CHAPTER 8

FINACIAL MANAGEMENT
Part 4/4
Internal Rate of Return
Edited by

Ir. Dr. Salina Budin

Edit by Ir dr bulan on 28 may 2017

 LEARNING OUTCOMES
1. Understand meaning of IRR
2. Calculate IRR for cash flow series
3. Understand difficulties of IRR
4. Determine multiple IRR values
5. Explain difference in public vs. private sector projects
6. Calculate B/C ratio for single project
7. Select best of multiple alternatives using B/C method

2012 by McGraw-Hill All

Rights Reserved
Judging proposed investments
Dont need to pre-specify minimum rate
of return i* in judging projects
Internal rate of return (IRR) is:
The interest rate that makes the present
worth of a project exactly 0
Project is desirable if i* < IRR,
Not otherwise (since present worth would
be negative)
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IRR Calculation and Project Evaluation
To determine IRR, find the i* value in the relation

PW = 0 or AW = 0 or FW = 0

Alternatively, a relation like the following finds i*

PWoutflow = PWinflow

For evaluation, a project is economically viable if

i* MARR (Minimum attractive rate of return)

2012 by McGraw-Hill All
Rights Reserved
7-4
Example
Consider a stream of costs and
revenues over time
Present worth equals:
$3924 at 18%
-$6051 at 20%

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Example
6000

4000

2000
Present Worth

0
17 18 19 20 21
-2000

-4000

-6000

-8000
Interest Rate

Assume function is linear in between

(True function actually lies slightly below)

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Example
Present worth equals:
$3924 at 18%, -$6051 at 20%
Slope = Delta Y/Delta X
= (-$6051 - $3924)/(20 - 18) = -4987.5
Want distance x such that height y = 0:
3924 - 4987.5x = 0 x=.8 IRR=18+.8
(True value = 18.76)

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Internal rate of return
Note that we dont need to consider
present worth:
As long as it is all in one time period

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Example
A factory starts operation at the end of
year 0:
Capital costs arise in years -2, -1, and 0
Can convert to present worth in year -2,
Or to value in year 0

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Example
Assume expenses of:
$300K for land in year -2
$800K for construction in year -1
$700K for construction in year 0
$200K for inventory in year 0

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Example
Convert to future value in year 0
For year -2: $300 (F/P, 10%, 2) = $363
For year -1: $800 (F/P, 10%, 1) = $880
For year 0: $900
Total: $2143
Can then convert future revenues to
year 0 to compute present worth

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Another example
Find IRR of a $10K, 7%, 20-year bond:
Bought for $8K
(Cant do without knowing purchase price!)
Bond pays:
7% of $10K = $700/year for 20 years
$10K in year 20
Would IRR be higher or lower than 7%?

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Another example
Present worth of bond at i* = 9%:
$700 (P/A, 9%, 20) = $6390
$10,000 (P/F, 9%, 20) = $1784
Purchase price = -$8000
Total = $174

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Another example
Present worth of bond at i* = 10%:
$700 (P/A, 10%, 20) = $5959
$10,000 (P/F, 10%, 20) = $1486
Purchase price = -$8000
Total = -$555

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Another example
Present worth equals:
$174 at 9%
-$555 at 10%
Would you expect the IRR to be:
Closer to 9%?
Closer to 10%?

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Another example
Present worth equals:
$174 at 9%, -$555 at 10%
Slope = DeltaY/Delta X
= (-$555 - $174)/(10 - 9) = -729
Want distance x such that height y = 0:
174 - 729x = 0 x = .24
IRR = 9 + .24 = 9.24

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More realistic example
Now assume that the bond pays:
$350 every six months for 20 years
$10K in year 20
Would IRR be higher or lower than the
previous value?
And why?

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More realistic example
Present worth at i* = 4% for 6 months:
$350 (P/A, 4%, 40) = $6927
$10,000 (P/F, 4%, 40) = $2083
Purchase price = -$8000
Total = $1010

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More realistic example
Present worth at i* = 5% for 6 months:
$350 (P/A, 5%, 40) = $6006
$10,000 (P/F, 5%, 40) = $1420
Purchase price = -$8000
Total = -$574

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More realistic example
Present worth equals:
$1010 at 4%, -$574 at 5% per 6 months
Slope = Delta Y/Delta X
= (-$574 - $1010)/(5 - 4) = -1584
Want distance x such that height y = 0:
1010 - 1584x = 0 x = .64
IRR = 4 + .64 = 4.64 per 6 months!

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More realistic example
How to convert to annual interest rate?
Nominal annual interest rate
= 2 (4.64) = 9.28%
Effective annual interest rate
= (1.0464)2 - 1 = 1.095 - 1 = .095
or 9.5%

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 Capital Investment Appraisal Techniques

Option 1- using calculation 3. Internal Rate of Return (IRR) (cont.)

Example:
An investment of $20,000 in new equipment will generate income of
$7000 per year for 3 years, at which time the machine can be sold for
an estimated $8000. If the companys MARR is 15% per year, should it
buy the machine?

DETERMINING THE NET PRESENT VALUE

Firm's cost of capital 15%

machine A Year-End Cash Flow

interest =i 0.15 0.2 0.18
Year= n Project A using Formula using Formula using Formula
investment of $20,000 0 -20,000 -20,000.00 -20,000.00 -20,000.00

generate income of
$7000 per year for 3 years 3 7,000 15,982.58 14,745.37 15,219.91
machine can be sold for
an estimated $8000 3 8,000 5,260.13 4,629.63 4,869.05
NPW present value 1,242.71 -625.00 88.96

Solve using interpolation technique. i* = 18.2% per year

Since i* > MARR = 15%, the company should buy the machine

2012 by McGraw-Hill All Rights Reserved

 Capital Investment Appraisal Techniques
3. Internal Rate of Return (IRR) (cont.)

Solve using interpolation technique.

Solve using interpolation technique.

Since i* > MARR = 15%, the company should buy the machine

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Option 2- using table
Example:
An investment of $20,000 in new equipment will generate income of
$7000 per year for 3 years, at which time the machine can be sold for
an estimated $8000. If the companys MARR is 15% per year, should it
buy the machine?

Trial and error

i = 15%
PW = -20,000 + 7000(P/A,15,3) +8000(P/F,15,3)
= -20000 + 15981 + 5260
= 1241

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i = 18%

PW = -20,000 + 7000(P/A,18,3) +8000(P/F,18,3)

= -20000 + 15218 + 4868.8
= 86.8

i = 20%
PW = -20,000 + 7000(P/A,20,3) +8000(P/F,20,3)
= -20000 + 14742 + 4629.6
= -628.4

Solve using interpolation technique.

i* = 18.2% per year
Since i* > MARR = 15%, the company should buy the machine

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Review
We learned how to
Find internal rate of return of a project:
Convert all costs, benefits to one time period
Try different interest rates until you find:
One where value of project is positive
One where value is negative
Interpolate to estimate IRR
Compare against minimum acceptable rate
of return i* to assess desirability

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