Overview
This lecture covers the Internal Rate of Return (IRR) as a capital budgeting rule, compares it to NPV and Payback methods, and explains how to handle conflicts between decision rules.
Internal Rate of Return (IRR) Rule
- IRR is the discount rate that sets a project's Net Present Value (NPV) to zero.
- IRR measures the average yearly return of a project.
- Accept a project if its IRR is higher than its cost of capital; reject it if IRR is lower.
- To calculate IRR, set the NPV equation to zero and solve for the discount rate.
- In Excel, use the
=IRR() function, specifying all yearly cash flows (including zeros for years with no cash flow).
IRR Calculation Example
- Project A: Cash flows are -$100 (Year 0), $10 (Year 1), $60 (Year 2), $80 (Year 3); IRR is 18.1%.
- Project B: Cash flows are -$100 (Year 0), $70 (Year 1), $50 (Year 2), $20 (Year 3); IRR is 23.6%.
Limitations of IRR
- IRR works for projects with conventional cash flows (initial outflow followed by inflows).
- Non-conventional cash flows (cash flow sign changes more than once) can result in multiple IRRs, making IRR rule unreliable.
- IRR does not account for project scale; higher IRR does not always mean better value if project size differs.
Comparing Capital Budgeting Rules
- NPV and IRR both consider time value of money and risk; preferred over the Payback Rule.
- For independent projects: Accept all projects with positive NPV and IRR > cost of capital.
- For mutually exclusive projects: Choose the one with the highest NPV (NPV rule) or highest IRR (IRR rule).
- Payback Rule: Accept projects that recoup investment within a set period; may give different results than NPV or IRR.
Conflicts Between Rules
- At higher cost of capital (ex: 10%), all rules may agree—accept both if independent, pick B if exclusive.
- At a lower cost of capital (ex: 5%), NPV and IRR may give conflicting recommendations; NPV rule is preferred for final decision.
Key Terms & Definitions
- Internal Rate of Return (IRR) — Discount rate at which project NPV equals zero.
- Net Present Value (NPV) — Present value of all project cash flows, both in and out.
- Cost of Capital — Required return to make a project worthwhile.
- Conventional Cash Flow — Cash flows with a single sign change (outflow to inflow).
- Mutually Exclusive Projects — Only one project out of several can be chosen.
Action Items / Next Steps
- Practice calculating IRR using Excel with provided cash flows.
- Know when to prioritize NPV rule if investment rules conflict.