Internal Rate of Return (IRR) for Financing Project
Internal rate of return (IRR) is the discount rate that makes Net Present Value (NPV) of investment zero.
NPV= Cash receipt – sum of present value of each cash outflow when NPV= 0, so Cash receipt = sum of present value of each cash outflow
Investing project has only one IRR.
Project Decision:
– if IRR<discount rate => accept the project
– if IRR>discount rate => Reject the project
Example:
Your friend lends you $100, but you return back $130 to him next year.
| Dates: | 0 | 1 |
| Cash Flow | $100 | -$130 |
Required:
- Assume that interest rate at bank is 15%. Do you accept this offer?
- Build NPV profile/graph, and mention about financing project from your friend.
Solution:
- Accept or Reject this offer
NPV=100-130/(1+r)^1
NPV=0, IRR = 30%
Decision:
IRR=30%
Discount rate = 15%
30%>15%, so reject this offer from him.
- Graph/profile
Financing project has a cash inflow at date 0 followed by a cash outflow at date 1.The NPV is negative when the discount rate is below 30 percent and otherwise.
When discount rate is less than 30%, we will reject this offer, so we should borrow bank instead.
When discount rate (borrowing rate) is greater than 30%, so we will borrow him.
Source:
- Phnom Penh HR
- Mcgraw-Hill – Fundamentals Of Corporate Finance