Question

Discuss and describe the process in which the internal rate of return is used to accept or reject projects.

Answer 1

IRR refers to Internal rate of return and it is an actual return on the investment (%) . It is the discount rate where the initial cash outflow ( the investment) is equal to the Present value of the cash inflows i.e Cash outflow = PV of cash inflows.

And we know, NPV (Net Present Value) = PV of cash inflow - Cash outflow

Hence, NPV=0

So, it is the discount rate where NPV=0. To work out the IRR we need to do trial and error NPV calculations, using different discount rates , to try and find out the discount rate where the NPV is 0.

But, by using only 2 NPV calculation and below formula we can find the IRR very easily and quickly.

Step 1: Select two rates one higher and one lower. Please note you can randomly select any rates ( for eg lower rate = 10% and higher rate= 15%)

Step 2: Calculate NPVs at both the rate.  

Step 3: Use this formula to get the IRR

IRR= L+ NPV L/NPV L - NPV H (H - L)

where, L= Lower discount rate

H= Higher discount rate

NPV L = NPV at lower rate

NPV H = NPV at higher rate

If the IRR is higher than the cost of capital, the project should be accepted. It is very useful as it considers time value of money, uses cash not profits and considers the whole life of the project.