The internal rate of return (IRR) is a modern technique used in capital budgeting/investment decision. It is a discount rate at which the present value of cash inflows is equal to the present value of cash outlays. IRR takes into account the time value of money. Under internal rate of return method, a project is accepted if the IRR is higher than or equal to the minimum required rate of return. In case of the competing projects, the project with the highest IRR is selected provided its IRR is higher than the cut-off rate.
IRR can be determined with the help of the following formula:
C= C1/(1+r) + C2/(1+r)2 + C3/(1+r)3 +…………….+ Cn/(1+r)n
Where,
C = Initial cash outflows at time zero
C1, C2, C3………Cn = Future net cash inflows at different period of time
r = Rate of discount/interest
2,3,……………n = Number of years
Determination of Internal Rate of Return
Cases where annual net cash flows are equal over the life of the project
In this case we have to first determine the present value factor. Present value factor can be determined by dividing the initial cost of investment by annual cash inflows.
Present value factor= Initial cost of investment/ Annual cash inflows
After determining the present value factor, we have to look at the present value annuity table to find out the rate at which the above calculated present value factor is equal to the present value given in the table at the number of the year equal to the life of the project. The rate nearest to the present value factor at the year equivalent to the life of the asset would be the IRR of the project.
Cases where annual net cash flows are not equal over the life of the project
In case of projects where annual cash inflows are not equal over the life of the project, IRR is calculated by hit and trial. Here, annual cashflows of the entire life of the project are discounted by applying an assumed discount rate to the present value. After deducting the initial cash outflow from the present value so computed we will get the net present value (NPV). If this NPV is positive, we have to apply higher rate of discount. If this higher rate of discount still gives a positive NPV, we have to increase the discount rate further till we get a negative NPV. When we find a negative NPV, the IRR must be in between these two rates.
Conclusion
Internal rate of return takes into account time value of money. Internal rate of return method can be used in both the cases where cashflows are equal or cash flows are unequal. In case of IRR method, determination of cost of capital is not a pre-requisite and therefore it is suitable in projects where cost of capital can not be determined easily. However, the IRR method assumes that the future earnings would be reinvested at the IRR rate for the remaining life of the project, which may not be justifiable in certain cases.