Internal Rate of Return

A brief encounter

Contents

• Definition

• Worked Example

• Example Comparisons

• Meaning of Results

• Summary

Definition

• Alternative version of DCF

• Shows maximum Interest Rate

Worked Example

Cash Flows Discount Factor Present Values £ 8% £

End of Year 0 -10,000 1.000 -10,000 1 + 3,000 0.926 + 2,778 2 + 4,000 0.857 + 3,428 3 + 5,000 0.794 + 3,970

NET PRESENT VALUE = +176

Meaning of Results• In example 4, an 8% discount factor gives an NPV of = +£176 and a 10%

discount factor gives an NPV of = -£214• So, a 2% discount swing produces a swing from positive to negative in the

NPV of 176 + 214 = £390. The IRR must therefore be at 8% + (176/390)*2% = 8.9%. We’ll call this 9%.

• What does this 9% mean? It presents the maximum rate of interest that could be paid on funds borrowed to finance the investment for it to be worthwhile. So, if money can only be borrowed to fund the project at, say, 12% interest rates then the project is not economically viable. It’s like borrowing money at 12% and investing it at 9% - a good way of going bust. On the other hand if money can be borrowed at 4% then it is economic to use such money to fund a project that will be generating 9%.

• It is a sort of break-even figure. If money can be borrowed more cheaply than that, then go ahead; if it cannot, abandon the project. Of course, it should always be remembered that factors other than the purely economic and financial may quite legitimately affect the decision as to whether to go ahead with an investment or not.

Summary

• IRR is an appraisal method that shows a maximum interest rate for a project

• The NPV will always equal Zero

• Modern software allows easy calculation