## Internal Rate of Return IRR

The internal rate of return (IRR) is perhaps the most sophisticated capital budgeting technique and also more difficult to calculate than NPV. The internal rate of return is the discount rate where the present value of the cash inflows exactly equals the initial investment. In other words, IRR is the discount rate when NPV = 0. Mathematically

The solution to problems involving IRR is basically a trial-and-error solution. Table 14-17 shows that with the cash inflows provided, and with a $5,000 initial investment, an IRR of 10% yielded a value of $3,722 for NPV. Therefore, as a second guess, we should try a value greater than 10% for IRR to generate a zero value for NPV. Table 14-17 shows the final calculation.

The table implies that the cash inflows are equivalent to a 31% return on investment. Therefore, if the cost of capital were 10%, this would be an excellent investment. Also, this project is "probably" superior to other projects with a lower value for IRR.

TABLE 14-17. IRR CALCULATION FOR PROJECT A CASH INFLOWS

IRR NPV

$3722

1593

TABLE 14-18. CAPITAL PROJECTS
Project |
IRR |
Payback Period with DCF |

A |
10% |
1 year |

B |
15% |
2 years |

C |
25% |
3 years |

D |
35% |
5 years |

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