University:
Grand Rapids Community College
Course:
Financial and Managerial Accounting: Information for Decisions - John J. Wild
Academic year:

2024
Views:

329

Pages:

2
Author:

stud_ice13

The Internal Rate of Return (IRR) is the discount rate at which an investment’s Net Present Value (NPV) is zero. It is used to evaluate the potential profitability of an investment. IRR represents the rate of return that a project generates based on its expected cash flows, effectively equating the project’s costs with its cash inflows over time. Steps to Calculate IRR IRR Calculation for Equal Cash Flows 1. Compute Present Value Factor: o Formula: Present Value Factor=Initial InvestmentAnnual Net Cash Flows o Example: For an asset requiring a $12,009 initial investment and generating $5,000 annually for three years, the PV factor is: PV Factor=12,0095,000=2.4018 2. Identify the Rate: o Locate the calculated PV factor in a present value of annuity table under the appropriate period (three years in this case) to find the corresponding discount rate. For a PV factor of 2.4018 in the threeperiod row, the IRR is identified as 12%. IRR Calculation for Unequal Cash Flows If cash flows vary each year, using IRR tables is inefficient. In this case, the IRR is typically calculated using financial calculators or spreadsheet software (e.g., Excel), which iteratively tests discount rates until the NPV reaches zero. Example: IRR Application For a machine costing $58,880 and generating $8,000 annually over 10 years: • • • Step 1: Calculate the PV factor: PV Factor=58,8808,000=7.36 Step 2: Locate the PV factor in the 10-period row of the annuity table, which indicates that the IRR is approximately 6%. Decision: Since the company’s hurdle rate is 6.5%, this IRR does not meet the minimum required rate, so the machine should not be purchased. Decision Rule for IRR • • If IRR > Hurdle Rate: Invest, as the project’s return exceeds the required rate of return. If IRR < Hurdle Rate: Do not invest. Comparing Projects with IRR When comparing multiple projects, those with IRRs significantly exceeding the hurdle rate are preferred, regardless of initial investment differences. Because IRR is a percentage, it can serve as a useful basis for comparison across projects of varying scales. Additional Considerations • Managerial Incentives: In practice, managers sometimes prioritize projects that meet earnings forecasts or other benchmarks, even if the IRR exceeds the cost of capital, due to performance incentives tied to short-term metrics. Summary IRR is a valuable measure for assessing investment potential, especially for projects where cash flows are predictable. It provides a clear metric for determining whether an investment will meet or exceed the company’s required return, making it an essential tool in capital budgeting and project prioritization.