Scribd
Upload
58 views13 pages

Understanding Internal Rate of Return

The document discusses internal rate of return (IRR) and net present value (NPV). IRR is a metric used to evaluate the profitability of potential investments. It takes into account the time value of money and opportunity cost. NPV compares the present value of cash inflows from an investment to the present value of cash outflows. The document uses examples to illustrate how to calculate IRR and compare potential projects based on their NPV and residual NPV to determine which has the higher rate of return. Based on the examples, Project A has a higher residual NPV than Project B and therefore a higher IRR of 21%.

Uploaded by

Aditya Anirudh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
58 views13 pages

Understanding Internal Rate of Return

The document discusses internal rate of return (IRR) and net present value (NPV). IRR is a metric used to evaluate the profitability of potential investments. It takes into account the time value of money and opportunity cost. NPV compares the present value of cash inflows from an investment to the present value of cash outflows. The document uses examples to illustrate how to calculate IRR and compare potential projects based on their NPV and residual NPV to determine which has the higher rate of return. Based on the examples, Project A has a higher residual NPV than Project B and therefore a higher IRR of 21%.

Uploaded by

Aditya Anirudh
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPT, PDF, TXT or read online on Scribd

IRR

Internal Rate of Return helps to


understand -
yield on an investment,
marginal efficiency of capital,
rate of return over cost,
time adjusted rate of return

In other words
it takes into consideration-
TIME VALUE OF MONEY
& OPPORTUNITY COST
IRR
How much we get by investing
Rs.100/-, Say at 10% -
Rs. 100 will be Rs. 110 after I YR
Rs. 100 will be Rs. 121 after II YR
Rs. 100 will be Rs. 133 after III YR
And so on
IRR
Rs.100 IN HAND NOW IS HAVING
MORE WORTH THAN Rs.100, THAT
IS AVAILABLE AFTER ONE YEAR

AT 10% DISCOUNT RATE -


Rs.110 after I yr is worth Rs.100 today
Rs.121 after II yr is worth Rs.100 today
Rs.131 after III yr is worth Rs.100 today
OR
Value of Re 1 today is Re 0.909 after I yr
Value of Re 1 today is Re 0.826 after II yr
Value of Re 1 today is Re 0.751 after III yr
WHY WE USE DISCOUNTING
METHOD FOR IRR?

TO FIND TIME VALUE OF


MONEY AND NET PRESENT
VALUE
WHAT IS
NPV?
PROJECT A : INVESTMENT OF Rs.1000
Yield from 1 to 5 Years300, 400, 400, 300 & 300
AT DISCOUNT RATE OF 15%

YEARS NET RETURNS @ 15% NPVs


1 YEAR 300 .870 261
2 YEAR 400 .756 302
3 YEAR 400 .658 263
4 YEAR 300 .572 172
5 YEAR 300 .497 149
TOTAL NPV 1147
OF NET
RETURNS
PROJECT -1000
COST
PROJECT B : INVESTMENT OF Rs.1000
Yield from 1 to 5 Years200, 300, 500, 400 & 300
AT DISCOUNT RATE OF 15%

YEARS NET RETURNS @ 15% NPVs


1 200 .870 174
2 300 .756 227
3 500 .658 329
4 400 .572 229
5 300 .497 149
TOTAL NPV OF 1108
INFLOWS
PROJECT COST -1000
TODAY
RESIDUAL NPV +108
WHICH PROJECT IS
PREFERABLE IN A TIME
HORIZON OF 5 YEARS?
A OR B

PROJECT A, AS RESIDUAL
NPV IS MORE.
WHAT IS IRR
of the Project?
TAKE EXAMPLE OF PROJECT A
IRR
YEAR Net at NPV at NPV at NPV
Income 15% 20% 25%
1 300 .870 261 .833 250 .800 240

2 400 .756 302 .694 277 .640 256

3 400 .658 263 .579 231 .512 205

4 300 .572 172 .482 145 .410 123

5 300 .497 149 .402 121 .328 98

NPV Total 1147 1024 922


Project 1000 1000 1000
cost
Res. NPV +147 +24 (-)78

RESIDUAL NPV AT 15% & 20% IS +VE. IT IS -VE AT 25%. SO, IRR LAY BETWEEN 20 TO 25%
TO FIND THE EXACT IRR WE USE THE
FOLLOWING ARITHMETIC FORMULA

Residual NPV
at Lower
Difference Discount Rate
Lower
IRR = Discount Rate + Between the
Two rates
X
*Sum of Residual
NPVs at Lower &
Higher Discount Rates

*Ignore (+) or (-)


of residual values
24
IRR = 20 + 5 X
(24 + 78)

=21%
IRR SHOULD BE MORE
THAN LENDING RATE

You might also like