time-adjusted rate of return (TARR)
Amit Shrivastava
rate earned on a proposal. It is the rate of interest that equates the initial investment (I) with the present value (PV) of future cash inflows. That is, at IRR, I = PV. or NPV (net present value) = 0. Under the internal rate of return method, the decision rule is: accept the project if IRR exceeds the cost of capital; otherwise, reject the proposal.
For example, consider the following data:
| Initial investment | $16,200 |
| Estimated life | 10 years |
| Annual cash inflows | $ 3000 |
| Cost of capital (minimum required of return) | 10% |
| Set up the following equality (I = PV): |
|
| $16,200 = $3000 × PV |
|
Then PV = $16,200/$3000 = 5.400, which stands somewhere between 12% and 14% in the 10-year line of table 4 in the back of the book. Because the investment's IRR (13.15%) is greater than the cost of capital (10%), the investment should be accepted.
The IRR method is easy to use as long as cash inflows are even from year to year. Where cash flows are uneven, the IRR must be determined by trial and error. Assume, for example, that a company is considering an investment project that promises cash inflows of $400,000, $600,000, and $1,000,000 for each of the next three years for a given investment of $1,490,000. The IRR is found by selecting a rate and discounting the cash inflows. If thePV is greater than I, select a higher rate until one is found that equates the PV of the cash inflows with I. In this example, the IRR is approximately 14%, determined as follows:
An advantage of the IRR method is that it considers the time value of money and is therefore more exact and realistic thanaccounting rate of returnDisadvantages are: (1) it fails to recognize the varying size of investment in competing projects and their respective dollar profitabilities, and (2) in limited cases, where there are multiple reversals in the cash-flow streams, the project could yield more than one internal rate of return.
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Thanks,
Dr. Amit Shrivastava
Asst. Professor -Finance & Accounting
Adani Institute of Infrastructure Management (AIIM)
Ahmedabad (Gujarat) INDIA
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