Preference decisions (IRR)

There are often many opportunities that pass the screening decision process. The bad news is not all can be acted on. Financial or resource constraints may preclude investing in every opportunity. Preference decisions, sometimes called rationing or ranking decisions, must be made. The competing alternatives are ranked.

The NPV of one project cannot be directly compared to another unless the investments are equal. As a result, the IRR is widely used for preference decisions. The higher the Internal rate of return, the more desirable the initiative.

The IRR, sometimes called the yield, is the rate of return over the life of an initiative. IRR is computed by finding the discount rate that equates the present value of a project’s cash outflows with the present value of its inflows. That is, the IRR is the discount rate resulting in an NPV of zero.

Take, for example, Case example 11. To compute the IRR, first find the discount rate that will result in a net present value of zero. The simplest approach is to divide the investment in the project by the expected net annual cash flow. This will yield a factor from which the IRR can be found.

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The IRR factor, 3.0303 in this case, is then located in the present value table in Appendix A to determine the rate of return it represents. Use the 5-period line since the programme has a five-year window. A scan on the 5-period line reveals that an IRR factor of 3.03 represents a rate of return between 19% and 20%.

Once the IRR is computed, compare against required rate of return. In this case, the required rate of return is 20%. Since the IRR is slightly less, it would likely be rejected during a screening decision. A summary is given in Table 5.7.

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The IRR for successful candidates can be directly compared to other successful candidates. Viable projects can then be ranked by their respective IRR. The projects with the highest rank are those with the highest IRR percentages.

Дата добавления: 2015-11-14