Page 132 - DMGT409Basic Financial Management

Unit 7: Capital Budgeting

? Notes
Did u know? This method is also known by following names:
1. Marginal efficiency of capital

2. Rate of return over cost
3. Time adjusted rate of return
4. Yield on investment

Computation of IRR is based on the cash flows after taxes. IRR is mathematically represented as
‘r’. It can be found by trial and error method. In this method the evaluator selects any discount

rate to compute present value of cash inflows. Generally the cost of capital is taken as fi rst trial.
If calculated present value of the cash inflows is higher than the present value cash outfl ows then

evaluator has to try at higher rate. On the other hand if the present value of cash inflows is lower

than the present value of cash outflows then evaluator has to try lower discounting factor. This

process will be repeated till the present value of cash inflows equals to the present value of cash
outfl ows.
Generally, IRR may lie between two discounting factors; in that case analyst has to use interpolation
formula for calculation of IRR. The formula is as follows:
⎡ LDPV − OI ⎤
IRR = LDF %+ Δ DF ⎥
⎢
⎣ LDPV − HDPV ⎦
Where, LDF = Discount factor of low trial
DDF = Difference between low discounting factor and High discounting factor

LDPV = PV of cash inflows at low discounting factor trial
HDPV = PV of cash inflows at high discounting factor trial

OI = Original investment
Or
C − 0
IRR = A + × (B − A )
C − D

Where,
A = Discounted factor of low trial
B = Discounted factor of high trial
C = Present value of cash inflow in the low trial

D = Present value of cash inflow in the high trial

O = Original or initial outlay

Accept-Reject Rule

Acceptance or reject rule of the project decides based upon the calculated IRR and Cost of capital
(Ko).

Accepted: IRR > Cost of capital (Ko)
Reject: IRR < Cost of capital (Ko)
Consider: IRR = Cost of capital (Ko)

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