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Lecture 9

1) The internal rate of return (IRR) is used to evaluate projects by accepting projects with an IRR greater than the cost of capital and rejecting projects with an IRR less than the cost of capital. 2) Computing the IRR can be easy if cash flows are in annuity form but becomes tedious if cash flows are not equal. Approximation methods like dominance and weighted average techniques are used. 3) The IRR considers the profitability of a project over its entire lifetime but its computational complexity and inability to consider project size are limitations.

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46 views

Lecture 9

1) The internal rate of return (IRR) is used to evaluate projects by accepting projects with an IRR greater than the cost of capital and rejecting projects with an IRR less than the cost of capital. 2) Computing the IRR can be easy if cash flows are in annuity form but becomes tedious if cash flows are not equal. Approximation methods like dominance and weighted average techniques are used. 3) The IRR considers the profitability of a project over its entire lifetime but its computational complexity and inability to consider project size are limitations.

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Tesfaye ejeta
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© © All Rights Reserved
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Download as PDF, TXT or read online on Scribd
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PROJECT ANALYSIS AND MANAGEMENT

Lecture 10
Decision rule

Course leader : Asst.Prof Tadele T


Decision rule

• If IRR is greater than the cost of capital, accept the


project;
• if IRR is less than the cost of capital, reject the project.
• Other things being equal, when two projects have the
same net initial investment but different IRRs the
project with higher IRR is preferred.
Cont…
Computation of IRR

Cash Flows Are Cash Flows are Not


in Annuity Form in Annuity Form

IRR can be
computation IRR
computed very
becomes tedious
easily
Example: 1
In the discussion of the NPV criterion (example
1), a project that required a NII of Br. 100,000
produced 16 annual cash flows of Br. 14,000 each. It
required a 10 % rate of return, and had an NPV of
Br. 9,536.
Since the NPV is positive at a discount rate of 10
%, the project’s actual rate of return exceeds 10%.
Dividing the NII by the value of one net cash inflow
and, then, locating the resulting quotient in the
present value annuity table, helps to obtain the IRR
for this project.
Cont…

Br.100,000/Br. 14,000 = 7.143


Table value IRR
7.379 11%
6.974 12%
the project’s table value (7.143) is between table
value of 6.974 and 7.379 in the present value
annuity table.
When a more exact IRR is needed, the following
steps typically will produce an IRR that is correct to,
at least, one decimal point:
Cont…

1. Identify the closest rates of return, as was done


above.
2. Compute the NPV for each of these two closest rates.
• (NPV/11%) = Br. 14,000(7.379) - Br. 100,000 = Br. 3,306
• (NPV/12%) = Br. 14,000, (6.974) - Br. 100,000 = - Br.
2,364
3. Compute the sum of the absolute values of the
NPVs obtained in step 2.
Br. 3,306 + Br. 2,364 = Br. 5,670
• 4. Divide the smaller discount rate identified in step
1 in to the sum obtained in step 3. Then add the
resulting quotient to the smaller discount rate:
• Br. 3,306/ Br. 5,670 = .58
• IRR = 11% + .58 = 11.58%
Computation of IRR When CFs are
Not in Annuity Form
It is necessary to make a good first guess of the project’s IRR.
This can be done in either of the following two ways:
1.If the cash flows, at least, approximate an annuity,
dominance techniques can be applied.
2.If the cash flows display no general annuity pattern, a
weighted average can be used.
Dominance Technique
Let us take a project with a NII of Br. 60,000, a required rate
of return of 13 %, and the following cash flows:
Year yearly Cash inflows
1 20,000
2 20,000
3 20,000
4 15,000
5 15,000
6 15,000
Cont…

The IRR for each of these replacement annuities is:


Replacement Table
Annuity Value IRR
Br. 20,000 60,000/ 20,000 = 3.0 24%
Br. 15,000 60,000/ 15,000 = 4.0 12%

Which of the two IRRs provides the better first guess?


