Page 225 - BA2 Integrated Workbook - Student 2017

Long-term decision making

Internal rate of return (IRR)

5.1 IRR technique

IRR calculates the rate of return at which the project has an NPV of zero. The IRR is
compared to the company's cost of capital (this is the target rate).

Decision criteria

 If the IRR is greater than the cost of capital the project should be
accepted.

 Faced with mutually exclusive projects, choose the project with the
higher IRR.

To calculate the IRR:

 Calculate two NPVs for the project at two different costs of capital. The higher
the discount rate – the lower the NPV will be.

 Use the following formula to find the IRR:

N L
IRR = L + ——— (H – L)
N L – N H

where: L = lower discount rate

H = higher discount rate

N L = NPV at the lower discount rate

N H = NPV at the higher discount rate.

Go over illustration 7

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