Lecture 14 & 15: Internal Rate of Return

Steven Golbeck
Northwestern University, Department of Industrial Engineering & Management Sciences

April 30 & May 2, 2012

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Internal Rate of Return
Internal Rate of Return (IRR) is the interest rate at which the benefits are
equivalent to the costs, or in other words, the NPV is equal to 0.
Example
A relative invests $5000 at the end of every year for a 40-year career. If they want $1
million (actual dollars) in savings at retirement, what interest rate must the
investment earn?
We want to determine r such that:
F =

39
X

5000(1 + r)39k = 1, 000, 000

k=0

or:

5000

(1 + r)40 1
r


= 1, 000, 000

Using the Excel SOLVER, we find that r = 7%.

So your relative must earn a rate of return equal to 7% in order to have that
much money in the bank upon retirement.
Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Example
7% is the IRR associated with a cashflow stream of:
(x0 , x1 , , x39 , x40 ) = (0, 5, 5, , 5, 1000 5)
That is, the NPV of this cash flow stream is equal to 0 for r = 7%. The present
value of all the payments into the savings account is equivalent to the lump sum
received at retirement.
Note that if your relative invested at a lower rate, they would have less upon
retirement. If your relative invested at a higher rate, they would have more upon
retirement.

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

What is IRR?
The Internal Rate of Return (IRR) of a cash flow stream:
(x0 , x1 , , xn1 , xn )
is defined as the rate i such that NPV=0 using i as the discount rate:
n
X
k=0

xk
=0
(1 + i)k

IRR has different interpretations depending upon the form of the cash flows:
1

Investment stream (first xk < 0 then xj > 0): the IRR is the rate of return on
the investment.

Borrowing stream (first xk > 0 then xj < 0): the IRR is the rate of cost, or rate
of financing.

So in one case, a high IRR is desirable (investment), whereas in the other case, a low
IRR is desirable (borrowing). We will mainly focus on investment streams.

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Why Use IRR?
IRR is widely used for evaluation of cash flow streams.
When talking about the profitability of an investment, people often think in terms
of the rate of return. IRR is a single rate, which makes it intuitive to understand.
The calculation of IRR does not depend on any external rate (hence called
internal), but only depends on the cash flow stream itself.

Figure: J. R. Graham and C. R. Harvey, The Theory and Practice of Corporate Finance: Evidence
from the Field, Journal of Financial Economics, MayJune 2001, pp. 187244.

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Equivalence to NPV Analysis

For both investment and borrowing stream, the IRR analysis is equivalent to NPV
Analysis.
INVESTMENT STREAM: NPV is decreasing function of discount rate r. Since
NPV(IRR)=0:
IRR > r if and only if NPV(r) > 0
BORROWING STREAM: NPV is increasing function of discount rate r. Since
NPV(IRR)=0:
IRR < r if and only if NPV(r) > 0

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

How to Calculate IRR
Typically done numerically, but sometimes it can be done by hand:
Use the Excel function: IRR(stream values, guess)
Use the Excel SOLVER (more on this later).
If n <= 2 (no more than 2 periods), you can calculate IRR by solving a quadratic
equation.
Question: Is there always a solution (real number) to the equation NPV(r)=0? Is the
solution always unique?
Consider the stream (x0 , x1 , , xn1 , xn ), if there is only 1 sign change, then
IRR exists and is unique.
A cash flow stream with only 1 sign change is either the investment stream or the
borrowing stream.
Determining and interpreting the IRR values associated with more complex cash flow
streams is beyond the scope of what we will cover, but it can be done (Prof. Hazen of
IEMS has done research on this topic)

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Example
A local firm sponsors a student loan program for the children of employees. No
interest is charged until graduation, and then the interest rate is 5%. Maria borrows
$9000 per year, and she graduates after 4 years. Since tuition must be paid ahead of
time, assume that she borrows the money at the start of each year.
If Maria makes five equal annual payments, what is each payment?
What is the IRR associated with Maria taking the loan?
Does the IRR indicate that this is an attractive arrangement for Maria?

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Example
A local firm sponsors a student loan program for the children of employees. No
interest is charged until graduation, and then the interest rate is 5%. Maria borrows
$9000 per year, and she graduates after 4 years. Since tuition must be paid ahead of
time, assume that she borrows the money at the start of each year.
If Maria makes five equal annual payments, what is each payment?
What is the IRR associated with Maria taking the loan?
Does the IRR indicate that this is an attractive arrangement for Maria?
The payments she makes are just those of a 5 year annuity with interest rate r = 5%
and Principal of P = $36, 000:

A = rP 1

1
(1 + r)5

1
= $8, 315.09

The cash flow stream is:

