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    2.2 AFM Investment Appraisal IRR 171223

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    Kushagra Bhandari

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    © All Rights Reserved
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    2.2 AFM Investment Appraisal IRR 171223

    Uploaded by

    Kushagra Bhandari
    17 views8 pages

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    17 views8 pages

    2.2 AFM Investment Appraisal IRR 171223

    Uploaded by

    Kushagra Bhandari

    Copyright:

    © All Rights Reserved
    Download as XLSX, PDF, TXT or read online from Scribd
    Download as xlsx, pdf, or txt
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    Year Amount DF @ 10% DCF DF @ 8% DCF

    0 -100,000 1.0000 -100,000 1.0000 -100,000


    1 20,000 0.9091 18,182 0.9259 18,519
    2 22,000 0.8264 18,182 0.8573 18,861
    3 26,000 0.7513 19,534 0.7938 20,640
    4 32,000 0.6830 21,856 0.7350 23,521
    5 40,000 0.6209 24,837 0.6806 27,223

    2,591 8,764

    IRR Internal rate of return which the project generates

    IRR That discounting rate at which my NPV = ZERO

    Hypothetical (not connected to the above table)


    Say at the discounting rate of 12%, my NPV is zero
    If I reduce my discounting rate, my NPV will become positive

    The rate at which NPV is ZERO is my IRR - 12%


    My cost of capital is 9%. So, if I discount at 9%, my NPV will become positive

    Decision Rule
    So, if IRR > Cost of capital, I should accept the project
    Cost of capital is my hurdle rate
    Which means my project should generate a return of more than my cost of capital for me to accept the projec

    14% IRR - Calculated

    Year Amount DF @ 9% DCF DF @ 12% DCF


    0 -100,000 1.000 -100,000 1.000 -100,000
    1 20,000 0.917 18,340 0.893 17,860
    2 22,000 0.842 18,524 0.797 17,534
    3 26,000 0.772 20,072 0.712 18,512
    4 32,000 0.708 22,656 0.636 20,352
    5 40,000 0.650 26,000 0.567 22,680

    NPV 5,592 -3,062

    IRR is that rate at which my NPV is ZERO NPV 0

    So, when my DF moves from 9% to 12%, my NPV changes from 5592 to -3062
    3.00% 8,654
    1.94% 5,592 IRR

    IRR 10.939%

    You can think of IRR as a growth rate. If someone says "this investment has an IRR of 15%," they are saying that if
    to this investment it will grow at a rate of 15% per year (doesn't necessarily have to be on a per year basis but that's t

    As for NPV, you can think of that as the difference between (i) what you actually received from an investment vs.
    (ii) what you would have received if your investment grew at some benchmark growth rate (the discount rate).

    it's helpful to forget the "it's the rate that sets the NPV to 0" definition of IRR for a moment and note that NPV and

    With these definitions in place, you can therefore see why investors might use an IRR instead of an NPV
    Knowing "by how much is my investment growing per year" is often more helpful than knowing
    "by how much is my investment exceeding some benchmark growth rate."
    BUT NOT ALWAYS

    10% is cost of capital

    DF @ 10% DCF DF @ 13%


    0 -6,000 1.000 -6,000 1.0000
    1 1,000 0.909 909 0.8850
    2 1,500 0.826 1,239 0.7831
    3 2,000 0.751 1,502 0.6931
    4 2,500 0.683 1,708 0.6133
    5 3,000 0.621 1,863 0.5428

    1,221

    When my rate of borrowing / cost of capital is 10%, NPV is 1221


    When I raise funds at 10% and employ it in this project, I generate NPV of 1221
    1221 indicates increase in shareholder wealth

    I need to know, at what rate does my project generate returns?


