Analysis of Financial Statements_16

ü Internal Rate of Return (IRR)

The Internal Rate of Return (IRR) is the discount rate that generates a zero net present value for a series of future cash flows. This essentially means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of a project (or an investment) equal its current market value.

•The IRR is the break-even discount rate.•

• IRR calculates an alternative cost of capital including an appropriate risk premium.

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ü Internal Rate of Return provides a simple ‘hurdle rate’, whereby any project should be avoided if the cost of capital exceeds this rate.

Usually a financial calculator has to be used to calculate this IRR, though it can also be mathematically calculated using the following formula:

In the above formula,

CF is the Cash Flow generated in the specific period (the last period being ‘n’).

IRR, denoted by ‘r’ is to be calculated by employing trial and error method.

Advantages

•It is easy to understand

•It considers the time value of money

•It takes into account total cash inflow & outflow

•It does not use the concept of reqd. rate of return

Disadvantages

•It involves tedious calculation

•It produces multiple rates which can be confusing

•While evaluating mutually exclusive proposals, the project with the highest would be picked up

(assuming no capital constraints).

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