Managerial Accounting 8.3: Internal Rate of Return (IRR) - YouTube

This is Kurt Heisinger, accounting professor  at Sierra College and author of Managerial  

Accounting. This video describes how to use the  internal rate of return or often referred to as  

IRR method to evaluate long-term investments.  If you haven't already looked at my net present  

value video you should look at that first before  we get into this method as this relates very  

closely to the net present value method. So the  internal rate of return does consider the time  

value of money, that's an important element of  the internal rate of return, and it represents  

the time adjusted rate of return, time adjusted  meaning it can be over a long period of time  

and we have to figure out what those dollars are  worth today and what that rate looks like today, in  

today's dollars. So it's the time adjusted rate of  return for the investment that is being considered.  

And these are long-term investments. These are  investments over say five or ten years. Things  

like, the consideration of building a  manufacturing facility somewhere, and does it  

make sense to do that. The internal rate of return  is the rate required to get the net present value  

to zero. So again take a look at the net present  value video to see how that's done. And then what  

we're doing here is trying to find the rate that  is needed to get a net present value of zero. And  

we will talk about that further a little bit later.  If the internal rate of return, that is stated as a  

rate, if the internal rate of return, the IRR,  is greater than the company's required rate  

of return then we accept the investment. We would  take it on. If the internal rate of return is less  

than the companies required rate of return  then we would reject the investment. So how  

do we calculate the internal rate of return. Most  managers do use some kind of spreadsheet software,  

such as Excel, to calculate the internal rate of  return. But we can also use trial and error. And  

we will talk about that here so you get a better  sense of what's going on. I always say it is

good to know what is going on in that black box  in that software. So we are going to take a look at  

doing this through trial and error, so you see  exactly how the internal rate of return is  

determined. The goal as I stated earlier  is to find the rate that generates a net present  

value, so we are trying to find right, that generates a  net present value of zero. And then once we have  

the rate we might do this for multiple projects,  and if those projects probably would weed out  

the projects that have an internal rate of return  that's greater than our company's required rate of  

return, and then once we do that and we see the  acceptable projects we might use the internal  

rate of return to rank those projects. So maybe  our, for example, required rate of return is 10%,  

and we have a project that we expect after finding  the internal rate of return to have an IRR of let's  

say 14%, maybe there is another project that has an  IRR of 16%, another one that has 25%. So we might  

use those rates also to rank those investments.  It does not mean we are going to necessarily pick  

the highest, the one that has the highest, internal  rate of return but that's a consideration for us.

Here is an example that we will use to determine  the internal rate of return and then ultimately  

to determine whether we want to take on this  long-term investment. This is the exact same  

example that I used for the net present value  example. So again go take a look at that video  

before you watch this one, and you will see the same  information and you'll have a better sense of what  

we're trying to accomplish here for the internal  rate of return. The example is we are Jackson's  

Quality Copies, we make copies for customers among  other things. And we are looking at purchasing a new  

copy machine. Our required rate of return, this  is very important, our required rate of return as  

a company is 10%. I talked again in the previous, in  the net present value video, about how to determine  

the required rate of return. So we have already done  that and if we have a project that yields a return  

an internal rate of return higher than 10%, then  we will go ahead and take it on, but if it is lower  

than 10% we won't. So that is our required rate  of return. Here are the cash flows. We are going  

to pay $50,000 for this new copier. It is going to last about 7 years. Annual maintenance costs,  

annual maintenance costs, will be $1,000 a year, and  then labor cost savings will be $11,000 a year. And  

we plan to sell this copier at the end of 7 years,  probably get a new one at that point. So we plan  

to sell this copier at the end of 7 years for  $5,000. These are our cash flows and let's map  

this out then on the next slide and determine what  our internal rate of return is. Now the goal is  

to find the rate that will yield a net present  value of 0, or approximately zero. This is going

be through trial and error. In Excel we could  find the exact rate, but here we will just find an  

approximation. Again take a look at the net present  value lecture that I've posted. That will give you  

much more information on how to find the net  present value. So I am not going to focus on that  

here. This is more about how to find the internal  rate of return, assuming that you know  

how to find already the net present value. So what  you see here, we are finding the internal rate of  

return, what you see here is the net present value  calculation using three different rates. So the  

first rate is 10%, and the net present value is  positive at 1,250 with a rate of 10%. Again  

we are trying to get the net present value as  close to zero as possible. And whatever rate is  

required to do that then becomes our internal rate  of return. So we are going to raise the rate because we  

want the net present value to go down, right. It is  positive here at 10%. And again this is trial and  

error. We just happen to start with 10%. So we are  going to raise the rate and see what our net present  

value is, knowing that the net present value will  go down from that 1,250 positive number. Then we go  

to 11%, we try 11%, and that gives us a net present  value number that is negative at 469. And what  

that means is, that the internal rate of return is  somewhere between these two rates, between 10% and  

11%, because at 10% our net present value is $1,250  positive and at 11% our net present value  

is $469 negative. So our internal rate of return  remember is the rate required to get a net present  

value of 0. And you'll see that we are very close.  It is somewhere in between here, it is somewhere in  

between 10 and 11%. As a result from this analysis  we can say that the internal rate of return is  

between 10% and 11%. And that is the best we can do  right now using trial and error, and the tables that are  

typically provided in a managerial accounting  textbook. The final step here then is to compare  

the internal rate of return to the company's  required rate of return, often called a hurdle rate.  

And the company as I mentioned on the previous  slide, the company's required rate of return is  

10%. Since this project is expected to yield an  internal rate of return that's higher than that,  

between 10 and 11%, we as a company would go ahead  and accept this investment. If the rate happened  

to be, internal rate of return, happen to be lower  than 10%, then we would reject this investment.