Cont…

Chances are that the IRR based on the Br. 20,000


annuity will provide a better first guess because it is
based on the cash flows that occur in the earliest
years of the original project. An alternative is to take
the arithmetic average of the IRRs of the two
annuities as follows:
.24 + .12 =. 18 or 18%
2
Cont…

NPV = Br. 20,000 (2.174)


+ 15,000(.516)
+ 15,000(.437)
+ 15,000(.370)
- 60,000
NPV = Br. 3,32.5
Since the NPV is positive, the actual IRR exceeds 18
percent. A second guess of the IRR at 21 percent is
made, based on the size of the NPV.
Cont…
NPV for the project discounted at 21 % is:
NPV= Br. 20,000(2.074)
+ 15,000(.467)
+ 15,000(.386)
+ 15,000(.319)
- 60,000
NPV = - Br. 940
Since the NPV is negative, the actual IRR is less than 21
percent.
Cont…

A third guess of the IRR at 20 % is made, based on


the preceding two guesses and their corresponding
NPVs. The NPV for the project discounted at 20
percent is:
NPV = Br. 20,000(2.106)
+ 15,000(.482)
+ 15,000(.402)
+15,000(.335)
- 60,000
 NPV = Br. 405
Thus, the actual IRR of the project is between 20
percent and 21 percent.
1. Compute the sum of the absolute values of the
NPVs for the two closest rates:
Br. 940 + Br. 405 = Br. 1,345
2. Divide the NPV of the smaller discount rate in to
the sum obtained above and then add the resulting
quotient to the smaller discount rate:
Br. 405/ Br. 1,345 = .30
IRR = 20% +. 30 =20.3%(actual IRR )
Weighted Average Technique
Assume a project that requires a net initial investment of Br.
16,000 produces the following cash flows:
Year Yearly Cash Flows
1. Br. 4,000
2. 6,000
3. 5,000
4. 5,000
5. 4,000
Cont…
Year Cash inflow Weight Cash inflow x Weight
1 Br. 4,000 5 Br. 20,000
2 6,000 4 24,000
3 5,000 3 15,000
4 5,000 2 10,000
5 4,000 1 4,000
Totals 15 Br. 73,000
Weighted average cf = Br. 73,000/15 = Br. 4,867
Cont…

The next step is to use the weighted average cash inflow of


Br. 4,867 as an annuity that replaces the original set of cash
flows.
Br. 16,000/ Br. 4,867 = 3.288
By looking at present value annuity table, the number 3.288
corresponds, approximately, to an IRR of 16 percent.
Cont…

The NPV of the original project is now calculated by using a


16 % discount rate:
NPV = Br. 4,000(.862)=3448
+ 6,000(.743)=4458
+ 5,000 (.641)=3205
+ 5,000(.552)=2760
+ 4,000(.476)=1904
- 16,000
NPV = - Br. 225
Cont…
a second guess of IRR at 15 % is made. The NPV of the
project discounted at 15% is:
NPV = Br. 4,000(.870)=3480
+ 6,000(.756)=4536
+ 5,000(.658)=3290
+ 5,000(.572)=2860
+ 4,000(.497)=1988
- 16,000
NPV= Br. 154
Cont…

• IRR for the project is between 15 % & 16 %


Then Br. 225 + Br. 154 = Br. 379
Br. 154/ Br. 379 = .41
IRR = 15% + .41 = 15.41%
Merits of the IRR Criterion
• IRR takes into account the time value of money and it is a
profit-oriented tool.
• IRR considers the profitability of the project for its entire
economic life.
• The determination of cost of capital is not a pre-requisite for
the use of IRR criterion and, hence, it is a better criterion
than NPV
Limitations of the IRR
• The IRR is the most computationally tedious
• A more significant disadvantage of this criterion is its
inability to consider the size of a project’s net initial
investment.

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