**Unformatted text preview: **s life.
• The internal rate of return is computed by
• The internal rate of return is computed by
ffinding the discount rate that will cause the
inding the discount rate that will cause the
net present value of a project to be zero.
net present value of a project to be zero. 16-8 Internal-Rate-of-Return Method
Internal-Rate-of-Return
• Black Co. can purchase a new machine at a
• Black Co. can purchase a new machine at a
cost of $104,320 that will save $20,000 per
cost of $104,320 that will save $20,000 per
year in cash operating costs.
year in cash operating costs.
• The machine has a 10-year life.
• The machine has a 10-year life. 16-9 Internal-Rate-of-Return Method
Internal-Rate-of-Return
Future cash flows are the same every year in
this example, so we can calculate the
internal rate of return as follows:
Investment required
Net annual cash flows
Net
$104, 320
$20,000
$20,000 = Present value factor
Present = 5.216
5.216 16-10 Internal-Rate-of-Return Method
Internal-Rate-of-Return
The present value factor (5.216) is located on
The present value factor (5.216) is located on
tthe Table IV in the Appendix. Scan the 10he Table IV in the Appendix. Scan the 10period row and locate the value 5.216. Look
period row and locate the value 5.216. Look
att the top of the column and you find a rate of
a the top of the column and you find a rate of
14% which is the internal rate of return.
14% which is the internal rate of return.
$104, 320
$20,000
$20,000 = 5.216 16-11 Internal-Rate-of-Return Method
Internal-Rate-of-Return
Here’s the proof . . . 16-12 Comparing the NPV and IRR
Methods
Methods Net Present Value
Net Present Value
y The cost of capital is
y The cost of capital is
used as the actual
used as the actual
discount rate.
discount rate.
y Any project with a
y Any project with a
negative net present
negative net present
value is rejected.
value is rejected. Internal Rate of Return
y The cost of capital is
compared to the internal
rate of return on a
project.
y To be acceptable, a
project’s rate of return
must be greater than
the cost of ca...

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