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Financial Management

( MGT201 )

Internal Rate of Return (IRR)


Prepared
~ by ~
Instructor
MGT201

Virtual University of Pakistan


IRR
Internal Rate of Return
Prepared
~ by ~
Instructor
MGT201

Virtual University of Pakistan


What is IRR ?
 The discount rate often used in capital budgeting that makes
the net present value of all cash flows from a particular
project equal to zero.

 Generally speaking, the higher a project's internal rate of


return, the more desirable it is to undertake the project.

 As such, IRR can be used to rank several prospective projects


Prepared a firm is considering. Assuming all other factors are equal
among the various projects, the project with the highest IRR
~ by ~ would probably be considered the best and undertaken first.
Instructor
MGT201  IRR is sometimes referred to as “Economic Rate of Return
(ERR)".

Virtual University of Pakistan


FINDING IRR
(Trial & Error Method with Interpolation Formula)
 A project involves an initial Cash Flows
outlay of Rs. 240,000. The Years (Rs.)
estimated net cash flows
for the project are as
given: 1. 140,000

 The company’s required


2. 80,000
rate of return is 13 percent.
Prepared 3. 60,000
~ by ~
 Calculate the IRR for the
4. 20,000
Instructor project. Is the project
MGT201 feasible assuming all other
factors are equal ? 5. 20,000

Virtual University of Pakistan


Trial & Error Method
(By applying different discount rates)

At 15 % discount rate:

NPV = - 240,000+[140,000/(1.15)]+[80,000/(1.15)2]+[60,000/(1.15)3]+[20,000/(1.15)4]+[20,000/(1.15)5]

= - 240,000 + 121,739 + 60,491 + 39,450 + 11,435 + 9,944

= - 240,000 + 243,059

= Rs. 3,059

At 17 % discount rate:
Prepared
NPV = - 240,000+[140,000/(1.17)]+[80,000/(1.17)2]+[60,000/(1.17)3]+[20,000/(1.17)4]+[20,000/(1.17)5]
~ by ~
= - 240,000 + 119,658 + 58,441 + 37,463 + 10,673 + 9,122
Instructor
= - 240,000 + 235,357
MGT201
= Rs. – 4,643

Virtual University of Pakistan


Finding
By using 15% rate we have a positive figure
that is greater than zero whereas by using
17% rate we have a negative figure that is
lesser than zero. NPV appears to be zero
between 15% and 17%, so IRR is somewhere
in that range. By using INTERPOLATION
Prepared
Technique or Formula, we can find that the
~ by ~
Instructor
IRR is about 15.79%.
MGT201

Virtual University of Pakistan


Interpolation Technique
(For Finding IRR)

Rate NPV
0.15 Rs.3,059
X Rs.3,059
0.02 IRR 0 Rs.7,702

0.17 -Rs.4,643
Prepared
~ by ~
Instructor
X Rs.3,059
=
MGT201
.02 Rs.7,702
Interpolation Technique
(For Finding IRR)

X

Prepared
~ by ~ IRR = Lower Rate + X
Instructor
IRR = 0.15 + 0.0079
MGT201
IRR = 0.1579 or 15.79%
Virtual University of Pakistan
Prepared
OR
~ by ~
Instructor
MGT201

Virtual University of Pakistan


Interpolation Formula
(For Finding IRR)

IRR = Lower discount Rate + Difference between the two discount


rates x (NPV at lower discounted rate / absolute difference between
the NPVs of the two discount rates)

= 15 + ( 17 – 15 ) x ( 3,059 / (3,059 – ( - 4643 ))


= 15 + 2 x ( 3,059 / 7,702 )
= 15 + 2 x 0.3972
= 15 + 0.7944
Prepared
~ by ~ IRR = 15.79 % Approx.
Instructor
MGT201

Virtual University of Pakistan


Now Applying 15.79%, We have NPV nearer to Zero

NPV = -240,000+[140,000/(1.1579)]+[80,000/(1.1579)2]
+[60,000/(1.1579)3]+[20,000/(1.1579)4]+[20,000/(1.1579)5]

= - 240,000 + 120,909 + 59,669 + 38,649 + 11,126 + 9,609

= - 240,000 + 239,962

Prepared NPV = Rs. 38  Nearer to Zero


~ by ~
Instructor
MGT201

Virtual University of Pakistan


Project Feasibility

The project is feasible as its Internal Rate of Return


(IRR) is greater than the company’s required rate of
return, assuming all other factors are equal*.

*( If there are two mutually exclusive projects and


both have IRR greater than the company’s required
Prepared
rate of return then the project with higher NPV will
~ by ~
be preferred. In other words, other capital budgeting
Instructor
techniques will be employed. )
MGT201

Virtual University of Pakistan


Dear Students !

It is hoped that…..
You’d be now able to find out IRR easily.

. . . GOOD LUCK . . .
Prepared
~ by ~
Instructor
Instructor MGT201
MGT201
Virtual University of Pakistan

Virtual University of Pakistan

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