Capital Budgeting Question

CFA Level I
#1

I was trying to study about the IRR through Irfanullah Financial Training videos.

He said:

IRR is the measure of return for a given project. For example, if we invest 100 and get back 115 IRR is 15%

Similarly, if we invest 100 and get 20 in first year and 120 in second year IRR is 20%

But, it is tough to calculate IRR by this approach when we invest 100 and get 70 in 1st year, 60 in 2nd year.

Should’nt the IRR be 15% in this case, as we get 130 returns in 2 years? I know 15% is wrong as at that rate NPV isn’t zero. But what am I doing wrong?

Thank you very much for your help :slight_smile:

#2

You’re ignoring the time value of money.

Getting 70 in 1 year and 60 in 2 years is worth more than getting 15 in 1 year and 115 in 2 years.

The IRR is 20% in your example.

#3

If that is the case then how do we get 20% when we invest 100 and get 20 in 1st year and 120 in 2nd year?

#4

Think of a 2-year bond, par value = 100, coupon rate = 20%. If it sells at par, its YTM is 20%. You pay 100, in one year you get 20 (coupon), and in 2 years you get 120 (coupon plus par).

#5

IRR’s are calculated by iteration, so they can not be fast calculated by mind, it depends on the type of cash flows (volatility) and the time of the project.

#6

Thank you very much Harrogath and S2000Magician!

#7

My pleasure.