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Internal Rate of Return Method:

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Learning objectives of this article:

1. Define and explain the internal rate of return method of capital investment evaluation.
2. How is it calculated?
3. What are advantages and disadvantages of this method?

Contents:

Definition and Explanation:

Internal rate of return method is also known as time adjusted rate of return method. This method uses the concept of present values to compute the rate of return from expected net cash flows from capital investment proposals. This method is very similar to the net present value method of capital investment evaluation. The net present value method focuses on the present value of net cash flows. However the internal rate of return method starts with the net cash flows and, in a sense, work backwards to determine the rate of return expected from the proposal.

Example:

The management is considering to acquire  an equipment costing \$97,360. It is expected that the equipment will provide equal annual cash flows of \$20,000 for a period of 7 years. Should management accept this investment proposal?

Solution:

When equal annual cash flows are expected from an investment proposal, as in our example, the following procedure is followed to evaluate investment proposal using internal rate of return method:

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

In our example, the amount to be invested is \$97,360 (cost of the equipment) and expected annual cash inflow is \$20,000. Thus, the present value factor for an annuity of \$1 is 4.868, computed as follows:

\$97,360 / \$20,000

= 4.868

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 in step 1.

3. Identify the internal rate of return by the heading of the column in which the present value factor is located.

In our example, the present value factor is 4.868. For a period of seven years, the partial present value of an annuity of \$1 table indicates that the factor is related to a percentage of 10%, as shown below:

 Year 6% 10% 12% 1 .943 .909 .893 2 1.833 1.736 1.690 3 2.673 2.487 2.402 4 3.465 3.170 3.037 5 4.212 3.791 3.605 6 4.917 4.355 4.111 7 → 5.582 4.868 ↑ 4.564 8 6.210 5.335 4.968 9 6.802 5.759 5.328 10 7.360 6.145 5.650

Thus, the 10% is the internal rate of return for this proposal.

The investment in the new equipment is desirable if the minimum acceptable rate of return for similar proposals is 10% or less.

When several alternative proposals exist, they are often ranked by their internal rate of return. The higher the internal rate of return, the most desirable the investment proposal.

Advantages and Disadvantage of Internal Rate of Return Method:

Advantage:

1. The present value of the cash flows over the entire useful life of the investment proposal is considered.
2. All investment proposals are placed on a common basis for comparison by determining a rate of return for each proposal.

Disadvantages:

1. The computations are more complex than any other method of evaluating investment proposals.
2. Internal rate of return method assumes than the cash received from a proposal during its useful life will be invested again at the internal rate of return. But it may not always be reasonable because of changing economic conditions.
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More study material from this topic:

 Methods for the evaluation of capital investment analysis Average rate of return or accounting rate of return method Cash payback method Net present value method Internal rate of return method Simple interest Future value of a single sum Future value of an annuity Present value of a single sum Present value of an annuity Qualitative consideration in capital investment analysis Capital investment analysis and unequal proposal lives Capital rationing decision process Difference between simple interest and compound interest Difference between nominal and effective interest rate Future value of \$1 table Present value of \$1 table Present value of ordinary annuity table Future value of ordinary annuity table

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