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Presentation on theme: "CAPITAL BUDGETING TECHNIQUES"— Presentation transcript:



3 IRR Definition: is the discount rate that generates a zero net present value for a series of future cash flows. This means that IRR is the rate of return that makes the sum of present value of future cash flows and the final market value of a project (or an investment) equal its current market value. Company Logo

4 IRR (Cond’t) Formula: CF0 + CF1/ (1+r)1+ CF2/ (1+r)2+ CF3/ (1+r)3+…+ CFn/ (1+r)n = 0 Where: IRR : denoted by ‘r’ CF: cash flow If IRR > = r Accept the project If IRR < r Reject the project Company Logo

5 IRR (Cond’t) The advantage :
- The target IRR is used to describe the attractiveness of the project because the IRR is an indicator reflects the profitability of the project, one hand it expresses the interest rate that the project brings on invested capital, on the other hand it shows the maximum interest loan rate which the project can accept it. Company Logo

6 IRR (Cond’t) Disadvantage:
- The application of this criterion may not be accurate if the account exists to balance negative cash flows (NCF) significantly during project operation. At that time the project’s NPV will change sign several times when it discounted at various discount rates and whenever it changes mark leads to a different IRR was determined that we do not know what is the proper value for the assessment Company Logo

7 NPV NPV is the sum present value of the net income that the project brings in its life cycle. In other words, NPV is used in capital budgeting to analyze the profitability of an investment or project. Formula : NPV = ∑Ct/ (1+r)t – C0 - If NPV > = 0 Accept the project - If NPV < Reject the project Company Logo

8 BULLOCK GOLD MINING Seth Bullock, the owner of Bullock Gold Mining, is evaluating a new gold mine in South Dakota. Dan Dority, the company’s geologist, has just finished his analysis of the mine site. He has estimated that the mine would be productive for eight years, after which the gold would be completely mined. Dan has taken an estimate of the gold deposits to Alma Garrett, the company’s financial officer. Alma has been asked by Seth to perform an analysis of the new mine and present her recommendation on whether the company should open the new mine. Company Logo

9 BULLOCK GOLD MINING Alma has used the estimates provided by Dan to determine the revenues that could be expected from the mine. She has also projected the expense of opening the mine and the annual operating expenses. If the company opens the mine, it will cost $ 725 million today, and it will have a cash outflow of $80 million nine years from today in costs associated with closing the mine and reclaiming the area surrounding it. The expected cash flows each year from the mine are shown in the table. Bullock Mining has a 12 percent required return on all of its gold mines. Company Logo

10 BULLOCK GOLD MINING Year Cash Flow 0 -$725,000,000 1 90,000,000
$725,000,000 ,000,000 ,000,000 ,000,000 ,000,000 ,000,000 ,000,000 ,000,000 ,000,000 ,000,000 Company Logo

11 BULLOCK GOLD MINING 1.Construct a spreadsheet to calculate the internal rate of return (IRR) and net present value (NPV) NPV = $ 28,373,022 > 0 IRR = 13% > r = 12% (required return) 2.Based on the analysis, should the company open the mine? → The project is high economic effective and is accepted. In other words, the company should open the mine. Company Logo

12 CONCLUSION : The IRR is the discount rate that makes the estimated NPV of an investment equal to zero; it is sometimes called the discounted cash flow (DCF) return. The IRR rule is to take a project when its IRR exceeds the required return. IRR is closely related to NPV , and it leads to exactly the same decisions as NPV for conventional, independent projects. Company Logo

13 CONCLUSION (Contd’) When project cash flows are not conventional , there may be no IRR or there may be more than one. More seriously, the IRR can not be used to rank mutually exclusive projects; the project with the highest IRR is not necessarily the preferred investment. Company Logo

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