The higher is the value of the IRR from your desired rate of return, the more attractive is the project.What is internal rate of return (IRR)?The Internal rate of return is that return which is generated for each rupee invested in the project for a specific period. You can also say that it is the rate of return at which your net present value (NPV) of the project becomes zero. It is a discounted cash flow technique and a measure of the investment performance. ## Understanding the attractiveness:
For example, there are two project with the following information
The discount rate is the minimum return you are expecting from the project. Although, the project B has the higher IRR value than that of project A.
But project A is more attractive than the project B. It is because you are getting 50% more of what you are expecting in project A while in the case of the project B, you are getting 33.33% more of what you are expecting.
**You can see that project A is offering 50% more than the discount rate or the expected return despite having the lower IRR value than that of project B, which is offering 33.33% more than its expected return.**
## The formula & the calculation
\(\frac{CF_1}{(1+IRR)^1}+\frac{CF_2}{(1+IRR)^2}+....+\frac{CF_n}{(1+IRR)^n)} - initial\ investment = 0\)
We will calculate the value of irr through hit and trial method:**Guess the value of r and calculate the value of NPV****If NPV > 0, then increase the value of r and re-calculate NPV****If NPV < 0, then decrease the value of r and re-calculate NPV****If NPV is close to zero then IRR is equal to the value of r**
For example, the project X has the following information:*Initial Investment: Rs. 2,00,000**Life of the project: 4 years**Discount rate or the expected return: 10%**Projected cash inflows:*
*Year 1: Rs. 70,000**Year 2: 1,00,000**Year 3: 80,000**Year 4: 60,000*
The solution:
**Assume irr = 10% and calculate the NPV of the project, we get**:
The value Rs. 47367 > 0, **Increase the value of****irr****say to 15%, re-calculate NPV as explained above, we get,**
**Again, NPV > 0, increase the value of****irr****say to 20%, we get,**
**Slightly increase the value of****irr****say 21%, then re-calculate NPV, we get**
**It means that the value of r is in between 20% and 21%, or more towards 21%.**
This is one of the simplest methods of calculating the IRR of the project.
Therefore, we can say that the internal rate of return of the project is around 21% (annually) and its attractiveness is(21% - 10%)/10% = 2.1 or 210%## The advantages- It considers the time value of the money in evaluating the projects.
- It is simple to interpret. A project having higher IRR is preferred over the project with a lower value of IRR.
## The disadvantages- It ignores the size of the project by ignoring the actual dollar benefit. A project value of Rs. 10,000 with IRR of 30% is preferred over the project with value Rs. 10, 00,000 with IRR of 15%.The rupee benefit in the latter project is Rs. 1, 50,000 while that the first one has the rupee benefit of Rs. 30,000 only (The rupee benefit in the first project is more than that of the second one, the IRR ignores this benefit).
- It is not helpful in comparing two mutually exclusive projects.
- It does not consider the cost of capital; therefore it is not suitable for comparing projects with different duration.
- It assumes that cash inflows generated by the project are re-invested at the same rate of return, which is impractical.
## Conclusion:
When you have two feasible projects in your hand, do calculate their relative attractiveness in addition to their Internal rate of returns. A higher value of the attractiveness helps you in shortlisting the profitable project and you will benefit as an investor.
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