Internal Rate of Return Flashcards
The Rule for IRR
To find the IRR, we find the rate of return which makes the NPV=0
range
HDR - LDR
ratio
[+NPV]/ (+NPV – (-NPV)]
HIGH discount rate results in a…
-NPV
LOW discount rate results in a…
+ NPV
IRR formula- Linear interpolation formula
IRR = LDR + RATIO*RANGE
IRR, The Decision Rule (IRR ≥ k)
•Decision Rule If IRR ≥ k, (where k is the cost of capital) then accept the project. Otherwise reject.
Problems with IRR (reinvestment assumption)
assumes that the cash flows generated by the project are reinvested at the same rate as the IRR.
Scale of Contribution ( refer to IRR)
It’s possible to get a large IRR on a relatively small project. It doesn’t indicate the scale of the contribution
Problems with IRR (- Followed by + followed by -)
There might be more than one IRR making it impossible to apply the technique effectively
Problems with IRR (sum total of the contribution )
IRRs can’t be added to get a sum total of the contribution to value of all projects. This is by contrast with NPV which can.
NPV and discount rate crossover
The NPV versus Discount Rate schedule for two different projects may crossover. In this case NPV and IRR can conflict in terms of decision making criteria.
What is payback
Payback is the length of time that it takes for the project cash flows to pay back the original investment.
Decision rule for payback
Accept all projects with payback less than some predetermined maximum
Payback advantages
• – simple and straightforward
• - emphasises early recovery of investment funds. May help in resolving large amounts of uncertainty