    This rate is my IRR

    If I increase my Discounting rate, I make it 13%


    Zero Net Present Value means that the rate of return of the project is equal to the
    discounting rate of the project. In simple words, at this point project's cash flows are
    equal to project's costs. This rate is known as IRR

    IRR is the rate of return at which the net present value of a project would be zero. So,
    if the cost of capital for a project is higher than its IRR, then the project is not feasible
    because then the NPV would be negative (as the present value of inflows will go down
    due to a higher rate). Put differently, it means that for a project to be undertaken , its
    cost of capital should be lower than its IRR.

    100 114 129.96

    IRR = 14% Cost of capital = 12%


    At IRR, my NPV = ZERO
    If I go below 14%, my Discounting Factors will rise
    Consequently, my NPV will turn Positive
    So, if my IRR is 14% and cost of capital = 12%
    Without calculation also, I can safely conclude that
    - If I discount at 12%, my NPV will be positive

    apital for me to accept the project

    DF @ 11% DCF
    1.000 -100,000
    0.901 18,020
    0.812 17,864
    0.731 19,006
    0.659 21,088
    0.593 23,720

    8,654 -302 10.8975

    ** When we discount using IRR of 10.94%, the NPV should come as ZERO
    However, the IRR is an approximation. So, we will rarely get NPV of ZERO
    = L + [NL /(NL - NH) * (H - L)]
    L = Lower Limit
    H = Higher Limit NL = NPV at lower limit
    NH = NPV at higher limit
    = 10.94

    RR of 15%," they are saying that if you put your money


    to be on a per year basis but that's the typical time period used).

    y received from an investment vs.


    rowth rate (the discount rate).

    a moment and note that NPV and IRR are just ways of describing compound growth.

    IRR instead of an NPV


    ul than knowing

    DCF DF @ 15%
    -6,000 1.0000 DCF DF @ 20% DCF
    885 0.8696 -6,000 1.0000 -6,000
    1,175 0.7561 870 0.8333 833
    1,386 0.6575 1,134 0.6944 1,042
    1,533 0.5718 1,315 0.5787 1,157
    1,628 0.4972 1,429 0.4823 1,206
    1,492 0.4019 1,206
    607
    240 -556

    t, I generate NPV of 1221


    A project has the following cashflows.
    Calculate IRR
    Cost of capital is 8%

    Year Amount
    0 -100,000
    1 20,000
    2 22,000
    3 26,000
    4 32,000
    5 40,000

    Year Amount DF @ 10% DCF DF @ 15%


    0 -100,000 1.000 -100,000 1.000
    1 20,000 0.909 18,180 0.870
    2 22,000 0.826 18,172 0.756
    3 26,000 0.751 19,526 0.658
    4 32,000 0.683 21,856 0.572
    5 40,000 0.621 24,840 0.497
    2,574

    IRR = L + [NL /(NL - NH) * (H - L)]


    L = Lower Limit NL = NPV at lower limit
    H = Higher Limit NH = NPV at higher limit

    = 10.97%

    Let us check whether at 10.97%, NPV is ZERO

    Year Amount DF @ 10.97% DCF


    0 -100,000 1.000 -100,000
    1 20,000 0.901 18,023
    2 22,000 0.812 17,865
    3 26,000 0.732 19,026
    4 32,000 0.659 21,102
    5 40,000 0.594 23,770
    -213

    IRR is an estimate and due to interpolation, the value is an approximate value


    DCF
    -100,000
    17,391
    16,635
    17,095
    18,296
    19,887
    -10,695

    L = NPV at lower limit


    H = NPV at higher limit
    Internal Rate of Return

    Advantages
    - Considers the time value of money
    - is a percentage and therefore easily understood
    - uses cash flows not profits
    - considers the whole life of the project
    - means a firm selecting projects where the IRR exceeds the cost of capital should increase shareholders' wealth

    Disadvantages
    - It is not a measure of absolute profitability.
    - Interpolation only provides an estimate and an accurate estimate requires the use of a spreadsheet programme.
    - It is fairly complicated to calculate.
    - Non-conventional cash flows may give rise to multiple IRRs which means the interpolation method can't be used.

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