Interpolation

Copyright 2003, Alan Marshall

Example
To illustrate how we interpolate, we shall use Question 4-1 in the Study Guide In that question, the IRR was estimated using interpolation We had two points: In part (a), we obtained an NPV of -2,844.21 at a rate of 13% To estimate IRR, we tried a rate of 10% and got an NPV of 1,098.76 This is graphed on the next slide
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2 Points Graphed
1,500 1,000 500 0 9 -500 NPV ($) -1,000 -1,500 -2,000 -2,500 -3,000 -3,500 Rate (%) 10 11 12 13 14

(10%, $1,098.76)

(13%, -$2,844.21)

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The NPV Profile

The NPV profile shows what the NPV would be a various discount rates For normal projects, the NPV profile is slightly convex (slight curvature toward the origin), but over small intervals, the assumption that it is a straight line is not too bad

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NPV Profile
1,500 1,000 500 0 9 -500 NPV ($) -1,000 -1,500 -2,000 -2,500 -3,000 -3,500 Rate (%) 10 11 12 13 14

(10%, $1,098.76)

(13%, -$2,844.21)

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The IRR
Since the IRR is the rate that results in an NPV of zero, the IRR is the point on the NPV profile where it crosses the horizontal axis

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NPV Profile
1,500 1,000 500 0 9 -500 NPV ($) -1,000 -1,500 -2,000 -2,500 -3,000 -3,500 Rate (%) 10 11 12 13 14

(10%, $1,098.76)

IRR

(13%, -$2,844.21)

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IRR Estimate
We can see that the IRR is a little below 11% Interpolation allows us to estimate the IRR within an acceptable error factor

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Interpolation
We know that the IRR is between 10% and 13%, a range of 3% The range between the NPVs corresponding to these rates is 2,844.21 + 1,098.76 = 3,942.97

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Where is the IRR?

1,098.76 = 0.27866 = 27.866% 3,942.97
The IRR is 27.866% above the minimum of the range 10% to 13%, or 3% x 0.27866 = 0.836 above 10% 10% + 0.836% = 10.836%
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Alternative
We could also determine this point by starting at the upper limit of the 10%-13% range We interpolated down from the upper value in the solution of 4-1, whereas we went up from the lower value in 4-2

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Where is the IRR?

2,844.21 = 0.72134 = 72.134% 3,942.97
The IRR is 72.134% below the maximum of the range 10% to 13%, or 3% x 0.72134 = 2.164 below 13% 13% - 2.164% = 10.836%
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A Visual Explanation

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Visual Explanation
Lets recall the NPV profile graph, but add the lines indicating the rise (vertical change) and run (horizontal change) We will only concern ourselves with the absolute values of these changes, ignoring the signs The values of the rise and run are shown

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NPV Profile
1,500 1,000 500 0 9 -500 NPV ($) -1,000 -1,500 -2,000 -2,500 -3,000 -3,500 Rate (%) 10 11 12 13 14

(10%, $1,098.76)

$3,942.97

3%

(13%, -$2,844.21)

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Triangles
This triangle will help us find the IRR, where the profile crosses the horizontal axis In fact, the axis creates a second, smaller congruent triangle, shown in red on the next slide

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Congruent Triangles
1,500 1,000 500 0 9 -500 NPV ($) -1,000 -1,500 -2,000 -2,500 -3,000 -3,500 Rate (%) 10 11 12 13 14

(10%, $1,098.76)

(13%, -$2,844.21)

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Congruent Triangles
One property of congruent triangles is that the ratios of their sides is always equal
This is a fundamental relationship that allows us to use trigonometry

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Congruent Triangles
1,500 1,000 500 0 9 -500 NPV ($) -1,000 -1,500 -2,000 -2,500 -3,000 -3,500 Rate (%) 10

(10%, $1,098.76) $1,098.76

x%

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12

13

14

$3,942.97

3%

(13%, -$2,844.21)

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Using the Congruent Triangles

This allows us to set up the following relationship:

3% x% = 3,942.97 1,098.76 1,098.76 x% = 3% = 0.84% 3,942.97 IRR = 10% + 0.84% = 10.84%

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