Computing Internal Rate of Return

Steps for computing Internal Rate of Return:

Case 1: When cash inflows are equivalent to the life of asset:

Ist Step: When any asset will give equivalent return, then you can simply compute present value factor by dividing initial cash outflow with the yearly cash inflow.

Present Value Factor = Initial Investment cost / annual cash flow

Assume initial investment cost = Rs. 50000
Life of the asset = 5 years
Estimated yearly cash flow = Rs. 12500
Present Value factor = 50000/12500 = 4

IInd Step: Then we will observe present value annuity table and with this we can determine the value of IRR.
As we observe from the present value annuity table that 8% for 5 years period, the current value is 3.99 or around 4.

Therefore, internal rate of return is 8%

We will compare this rate with the cut off or minimum standard rate of return and when this rate is more than minimum rate then this proposal is accepted.

Case 2: Whenever the annual cash flows are unequal over the life of assets and current value of cash inflows and cash outflows will equivalent at particular rate :-

Second condition is completely on the basis of hit and trial. This condition is similar to experiment in laboratory. A few people know I had worked in chemical science lab, where my boss scientist always prepared some mixture for invention and he ordered me to mix chemical and 90% his experiment failed however he did not drop his confidence. Similar to this, finance manager has to suppose the rate. Suppose it might be 5%, 6% or more and then he has to find factor value of this rate and multiply it with the real value of cash inflows and cash outflows. When both are equivalent at particular rate that, that rate will be internal rate of return.

Case 3: Whenever the annual cash flows are unequal over the life of  assets and current value of cash inflows and cash outflows will equivalent among two rates :-

There is minimum possibility of second situation where total present value will be zero. Some time present value of cash inflows might excess from present value of cash outflow or sometime cash outflow might excess from cash inflows, then we will compute internal rate of return on the following formula:
IRR = Lower rate + [(NPV at lower rate)/(NPV at lower rate - NPV at higher rate)] X (Higher rate - Lower rate)

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