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Lesson 27. IRR METHOD OF CAPITAL BUDGETING
Module 5. Investment decision
Lesson 27
IRR METHOD OF CAPITAL BUDGETING
27.1 Internal Rate of Return (IRR)
In the computation of Internal Rate of Return (IRR), the time value of money is accounted. The method of working IRR provides the knowledge of actual rate of return from the different projects. Thus IRR is known as ‘marginal efficiency of capital or yield on the investment’. It is the discount rate at which the present values of the net cash flows are just equal to zero, i.e., NPW = zero. When NPW is set equal to zero, the equation is solved for ‘I’. This is the internal rate of return. The IRR must be found out by trial and error with some approximation.
In the working procedure, an arbitrary discount rate is assumed and its corresponding NPW is arrived at. The positive NPW value of the project indicates that IRR is still higher and the next assumed arbitrary IRR value must be comparatively higher than the initial level. This process is continued until NPW becomes negative. Then by interpolation method the exact IRR is found out using the following formula:
(Internal Rate of Return) = (Lower Discount Rate) + (Differences between the two discount rates) (Present worth of the cash flow at the lower discount rate)/Absolute difference between the present worths of the cash flow at the two discount rates)
Year 
Costs (in Rs.) 
Gross income (in Rs.) 
Net income (in Rs.) 
Discount factor (40%) 
Net present worth (in Rs.) 
Discount factor (43%) 
Net Present worth (in Rs.) 
1 
38,900 
 
38,900 
0.7143 
27,786.27 
0.6993 
27,202.77 
2 
9,239 
28,475 
19,236 
0.5102 
9,814.21 
0.48902 
9,406.4 
3 
10,573 
32,550 
21,975 
0.3644 
8,007.69 
0.3419 
7,513.25 
4 
11,952 
35,610 
23,658 
0.2603 
6,158.17 
0.2391 
5.656.62 
5 
12,858 
39,802 
26,944 
0.1859 
5,008.89 
0.1672 
4,505.04 



52,913 

1,202.69 

121.46 
IRR = 40 + 3 (1202.69 / 1202.69+121.46)
= 40 + 3 (0.9083)
= 40 + 2.7249
= 42.7249
Table 27.2 Estimation of IRR for Dairy farm (Hypothetical)
Year 
Costs (in Rs.) 
Gross income (in Rs.) 
Net income (in Rs.) 
Discount factor (40%) 
Net present worth (in Rs.) 
Discount factor (30%) 
Net Present worth (in Rs.) 
End of 6^{th} year 
25,000 
 
25,000 
0.262 
6550 
0.207 
5,175 
End of 7^{th} year 
4,250 
10,260 
6,010 
0.21 
1,262.01 
0.159 
955.59 
End of 8^{th} year 
4,792 
12,550 
7,758 
0.168 
1,303.30 
0.123 
954.23 
End of 9^{th} year 
5,368 
14,530 
9,162 
0.134 
1,227.71 
0.094 
861.23 
End of 10^{th} year 
5,975 
16,275 
10,300 
0.107 
1,102.10 
0.073 
751.90 
End of 11^{th} year 
6,456 
19,396 
12,940 
0.086 
1,112.84 
0.056 
724.64 
End of 12^{th} year 
7,187 
21,470 
14,283 
0.069 
985.53 
0.043 
614.17 



35,453 

443.49 

313.24 
IRR = 25 + 5 (443.49 / 443.49+313.24)
= 25 x 5 (0.586)
= 25 + 2.93
= 27.93