In this article, I’m going to be talking about IRR otherwise known as the Internal Rate of Return. Now the internal rate of return is a way of evaluating a project and coming up with a decision to accept or reject that project.
So this is very similar in a way to NPV (Net Present Value). Now when we think about NPV we think, if the NPV is greater than zero (0) then we should accept the project.
That’s our decision rule, so IRR is is kind of related in that sense and that ultimately it’s going
to lead to a decision rule, but first in order to understand what IRR is let’s kind of work a problem here with NPV and then show how we do it with IRR.
We have a project and this project is going to have this just going to be a one-year timeline and at the beginning of year or at your zero right now we’re going to have a cash outflow we’re going to invest $100 and then at the end of year one we’re going to receive a cash flow of $130.
So this is a very simple project here paying out $100 and then getting $130 back at the end. Now in order to calculate this with our NPV the other way, holding off IRR for a second and thinking about NPV, we’re going to need to know the discount rate. Little (r) we’ll call that and so let’s just say that the discount will let’s say it’s 8%.
Right now I’m just briefly going to go through how we would do this under NPV and refer to the NPV article if you haven’t seen this yet. The NPV is going to be negative 100 that cash outflow plus 130, but we’re going to take that $130 over (1 + r).
1 plus (+) that discount rate and we need to do that because of the time value of money. So ultimately that NPV is going to be 130 over 1.08 with this point .08 that’s just that 8% discount rate we’re converting it to a decimal and adding 1 to it.
Ultimately this is going to give us a net present value to this project of $20.37 so now if we think about our decision rule, well is this greater than zero? (20.37 > 0) Well yes, it is so, then according to the NPV you would accept this project and go ahead with it, but let’s think about IRR now. How IRR different from NPV? Well, ultimately what we’re going to do with IRR? So we are going to set the NPV equal to zero (0).