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Capital Investment Appraisal Method:Internal Rate Of Return

In the previous article on NPV, we noted that a positive NPV denotes that a project can be accepted as it generates excess returns over its cost of finance. Hence, vice-versa, we cannot accept a negative NPV as it cannot generate a return above the cost of finance.
How do we then interpret a zero NPV
Zero NPV is actually the Internal Rate of Return which is therefore the discount rate that causes:
The present value of all the future cash flows – the present value of the initial outlay to yield an NPV of zero.
Using the same cash flow’s details from the NPV case, we shall try to get the IRR:

Year O Year 1 Year 2 Year 3 Year 4
Initial Outlay (a) $100K
Net cash-flows (b) $20.00K $30.00K $40.00K $50.00K
Using PV factor of 10%
NPV=		 +$7.15K
Simulating it :
Using PV factor of 15%
NPV=		 +$0.5K
Using PV factor of 12%
NPV=		 $0.00K

To calculate the Internal Rate of Return, we can either use the interpolation method which is to take two discount rates, one rate that gives a positive NPV and another discount rate that give a negative NPV and interpolate the IRR.
Or you can use a calculator or a computer model (excel formula for IRR).

Interpretation of IRR:
If the IRR for the project is12% and the cost of capital used to finance it is lesser than 12%,then the project should be accepted.

This entry was posted on Monday, October 15th, 2007 at 5:13 am and is filed under b. Appraisal Methods. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

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