Internal Rate of Return
Internal Rate of Return
Meaning of Capital Budgeting
Capital budgeting can be defined as the process
of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. Capital budgeting addresses the issue of strategic long-term investment decisions.
Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization. Why Capital Budgeting is so Important?
Involve massive investment of resources
Are not easily reversible
Have long-term implications for the firm
Involve uncertainty and risk for the firm
Capital Budget Techniques
Net PresentValue
Discounted
BenefitCost/Profitability
Index Ratio
IRR
Capital Budget
Techniques
Accounting Rate of Return
Non Discounted
Payback
Period
Internal Rate of Return
The rate at which the net present value of cash
flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investment Project’s promised rate of return given initial
investment and cash flows.
Consistent with wealth maximization
Accept a project if IRR ≥ Cost of Capital
Question
The management is considering to acquire an equipment costing $1,00,000 . It is expected that the equipment will provide equal annual cash flows of $30,000 for a period of 4 years. Should management accept this investment proposal?
Solution By Present value factor for an annuity of $1
1.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
2. 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
Meaning of Capital Budgeting
Capital budgeting can be defined as the process
of analyzing, evaluating, and deciding whether resources should be allocated to a project or not. Capital budgeting addresses the issue of strategic long-term investment decisions.
Process of capital budgeting ensure optimal allocation of resources and helps management work towards the goal of shareholder wealth maximization. Why Capital Budgeting is so Important?
Involve massive investment of resources
Are not easily reversible
Have long-term implications for the firm
Involve uncertainty and risk for the firm
Capital Budget Techniques
Net PresentValue
Discounted
BenefitCost/Profitability
Index Ratio
IRR
Capital Budget
Techniques
Accounting Rate of Return
Non Discounted
Payback
Period
Internal Rate of Return
The rate at which the net present value of cash
flows of a project is zero, I.e., the rate at which the present value of cash inflows equals initial investment Project’s promised rate of return given initial
investment and cash flows.
Consistent with wealth maximization
Accept a project if IRR ≥ Cost of Capital
Question
The management is considering to acquire an equipment costing $1,00,000 . It is expected that the equipment will provide equal annual cash flows of $30,000 for a period of 4 years. Should management accept this investment proposal?
Solution By Present value factor for an annuity of $1
1.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
2. 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