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BA2087 FINANCIAL
MANAGEMENT
Video Lecture (6.4)
Topic 6: Capital Budgeting Technique-INTERNAL RATE OF RETURN (IRR)
1
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6. Internal Rate of Return-IRR
• The Internal Rate of Return (IRR) is the rate of return that
the firm will earn if it invests in the project
• IRR is the discount rate that EQUATES PV of inflows equal
to cost, and the NPV = 0:
NOTE: IRR can be found accurately through excel spreadsheet or financial
calculator, hence you will NOT be required to calculate the IRR in exam but
you need to understand the fundamental concepts of IRR and its
applications
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6. Internal Rate of Return-IRR
• Reason for IRR to use the discount rate that causes a
project’s NPV to equal zero is that the IRR is an
estimate of the project’s rate of return.
-> If this return > the cost of the funds (ie WACC) used
to finance the project, then the difference will value
add to the firm’s stockholders’ wealth.
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6. Internal Rate of Return-IRR
• Note that the IRR formula, is simply
the NPV formula, solved for the
particular discount rate that forces the
NPV to zero.
• Thus, the same basic equation is used
for both methods. The only difference
is that with the NPV method, the
discount rate is given and we find the
NPV, whereas with the IRR method,
the NPV is set equal to zero and we
find the interest rate that provides this
equality.
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6. Internal Rate of Return-Decision Rule
Criteria: IRR vs WACC
Independent
 If IRR > the project’s
WACC, then the project
should be accepted.
 If IRR is < than the
project’s WACC, then
reject the project.
Mutually Exclusive
 Accept the mutually exclusive
project with the highest IRR,
provided that the project’s
IRR is greater than its WACC.
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7. NPV vs IRR- Conflicting Decisions
Recall example in NPV
Year
(t)
Cashflow for Project S Cashflow for Project L
0
-$1,000
-$,1000
1
$500
100
2
$400
300
3
$300
400
4
$100
675
Project S
Project L
NPV
$78.82
$100.40
IRR
14.489%
13.55%
NPV
Project S
Project L
Independent Mutually Exclusive
Accept
Reject
Accept
Accept
IRR
Project S
Project L
Independent
Accept
Accept
Mutually Exclusive
Accept
Reject
Note:
 NPV and IRR criteria provide the same result if the projects are independent.
A conflict will exist between the NPV and the IRR criteria if the projects are mutually
exclusive
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7. NPV vs IRR- Conflicting Decisions
Two basic conditions for the conflicts:
1. Timing differences.
If most of the cash flows from one project come in early while most of those from
the other project come in later,
( This is the reason for the conflict between our Projects S and L)
2. Project size (or scale) differences.
If the amount invested in one project is larger than the other, this can also lead to
conflict.
whenever conflicts exist between mutually exclusive projects, use the NPV method.
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8: Reinvestment Assumptions
• whenever conflicts exist between mutually exclusive projects,
use the NPV method.
• The NPV calculation is based on the assumption that
cash inflows can be reinvested at the project’s cost of
capital , whereas the IRR calculation is based on the
assumption that cash flows can be reinvested at the IRR
itself.
• NPV assumes reinvestment at the cost of capital is
generally a more reasonable assumption.
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In Summary we have covered
 Similarity of IRR formula with NPV
 Decisions Rule
 conflicting decisions between NPV and IRR
 reinvestment assumptions
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Next Episode
• Let’s move on tour next topic on
Topic 7: Cash Budgeting