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Formula:: Where

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37 views3 pages

Formula:: Where

Uploaded by

General Use
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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IRR:

The IRR is the rate at which the project breaks even i.e. Internal Rate of Return, often simply
referred to as the IRR, is the discount rate that causes the net present value of future cash flows
from an investment to equal zero.

Formula:
Internal Rate of Return:

= R1 + [ (NPV1 x (R2 – R1)% ÷ (NPV1 – NPV2) ]


Where:
R1 = Lower discount rate
R2 = Higher discount rate
NPV1 = Higher Net Present Value (derived from R1)
NPV2 = Lower Net Present Value (derived from R2)

Calculation:
Step 1: Select 2 discount rates for the calculation of NPVs
try your best to keep the two discount rates that you select within a reasonable range to
improve the accuracy of your calculation.
Step 2: Calculate NPVs of the investment using the 2 discount rates
You shall now calculate the net present values of the investment on the basis of each
discount rate selected in Step 1.

Step 3: Calculate the IRR


Using the 2 discount rates from Step 1 and the 2 net present values derived in Step 2,
you shall calculate the IRR by applying the IRR Formula stated above.

Step 4: Interpretation
The decision rule for IRR is that an investment should only be selected where the cost of
capital (WACC) is lower than the IRR.

The decision rule above will lead to the same conclusion as the NPV analysis where only
one investment is being considered.

Where multiple investments are being considered, IRR should not be used as the primary
appraisal tool because NPV analysis provides a better measure of the impact of different
projects on the shareholder wealth. IRR should still be used, however, as a risk
assessment tool to measure the sensitivity of different investment options towards the
cost of capital.

Example

Mr. A is considering investing $250,000 in a business.

The cost of capital for the investment is 13%.

Following cash flows are expected from the investment:


Year $
0 (250,000)
1 50,000
2 100,000
3 200,000

Calculate the IRR for the proposed investment and interpret your answer.
Solution

Step 1: Select 2 discount rates for the calculation of NPVs


We can take 10% (R1) and 20% (R2) as our discount rates.

Step 2: Calculate NPVs of the investment using the 2 discount rates


Net Present Value @ 10%

Cash Flow Discount Factor Present Value

A B AxB

(250,000) 1.000 (250,000)

50,000 0.909 45,450

100,000 0.826 82,600

200,000 0.751 150,200


Cash Flow Discount Factor Present Value

28,250
NPV1
Net Present Value @ 20%

Cash Flow Discount Factor Present Value

A B AxB

(250,000) 1.000 (250,000)

50,000 0.833 41,650

100,000 0.694 69,400

200,000 0.579 115,800

NPV2 -23,150

Step 3: Calculate the IRR


Internal Rate of Return:
= R1% + [(NPV1 x (R2 – R1)%) ÷ (NPV1 – NPV2)]
= 10% + [(28,250 x (20 – 10)%) ÷ (28,250 – (- 23,150))]
= 10% + [(28,250 x 10%) ÷ (28,250 + 23,150)]
= 10% + 5.5%
= 15.5%

Step 4: Interpretation
The investment should be accepted by Mr. A because the cost of capital (i.e. 13%) is
lower than the IRR of 15.5%.

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