Question

Internal Rate of Return Method

The internal rate of return (IRR) method uses present value concepts to compute the rate of return from a capital investment proposal based on its expected net cash flows. This method, sometimes called the time-adjusted rate of return method, starts with the proposal's net cash flows and works backward to estimate the proposal's expected rate of return.

Let's look at an example of internal rate of return calculation
with **even** cash flows.

A company has a project with a 5-year life, requiring an initial investment of $211,600, and is expected to yield annual cash flows of $53,000. What is the internal rate of return?

IRR Factor^{a} |
= | Investment^{b} |

Annual cash flows^{c} |

^{a}IRR Factor: This is the factor which
you’ll use on the table for the present value of an annuity of $1
dollar in order to find the percentage which corresponds to the
internal rate of return. |

^{b}Investment: This is the present value
of cash outflows associated with a project. If all of the
investment is up front at the beginning of the project, the present
value factor is 1.000. |

^{c}Annual Cash Flows: This is the amount
of cash flows to be received annually as a result of the
project. |

Calculation Steps

Present Value of an Annuity of $1 at Compound Interest.

IRR Factor = |
$ | = , rounded to 6 decimals |

$ |

The calculated factor corresponds to which percentage in the present value of ordinary annuity table?

%

Answer #1

IRR= 8%

The factor 3.99245 calculated corresponds to 8% in the present value of ordinary annuity at n=5.

art Three
Present Value Index
When funds for capital investments are limited, projects can be
ranked using a present value index. A project with a negative net
present value will have a present value index below 1.0. Also, it
is important to note that a project with the largest net present
value may, in fact, return a lower present value per dollar
invested.
Let's look at an example of how to determine the present value
index.
The company has a...

Net Present Value Method, Internal Rate of Return Method, and
Analysis for a Service Company
The management of Advanced Alternative Power Inc. is considering
two capital investment projects. The estimated net cash flows from
each project are as follows:
Year
Wind
Turbines
Biofuel Equipment
1
$390,000
$700,000
2
390,000
700,000
3
390,000
700,000
4
390,000
700,000
The wind turbines require an investment of $1,113,450, while the
biofuel equipment requires an investment of $1,812,300. No residual
value is expected from either...

Net Present Value Method, Internal Rate of Return Method, and
Analysis for a Service Company
The management of Advanced Alternative Power Inc. is considering
two capital investment projects. The estimated net cash flows from
each project are as follows:
Year
Wind
Turbines
Biofuel Equipment
1
$340,000
$710,000
2
340,000
710,000
3
340,000
710,000
4
340,000
710,000
The wind turbines require an investment of $970,700, while the
biofuel equipment requires an investment of $2,156,270. No residual
value is expected from either...

Net Present Value Method, Internal Rate of Return Method, and
Analysis
The management of Quest Media Inc. is considering two capital
investment projects. The estimated net cash flows from each project
are as follows:
Year
Radio Station
TV Station
1
$320,000
$610,000
2
320,000
610,000
3
320,000
610,000
4
320,000
610,000
Present Value of an Annuity of $1 at
Compound Interest
Year
6%
10%
12%
15%
20%
1
0.943
0.909
0.893
0.870
0.833
2
1.833
1.736
1.690
1.626
1.528
3...

Net Present Value Method, Internal Rate of Return Method, and
Analysis
The management of Quest Media Inc. is considering two capital
investment projects. The estimated net cash flows from each project
are as follows:
Year
Radio Station
TV Station
1
$350,000
$740,000
2
350,000
740,000
3
350,000
740,000
4
350,000
740,000
Present Value of an Annuity of $1 at
Compound Interest
Year
6%
10%
12%
15%
20%
1
0.943
0.909
0.893
0.870
0.833
2
1.833
1.736
1.690
1.626
1.528
3...

Understanding the IRR and NPV
The net present value (NPV) and internal rate of return (IRR)
methods of investment analysis are interrelated and are sometimes
used together to make capital budgeting decisions.
Consider the case of Blue Hamster Manufacturing Inc.:
Last Tuesday, Blue Hamster Manufacturing Inc. lost a portion of
its planning and financial data when both its main and its backup
servers crashed. The company’s CFO remembers that the internal rate
of return (IRR) of Project Delta is 11.3%,...

4. Internal rate of return (IRR) The internal rate of return
(IRR) refers to the compound annual rate of return that a project
generates based on its up-front cost and subsequent cash flows.
Consider the case of Blue Llama Mining Company: Blue Llama Mining
Company is evaluating a proposed capital budgeting project (project
Sigma) that will require an initial investment of $800,000. The
company has been basing capital budgeting decisions on a project’s
NPV; however, its new CFO wants to...

Internal rate of return (IRR)
The internal rate of return (IRR) refers to the compound annual
rate of return that a project generates based on its up-front cost
and subsequent cash flows. Consider this case:
Falcon Freight is evaluating a proposed capital budgeting
project (project Delta) that will require an initial investment of
$1,500,000.
Falcon Freight has been basing capital budgeting decisions on a
project’s NPV; however, its new CFO wants to start using the IRR
method for capital budgeting...

Modified internal rate of return (MIRR)
The IRR evaluation method assumes that cash flows from the
project are reinvested at the same rate equal to the IRR. However,
in reality the reinvested cash flows may not necessarily generate a
return equal to the IRR. Thus, the modified IRR approach makes a
more reasonable assumption other than the project’s IRR.
Consider the following situation:
Fuzzy Button Clothing Company is analyzing a project that
requires an initial investment of $500,000. The project’s...

2. Internal rate of return (IRR)
The internal rate of return (IRR) refers to the compound annual
rate of return that a project generates based on its up-front cost
and subsequent cash flows. Consider this case of Blue Llama Mining
Company:
Blue Llama Mining Company is evaluating a proposed capital
budgeting project (project Delta) that will require an initial
investment of $1,600,000.
Blue Llama Mining Company has been basing capital budgeting
decisions on a project’s NPV; however, its new CFO...

ADVERTISEMENT

Get Answers For Free

Most questions answered within 1 hours.

ADVERTISEMENT

asked 9 minutes ago

asked 18 minutes ago

asked 24 minutes ago

asked 27 minutes ago

asked 32 minutes ago

asked 48 minutes ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago

asked 1 hour ago