Capital Budgeting Question

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:

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.

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?

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).

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.

Thank you very much Harrogath and S2000Magician!

My pleasure.