Year
Cash Flow

0
9000

1
9000

2
9000

3
9000

Steven Golbeck

4
0

5
-8315

6
-8315

7
-8315

Lecture 14 & 15: Internal Rate of Return

8
-8315

9
-8315

Rate of Return Analysis

Year
Cash Flow

0
9000

1
9000

2
9000

3
9000

4
0

5
-8315

6
-8315

7
-8315

8
-8315

To determine the IRR, we solve for i such that the NPV of the cash flow stream is
equal to 0:
9
X
xi
=0
(1
+
i)k
k=0
In this case we can write this as:




1
9000
1
8315
1
9000 +
1

=0
i
(1 + i)3
(1 + i)4 i
(1 + i)5
Using Excel SOLVER, we obtain i = 2.66%.
The IRR represents the interest rate that makes the benefits received from the
loan equal to the payments she makes to pay it off.
In this case, the IRR< 5%, the interest rate that goes into effect after she
graduates, so Maria got a good deal on the loan.
Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

9
-8315

Rate of Return Analysis

Example
A corporation can pay for its liability insurance on an annual or quarterly basis. If paid
quarterly, the insurance costs $10,000. If paid annually, the insurance costs $35,000.
What is the IRR associated with paying in quarterly installments?

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Example
A corporation can pay for its liability insurance on an annual or quarterly basis. If paid
quarterly, the insurance costs $10,000. If paid annually, the insurance costs $35,000.
What is the IRR associated with paying in quarterly installments?
The corporation gets annual coverage either way, but if they pay in installments,
they are being charged interest since 4 10, 000 = 40, 000 > 35, 000.
You can think of insurance company loaning the corporation $35,000, and
financing it at an annual rate i compounded each quarter, with 4 equal
installments paying it off.
The rate i is the IRR, that is, the rate that makes the PV of the installment
payments equal to $35,000
#
"
10000
1
35000 = 10000 +
1

i
(1 + 4i )3
4
Using Excel SOLVER, we obtain that i = 0.388, so the annual interest rate
compounded quarterly that the insurance company is charging is 38.8%.
Clearly unless the corporation has no cash or cannot obtain a loan at a lower rate,
they should pay the upfront lump sum.
Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Incremental IRR
Suppose we are considering multiple investments, each with a different upfront
cost, x0 .
To determine which investment we should take on, we can perform Incremental
IRR analysis.
The idea is that you should continue to invest as long as each additional
increment of investment exceeds the MARR, assuring profit when taking into
account the cost of capital (here the MARR).
Intuition
Suppose you have project A and B, with B having a higher initial upfront cost.
Write B = A + (B A).
You can think of B as the cash flow from A plus an incremental return given by
B A.
If A has a desirable IRR, and B A has a desirable incremental IRR, then we
should make the larger investment in B.

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Incremental IRR
Here are the steps to determining which of several investments to choose by
computing incremental IRR:
1

First rank the alternatives in increasing order of the initial investment.

Compute the IRR of the option with the smallest initial investment. If the IRR
exceeds the MARR, then this is a viable investment. If IRR<MARR, it is not
viable and you should consider the option with the next smallest initial
investment. (if no IRR>MARR, none are viable).

When you have found an option with IRR>MARR, determine the internal rate of
return associated with the increment of investment required to move from the
current attractive investment option to the one requiring more initial investment.

If the IRR associated with this, called the incremental IRR, exceeds the MARR,
then the higher investment alternative is preferred and this becomes the preferred
alternative.

Continue to compute the incremental IRR associated with going from the
preferred alternative to the one with the higher initial investment.

When you have exhausted all alternatives, your investment decision is the
preferred alternative.

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Example
You are considering two projects for investment, and you can only invest in one:
Year
0
1

A
-10
15

B
-20
28

You have $30 in capital and any funds you do not invest in these projects may be
invested elsewhere at the MARR of 6%. Which should you choose?

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Example
You are considering two projects for investment, and you can only invest in one:
Year
0
1

A
-10
15

B
-20
28

You have $30 in capital and any funds you do not invest in these projects may be
invested elsewhere at the MARR of 6%. Which should you choose?

Year
0
1

A
-10
15

B
-20
28

B-A
-10
13

The IRR associated with B-A is found from:

0 = 10 + 13/(1 + i) = i = 0.30
Since i = 0.30 > 0.06 =MARR, we should invest our money in B.
If you rank according to IRR, A has a higher IRR than B, but alternative B has a
larger initial investment at which you earn an IRR higher than the MARR (recall
that any money you do not allocate to projects only earns the MARR of 6%).
Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Example
A firm is considering which of two devices to install to reduce costs. The firm can only
install one device. Both devices have useful lives of 5 years and no salvage value. If
the MARR is 7%, which device should they install?
Year
0
1
2
3
4
5

A
-1000
300
300
300
300
300

Steven Golbeck

B
-1350
375
375
375
375
375

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Example
A firm is considering which of two devices to install to reduce costs. The firm can only
install one device. Both devices have useful lives of 5 years and no salvage value. If
the MARR is 7%, which device should they install?
Year
0
1
2
3
4
5

A
-1000
300
300
300
300
300

B
-1350
375
375
375
375
375

First determine the IRR of A:

0 = 1000 +



300
1
1
iA
(1 + iA )5

which yields iA = 0.15 which exceeds the MARR.

