Internal Rate Of Return (IRR) Technique: A Reliable Project Evaluation Method

6 Pages / 1,462 Words Published On: 09-02-2021

Question:

Now that they have accumulated a deposit of $61,000, Rex and his partner Rhonda wish to use the deposit and take out a housing loan to purchase a home. The house costs $666,000. The loan is to be repaid in equal monthly instalments over a term of 25 years. Rhonda recalls that the interest rate quoted by the bank is an annual nominal rate of 6.5%pa. Rex has misplaced the paperwork showing the annual effective rate, so you may need to work this out. Interest is added monthly. They would like to know:

a)How much is the monthly repayment?

b)How much interest will be paid in the 104th repayment?

c)How much would Rex and Rhonda owe the bank immediately before making the 200th repayment?

1) “The Internal rate of return (IRR) technique is reputed to be one of the most reliable project evaluation methods there is.”

2) Discuss and compare the attributes that give the IRR method its reliability and assess its capacity to price real options.

3) Your answer should be in long-form, and of approximately 1000 words.

Answer:

Question 1:

Que 1 a)
Calculation of monthly payment
Loan	$ 605,000.00
Tenure (months)	300
Interest rate monthly	0.54%
EMI	$4,085

Que 1 b)
The interest amount after 104th EMI
EMI No.	Opening balance loan	EMI	Interest	Closing balance loan
104	493969.3	4085.003	2675.667	492560

Que 1 c)
Owed money from bank after 200th payment
EMI No.	Opening balance loan
201	314762.3

Question 2:

0	1	2	3	4	5	6	7	8	9	10	11	12	13	14	15
															123,750
		-$1,138.26	-$1,199.15	-$1,263.31	-$1,330.90	-$1,402.10	-$1,477.11	-$1,556.14	-$1,639.39	-$1,727.10	-$1,819.50	-$1,916.84	-$2,019.39	-$2,127.43	0

EMI No.	Opening balance loan	EMI	Interest	Closing balance loan
1	119750	6406.625	$5,404.90	$114,345.10
2	$114,345.10	$6,117.46	$5,694.07	$108,651.03
3	$108,651.03	$5,812.83	$5,998.70	$102,652.33
4	$102,652.33	$5,491.90	$6,319.63	$96,332.70
5	$96,332.70	$5,153.80	$6,657.73	$89,674.97
6	$89,674.97	$4,797.61	$7,013.92	$82,661.05
7	$82,661.05	$4,422.37	$7,389.16	$75,271.88
8	$75,271.88	$4,027.05	$7,784.48	$67,487.40
9	$67,487.40	$3,610.58	$8,200.95	$59,286.45
10	$59,286.45	$3,171.82	$8,639.70	$50,646.74
11	$50,646.74	$2,709.60	$9,101.93	$41,544.81
12	$41,544.81	$2,222.65	$9,588.88	$31,955.93
13	$31,955.93	$1,709.64	$10,101.89	$21,854.04
14	$21,854.04	$1,169.19	$10,642.34	$11,211.70
15	$11,211.70	$599.83	$11,211.70	$0.00


EMI No.	Opening balance loan	EMI	Interest	Closing balance loan
1	123750			$123,750.00
2	$123,750.00	$6,620.63	$6,832.32	$116,917.68
3	$116,917.68	6255.09563	$7,197.85	$109,719.82
4	$109,719.82	5870.01043	$7,582.94	$102,136.88
5	$102,136.88	5464.32318	$7,988.63	$94,148.26
6	$94,148.26	5036.93166	$8,416.02	$85,732.24
7	$85,732.24	4586.67469	$8,866.28	$76,865.96
8	$76,865.96	4112.32897	$9,340.62	$67,525.34
9	$67,525.34	3612.60576	$9,840.34	$57,685.00
10	$57,685.00	3086.14736	$10,366.80	$47,318.19
11	$47,318.19	2531.52343	$10,921.43	$36,396.77
12	$36,396.77	1947.22712	$11,505.72	$24,891.05
13	$24,891.05	1331.67096	$12,121.28	$12,769.77
14	$12,769.77	683.182545	$12,769.77	$0.00

Question 3:

Que 3 a)
Calculation of rate

Maturity Price	98980
Time (days)	90
Face value	100000
Rate	4.25%

Que 3 a)
Calculation of effective annual rate and price

Maturity Price	98980
Time (days)	90
Face value	100000
Rate	4.25%
Effective annual yield	18.11%
Price	18114.78


Que 3 a)
Calculation of effective annual rate and price

Maturity Price	98980
Time (days)	90
Face value	100000
Rate	4.25%

These rates are different from each other because of the different concepts. Such as, the effective annual yield explains about the annual rate of the business while the effective yield brief about the rate for the maturity period of the bill.

