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Where,
N=total number of periods
T= the time of the cash flow
i= the discount rate (the rate of return that could be earned on an
investment)
Rt = the net cash flow i.e. cash inflow cash outflow at time t (R0: it is
subtracted from the whole as any initial investments during first year is
not discounted for NPV purpose)
NPV EXAMPLE
Example :
Investment of $9000.
Net cash flows of $5090, $4500 and $4000 at the
end of years 1, 2 and 3 respectively.
Assume required rate of return is 10% p.a.
What is the NPV of the project?
Solution:
Apply the NPV formula given.
n
NPV
Ct
t 1 1 k
C0
5090
4500
4000
9000
2
3
1.10 1.10 1.10
By setting the NPV formula to zero and treating the rate of return as the
unknown, the IRR is given by:
1 k
t 1
Ct
C0 0
where:
C0 = initial cash outlay on project
Ct = net cash flow generated by project at time t
n = life of the project
r = internal rate of return
9000
2
3
1 IRR (1 IRR )
(1 IRR )
IRR 25 %
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IRR allows managers to rank projects by their overall rates of return rather than their net
present values, and the investment with the highest IRR is usually preferred.
Ease of comparison makes IRR attractive, but there are limits to its usefulness.
For Example, IRR works only for investments that have an initial cash outflow (the purchase of
the investment) followed by one or more cash inflows.
Also, IRR does not measure the absolute size of the investment or the return. This means that
IRR can favor investments with high rates of return even if the dollar amount of the return is
very small.
For Example, a $1 investment returning $3 will have a higher IRR than a $1 million investment
returning $2 million. Another short-coming is that IRR cant be used if the investment
generates interim cash flows. Finally, IRR does not consider cost of capital and cant compare
projects with different durations.
IRR is best-suited for analyzing venture capital and private equity investments, which typically
entail multiple cash investments over the life of the business, and a single cash outflow at the
end via IPO or sale.
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o If there are multiple positive and negative future cash flows, there may be multiple
IRRs.
o Undoing a project generates the same IRR as doing the project.
o The IRR rule cannot compare two competing projects. One project could have a higher
IRR but a lower NPV.
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Advantages of IRR
The IRR method is easily understood, it recognizes the time value of money,
and compared to the NPV method is an indicator of efficiency.
KEY POINTS
The IRR method is very clear and easy to understand. An investment is
considered acceptable if its internal rate of return is greater than an
established minimum acceptable rate of return or cost of capital.
The IRR method also uses cash flows and recognizes the time value of
money.
The internal rate of return is a rate quantity, an indicator of the efficiency,
quality, or yield of an investment.
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Disadvantages of IRR
IRR can't be used for exclusive projects or those of different durations; IRR may
overstate the rate of return.
KEY POINTS
The first disadvantage of IRR method is that IRR, as an investment decision tool,
should not be used to rate mutually exclusive projects, but only to decide whether
a single project is worth investing in.
IRR overstates the annual equivalent rate of return for a project whose interim
cash flows are reinvested at a rate lower than the calculated IRR.
IRR does not consider cost of capital; it should not be used to compare projects of
different duration.
In the case of positive cash flows followed by negative ones and then by positive
ones, the IRR may have multiple values.
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Cont
Independent investments:
For independent investments, both the IRR and NPV methods lead to
the same accept/reject decision, except for those investments where
the cash flow patterns result in either multiple or no internal rate(s) of
return.
By applying
NPV as time value of money (money figure)
IRR calculate the investments profitability as an interest rate
(percentage figure)
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