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Example
Next, do the Incremental IRR analysis:
Year
0
1
2
3
4
5
0 = 350 +

A
-1000
300
300
300
300
300
75
iBA

B
-1350
375
375
375
375
375

1

B-A
-350
75
75
75
75
75
1

(1 + iBA )5

which yields iBA = 0.02, which is smaller than the MARR, so choose alternative A.

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Rate of Return Analysis

Summary
You can use IRR analysis for acception-rejection decisions when the cash flow
streams are either of the investment or borrowing type.
When ranking mutually exclusive alternatives (you can only select one of the
projects), use incremental analysis.
For more complicated cash flow streams (more than one sign change), IRR
analysis is more subtle. NPV analysis is likely easier.

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Capital Budgeting

Funding Multiple Projects

So far we only considered the possibility of funding a single project.
Suppose we have a fixed budget, and can allocate it to multiple projects, with
any remaining funds invested at the MARR.
To make the optimal set of investments, we need to go beyond basic NPV/IRR
analysis.
We need to use basic integer programming.

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Project
1
2
..
.
n-1
n

Upfront Cost
(ci > 0)
c1
c2
..
.
cn1
cn

NPV
(bi > 0)
b1
b2
..
.
bn1
bn

Let xi be a variable equal to 0 or 1 with the interpretation that:


0 Do not invest in Project i
xi =
1 Invest in Project i
Given a fixed budget of C, the optimal investment allocation (the set of xi = 1 and
0), is found by solving:
maximize

subject to:

n
X
i=1
n
X

b i xi
c i xi C

i=1

xi = 0 or 1 for i = 1, 2, n
Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Capital Budgeting
Project
1
2
3
4

Upfront Cost
500
400
200
300

PV(future cash flows)

800
600
270
385

NPV
300
200
70
85

Example
We are considering 4 projects, but only have a budget of 1000. Which should we
fund?
The problem is set up as:
maximize
subject to:

300x1 + 200x2 + 70x3 + 85x4

500x1 + 400x2 + 200x3 + 300x4 1000
xi = 0 or 1 for i = 1, 2, 3, 4

We will use Excel SOLVER to determine which projects to fund. See

CapitalBudgeting.xlsx.
The result is that we invest in Project 1 and 2, such that x1 = x2 = 1 and
x3 = x4 = 0 with a total upfront investment of 900 and NPV of 500.
Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Capital Budgeting

Interdependent Projects
Now suppose we have multiple investment opportunities, but for each opportunity
there are multiple options.
Example:
We can invest in a production line, but can only choose one type of machine from
several alternatives
In addition, we can invest in R&D, but only fund at most one project.

We have to expand upon the framework we introduced for capital budgeting.

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

OPTION
1
2
..
.
n1 1
n1

PROJECT 1
Upfront Cost
c11
c12
..
.
c1(n1 1)
c1n1

NPV
b11
b12
..
.
b1(n1 1)
b1n1

OPTION
1
2
..
.
nm 1
nm

PROJECT m
Upfront Cost
cm1
cm2
..
.
cm(nm 1)
cm,nm

NPV
bm1
bm2
..
.
bm(nm 1)
bm,nm

Here we have m possible projects/investment opportunities, and for each one we

have ni options, where i labels the project under consideration.
Suppose that for each project, we can fund 0 or 1 of the options.
Let xij be a variable equal to 0 or 1 with the interpretation that:

0 Do not invest in Option j of Project i
xij =
1 Invest in Option j of Project i

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return

Interdependent Capital Budgeting

Here we have m possible projects/investment opportunities, and for each one we
have ni options, where i labels the project under consideration.
Suppose that for each project, we can fund 0 or 1 of the options.
Let xij be a variable equal to 0 or 1 with the interpretation that:

0 Do not invest in Option j of Project i
xij =
1 Invest in Option j of Project i
Given a fixed budget of C, the optimal investment allocation (the set of xi = 1
and 0), is found by solving:

maximize

ni
m X
X

bij xij

i=1 j=1

subject to:

ni
m X
X

cij xij C

i=1 j=1
ni
X

xij = 0 or 1, for all i

j=1

xij = 0 or 1, for all i, j

Steven Golbeck

Lecture 14 & 15: Internal Rate of Return