Internal Rate of Return

Internal Rate of Return

Meaning of Capital Budgeting
 Capital budgeting can be defined as the process

of analyzing, evaluating, and deciding whether resources should be allocated to a project or not.  Capital budgeting addresses the issue of strategic long-term investment decisions.
 Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization. Why Capital Budgeting is so Important?

 Involve massive investment of resources
 Are not easily reversible
 Have long-term implications for the firm
 Involve uncertainty and risk for the firm

Capital Budget Techniques
Net PresentValue

Discounted

BenefitCost/Profitability
Index Ratio

IRR

Capital Budget
Techniques

Accounting Rate of Return
Non Discounted
Payback
Period

Internal Rate of Return
 The rate at which the net present value of cash

flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investment  Project’s promised rate of return given initial

investment and cash flows.
 Consistent with wealth maximization
 Accept a project if IRR ≥ Cost of Capital

Question
The management is considering to acquire an equipment costing $1,00,000 . It is expected that the equipment will provide equal annual cash flows of $30,000 for a period of 4 years. Should management accept this investment proposal?

Solution By Present value factor for an annuity of $1
1.Determine a present value factor for an annuity of $1 using the following formula:

Present value factor for an annuity of $1 = Amount to be invested / Equal annual cash inflows
2. Locate the present value factor (determined in step 1) in the present value of an annuity of $1 table. First locate the number of years of expected useful life of the investment and then proceed horizontally across the table until you find the present value factor determined