Rate of Return IRR or DCFRR

The investor s rate of return (IRR), also called the discounted cash flow rate of return (DCFRR), is the interest rate that gives a net present value of zero. Since the net present value is a complex nonlinear function of the interest rate, an iterative procedure (easily accomplished using a spreadsheet) is required to solve 

When comparing proposed processes, the largest IRR is the most desirable. Note, however, that sometimes the process having the largest IRR has the smallest NPV. In many cases, especially when the alternatives have widely disparate investments, both the NPV and the IRR are effective measures. This is especially true when the alternatives are comparable in one measure but are very different in the other. The following example computes both the NPV and the IRR. 

For the process considered in Example 17.14, but with MACRS depreciation for a 5-yr class life as determined in Example 17.27, calculate, over an estimated life of 15 yr, including years 1997-1999 when the plant is being constructed (a) the NPV for a nominal interest rate of 15% compounded annually and (b) the nominal interest rate for the IRR method (i.e., for NPV = 0). For the first 2 yr of plant operation, when at 45 and 67.5% of capacity, the cost of production, exclusive of depreciation, is 55 million and 78 million, respectively. 

It is of interest to examine the annual cash flows on nondiscounted and discounted bases, as shown in the bar graphs below. The first graph is for the former. For discounted cash flows, the second graph is for an interest rate of 15%, while the third graph is for the IRR of 19%. Note that discounted cash flows during the time of plant operation are much smaller than those for the nondiscounted cash flows in the first graph. 

Finally, when calculating annual discounted cash flows, it is not difficult to account for inflation in estimating revenues and costs, when the inflation factors are known. Inflation is considered in the following subsection, but was not included in this example so as to enable the reader to trace the calculations of the cash flows more easily.  

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