Internal Rate of Return
The time adjusted (or internal) rate of return may be defined as the maximum rate of interest that could be paid for the capital employed over the life of an investment without loss on the project (National Association of Accountant, U.S.A.). Alternatively internal rate of return may be defined as the discounting rate that makes the present value of project (future cash flows) equal to the cost of project.
This method of D.C.F. is to be used when (a) the cost of investment and (b) the annual cash inflows are known, while the unknown rate of earnings (or discount rate) is to be calculated. Here, each year’s receipt is treated as a separate variable because, amount remaining the same, the discounted cash flows will be different time elements. Thus, in the language of compound interest, the internal or time-adjusted rate of return will be that rate which the present values of cash inflows and outflows offset each other.
The determination of this rate of return is one of the difficult problem connected with this method and involves a trial –and-error procedure using present value table. The two or three different rate. The rate at which the total present value of all future cash inflows will be equal to the initial cost of investment is the internal rate of return. It represents the maximum cost of capital for which the firm could go for financing the project. If this cost the cut off rate is given a project. Will be accepted only when the internal rate is more than, or equal to this rate or else it will be rejected. The ranking of different project shall be done, on the basis of the internal rate of return in descending order (higher the internal rate, better the project).
When the cash flow stream is an even series that is, the same each year, there really is no need for trial and error or for discounting each year’s cash flow separately for calculating the internal rate of return. We simply divide the initial outlay by the annual cash flow and search for the nearest discount factor for the given number of years in the Annuity Table (No. 11 given at the end of this lesson) showing present value of Re 1 received annually.