Internal Rate of Return (IRR)

The Internal rate of return is the discount rate which yields a zero net present value (P.Atrill, 2012:157). The higher the IRR, the more desirable to undertake the project. Thus, projects can be ranked accordingly and the highest will be selected. An attribute of the IRR is that it takes into account the power of compounding interest and assumes that all cash flows are reinvested at the IRR.

To obtain the IRR, the trial and error approach is applied. At 3% interest rate, we obtained the following:

Now: Present value (PV) = -$1350k

Year 1: PV = $700k / 1.03 = $679.63k

Year 2: PV = $750k / 1.03² = $706.95k

Adding those up gets NPV = -$1350k + $679.63k + $706.95k = $36.58k

The results shows a positive NPV, thus a larger interest rate is needed to derive a negative NPV in order to calculate the IRR. For this purpose, a 10% interest rate is selected.

Now: PV = -$1350k

Year 1: PV = $700k / 1.10 = $636.37k

Year 2: PV = $750k / 1.10² = $619.8k

Adding those up gets NPV = -$1350k + $636.37k + $619.8k = -$93.83k

Using the figures obtained, this can be tabulated into the table below:

Year	Cash Flow ($’000)	DF@3%	DF@10%	PV@3%	PV@10%
0	(1350)	1	1	(1350)	(1350)
1	700	0.9709	0.9091	679.63	636.37
2	750	0.9426	0.8264	706.95	619.8
				36.58	(93.83)

Using the above calculations, we could easily derive the IRR using the following formula and plot it into a graph.

IRR = NPV1 + (DR2-DR1) x NPV1 / (NPV1 – NPV2)

IRR = 3% + (10% - 3%) x 36.58/ 130.41

       = 3% + 1.96% = 4.96% = 5%

According to Berk (2011), the company should undertake the project since its IRR (5%) exceeds the cost of capital (3%).