Introduction to Corporate Finance

9: Capital Budgeting Process and Decision Criteria

9-5 INTERNAL RATE OF RETURN

As methods used for evaluating investment projects, payback, discounted payback and accounting-based

methods suffer from common problems – the complete or partial failure to make adjustments for the

time value of money and for risk. Alternative methods, such as NPV, correct these shortcomings.

Perhaps the most popular and intuitive of these alternatives is the internal rate of return (IRR) method.

An investment’s internal rate of return is analogous to a bond’s yield-to-maturity (YTM), a concept we

introduced in Chapter 4. Recall that a bond’s YTM is the discount rate that equates the present value of

its future cash flows to its market price. The YTM measures the compound annual return that an investor

earns by purchasing a bond and holding it until maturity (provided that all payments are made as promised

and that interest payments can be reinvested at the same rate). Likewise, an investment project’s IRR is

the compound annual rate of return on the project, given its up-front costs and subsequent cash flows.

9-5a FINDING A PROJECT’S IRR

In mathematical terms, the IRR is the discount rate, r, that makes the net present value of all project

cash flows equal to zero:

Eq. 9.2

rrrr

$0 rIRR

(1 )(1)(1 )(1)

== 0 +^112233 ;.

+

+

+

+

+

+...+

+

NPV CF =

CF CF CF CFn

n

To find a project’s IRR, we must begin by specifying the project’s cash flows. Next, using a financial

calculator, a spreadsheet or even trial and error, we find the discount rate that equates the present value

of cash flows to zero. Once we have calculated the IRR, we compare it with a pre-specified hurdle rate

established by the company. The hurdle rate represents the company’s minimum acceptable return for a

given project, so the IRR decision rule is to invest only if the project’s IRR exceeds the hurdle rate; otherwise,

reject the project.

But where does the hurdle rate come from? How do companies decide whether to require projects to

exceed a 10% hurdle or a 20% hurdle? The answer provides insight into another advantage of IRR over

relying on a project’s payback period or accounting rate of return. A company should set the hurdle rate

equal to market returns on similar investments. For example, if the project at hand involves expanding

a fast-food restaurant chain, then the hurdle rate should reflect the returns that fast-food businesses of

similar risk offer investors. Therefore, the IRR method, like the NPV method, establishes a hurdle rate

or a decision criterion that is market based, unlike the payback and accounting-based approaches, which

establish arbitrary thresholds for investment approval. In fact, for a given project, the hurdle rate used in

IRR analysis should be the discount rate used in NPV analysis.

LO9.4

internal rate of return

(IRR)

The compound annual rate of

return on a project, given its

up-front costs and subsequent

cash flows

What’s the relationship

between a project’s NPV and

its IRR?

thinking cap

question

THE IRR OF A MASTER’S DEGREE

A decision that many people face is whether to

invest the time and money necessary to earn a

post-graduate degree. Suppose that you are

trying to evaluate the financial merits of staying

at university for one more year to earn a master’s

degree. You decide that you will undertake this

finance in practice