Principles of Managerial Finance

FIGURE 9.3 Calculation of IRRs for Bennett Company’s Capital Expenditure Alternatives

Time lines depicting the cash flows and IRR calculations for projects A and B

404 PART 3 Long-Term Investment Decisions

1

$14,000

0

$42,000

42,000

IRR?

NPVA = $ 0

IRRB = 21.7%

IRRA = 19.9%

2

$14,000

3

$14,000

4

$14,000

5

$14,000

1

$28,000

0

$45,000

45,000

NPVB = $ 0

IRR?

IRR?

IRR?

IRR?

IRR?

2

$12,000

3

$10,000

4

$10,000

5

$10,000

Project A

Project B

End of Year

End of Year

WW

W

These criteria guarantee that the firm earns at least its required return. Such an

outcome should enhance the market value of the firm and therefore the wealth of

its owners.

Calculating the IRR

The actual calculation by hand of the IRR from Equation 9.2a is no easy chore.

It involves a complex trial-and-error technique that is described and demon-

strated on this text’s Web site:www.aw.com/gitman.Fortunately, many finan-

cial calculators have a preprogrammed IRR function that can be used to sim-

plify the IRR calculation. With these calculators, you merely punch in all cash

flows just as if to calculate NPV and then depress IRR to find the internal rate

of return. Computer software, including spreadsheets, is also available for sim-

plifying these calculations. All NPV and IRR values presented in this and sub-

sequent chapters are obtained by using these functions on a popular financial

calculator.