Internal Rate of Return and Net Present Value
- 02:03
Understand the definition of Internal Rate of Return and Net Present Value
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Glossary
Discount Rate Discounting Investment AppraisalTranscript
Here we can see that this project has three cash inflows of 100, 103, and 106. If we discount those cash flows at a discount rate of 7%, we arrive at a present value of those cash flows of 93.5, 90.0, and 86.5 respectively. To arrive at the net present value, we simply deduct the present value of the investment, which is 220, giving an NPV of 49.9. The fact that this is positive is a good thing. It means the project is viable. Literally, the present value of the cash inflows is in excess of the initial investment at times zero. You'll also notice that Excel has a function for calculating the NPV. All you need to do is point it at the discount rate and the cash flows starting at year one, and it will calculate the sum of their present values. However, it's also worth noting that you'll also need to deduct any zero cash outflow as the function assumes that the first cash flow occurs in year one. If you think about how discounting works, an increase in the discount rate from 7% to say 8% would reduce the present value of the cash inflows and therefore reduce the NPV. So there must be a point when the discount rate increases to such an extent that the NPV becomes zero. This is referred to as the internal rate of return. Usefully Excel has an IRR function. Applying it to these numbers tells us the IRR is 18.9%. The fact that it's above the discount rate or the cost of financing is a good thing. You'll notice on the bottom right of the slide, the NPV has been recalculated at the IRR of 18.9%. As expected, this produces an NPV of zero. It should now be clear that if the NPV is positive at a given discount rate, then the IRR should also be above that discount rate as is the case in this example.