Page 180 - DMGT521_PROJECT_MANAGEMENT

Unit 10: Measuring Project Profitability

10.4 Internal Rate of Return Notes

The Internal Rate of Return (IRR) or Economic Rate of Return (ERR) is a rate of return used in
capital budgeting to measure and compare the profitability of investments. It is also called the
Discounted Cash Flow Rate of Return (DCFROR) or the Rate of Return (ROR). In the context of
savings and loans the IRR is also called the effective interest rate. The term internal refers to the
fact that its calculation does not incorporate environmental factors (e.g., the interest rate or
inflation).

The internal rate of return on an investment or project is the “annualized effective compounded
return rate” or “rate of return” that makes the net present value (NPV as NET*1/(1+IRR)^year)
of all cash flows (both positive and negative) from a particular investment equal to zero.
In more specific terms, the IRR of an investment is the discount rate at which the net present
value of costs (negative cash flows) of the investment equals the net present value of the benefits
(positive cash flows) of the investment.
IRR calculations are commonly used to evaluate the desirability of investments or projects. The
higher a project’s IRR, the more desirable it is to undertake the project. Assuming all projects
require the same amount of up-front investment, the project with the highest IRR would be
considered the best and undertaken first.
A firm (or individual) should, in theory, undertake all projects or investments available with
IRRs that exceed the cost of capital. Investment may be limited by availability of funds to the
firm and/or by the firm’s capacity or ability to manage numerous projects.

10.4.1 Uses

Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or
yield of an investment. This is in contrast with the net present value, which is an indicator of the
value or magnitude of an investment.
An investment is considered acceptable if its internal rate of return is greater than an established
minimum acceptable rate of return or cost of capital. In a scenario where an investment is
considered by a firm that has equity holders, this minimum rate is the cost of capital of the
investment (which may be determined by the risk-adjusted cost of capital of alternative
investments). This ensures that the investment is supported by equity holders since, in general,
an investment whose IRR exceeds its cost of capital adds value for the company (i.e., it is
economically profitable).

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Caution For some professional investors, their investment funds are committed to target
a specified rate of return. In such cases, that rate of return should be selected as the discount
rate for the NPV calculation.

10.5 BCR Method

The total discounted benefits are divided by the total discounted costs. Projects with a benefit-
cost ratio greater than 1 have greater benefits than costs; hence they have positive net benefits.
The higher the ratio, the greater the benefits relative to the costs. Note that simple benefit-cost
ratio is insensitive to the magnitude of net benefits and therefore may favor projects with small
costs and benefits over those with higher net benefits. (This problem can be eliminated by the
use of the incremental benefit-cost ratio or the net present value.)

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