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Week 10 - ACCY 111 RJD Lecture 7

Manually the internal rate of return can be

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Manually, the Internal Rate of Return can be calculated via a process of trial and error. Alternatively computer spreadsheet packages and financial calculators can do all that for you.
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Internal rate of Return (IRR) IRR Method: IRR = The rate at which PV inflows = Pv outflows Net Cash Flows 30% discount factor Present Value Immediately cost of saw mill (1,000,000) 1.000 (1,000,000) end of year 1 net profit before depreciation 200,000 .769 153,800 end of year 2 net profit before depreciation 400,000 .592 236,800 end of year 3 net profit before depreciation 600,000 .455 273,000 end of year 4 net profit before depreciation 600,000 .350 210,000 end of year 5 net profit before depreciation + disposal proceeds 400,000 .269 107,600 1,200,000 (18,800) IRR = 29.16%
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Internal Rate of Return (IRR) as the required rate of return increases the net present value decreases
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Internal rate of Return (IRR) IRR Decision Rule: Accept the highest IRR, usually a minimum required return A firm (or individual) should, in theory, undertake all projects or investments available with IRRs that exceed the cost of capital. However, investment may be limited by availability of funds to the firm and/or by the firm's capacity or ability to manage numerous projects.
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Internal rate of Return (IRR) Advantages of IRR: Is based on all cash flows, incorporates the time value of money, specifies an actual expected return Disadvantages of IRR: Difficult to calculate, there may be multiple returns, is not based on wealth increments
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A comparison of IRR and NPV $NPV % Rate of Return Accept Positive NPV Reject negative NPV 0 IRR + -
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Discounted cash flow methods Relevant costs should be determined and used, e.g. ignore costs already incurred, past costs etc. Future costs should also in some cases be ignored e.g. costs that will be incurred whether or not the project goes ahead Opportunity costs arising from benefits foregone must be included
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Discounted cash flow methods Taxation on profits and also tax relief should be accounted for Interest payments should not be included when using DCF techniques as the discount factor already takes account of cost of financing
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Discounted cash flow methods For most projects, a simple accept or reject decision should be the same Differences arise in the conclusions between IRR and NPV in the following situations: Mutually exclusive projects Capital rationing situations
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Mutually exclusive projects Mutually exclusive projects are projects where a choice has to be made between alternatives, but in which only one can actually be undertaken. As a general rule, the internal rate of return is dependent on the magnitude of the outlay – the higher the outlay, the lower the rate of return. Where capital funds are in short supply the internal rate of return will tend to favour smaller projects.
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Capital rationing Capital rationing occurs when there are limits imposed on the amount of capital invested Capital rationing leads to the need to rank projects in
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Manually the Internal Rate of Return can be calculated via...

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