few values for i’. A good starting point is to use the MARR. When we get
both positive and negative PW values for at least two different i’, we will draw a line between
these points on the analytical plane and find the i’ point that makes PW zero (0) by employing
triangle ratio rules.
1+0.20 6 −1 1
■ At i’=20%: 𝑃𝑊 = −$345,000 + $98,000 × + $115,000 × = $19,413
𝑖 ′ × 1+0.20 6 1+0.20 6

■ Since the PW is positive at 20% we know that i’>20%.

■ Now that we have both a positive and a negative PW, the answer is the IRR is between 20%
and 25% which can be indicated as (20% ≤ 𝐼𝑅𝑅 ≤ 25%).
■ The linear interpolation method won’t give the exact IRR but it will give the best
approximation.
 $25.000,00
A d B
$20.000,00
$15.000,00
$10.000,00
$5.000,00
Present Worth

$- i’
0,00 0,05 0,10 0,15 0,20 0,25 0,30
$-5.000,00
$-10.000,00
$-15.000,00
$-20.000,00
$-25.000,00 C
$-30.000,00
i'
 𝐵𝐴 𝑑𝐴 25% − 20% 𝑖 ′ % − 20%
= → =
|𝐵𝐶| |𝑑𝑖 ′ | $19,413 − (−$25,621) $19,413 − $0

→ 𝑖 ′ ≈ 22.16% ≥ 20% = 𝑀𝐴𝑅𝑅

→ The IRR Decision condition was: 𝐼𝑅𝑅 = 𝑖′ ≥ 𝑀𝐴𝑅𝑅.

■ Sullivan, W. G., Wicks, E. M. & Koelling, C. P. (2015). Chapter 5: Evaluating a Single