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Capital Budgeting Decisions Part II Chapter 9 074

# Capital Budgeting Decisions Part II Chapter 9 074 -...

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Internal Rate of Return The Internal Rate of Return (IRR) is the “implicit” rate at which an investment yields a return on investment.

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The Internal Rate of Return Method For Example: The internal rate of return (IRR) is the interest yield promised by an investment project over its useful life. The internal rate of return (IRR) is computed by finding the discount rate that will cause the net present value of a project to be zero .
The Net Present Value Method For example, would the IRR for Madison Co. be > or < 10%?

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Simplistic Approach: Equal Annual Cash Flows ONLY Kennedy Company can purchase a new machine at a cost of \$104,320 (current cash outflow) that will save \$20,000 per year (future cash inflow) in cash operating costs. The machine has a 10-year life Will this investment provide a “profitable” return for reporting purposes? Does it satisfy the standard set by management?
IRR Given that the NPV must be zero when the Discount Rate is equal to the implicit Internal Rate of Return for a project: It follows that: (Some PV Factor) (X) (Equal Annual Cash Flow) Less the (Investment) = ZERO

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Given that the NPV must be zero when the Discount Rate is equal to the implicit Internal Rate of Return for a project: It follows that: (What 10 year PV Factor) X (\$20,000) - (\$104,320) = \$0 Read this as: What Present Value factor (from the 10 year row and some implicit discount rate), times the even annual cash flow of \$20,000, will result in a Net Present Value of ZERO, after covering the initial Investment of \$104,320? (Some PV Factor) (X) (Equal Annual Cash Flow) Less the (Investment) = ZERO IRR
Given that the NPV must be zero when the Discount Rate is equal to the implicit Internal Rate of Return for a project: It follows that: The Present Value of Cash Outflows must EXACTLY equal The DPV of future Cash Inflows (which must equal) Some Factor(s) times the annual Cash Inflow(s) IRR

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Given that the NPV must be zero when the Discount Rate is equal to the implicit Internal Rate of Return for a project: It follows that: The Present Value of Cash Outflows must EXACTLY equal The DPV of future Cash Inflows (which must equal) Some Factor(s) times the annual Cash Inflow(s) IRR \$104,320 = PV Factor (X) \$20,000
\$104,320 = some PV Factor (X) \$20,000 \$104,320/\$20,000 = some PV Factor (X) 5.216 = some PV Factor (X) IRR

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Remember: When working with equal annual cash inflows, the PV factor used to discount those cash inflows will be found by entering the “Big Number Table” for the at the Discount Rate for the given number of periods over which the Cash Inflow is enjoyed. Here we know the cash flow (\$20,000) and the time of benefit (10 years) 5.216 = PV Factor (X) IRR
Periods 10% 12% 14% 1 0.909 0.893 0.877 2 1.736 1.690 1.647 . . . . . . . . . . . . 9 5.759 5.328 4.946 10 6.145 5.650 5.216 So, enter the table at 10 years and move across until you find the column in which the PV factor (5.216) resides In the 10 period row, locate the column that contains a factor as near as possible to the required 5.216 = PV Factor (X) IRR

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Periods 10% 12% 14% 1 0.909 0.893 0.877 2 1.736 1.690 1.647 . . . . . . . . . . . .
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Capital Budgeting Decisions Part II Chapter 9 074 -...

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