Internal Rate of Return

1. Internal Rate of Return FIN 321 Erin Kelso & Jen Wroblewski Thursday, February 1st

2. What is IRR? • The discounted rate that equates the present value of a project’s expected cash inflows to the present value of the project’s costs

3. What is IRR? • The discount rate which sets the NPV of all cash flows equal to 0. • Helps to determine the YIELD on an investment.

4. How do we calculate IRR? • NPV = Net Present Value of the project • Initial Investment • Ct=Cash flow at time t • IRR = Internal Rate of Return

5. Calculating IRR… • Set the NPV = 0 • Plug in your Cash Flows & Initial Investment • Solve for IRR! • This is the same equation used for NPV, except you know your interest rate, i.

6. Using the Financial Calulator • BA II Plus • Go to the Cash Flow worksheet, plug in CFo, CF1, and so on… • Go to the IRR button and click CPT (compute) and you will get your IRR!

7. So now what? • Once you’ve calculated IRR • If IRR is greater than the cost of capital, then you’ve got a GOOD project on your hands (go for it!). • If IRR is less than the cost of capital, then you’ve got a BAD project on your hands (don’t undertake the project…). • If the IRR and cost of capital are equal, then you should use another method to evaluate the project! • Basically, the higher the IRR, the better the project

8. Example IRR Problem • You are debating whether or not to invest in your best friend’s business idea, so use IRR to evaluate the project: • Cost of Capital: 10% • Initial Investment: -$200 • Cash Flows over the past 5 years: • Years 1 & 2: $50 • Years 3 & 4: $100 • Year 5: $125

9. Compute IRR! • A. 15.36% • B. 31.20% • C. -17.29% • D. 26.04% • E. none of the above

10. And the Answer is…. • In your calculator: • CFo=-200 Enter • C01=50 Enter • F01=2 Enter • C02=100 Enter • F02=2 Enter • C03=125 Enter • F03=1 Enter • IRR CPT • IRR =

11. Try another one… • Your friend’s got another business scheme…see if you want to help him out! • Cost of Capital: 5% • Initial Investment: -$1500 • Cash Flows over the past 5 years: • Years 1,2 & 3: $100 • Year 4: $200 • Year 5: $500

12. Compute IRR again! • A. 2.61% • B. -9.66% • C. 10.65% • D. -21.79% • E. none of the above

13. And the answer is… • In your calculator: • CFo=-1500 Enter • C01=100 Enter • F01=3 Enter • C02=200 Enter • F02=1 Enter • C03=500 Enter • F03=1 Enter • IRR CPT • IRR =

14. Is IRR always a good choice? • IRR is useful in deciding whether or not to invest in a single project • When multiple projects are being considered, IRR is not a good investment tool to use to evaluate which project to choose. • The IRR calculation automatically assumes that all cash outflows are reinvested at the IRR, but doesn’t evaluate what the investor does with cash inflows, which would have an effect on the true IRR.

15. Multiple IRRs • When projects have non-normal cash flows, multiple IRRs may occur • A non-normal cash flow occurs when a project calls for a large cash outflow sometime during or at the end of its life • There is no way to know which IRR is correct

16. Sign changes in the Cash Flows • IRR evaluates a project correctly when there is an initial negative cash flow, followed by a series of positive ones (-+++). • If the signs are reversed (+---), that will change the accurateness of the IRR calculation. • If there are multiple sign changes in the cash flows (+-+-+) or (-+-+-), your calculation would result in multiple IRRs, also making the project very difficult to evaluate.

17. NPV vs. IRR • NPV and IRR methods will always lead to the same accept/reject decisions for independent projects • NPV and IRR can give conflicting rankings for mutually exclusive projects (you must pick one project, you cannot accept both)

18. NPV vs. IRR • NPV profiles of projects can cross when project size differences exist (the cost of one project is larger than that of the other) or when timing differences exist (most of the cash flows from one project come in the early years, while most of the cash flows from the other project come in the later years)

19. NPV vs. IRR • If the cost of capital is greater than this crossover rate, the two methods give same answer • If the cost of capital less than crossover rate, two methods give separate answers

20. NPV vs. IRR? • The NPV calculation will usually always provide a more accurate indication of whether or not a project should be undertaken or not. • However, since IRR is a percentage, and NPV is shown in $$, it is more appealing for a manager to show someone a particular rate of return, as opposed to $$ amounts.

21. Why do we use IRR? • IRR is necessary from a capital budgeting standpoint. • Just as NPV is a way to evaluate an investment, IRR provides more insight into whether or not a project/investment should be undertaken. • More useful for long term investments, with multiple cash flows

22. Modified Internal Rate of Return • Another capital budgeting tool for investments • Assumes that the project’s cash flows are reinvested at the cost of capital, not at the IRR. • This slight difference, makes the MIRR more accurate than the IRR.

23. Any Questions?

24. Sources • “Internal Rate of Return”. Wikipedia.org. http://en.wikipedia.org/wiki/Internal_rate_of_return • “Internal Rate of Return – IRR”. Investopedia.com. http://www.investopedia.com/terms/i/irr.asp