Internal rate of return is the rate of return at which the NPV of the project is equal to zero. In other words IRR is that discount rate that makes the present value of all cash outflows equal to the present value of all after tax cash inflows.

Decision rule in case of IRR is that, the IRR must be greater than the cost of capital or the hurdle rate. Therefore if IRR is greater than the cost of capital then accept the project else reject the project.

The calculation of IRR is a very cumbersome process as it can only be done by hit and trial method. Only once we have a fair idea about where the IRR will be we can use the unitary method to calculate a more good approximate value of the IRR. It is always advisable to calculate IRR using Microsoft Excel or using a financial calculator as it saves a lot of time.

Example:

Calculate the IRR of each of the following project and comment which one should be accepted:

Year Project A Project B Project C

-3000 -3000 -3000

1500 300 1000

2 1200 900 1000

900 1200 1000

300 1800 1000

Solution:

IRR Project A = 14.48%

IRR Project B = 11.79%

IRR Project C = 12.58%

According to IRR criteria Project A must be chosen as it has got the highest IRR.

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