UNIVERSITY OF BURAO

Student name.

1. Mahamed faysal saeed

2. Mustafe ridwaan abdirahman

3. Adnan osman mahamed

Marks---------------------------?

Lecturer: Mahamoud Ali Handule

LEARNING OBJECTIVES
LEARNING OBJECTIVES

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After studying this chapter, you should be able to:

 Identify for Internal Rate of Return .

 When Is Used For Internal Rate Of Return
 Its Advantages And Disadvantage
 Decision rules
 Compare NPV vs. IRR

Internal Rate of Return (IRR)

Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project
zero. In other words, it is the expected rate of return that will be earned on a project or investment.When
calculating IRR, expected cash flows for a project or investment are given, and the NPV equals zero. The
initial cash investment for the beginning period will equal to the present value of the future cash flows of
that investment.

When is used for Internal Rate of return

Companies take on various projects to increase its revenue or cut down costs. A great new business idea
may require investing in the development of a new product to achieve this goal.

In capital budgeting, senior leaders would like to know the return on these investments, and the IRR is
one method that allows them to compare and rank projects based on their yield, and the one with the
highest IRR is usually preferred.

Advantages Of IRR

1. IRR method considers the time value of money.

2. IRR method discloses the maximum rate of return the project can give.

3. IRR method considers and analysis all cash flows of entire project.

4. IRR method ascertains the exact rate of return the project earns

Disadvantages of internal rate of return

Ignores Size of Project

A disadvantage of using the IRR method is that it does not account for the project size when comparing
projects. Cash flows are simply compared to the amount of capital outlay generating those cash flows.
Using the IRR method alone makes the smaller project more attractive, and ignores the fact that the larger
project can generate significantly higher cash flows and perhaps larger profits

Ignores Future Costs

The IRR method only concerns itself with the projected cash flows generated by a capital injection and
ignores the potential future costs that may affect profit. If you are considering an investment in trucks, for

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example, future fuel and maintenance costs might affect profit as fuel prices fluctuate and maintenance
requirements

Decision Rules Of IRR

If projects are independent

* Accept the project which has higher IRR than cost of capital(IRR> k).

* Reject the project which has lower IRR than cost of capital(IRR

If projects are mutually exclusive

* Accept the project which has higher IRR

* Reject other projects

For the acceptance of the project, IRR must be greater than cost of capital. Higher IRR is accepted among
different alternatives.

Financial managers and business owners usually like performance measures expressed in percentages
instead of dollars. As a result, they tend to like capital budgeting decisions expressed as a percentage, like
internal rate of return (IRR) instead of in a dollar amount, like net present value (NPV). However, there is
a problem. Even though internal rate of return is usually a reliable method of determining whether or not
a capital investment project is a good investment for a business firm, there are conditions under which it
is not reliable but net present value is.

Compare 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

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 dollar $$, it is more appealing for a manager
to show someone a particular rate of return, as opposed to $$ amounts.

Source we get this document

 “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

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The relationship between IRR, opportunity cost and NPV

1. IF IRR >discount rate opportunity cost the NPV is positive

2. IF IRR < opportunity cost the NPV is negative .
3. IF IRR = opportunity cost the is zero

NB. As long as the Npv is positive the project is financial accepted the moment that NPV is negative the
project is not financially acceptable

Example 1
A project A is invested $136,000 and the cash flow of five years are $30,000 $40,000 $60,000 $30,000
and $20,000 respectively the discount factors are 10% and 12% calculate the IRR ? while npv is zero

Solution

Given
YEAR CASH INFLOW DISCOUNT %10 PV
1 $30,000 0.909 $27270
2 $40,000 0.826 $33040
3 $60,000 0.751 $45060
4 $30.000 0.683 $20490
5 $20,000 0.621 $12420
NPV= $138280

NPV> cost of investment so %10 is not real IRR

YEAR CASH INFLOW DISCOUNT %12 PV

1 $30,000 0.893 $26790
2 $40,000 0.797 $31880
3 $60,000 0.712 $452720
4 $30.000 0.636 $19080
5 $20,000 0.537 $11340
NPV =
$13810
NPV < cost of investment so 12% is not real IRR but you understand that IRR is between 10% and 12%

Discount 10% discount 12%

Npv = $138280 npv $131810

IRR=∑R%+∑ NPV1-Investment] ]2 138280-136000=$2280 And

Npv1- npv2 $ 138280-131810=$6470

IRR =%10 +2280/6470*2 =0.7

IRR=%10+0.7
IRR=%10.7 so PV=COST OF INVESTMENT

Example 2
Company is considering investing $250.000 in a business and the following cash inflow are expected
from investment $50.000 $100.000 and $200.000 respectively the discount rates are 10% and 20%

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YEAR CASH INFLOW DISCOUNT 10% PV
0 (-250,000)
1 $50.000 0.909 $45,450
2 $100.000 0.826 $82,600
3 $200.000 0.751 $150,200
Npv = $28,250

YEAR CASH INFLOW DISCOUNT 20% PV

1 $50.000 0.833 $41650

2 $100.000 0.694 $69400
3 $200.000 0.579 $115800

Calculate IRR
IRR= RI% +NPVI*(RI-R2)
NPVI-NPV2
IRR = %10+28250*(%20-%10)
28250-(-23150)
IRR= +28250*%10/28250+23150 =282500/51400 =5.49
So
IRR = %10+5.5 =15.5%

 http://www.investopedia.com/terms/i/irr.asp

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