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6-Internal Rate of Return

The document discusses the Internal Rate of Return (IRR), defining it as the discount rate that makes the Net Present Value (NPV) zero. It outlines different types of rates of return, including Minimum Acceptable Rate of Return (MARR) and External Rate of Return (ERR), and provides examples of calculating IRR through various investment scenarios. Additionally, it emphasizes the importance of incremental cash flow analysis for comparing mutually exclusive alternatives based on IRR.

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kankshitha JB
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15 views20 pages

6-Internal Rate of Return

The document discusses the Internal Rate of Return (IRR), defining it as the discount rate that makes the Net Present Value (NPV) zero. It outlines different types of rates of return, including Minimum Acceptable Rate of Return (MARR) and External Rate of Return (ERR), and provides examples of calculating IRR through various investment scenarios. Additionally, it emphasizes the importance of incremental cash flow analysis for comparing mutually exclusive alternatives based on IRR.

Uploaded by

kankshitha JB
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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INTERNAL RATE

OF RETURN
INTRODUCTION
 The IRR is defined as the discount rate
that forces the NPV to be zero.
EXAMPLE
If a Rs.5000 is invested on a machine with a 5
year useful life and an equivalent uniform
annual benefits of Rs. 1252, then the cash
flows is as shown below,

An appropriate question is, What rate of


return would we receive on this
TYPES OF RATE OF
RETURN
Rate of return is the percentage that indicates the
relative yield on different uses of capital.
Following rate of returns are frequently used,
The minimum acceptable rate of return (MARR)
 Lowest level of return at which the investment is
acceptable.
 The limit is set by individuals or organizations.
 It ensures the best possible use of limited resources.
The Internal Rate of Return (IRR)
 It is the rate on the unrecovered balance of
the investment where the terminal balance
is zero.

External Rate of Return (ERR)


 It is the possible rate of return for an
investment under current economic
conditions
TO SUMMARIZE
 IRR is the return which a proposal is fetching based
on the cash inflows and outflows (i.e. at Present
worth of costs = present worth of benefits).

 MARR is the opportunity what an organization have


to earn if the money is not invested in the new
proposal.

 Return expected based on the prevailing economic


conditions.
PROCEDURE
 To calculate rate of return on an investment, we must
convert the various consequences of the investment into
cash flow.
 Then will solve the cash flow for unknown value of internal
rate of return (IRR).
Five forms of cash flow equations are as follows:
INGLE SIMPLE INVESTMENT

1. An $8200 investment returned $2000


per year over a 5-year useful life. What
was the rate of return on the
investment?
2. West Texas Oil has paid Rs.300000 for producing
oil well. Field engineers estimate that net receipts
will be Rs.120000 for the first year of operation
which then decreases every year at a constant
amount. The yearly reduction amount is 15
percent of the first year receipt. It plans to sell
well after 5 years for Rs. 80000.
 Calculate the IRR.
 How does this seem financially if their MARR is
20%?
3. A patch of land adjacent to the proposed international
airport is likely to increase in value. The cost of land now is
INR 8,00,000 and is expected to be worth INR 15,00,000
within 5 years. During this period it can be rented for small
scale industry at INR 15000 per year. Annual taxes are
presently is INR 8500 and likely to remain constant. What
rate of return will be earned on the investment if the
estimates are accurate?
INCREMENTAL CASH FLOW ANALYSIS

Under some circumstances, project ROR values do not


provide the same ranking of alternatives as do PW,
AW, and FW analyses. This situation does not occur if
we conduct an incremental cash flow ROR analysis.
COMPARING MUTUALLY
EXCLUSIVE ALTERNATIVES
BASED ON IRR
• Issue: Can we rank the mutually exclusive
projects by the magnitude of its IRR?
Incremental analysis can be defined as the
n A1 A2
examination of the differences between
0 -$1,000 -$5,000
alternatives.
By emphasizing
1 $2,000
alternatives, $7,000
we are really
deciding whether or not differential
100% > costs
40% are
IRR
justified by differential benefits.
PW (10%) $818 < $1,364
CONVENTION

Only for the purpose of simplification, use the


convention that between two alternatives, the
one with the larger initial investment will be
regarded as alternative B.
GENERAL TYPES OF
INCREMENTAL IRR NUMERICAL
The initial investment and annual cash
flows for each alternative (excluding the
salvage value) occur in one of two patterns:

1. Revenue alternative, where there are


both negative and positive cash flows.
2. Service alternative, where all cash flow
estimates are negative.
STEPS IN INCREMENTAL IRR ANALYSIS
1. Calculate the IRR or NPV and ensure that all the
alternatives are having IRR>MARR.

2. Select only those alternatives whose IRR>MARR for


incremental analysis

3. Arrange selected alternatives according to ascending


order of First Cost.

4. Perform incremental alternatives for first two


alternatives.

5. Selected alternatives to be compared with the next


alternative and do until all alternatives are compared.
4. For MARR of 6% and each alternative having

a life of 20 years with no salvage value and

cost information as shown in table below,

A B C
Initial Costs, $ 2000 4000 5000
Uniform annual 410 639 700
benefit, $/year

Which Alternative is preferred? Use Incremental

IRR method.
A B C
Initial Costs, $ 2000 4000 5000
Uniform annual benefit, 410 639 700
$/year
Step 1: Calculate IRR for each Alternative
Individually
Since all IRR > MARR, None of the
Alternative is Rejected.

Now Carrying out Incremental IRR


between the 3 Alternatives
A B C
Initial Costs, $ 2000 4000 5000
Uniform annual benefit, 410 639 700
$/year
Step 2: Arranging the Selected Alternatives in Ascending
Order of Initial Cost,
Performing the Incremental IRR analysis between the first
two (pair) alternatives and the selected one is considered
for the next iteration, this continues till the last
alternative
5. In 2000, Bell Atlantic and GTE merged to form a giant
telecommunications corporation named Verizon
Communications. As expected, some equipment
incompatibilities had to be rectified, especially for long
distance and international wireless and video services.
One item had two suppliers-a U.S. firm (A) and an Asian
firm (B). Approximately 3000 units of this equipment were
needed. Estimates for vendors A and B are given for each
unit. Determine which vendor should be selected if the
MARR is 15% per year.
A B
Initial Cost, $ -8000 -13000
Annual Cost, $ -3500 -1600
Salvage Value, 0 2000
$

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