Internal Rate of Return (IRR)

Internal rate of return (IRR) is the discount rate at which the net present value of an investment
becomes zero. In other words, IRR is the discount rate which equates the present value of the future
cash flows of an investment with the initial investment. It is one of the several measures used for
investment appraisal.

Decision Rule

A project should only be accepted if its IRR is NOT less than the target internal rate of return. When
comparing two or more mutually exclusive projects, the project having highest value of IRR should be
accepted.

IRR Calculation

The calculation of IRR is a bit complex than other capital budgeting techniques. We know that at IRR,
Net Present Value (NPV) is zero, thus:

NPV = 0; or

PV of future cash flows − Initial Investment = 0; or

CF1 + CF2 + CF3 + ... − Initial Investment = 0

( 1 + r )1 ( 1 + r )2 ( 1 + r )3

Where,

r is the internal rate of return;

CF1 is the period one net cash inflow;

CF2 is the period two net cash inflow,

CF3 is the period three net cash inflow, and so on ...

But the problem is, we cannot isolate the variable r (=internal rate of return) on one side of the above
equation. However, there are alternative procedures which can be followed to find IRR. The simplest of
them is described below:

Guess the value of r and calculate the NPV of the project at that value.

If NPV is close to zero then IRR is equal to r.

If NPV is greater than 0 then increase r and jump to step 5.

If NPV is smaller than 0 then decrease r and jump to step 5.

Recalculate NPV using the new value of r and go back to step 2.

Example

Find the IRR of an investment having initial cash outflow of $213,000. The cash inflows during the first,
second, third and fourth years are expected to be $65,200, $96,000, $73,100 and $55,400 respectively.

Solution

Assume that r is 10%.

NPV at 10% discount rate = $18,372

Since NPV is greater than zero we have to increase discount rate, thus

NPV at 13% discount rate = $4,521

But it is still greater than zero we have to further increase the discount rate, thus

NPV at 14% discount rate = $204

NPV at 15% discount rate = ($3,975)

Since NPV is fairly close to zero at 14% value of r, therefore

IRR ≈ 14%
Net Present Value (NPV)
Net present value is the present value of net cash inflows generated by a project including
salvage value, if any, less the initial investment on the project. It is one of the most reliable
measures used in capital budgeting because it accounts for time value of money by using
discounted cash inflows.

Before calculating NPV, a target rate of return is set which is used to discount the net cash
inflows from a project. Net cash inflow equals total cash inflow during a period less the expenses
directly incurred on generating the cash inflow.

Calculation Methods and Formulas

The first step involved in the calculation of NPV is the determination of the present value of net
cash inflows from a project or asset. The net cash flows may be even (i.e. equal cash inflows in
different periods) or uneven (i.e. different cash flows in different periods). When they are even,
present value can be easily calculated by using the present value formula of annuity. However, if
they are uneven, we need to calculate the present value of each individual net cash inflow
separately.

In the second step we subtract the initial investment on the project from the total present value of
inflows to arrive at net present value.

Thus we have the following two formulas for the calculation of NPV:

When cash inflows are even:

1 − (1 + i)-n
NPV = R × − Initial Investment
i

In the above formula,

R is the net cash inflow expected to be received each period;
i is the required rate of return per period;
n are the number of periods during which the project is expected to operate and generate cash
inflows.

When cash inflows are uneven:

R1 R2 R3
NPV = 1 + 2 + + ... − Initial Investment
(1 + i) (1 + i) (1 + i)3
Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second period;
R3 is the net cash inflow during the third period, and so on ...

Decision Rule
Accept the project only if its NPV is positive or zero. Reject the project having negative NPV.
While comparing two or more exclusive projects having positive NPVs, accept the one with
highest NPV.

Examples
Example 1: Even Cash Inflows: Calculate the net present value of a project which requires an
initial investment of $243,000 and it is expected to generate a cash inflow of $50,000 each month
for 12 months. Assume that the salvage value of the project is zero. The target rate of return is
12% per annum.

Solution

We have,
Initial Investment = $243,000
Net Cash Inflow per Period = $50,000
Number of Periods = 12
Discount Rate per Period = 12% ÷ 12 = 1%

Net Present Value

= $50,000 × (1 − (1 + 1%)^-12) ÷ 1% − $243,000
= $50,000 × (1 − 1.01^-12) ÷ 0.01 − $243,000
≈ $50,000 × (1 − 0.887449) ÷ 0.01 − $243,000
≈ $50,000 × 0.112551 ÷ 0.01 − $243,000
≈ $50,000 × 11.2551 − $243,000
≈ $562,754 − $243,000
≈ $319,754

Example 2: Uneven Cash Inflows: An initial investment on plant and machinery of $8,320
thousand is expected to generate cash inflows of $3,411 thousand, $4,070 thousand, $5,824
thousand and $2,065 thousand at the end of first, second, third and fourth year respectively. At
the end of the fourth year, the machinery will be sold for $900 thousand. Calculate the present
value of the investment if the discount rate is 18%. Round your answer to nearest thousand
dollars.

