FM11_Ch_10_Tool_Kit

# Internal rate of return irr the internal rate of

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Unformatted text preview: te of return is defined as the discount rate that equates the present value of a project's cash inflows to its outflows. In other words, the internal rate of return is the interest rate that forces NPV to zero. The calculation for IRR can be tedious, but Excel provides an IRR function that merely requires you to access the function and enter the array of cash flows. The IRR's for Project S and L are shown below, along with the data entry for Project S. Expected after-tax net cash flows (CF t) Year (t) 0 1 2 3 4 Project S Project L (\$1,000) (\$1,000) 5 00 100 4 00 300 300 4 00 100 6 00 IRR S = 14 .4 9% 11.79% IRR L = T he IRR function assumes payments occur at end of periods, so that function does not have to be adjusted. Notice that for IRR you must specify all cash flows, including the time zero cash flow. This is in contrast to the NPV function, in which you specify only the future cash flows. The IRR method of capital budgeting maintains that projects should be accepted if their IRR is greater than the cost of capital. Strict adherence to the IRR method would further dictate that mutually exclusive projects should be chosen on the basis of the greatest IRR. In this scenario, both projects have IRR's that exceed the cost of capital (10%) and both should be accepted, if they are independent. If, however, the projects are mutually exclusive, we would chose Project S. Recall, that this was our determination using the NPV method as well. The question that naturally arises is whether or not the NPV and IRR methods will always agree. When dealing with independent projects, the NPV and IRR methods will always yield the same accept/reject result. 'However, in the case of mutually exclusive projects, NPV and IRR can give conflicting results. One shortcoming of the internal rate of return is that it assumes that cash flows received are reinvested at the project's internal rate of return, which is not usually true. The nature of the congruence of the NPV and IRR methods is further detailed in a latter section of this model. Multiple IRR's Because of the mathematics involved,...
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