![]() ![]() This is a disadvantage of the IRR method. The IRR assumes that the cash flows are reinvested at the internal rate of return when they are received. Placing these cash flows in a timeline results in the following ( Table 16.8):įigure 16.3 NPV Profile Graph for a Project with Two IRRs Then, the following year, your company would be required to convert the facility into a public park area for the city, which is expected to cost $620 million. The facility would be used for one year and generate cash inflows of $950 million. The construction cost would be $350 million. Suppose your company is considering building a facility for an upcoming Olympic competition. This can happen when negative cash flows occur in more than one period in the project. ![]() Another disadvantage of using the IRR method is that there may not be a single mathematical solution to an IRR problem. Later in this chapter, we will look at how to use a spreadsheet to do these calculations. With today’s technology, this is no longer a major consideration. Before the prevalence of financial calculators and spreadsheets, calculating the exact IRR was difficult and time-consuming. The IRR is about, but not exactly, 14%, because NPV is not exactly equal to zero (just very close to zero) when we use 14% as the discount rate. We knew the IRR was about 14% for the embroidery machine project because we had previously calculated the NPV for several discount rates. One disadvantage of using IRR is that it can be tedious to calculate. Investors like to speak in terms of annual percentage returns when evaluating investment possibilities. The primary advantage of using the IRR method is that it is easy to interpret and explain. Table 16.7 Calculator Steps for IRR Advantages After these cash flows are entered, simply compute IRR in the final step. To calculate IRR, begin by entering the cash flows for the project, just as you do for the NPV calculation (see Table 16.7). A problem that might require 30 minutes of detailed mathematical calculations by hand can be completed in a matter of seconds with the assistance of a financial calculator.Īll the information your calculator needs to calculate IRR is the value of each cash flow and the time period in which it occurs. Your calculator uses the same type of trial-and-error iterative process, but because it uses an automated process, it can do so much more quickly than you can. A company should reject any project that has an IRR less than the company’s cost of attracting funds the cash flows from such a project are not enough to compensate the investors for the use of their funds.Ĭalculating IRR without a financial calculator is an arduous, time-consuming process that requires trial and error to find the discount rate that makes NPV exactly equal zero. The cash flow from these projects will be great enough to cover the cost of attracting money from investors in addition to the other costs of the project. In other words, a company wants to accept projects that have an IRR that exceed the company’s cost of attracting funds. However, if it costs Sam’s more than 14% to attract capital, the embroidery machine should not be purchased. Therefore, if Sam’s Sporting Goods can attract capital for less than 14%, the IRR exceeds the cost of capital and the embroidery machine should be purchased. The NPV profile graph for the embroidery machine crossed the horizontal axis at 14%. If the IRR is less than the cost of capital, a project should be rejected. If the IRR is greater than the cost of capital, a project should be accepted. The IRR is the discount rate at which the NPV profile graph crosses the horizontal axis. ![]()
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