In the previous article on NPV, we noted that a positive NPV denotes that a project can be accepted as it generates excess returns over its cost of finance. Hence, vice-versa, we cannot accept a negative NPV as it cannot generate a return above the cost of finance.
How do we then interpret a zero NPV
Zero NPV is actually the Internal Rate of Return which is therefore the discount rate that causes:
The present value of all the future cash flows – the present value of the initial outlay to yield an NPV of zero.
Using the same cash flow’s details from the NPV case, we shall try to get the IRR:
| Year O | Year 1 | Year 2 | Year 3 | Year 4 | |
| Initial Outlay (a) | $100K | ||||
| Net cash-flows (b) | $20.00K | $30.00K | $40.00K | $50.00K | |
| Using PV factor of 10% NPV= | +$7.15K | ||||
| Simulating it : | |||||
| Using PV factor of 15% NPV= | +$0.5K | ||||
| Using PV factor of 12% NPV= | $0.00K |
To calculate the Internal Rate of Return, we can either use the interpolation method which is to take two discount rates, one rate that gives a positive NPV and another discount rate that give a negative NPV and interpolate the IRR.
Or you can use a calculator or a computer model (excel formula for IRR).
Interpretation of IRR:
If the IRR for the project is12% and the cost of capital used to finance it is lesser than 12%,then the project should be accepted.
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