Solution
PV Factors:
Year 1 = 1 ÷ (1 + 18%)^1 ≈ 0.8475
Year 2 = 1 ÷ (1 + 18%)^2 ≈ 0.7182
Year 3 = 1 ÷ (1 + 18%)^3 ≈ 0.6086
Year 4 = 1 ÷ (1 + 18%)^4 ≈ 0.5158

The rest of the problem can be solved more efficiently in table format as show below:

Year 1 2 3 4
Net Cash Inflow $3,411 $4,070 $5,824 $2,065
Salvage Value 900
Total Cash Inflow $3,411 $4,070 $5,824 $2,965
× Present Value Factor 0.8475 0.7182 0.6086 0.5158
Present Value of Cash Flows $2,890.68 $2,923.01 $3,544.67 $1,529.31
Total PV of Cash Inflows $10,888
− Initial Investment − 8,320
Net Present Value $2,568 thousand

Advantage and Disadvantage of NPV

Advantage: Net present value accounts for time value of money. Thus it is more reliable than
other investment appraisal techniques which do not discount future cash flows such payback
period and accounting rate of return.

Disadvantage: It is based on estimated future cash flows of the project and estimates may be far
from actual results.

NPV
Show All

Calculates the net present value of an investment by using a discount rate and a series of future
payments (negative values) and income (positive values).

Syntax

NPV(rate,value1,value2, ...)
Rate     is the rate of discount over the length of one period.

Value1, value2, ...     are 1 to 29 arguments representing the payments and income.

 Value1, value2, ... must be equally spaced in time and occur at the end of each period.
 NPV uses the order of value1, value2, ... to interpret the order of cash flows. Be sure to enter
your payment and income values in the correct sequence.
 Arguments that are numbers, empty cells, logical values, or text representations of numbers are
counted; arguments that are error values or text that cannot be translated into numbers are
ignored.
 If an argument is an array or reference, only numbers in that array or reference are counted.
Empty cells, logical values, text, or error values in the array or reference are ignored.

Remarks

 The NPV investment begins one period before the date of the value1 cash flow and ends with
the last cash flow in the list. The NPV calculation is based on future cash flows. If your first cash
flow occurs at the beginning of the first period, the first value must be added to the NPV result,
not included in the values arguments. For more information, see the examples below.
 If n is the number of cash flows in the list of values, the formula for NPV is:

 NPV is similar to the PV function (present value). The primary difference between PV and NPV is
that PV allows cash flows to begin either at the end or at the beginning of the period. Unlike the
variable NPV cash flow values, PV cash flows must be constant throughout the investment. For
information about annuities and financial functions, see PV.
 NPV is also related to the IRR function (internal rate of return). IRR is the rate for which NPV
equals zero: NPV(IRR(...), ...) = 0.

Example 1

The example may be easier to understand if you copy it to a blank worksheet.

How to copy an example

  A B

1 Data Description

2 10% Annual discount rate

3 -10,000 Initial cost of investment one year from today

4 3,000 Return from first year

5 4,200 Return from second year

 6,800 Return from third year

6 Formula Description (Result)

=NPV(A2, A3, A4, A5, A6) Net present value of this investment (1,188.44)

In the preceding example, you include the initial $10,000 cost as one of the values, because the
payment occurs at the end of the first period.

Example 2

The example may be easier to understand if you copy it to a blank worksheet.

How to copy an example

A B

Data Description

  Annual discount rate. This might represent the rate of inflation or the interest
8%
rate of a competing investment.
1
-40,000 Initial cost of investment
2
8,000 Return from first year
3
9,200 Return from second year
4
10,000 Return from third year
5
12,000 Return from fourth year
6
14,500 Return from fifth year
7
Formula Description (Result)
8
=NPV(A2, A4:A8)+A3 Net present value of this investment (1,922.06)

=NPV(A2, A4:A8, Net present value of this investment, with a loss in the sixth year of 9000 (-
-9000)+A3 3,749.47)

In the preceding example, you don't include the initial $40,000 cost as one of the values, because
the payment occurs at the beginning of the first period.