Accounting Business Reporting for Decision Making

514 Accounting: Business Reporting for Decision Making

ILLUSTRATIVE EXAMPLE 12.5

Using the trial and error method of calculating IRR

Remembering the data from the Coconut Plantations example (given below), the problem is to find the

discount rate that will result in the sum of all the discounted positive cash flows less the value of the

initial investment ($120 000) equalling zero.

Year Expected cash flows ($000)

0 (initially) – 120

1 30

2 60

3 50

4 100

Let us go through the trial and error method. We know from our calculation in illustrative example

12.4 that the NPV is a healthy $62 720 at a 10 per cent discount rate, and thus the IRR must be more

than 10 per cent, because the NPV is positive and much larger than zero. What happens to our NPV if

a 20 per cent rate is used? The NPV will be $23 820, and still considerably larger than zero. From this

drop in the NPV, you could deduce that 30 per cent would probably be too much and the NPV would

be negative, so try 25 per cent. The NPV is still positive at $8960. We might now try 28 per cent. At

28 per cent, the NPV is $1140. A discount rate of 29 per cent is probably too much, but let us try it just

for fun. Answer: −$1290. So, 29 per cent is too high a discount rate and the calculated IRR is 28 per cent.

(When using a spreadsheet, you could easily refine this answer to several decimal points of accuracy.)

Having done the calculation, the question then is: what does it mean? An IRR of 28 per cent is likely

to exceed the manufacturers’ RRR, which may be as low as 10–12  per cent, and thus the project

is acceptable on this measure. Manufacturers undertaking this project will have their cost of capital

returned, plus extra return, which will increase their wealth.

Advantages and disadvantages of IRR

The advantages of the IRR method are that it takes into account:

• all of the expected cash flows


• the timing of expected cash flows (cash flows received sooner are given higher weight)


• a concept (rate of return) familiar to managers.

The disadvantages are that the method:

• ignores the scale of projects, so it does not focus on the generation of absolute wealth


• in some cases, produces two IRR values (or in some circumstances, no IRR)


• in some cases, conflicts with NPV rankings of projects.

If potential investments are of markedly different scale, acceptance of one or several small projects with

high IRRs may not increase wealth for the entity to the same extent as one large project with a lower IRR. For

example, the Qantas Group may have an opportunity to service a new passenger route to Western Europe from

Australia. To do this it would need a new plane worth $20 million, from which it calculates it would earn a return

of 20 per cent. At the same time, it may have another three potential routes in mind (which are much closer to

Australia) which require smaller planes and would average $4 million in costs each, but which have IRRs of

30 per cent. On the basis of the high IRRs, the Qantas Group might be tempted to accept the $12 million smaller

plane/shorter route option to earn the 30 per cent return. However, if it does so, it will earn $3.6 million, whereas

it could have earned $4 million from the longer route Western Europe option which has a lower IRR.

Effects of unconventional cash flows

So far we have discussed projects with conventional cash-flow patterns. That is, there is a large ini-

tial cash outflow, followed by many years of net cash inflows. However, there are projects that have