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# Internal Rate of Return

The Internal Rate of Return (IRR) of a Capital Budgeting project is the discount rate at which the Net Present Value (NPV) of a project equals zero. The IRR decision rule specifies that all independent projects with an IRR greater than the cost of capital should be accepted. When choosing among mutually exclusive projects, the project with the highest IRR should be selected (as long as the IRR is greater than the cost of capital).

where

• CFt = the cash flow at time t and

The determination of the IRR for a project, generally, involves trial and error or a numerical technique. Fortunately, financial calculators greatly simplify this process.

The example below illustrates the determination of IRR. Consider Capital Budgeting projects A and B which yield the following cash flows over their five year lives. The cost of capital for both projects is 10%.

 Project A Project B Year Cash Flow Cash Flow 0 \$-1000 \$-1000 1 500 100 2 400 200 3 200 200 4 200 400 5 100 700

 Internal Rate of Return Project A: Project B:

Thus, if Projects A snd B are independent projects then both projects should be accepted since their IRRs are greater than the cost of capital. On the other hand, if they are mutually exclusive projects then Project A should be chosen since it has the higher IRR.

 Example Problems Find the IRR for the following Capital Budgeting project. Year Cash Flow 0 \$ 1 \$ 2 \$ 3 \$ 4 \$ 5 \$ IRR: %

© 2002 - 2010 by Mark A. Lane, Ph.D.