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Investment Appraisal Method: Internal Rate of Return (IRR)
Published by slang May 6th, 2006 in Long-Term Decisions[ Go to Content Page to see ALL articles relating to this Category ]
In the previous article on NPV, we noted that a positive NPV denotes that a project can be accepted as it generates excess returns over its cost of finance. Hence, vice-versa, we cannot accept a negative NPV as it cannot generate a return above the cost of finance.
How do we then interpret a zero NPV
Zero NPV is actually the Internal Rate of Return which is therefore the discount rate that causes:
The present value of all the future cash flows – the present value of the initial outlay to yield an NPV of zero.
Using the same cash flow’s details from the NPV case, we shall try to get the IRR:
| Year O | Year 1 | Year 2 | Year 3 | Year 4 | |
| Initial Outlay (a) | $100K | ||||
| Net cash-flows (b) | $20.00K | $30.00K | $40.00K | $50.00K | |
| Using PV factor of 10% NPV= |
+$7.15K | ||||
| Simulating it : | |||||
| Using PV factor of 15% NPV= |
+$0.5K | ||||
| Using PV factor of 12% NPV= |
$0.00K |
To calculate the Internal Rate of Return, we can either use the interpolation method which is to take two discount rates, one rate that gives a positive NPV and another discount rate that give a negative NPV and interpolate the IRR.
Or you can use a calculator or a computer model (excel formula for IRR).
Interpretation of IRR:
If the IRR for the project is12% and the cost of capital used to finance it is lesser than 12%,then the project should be accepted.
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why is the net present value of investment appraisal considered to be theoretically superior to other methods of investment found in the literture
As there are many methods of appraising capex projects which have the pros and cons.
However,if you refer to my earlier article on :Criteria of a Good Investment Appraisal Method, it seems that NPV met the following criteria:
it recognizes the time value of money,
it considers the risk associated with an investment,
it takes the full economic life of the investment into account,
it is not an arbitrary decision rule which relies on interpretation,
it focuses on cash flows
NPV is also in line with EVA concept.
Apart from NPV’s disadvantage in terms of capital rationing, it still offers many good benefits when using it, hence it is still the most superior method.
Thks!
Dear Correspondent,
Please avail me with reference notes for various metthods of investment appraisal available to a management accountant of a company of ypur choice.
This information shall only be used strictly for course work and assignment at Uganda Christian University Mukono - Uganda.
Thanks in advance,
Atim Irene
Mbale - Uganda
Dear Correspondent,
Please thanks for that information, but I still request you to give me a piece of information concerning advantages and disadvantages of the various methods of investment appraisal.
Thank You,
Atim Irene