Question 5.S2.P.2: A project costing Rs 5,60,000 is expected to produce annual ......
A project costing Rs 5,60,000 is expected to produce annual net cash benefits (CFAT) of Rs 80,000 over a period of 15 years. Estimate the internal rate of return (IRR). Also, find the pay back period and obtain the IRR from it. How do you compare this IRR with the one directly estimated?
\text { PB value }=\frac{\text { Rs } 5,60,000}{\text { Rs } 80,000}=7.000
The factors closet to 7.000 are 7.191 at 11 per cent rate of discount and 6.811 at 12 per cent rate of discount against 15 years (Table A-4). The actual IRR would be between 11 and 12 per cent.
Using interpolation, the IRR would be 0.11+0.005(0.19 \div 0.38)=11.5 per cent.
IRR determination through PB period The reciprocal of the PB period is a good approximation of the IRR if, (i) the life of the project is at least twice the PB period, and (ii) the project generates annuity cash inflows. Accordingly, IRR would be the reciprocal of the PB period, i.e. 1 / 7=0.1428=14.28 per cent.
Comparison: The two IRRs are different. But the IRR which is directly estimated is correct as at this rate of discount, NPV of cash flow stream of the project would be zero. The NPV cannot be zero at 14.28 per cent. The IRR through the PB period is only an approximate measure.