The internal rate of return (IRR) of a project is the discount rate which makes its NPV equal to zero. Internal rate of return is a percentage discount rate used in capital investment appraisal, which bring the cost of a project and its future cash inflows into equality. It is the rate of return which equates the present value of anticipation net cash flows with the initial outlays. The IRR is defined as the rate which the net present value is zero. The test of profitability of unity a project is relationship
Relationship between the internal rate of return of the project and the minimum acceptable rate of return.
ACCEPTANCE RULE:
The accept-or-reject rule, using the IRR method, is to accept the project if its internal rate of return is higher than the opportunity cost of capital (r>k). ‘k’ is also known as required rate of return , or the cut-off, or hurdle rate. The project shall be rejected if its internal rate of return is lower than the opportunity cost of capital (r>k). The decision maker may remain indifferent if the internal rate of return is equal to the opportunity cost of capital.
MERITS:
• It recognizes the time value of money.
• It considers the total benefits arising out of proposals over its lifetime.
• The future discount rate normally varies due to longer time span. This rate can be
• This method is particularly useful for the selection of mutually exclusive projects.
• The method of project selection is instrumental in achieving the financial objectives i.e; the maximization of shareholders wealth.
DEMERITS:
• It is difficult to calculate as well as to understand it as compared to accounting rate of return method, or payback period method.
• Calculation of the desired rate of return present serious problems generally cost of capital is the basis of determining the desired rate.
• The calculation of cost of capital is itself complicated. Moreover desired rate of return vary from year to year.
PROFITABILITY INDEX :
The profitability index is also called benefit cost ratio. The profitability index is the present value of anticipated net future cash flows divided by the initial outlay. The only difference between the net present value method and profitability index method is that when using the NPV technique, the initial outlay is deducted form the present value of anticipated cash flows, whereas with profitability index approach, the initial cash outlay is used as divisor.
PI = PV of cash inflow / initial cash investment PAYBACK PERIOD :
The payback period is usually expressed in years it takes the cash inflow from a capital investment project to equal to cash outflow. When deciding between two and more competing projects the usual decision is to accept the one with the shortest payback. This method recognizes the recovery of the original capital invested in a project. The basic element of this method is a calculation of recovery time, by accumulation of the cash inflows year by year until the cash inflows equal to the amount of the original investment. In simple terms, it can be defined as the number of years required to recover the cost of the investment.
MERITS :
• It is simple to apply and easy to understand.
• In case of capital rationing a company is compelled to invest in projects having shortest payback period.
• This method is most suitable when the future is every uncertain. The shorter the payback period, the less risky is the project.
• This method gives an indication to the prospective investor specifying when their funds are likely to be repaid.
• It does not involve assumptions about future interest rates.
DEMERITS :
• It ignores the cash generation beyond the payback period.
• It fails to take into account the timings of returns and the cost of capital. It fails to consider the whole lifetime of the projects.
• It does not indicate whether an investment should be accepted or rejected, unless the payback period is compared with an arbitrary managerial target.
ACCOUNTING RATE RETURN :
The ARR method is also known as return on investment or return on capital employed.
This method employs the normal accounting technique to measure the increase in profit expected to result from an investment by expressing the net accounting profit arising from the investment as a percentage of that capital investment.
ARR = Avg profit after tax / Avg investment * 100
ACCEPTANCE RULE :
As an accept – or – reject criterion, this method will accept all those projects which have ARR less than the minimum rate. This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.
MERITS :
1. It is easy to calculate because it makes use of readily available accounting information.
2. It is not concerned with the cash flows but rather based upon profits, which are reported in annual accounts and sent to shareholders.
3. Unlike payback period method, this method takes into consideration all the years involved in the life of the project.
4. Where a number of capital investment proposals are being consider, a quick decision can be taken by use of ranking the investment proposals.