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Evaluate The Acceptability of An Investment Project Using The Internal Rate of Return Method

1. The internal rate of return (IRR) method evaluates investment projects by calculating the discount rate that results in a net present value of zero for the project's cash flows. 2. For projects with uneven cash flows, the IRR must be found using trial and error or spreadsheet calculations rather than a formula. 3. Projects are accepted if their IRR is greater than or equal to the required rate of return, and rejected if the IRR is less than the required rate of return.

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35 views

Evaluate The Acceptability of An Investment Project Using The Internal Rate of Return Method

1. The internal rate of return (IRR) method evaluates investment projects by calculating the discount rate that results in a net present value of zero for the project's cash flows. 2. For projects with uneven cash flows, the IRR must be found using trial and error or spreadsheet calculations rather than a formula. 3. Projects are accepted if their IRR is greater than or equal to the required rate of return, and rejected if the IRR is less than the required rate of return.

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janeperdz
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© © All Rights Reserved
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Download as PPTX, PDF, TXT or read online on Scribd
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CHAPTER 13

EVALUATE THE ACCEPTABILITY OF AN


INVESTMENT PROJECT USING THE
INTERNAL RATE OF RETURN METHOD

P E R D I Z O , M I L J A N E P.
DI SC O UN T E D CA S H F L OW S- T HE I NT E R NA L R AT E O F R E T U R N M E T H O D
T H E I N T E R N A L R AT E OF R E T UR N ( I R R ) I S T HE R AT E OF R E T UR N
ON A N I N V E ST M E N T OV E R IT S U SE FU L L I FE . T H E I NT E R N AL R AT E OF
R E T U R N O F A P R O J E C T I S T H E D IS C O UN T R AT E T H AT WI L L R E SU LT I N A
Z E R O N E T PR E SE NT VA L U E F OR T H E P R OJ E C T.

• The case of even cash flows. When the cash flows associated with an investment are
the same every year, the net present value of the project can be computed as follows:
• Net present value = Investment required (show as a negative number)
• + (Net annual cash flow times the PVIFA ). ( Present value factor for an annuity)
•  The internal rate of return is the discount rate that results in a zero net present value.
Setting the net present value equal to zero above and solving for the "Present value
factor for an annuity" (PVIFA) yields the following formula:
• Factor of the IRR = Investment required / Net annual cash inflow
• 2. The problem of uneven cash flows. When cash flows are uneven, the above
formula cannot be used to find the factor that results in a zero net present value.
Instead, it may be necessary to resort to trial and error. Doing this by hand can
be quite a chore, but is fairly easy if the problem is set up on a computer
spreadsheet. Also, computer spreadsheets contain macros (such as "solver" in
Excel) that can automate the trial and error process.
• 3. Using the internal rate of return. The internal rate of return of any
investment is compared to whatever rate of return the organization requires on
its investment projects. If the internal rate of return is equal to or greater than
the required rate of return, then the project is acceptable. If the internal rate of
return is less than the required rate of return, the project is rejected. Of course,
non-financial factors may override these rules.
• Cost of Capital as a Screening Tool. The cost of capital can be used as a
screening tool in both discounted cash flow methods. When the internal rate
of return method is used, the cost of capital is the hurdle rate that a project
must clear for acceptance. When the net present value method is used, the
cost of capital is the discount rate.
•  F. Net Present Value versus Internal Rate of Return
•  1. The net present value method is simpler to use. It does not require trial-
and-error methods.
•  2. The internal rate of return method assumes that the cash flows can be
reinvested at whatever the internal rate of return turns out to be-even if the
internal rate of return is very high. The net present value method assumes
that cash flows can be reinvested at the discount rate. The assumption made
under the net present value method is usually more realistic.
• Expanding the Net Present Value Approach. The net
present value approach can be expanded to include two
alternatives and to integrate the concept of relevant costs.
Two approaches-the total-cost approach and the incremental-
cost approach-are used to compare competing investment
projects.
• 1. The Total-Cost Approach. In the total-cost approach to
net present value, all cash inflows and all cash outflows are
included in the computation of net present value for each
alternative. The net present value figures for each of the two
alternatives are compared and the alternative with the higher
net present value is preferred.
• 2. The Incremental-Cost Approach. Under the incremental-cost
approach, only those costs and revenues that differ between the
alternatives are included in the discounted cash flow analysis. When only
two alternatives are being considered, the incremental-cost approach offers
a simpler, more direct route to a decision.
• 3. Evaluating an investment with uncertain cash flows. In practice, of
course, future cash flows are seldom known with certainty. In principle,
this complication can be incorporated into net present value analysis in a
number of ways. We approach the problem from the perspective of using a
sort of breakeven analysis. We ask how large would this particulare cash
flow have to be to change the decision? The decision maker may not know
exactly what the cash flow is going to be, but may be fairly confident that
it will be larger (or smaller) than this critical value.

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