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The Internal Rate of Return (IRR)
The IRR is another project appraisal method using DCF techniques.
The IRR represents the discount rate at which the NPV of an investment is zero. As such it represents a breakeven cost of capital.
Decision rule:
Projects should be accepted if their IRR is greater than the cost of capital.
IRR
Using the NPV method, PVs are calculated by discounting cash flows at a given cost of capital, and the difference between the PV of costs and the PV of benefits is the NPV. In contrast, the IRR method of DCF analysis is to calculate the exact DCF rate of return that the project is expected to achieve.
If an investment has a positive NPV, it means it is earning more than the cost of capital. If the NPV is negative, it is earning less than the cost of capital. This means that if the NPV is zero, it will be earning exactly the cost of capital.
Conversely, the percentage return on the investment must be the rate of discount or cost of capital at which the NPV equals zero. This rate of return is called the I RR or the DCF yield and if it is higher than the target rate of return then the project is financially worth undertaking.
Calculating the IRR using linear interpolating
The steps in linear interpolation are:
Calculate two NPVs for the project at two different costs of capital
Use the following formula to find the IRR:
Where:
L = Lower rate of interest
H = Higher rate of interest
NL = NPV at lower rate of interest
NH = NPV at higher rate of interest.
The diagram below shows the IRR as estimated by the formula
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