By Jackie, Researcher

Topic: Education

Area of discussion: Finance; Management
& Cost Accounting

Chapter: Investment appraisal methods –
Internal Rate of Return (IRR)

The objectives of this research are to
analyze few different methods which are available to calculate Internal Rate of
Return. There are some advantages and disadvantages of using each method as
none of them are perfect. Basically, there are three types of methods which I
saw students often use in examinations and these methods are usually
recommended in any relevant academic text books too. They are trial and error
method, reverse calculation method, and linear interpolation method. For this
discussion, I have randomly taken one question from previous college’s
Management Accounting exam and I will apply all these three methods into the
same question and we shall see which method is more preferable, faster or
perhaps easier to use.

**Introduction**

Ideally, the Internal Rate of Return
(IRR) of an investment project is the cost of capital or required rate of
return which, when used to discount the cash flows of a project, it will
produce a net present value of zero.

Let’s take a look at this question:

__Trial and error method__

Only use
this method if there is no other better method available. It is very time
consuming and thus, not recommended in exams.

__Reverse calculation method__
Highly recommended (simplest and most direct approach) especially
when the discount factor is a whole number and the net cash inflow is the same
for every year. Not suitable for discount factor that comes along with decimals
as well as different annual net cash inflow.

__Linear interpolation method__

It is appropriate to use when two NPV points are known. It
is suitable for condition where the discount factor comes along with decimal
place or when the annual cash inflow is different. However, the main weakness
is “the further the two NPV points located from each other, the less accurate
and reliable the computed rate will be”. Thus, the computed figure can only
serve as approximation as it was not accurate.

We say ‘approximately’ since, in using linear interpolation we
have drawn a straight line between two points on a project NPV line that is in
fact a curve. The straight line will not cut the x-axis at the same place as
the project NPV curve, so the value we obtained by interpolation is not the
actual value of the IRR, but only an estimated value.

Illustration
of why the IRR estimated by a single linear interpolation is only an approximation
of the actual IRR of an investment project. |

__Additional support material: PVIFA’s table__

**Additional readings, related links and references:**

Calculating
Internal Rate of Return Using Excel or a Financial Calculator

How to
calculate Internal Rate of Return (IRR), and when is the time and in what
situation IRR is not recommended to use?

Advantages
and disadvantages of Internal Rate of Return (IRR)

Finding
Internal Rate of Return (IRR) using Excel

Calculating
Internal Rate of Return (IRR) and Net Present Value (NPV) using Excel

http://www.youtube.com/watch?v=xzqpfpq6vSk&feature=related
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