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Procedure for Calculation

(a) Where cash inflows are uniform. In any project, the cash inflows are uniform. The IRR can be calculated by locating the factor in annuity table. The factor is calculated as follows.

 

F = I/ C

Where, F = Factor to be located

I = Initial Investment

c = Cash inflow per year

 

The factor, thus calculated, will be located in table II on the line, representing number of years corresponding to estimated useful life of the asset.

 

(b) Where cash inflows are not uniform. The internal rate of return is calculated by making trial    and error method.

 

Procedure

 

(i) First trial rate may be calculated in the following way.

In order to have an approximate idea about the rate, it will be better to find out the factor to be calculated in the following formula.

 

F =I/ C

 

 

The above factor is treated as first trial rate.

(ii) The second trial rate and third trial rate are determined.

(iii) After applying the second and third trial rates, we have to apply the following formula for   the purpose of arriving at exact IRR.

 

IRR = Lower trial rate + NPV at lower rate / NPV at lower rate – NPV at higher rate x

 

Difference between higher and lower trial rate

 

(iii) Profitability Index Method

 

It is a time adjusted method of evaluating profitability of the investment proposals. By calculating the profitability indices for various projects the financial manager can rank the projects according to their profitability.

Profitability index =Present value of cash inflows/Initial cash outlay

(Or)

Present value of future cash inflows / Present value of future cash outflows x 100

 

 Decision Rule

 

Present value index of the project is equal to or more than 1 or 100% is to be selected.

 

(iv) Discounted Pay Back Method

 

Under this method, the present values of all cash inflows and outflows are calculated at an appropriate discount factor. The present values of all inflows are cumulated in order of time. The cumulative present value of cash inflows equals the present value of cash outflows. It is known as discounted pay back period.

For example,

Project cost is xxx

Year                cash inflow                 p/v                   DCF

1

2

3

4

5

 

Sum of discounted cash flows equals the cash outflow. It is referred as discounted pay back period. Normally, the project which gives a shorter pay back period under the discounted cash flow is accepted.