Question 4:

Current price of Yield:

Bond	Term to maturity (years)	Coupon rate (% p.a.)	Face value	Current Yield (%)	Current price
A	3	8	$ 100	7%	$81.63
B	4	10	$ 100	7%	$76.29
C	5	12	$ 100	7%	$71.30

Calculation of duration of each bond:

Calculation of Duration
	A	B	C
Bond price	$81.63	$76.29	$71.30
Time	3	4	5
P.V. Factor	0.8163	0.7629	0.7130
P.V.	$66.63	$58.20	$50.83
Fair value	$ 100	$ 100	$ 100
Duration (time)	0.67	0.58	0.51

Calculation of current price:

Bond	Term to maturity (years)	Coupon rate (% p.a.)	Face value	Current Yield (%)	Current price
A	3	8	$ 100	8%	$79.38
B	4	10	$ 100	8%	$73.50
C	5	12	$ 100	8%	$68.06

It explains that the changes into the market interest rate would also affect the market price of the bond.

Question 5:

“The Internal rate of return (IRR) technique is reputed to be one of the most reliable project evaluation methods there is.” In case of capital budgeting, huge number of approaches is there to evaluate any business project or other approaches of the business each of the capital budgeting process has its own advantages and disadvantages. If all the other factors of the business are equal, than mainly IRR and NPV valuation model are applied by the businesses to reach over a conclusion about the acceptance or not acceptance of the business. The great strength of IRR method is that it uses one single discount rate to measure the project and the investment proposal f the business.

IRR is a metric which assists the business to evaluate the total profitability from the potential project or the investment of the business. IRR is a discount rate that makes the NPV of all the cash flows of a specific investment proposal to zero. The calculations of IRR rely on the below formula:

(Kaplan and Atkinson, 2015)

If through applying a specific %, the NPV becomes zero than that particular % is internal rate of return of the project. This rate of return is compared with the cost of capital of the business to measure that whether the business would be able to generate more profits than the cost of the business. Higgins (2012) has considered that this is the finest approach of capital budgeting process because the outcome from this technique makes it simple for the business to evaluate that whether the project must be accepted by the business or not.

If the internal rate of return of the project is higher than the cost of capital of the business then the project should be accepted or vice versa. In some of the cases, the NPV of the project is quite higher but the IRR rate is lower than the cost of capital, it explains that the project would generate the profits but the level of profits are lower than the total cost of the business.

Krantz, (2016) has also explained into his study that IRR is the reliable technique because it takes the concern on all the related factors of the business to measure that whether the investment proposal would be better for the company or not. Generally, the higher the internal rate of return of a project would be the more desirable the project would be to undertake. Internal rate of return approach could be used to rank the multiple investment proposals on a relatively even basis which makes it easier for the organization to make better decision about the performance of the business. Assume that the investment cost are equal among the projects, the investment proposal with the huge IRR would probably be considered the best project and must be undertaken by the business firstly.

The Kinsky (2011) has expressed that the IRR method is more reliable than other approaches of capital budgeting because of the following points:

Time value of money:

The one of the most important thing in the IRR approach is that it takes the concern of accounting rate of return to measure the acceptability of the project which makes it more reliable and the outcome gives a good base to the company to make a better conclusion.

Simplicity:

The most attractive thing about the IRR approach is that it is very simple to interpret and it is quite simple for the business to visualise for the managers that why this project must be accepted. It takes the concern of related figures measure the acceptability of the project which makes it more reliable and the outcome gives a good base to the company to make a better conclusion (Kurth, 2013).

Hurdle rate:

Hurdle rate is a subjective thing to decode. The hurdle rate is not required to find in the IRR approach. It is not dependent on the hurdle rate and thus it becomes easier for the business to rely on the related outcome of the business which makes it more reliable and the outcome gives a good base to the company to make a better conclusion.

Required rate of return is rough estimate:

Required rate of return is a rough estimated which is used by the business and the managers to evaluate the project (Lee and Lee, 2006). The required rate of return is not required to find in the IRR approach. It is not dependent on the required rate of return and thus it becomes easier which makes it more reliable and the outcome gives a good base to the company to make a better conclusion.

IRR is the reliable technique because it takes the concern on all the related factors of the business to measure that whether the investment proposal would be better for the company or not (Lord, 2007). Generally, the higher the internal rate of return of a project would be the more desirable the project would be to undertake.

The above approaches and the points explain that the IRR approach is one of the most reliable techniques to measure that whether the project should be accepted by the business or not. The great strength of IRR method is that it uses one single discount rate to measure the project and the investment proposal of the business which could be compared with the cost of capital of the business to measure the difference between the total cost and the total return of the business. IRR is a metric which assists the business to evaluate the total profitability from the potential project or the investment of the business. IRR is a discount rate that makes the NPV of all the cash flows of a specific investment proposal to zero. So, it could be concluded that the IRR approach is one of the significant approach to reach over a conclusion about the performance of the business.

References:

Higgins, R. C., 2012. Analysis for financial management. McGraw-Hill/Irwin.

Kaplan, R.S. and Atkinson, A.A., 2015. Advanced management accounting. PHI Learning.

Kinsky, R. 2011. Charting Made Simple: A Beginner's Guide to Technical Analysis. John Wiley and Sons.

Krantz, M. 2016. Fundamental Analysis for Dummies. London: John Wiley and Sons.

Kurth, S. 2013. Critical Review about Implications of the Efficient Market Hypothesis. GRIN Verlag.

Lee.C.F and Lee, A, C,.2006. Encyclopedia of finance, Springer science, new York

Lord, B.R., 2007. Strategic management accounting. Issues in Management Accounting, 3.

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