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Learning objectives of this
article:
-
Define and explain the internal
rate of return method of capital investment
evaluation.
-
How is it calculated?
-
What are advantages and
disadvantages of this method?
Contents:
Internal rate of return method
is also known as time adjusted rate of return
method. This method uses the concept of
present values to compute the rate of return from
expected net cash flows from capital investment
proposals. This method is very similar to the net
present value method of capital investment
evaluation. The net present value method focuses on
the present value of net cash flows. However the
internal rate of return method starts with the net
cash flows and, in a sense, work backwards to
determine the rate of return expected from the
proposal.
The management is considering to
acquire an equipment costing $97,360. It is
expected that the equipment will provide equal
annual cash flows of $20,000 for a period of 7
years. Should management accept this investment
proposal?
Solution:
When equal annual cash flows are
expected from an investment proposal, as in our
example, the following procedure is followed to
evaluate investment proposal using internal rate of
return method:
-
Determine a present value factor
for an annuity of $1 using the following
formula:
Present value factor for an annuity of $1 =
Amount to be invested / Equal annual cash
inflows
In our example, the amount to be invested is
$97,360 (cost of the equipment) and expected
annual cash inflow is $20,000. Thus, the present
value factor for an annuity of $1 is 4.868,
computed as follows:
$97,360 / $20,000
= 4.868
- Locate the present value factor (determined
in step 1) in the present value of an annuity of
$1 table. First locate the number of years of
expected useful life of the investment and then
proceed horizontally across the table until you
find the present value factor determined in step
1.
- Identify the internal rate of return by the
heading of the column in which the present value
factor is located.
In our example, the present value factor is
4.868. For a period of seven years, the partial
present value of an annuity of $1 table
indicates that the factor is related to a
percentage of 10%, as shown below:
| Year |
|
6% |
10% |
|
12% |
| 1 |
|
.943 |
.909 |
|
.893 |
| 2 |
|
1.833 |
1.736 |
|
1.690 |
| 3 |
|
2.673 |
2.487 |
|
2.402 |
| 4 |
|
3.465 |
3.170 |
|
3.037 |
| 5 |
|
4.212 |
3.791 |
|
3.605 |
| 6 |
|
4.917 |
4.355 |
|
4.111 |
|
7 |
→ |
5.582 |
4.868 |
↑ |
4.564 |
| 8 |
|
6.210 |
5.335 |
|
4.968 |
| 9 |
|
6.802 |
5.759 |
|
5.328 |
| 10 |
|
7.360 |
6.145 |
|
5.650 |
Thus, the 10% is the internal rate of return
for this proposal.
The investment in the new equipment is
desirable if the minimum acceptable rate of
return for similar proposals is 10% or less.
When several alternative proposals exist, they
are often ranked by their internal rate of return.
The higher the internal rate of return, the most
desirable the investment proposal.
Advantage:
- The present value of the cash flows over the
entire useful life of the investment proposal is
considered.
- All investment proposals are placed on a
common basis for comparison by determining a
rate of return for each proposal.
Disadvantages:
- The computations are more complex than
any other method of evaluating investment
proposals.
- Internal rate of return method assumes
than the cash received from a proposal
during its useful life will be invested
again at the internal rate of return. But it
may not always be reasonable because of
changing economic conditions.
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