Study guide references E3(g), (h) and (i) refer explicitly to the Internal Rate of Return (IRR). Not only do candidates need to be able to perform the calculation, they need to be able to explain the concept of IRR, how the IRR can be used for project appraisal, and to consider the merits and problems of this method of investment appraisal. In short, IRR can be examined in both a written or calculation format, within either section A or section B of the exam.
When this topic is examined, candidates have historically not performed very well, showing a lack of understanding of how the calculation works and what the IRR is.
What is the IRR?
The IRR can be defined as the discount rate which, when applied to the cash flows of a project, produces a net present value (NPV) of nil. This discount rate can then be thought of as the forecast return for the project. If the IRR is greater than a preset percentage target, the project is accepted. If the IRR is less than the target, the project is rejected.
Considering the definition leads us to the calculation. The IRR uses cash flows (not profits) and more specifically, relevant cash flows for a project. To perform the calculation, we need to take the cash flows of a project and calculate the discount factor that would produce a NPV of zero.
If the cash flows of a ‘normal’ (cash outflow followed by a series of cash inflows) project are taken and discounted at different discount rates, it will be possible to plot the following graph: