Internal Rate of Return

Method

l Calculate the discount rate which makes the NPV zero

» Question: How high could the cost of capital be, so that the
NPV of a project is still positive?
l The higher the IRR the better the project

Advantages

l Calculation does not demand knowledge of the cost of capital

l Many people find it a more intuitive measure than NPV
l Usually gives the same signal as NPV

Internal Rate of Return (IRR)

l The IRR is the discount rate, IRR, that makes NPV = 0.
CFt
∑ t = 1 (1 +
T
NPV = − I=0
IRR)t

l IRR Rule for investment projects:

» Accept project if IRR > rp.
» Reject project if IRR < rp.

1
 IRR Example

l Consider, once again, the drug company that has the

opportunity to invest $100 million in the development of a new
drug that will generate after-tax cash flows of $20 million per
year for the next 15 years. What is the IRR of this investment?
l The IRR makes NPV = 0.

1 − (1 + IRR)− 15
NPV = * 20 − 100 = 0
IRR

l This gives IRR = 18.4%.

l Accept the project if rp < 18.4%.
» At r=10%, accept project
» At r=20%, reject project

IRR: A Graphical Interpretation

$250.00

$200.00

$150.00
NPV

$100.00

$50.00

$0.00
0%

3%

6%

9%

%
%

($50.00)
18
12

15

21

24

Discount rate

IRR=18.42%

2
 IRR Example (2)

l Consider again the example above

Time 0 1 2 3
-100.00 -50.00 30.00 200.00
l Then the IRR solves:
50 30 200
NPV = − 100 − + + =0
1 + IRR (1 + IRR)2 (1 + IRR)3

» IRR=18.29%
» Accept project if rp<18.29%

IRR Problems I:
Borrowing or Lending?

l Consider the following two investment projects faced by a firm

with rp = 10%.

Project 0 1 2 IRR NPV @ 10%

B -5000 0 9800 40% 3099
C 5000 -9800 40% -3099

l Both projects have an IRR = 40%, but only project B is

acceptable.
» What is happening here?
» How can you modify the IRR rule so that it works?

3
 NPV Profiles

5000
4000
3000
2000
1000
B
NPV

0
C
0%

10%

20%

30%

40%

50%

60%

70%
-1000
-2000
-3000
-4000
-5000

Discount Rate

IRR Problems II:

Multiple IRRs

l Consider a firm with the following investment project and a discount

rate of rp = 25%.

Project 0 1 2 IRR NPV @ 10% NPV @ 20%

E -5000 16000 -12000 100%, 20% -372 0

l Typical if investment at the end:

» Repair environmental damage
» Dismantling of machine
– Nuclear power plants
l This project has two IRRs: one above rp and the other below rp. Which
should be compared to rp?
» Should the firm take this project?
– NPV@25%=120
8

4
 NPV Profile
l General rule:
IRR works only if sign of CFs
400
changes once:
200
» If negative first, then
0 investment, positive NPV:
0% 20% 40% 60% 80% 100%
-200 IRR>Cutoff
NPV

-400 » If positive first, then

-600
financing, positive NPV:
IRR<Cutoff
-800
l If pattern changes signs n
-1000
Discount rate times, there will be n different
IRRs!

IRR Problems III:

Mutually Exclusive Projects with different time horizon

l Consider the following two mutually exclusive projects. The discount

rate is rp = 20%.
Project 0 1 2 IRR NPV
(k=20%)
A -5,000 8,000 0 60% 1,667

B -5,000 0 9,800 40% 1,806

l Despite having a higher IRR, project A is less valuable than project B.

10

5
 NPV Profiles
l IRR does not take into
5000 account:
4000 » Capital outlay: project
Project A
3000 with higher IRR has lower
Project B
2000 NPV (scale effect)
1000 » Time horizon:
NPV

0
– Project A achieves
-1000 0 0.2 0.4 0.6 0.8 1
higher return over 1
-2000 Discount Rate, k
period
-3000
– Project B achieves
mediocre return over 2
periods
l Implicit reinvestment
assumption
11

IRR Problems IV:

Mutually Exclusive Projects with different scale

l Consider the following two mutually exclusive projects:

Project 0 1 2 IRR NPV @ 10% NPV @ 20%
A -5000 8000 0 60% 2273 1667
D -10000 15000 0 50% 3636 2500

» Project A has higher IRR

» Project D has higher NPV at discount rates of 10% or 20%
l IRR is independent of scale
» Implicit assumption that additional funds can be invested at
the same discount rate

12

6
 NPV Profiles

6000

5000 A

4000 D

3000

2000
NPV

1000

0
0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%
-1000

-2000

-3000
Discount Rate

13