Capital Budgeting: Internal Rate of Return

As the name indicates the internal rate of return method indicates the rate of return associated with the project. This is the rate of return that an investor can expect to be returned from the project. In other words the internal rate of return can be determined as the interest yield by the project with the proposed capital spent upon the project when the NPV is zero. Hence the internal rate of return can use the data of NPV to find out the degree of profitability of a project. In order to accept financing for the project the internal rate of return of the project must be greater than or at least equal to the required rate of return of a company.

Internal Rate of Return of a project can be determined in two steps where in the first step the factor of internal rate of return is calculated by dividing the capital investment required for the project with annual net cash flows within the company. In the next step the calculated factor is compared in the Annuity Table by comparing the actual useful life of the project to the number of periods of that service life. The closest discount rate in the annuity table to that of the factor is the actual internal rate of return for that project. Due to this factor most of the time the Internal Rate of Return Method is also called as Trial Error method of budgeting.

 

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