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122 Financial Management

Internal Rate of Return

When the present value of cash inflows are exactly equal to the present value of cash

outflows we are getting a rate of return which is equal to our discounting rate. In this

case the rate of return we are getting is the actual return on the project. This rate is

called the IRR.

=

=

n

i 1

( 1 kt)t C^0

NPV CF

Using the same formula as given in the NPV above, IRR will be the return when the

NPV is equal to zero as only then the present value of cash inflows will be equal to the

present value of the cash outflows.

NPV = 


=

• =

n

i 1

( 1 rt)t C^00

CF

=

=

+

n

i 1

t^0

t C

( 1 r)

CF

here CFt = cash flow at the end of year t

r = discount rate

n = life of the project

In the net present value calculation we assume that the discount rate (cost of capital) is

known and determine the net present value of the project. In the internal rate of return

calculation, we set the net present value equal to zero and determine the discount rate

(internal rate of return) which satisfies this condition.

Both the discounting methods NPV and IRR relate the estimates of the annual cash

outlays on the investment to the annual net of tax cash receipt generated by the

investment. As a general rule, the net of tax cash flow will be composed of revenue

less taxes, plus depreciation. Since discounting techniques automatically allow for the

recovery of the capital outlay in computing time-adjusted rates of return, it follows that

depreciation provisions implicitly form part of the cash inflow.

Internal rate of return method consists of finding that rate of discount that reduces the

present value of cash flows (both inflows and outflows attributable to an investment

project to zero. In other words, this true rate is that which exactly equalises the net

cash proceeds over a project's life with the initial investment outlay.

If the IRR exceeds the financial standard (i.e. cost of capital), then the project is prima

facie acceptable. Instead of being computed on the basis of the average or initial

investment, the IRR is based on the funds in use from period to period.