Internal Rate of Return

Internal rate of return is time adjusted

technique and covers the disadvantages of the
traditional techniques. It is also known as
time adjusted rate of return, discounted cash
flow, discounted rate of return, yield
method, and trial and error yield method.
In this method, discount rate is determined
internally, this method is called as the internal
rate of return method. The internal rate of
return can be defined as that rate of
discount at which the present value of
cash inflows is equal to the present value
of cash outflows.
Determination of IRR

Internal Rate of Return

(a)When the annual net Cash Flow are
equal over the life of the asset: firstly,
find out present value factor by dividing
initial outlay (cost of the investment) by
annual cash flow, i.e.

InitalOutlay
Present value factor=
AnnualCashFlow

Then consult present value annuity table:

Example:
Initial outlay= Rs. 50000
Life of the asset= 5years
Estimated annual cash- flow= 12500
Calculate the IRR.
Solution:
Present Value factor= initial outlay/ Annual
Cash Flow
= 50000/12500
=4
Consult Present value Annuity table for 5 years
periods at Present value factor of 4.

Present Value Annuity Table

Present value of an Annuity of
Re.
1
Year
6%
7%
8%
9%
10%
11%
12%
01

0.9434

0.9346

0.9929

0.9174

0.9091

0.909

0.2989

02

1.8334

1.8010

1.7833

1.7591

1.7355

1.7125

1.6900

03

2.6730

2.6243

2.5771

2.5313

2.4864

2.4437

2.4018

04

3.4651

3.3872

3.3121

3.2397

3.1699

3.1024

3.0373

05

4.2123

4.1002

3.9927

3.8896

3.7909

3.6959

3.6048

06

4.9173

4.7655

4.6229

4.4859

4.3553

4.2305

4.1114

07

5.5824

5.3839

5.2064

5.0429

4.8664

4.7122

4.5638

08

6.2098

5.9713

5.7466

5.5348

5.3349

5.1461

4.9676

09

6.8117

6.5152

6.2469

5.9852

5.7590

5.5370

5.3282

10

7.3601

7.0236

6.7101

6.4176

6.1446

5.8892

5.6502

So, IRR= 8 % approx.

Present value is 3.9927 which is nearly
equal to 4.

(b) When the annual cash flows are unequal over the
life of the asset:
Steps to be followed:
Step1. find out factor
Factor is calculated as follows:

InitialInvestment
F=
CashInflow
step 2. Find out positive net present value
Step 3. Find out negative net present value
Step 4. Find out formula net present value
Formula
PositiveNet Pr esentValue
DP
IRR = Base factor +

Difference in positive and

Negative net present value

Base factor = Positive discount rate

DP = Difference in percentage

A company has to select one of the

following two projects:
Project A

Project B

22000

20000

Year 1

12000

2000

Year 2

4000

2000

Year 3

2000

4000

Year 4

10000

20000

Cost
Cash Inflows:

Using the Internal Rate of Return method

suggest which is Preferable.

Project A
Year

Cash inflows

Discount rate Present

@ 10 %
Values

12000

.909

10908

4000

.826

3304

2000

.751

1502

10000

.683

6830

Total Present Value

22544

PV of outflows

22000

NPV

544

Year

Cash
inflows

Discount
rate @
10 %

Present
Values

Discount
Rate
@12%

Present
Value

12000

.909

10908

.769

9228

4000

.826

3304

.591

2364

2000

.751

1502

.455

910

10000

.683

6830

.350

3500

Fffff

Total Present Value

22544

16002

PV of outflows

22000

22000

NPV

544

(5998)

Year

Cash
inflow
s

Disco
unt
rate
@ 10
%

Prese
nt
Value
s

Disco
unt
Rate
@12%

Prese
nt
Value

Disco Prese
unt
nt
Rate@ Value
11%

12000

.909

10908

.769

9228

.833

9996

4000

.826

3304

.591

2364

.694

2776

2000

.751

1502

.455

910

.578

1156

10000

.683

6830

.350

3500

.482

4820

Fffff

Total Present
Value

22544

16002

18748

PV of outflows

22000

22000

22000

NPV

544

(5998)

(3252)

IRR = Base

PositiveNet Pr esentValue
DP
Difference
in positive and
factor
+
Negative net present value

IRR=
IRR=
IRR=
IRR=

10+ 544 /544-(-3252)*1

10+ 544/3796*1
10+.1433
10.14

2. Example: Initial Investment= 60000

Life of the Asset= 4 years
Estimated Net Annual Cash Flows:
1 year= 15000
2nd year= 20000
3rd year= 30000
4th year= 20000

Solution
Cash Flow Table at Various Assumed Discounted Rates of 10% 14%
& 15%
Year Annual
Cash
Flow

Discounted
rate@ 10%

Discounted
rate@ 12%

Discounted
rate@ 14%

Discounted
rate@ 15%

P.V.F

P.V.
(Rs.)

P.V.F

P.V.
(Rs.)

P.V.F

P.V.
(Rs.)

P.V.F

P.V.
(Rs.)

15000

.909

13635

.892

1338
0

.877

1315
5

.869

1303
5

20000

.826

16520

.797

1594
0

.769

1538
0

.756

1512
0

30000

.751

22530

.711

2133
0

.674

2022
0

.657

1971
0

20000

.683

13660

.635

1270
0

.592

1184
0

.571

1142
0

66345

6335

6059

5928

The present value of net cash flows at

14% rate of discount is Rs. 60595 and
at 15% rate of discount it is Rs. 59285.
so the initial cost of investment which
is Rs. 60000 falls in between these two
discount rate. At 14% the NPV is +595
but at 15% the NPV is -715, we may
say that IRR= 14.5% (approx)

Merits
1. It consider the time value of money.
2. It takes into account the total cash inflow
and outflow.
3. It does not use the concept of the
required rate of return.
4. It gives the approximate/nearest rate of
return.
Demerits
1. It involves complicated computational
method.
2. It produces multiple rates which may be
confusing for taking decisions.
3. It is assume that all intermediate cash

Accept/Reject criteria
If the present value of the sum total of the
compounded reinvested cash flows is
greater than the present value of the
outflows,
the
proposed
project
is
accepted. If not it would be rejected.