Managing Cash Flow

Investing Excess Cash 249
Investment (Year 0) $50,000
Cash flow returns
Year 1 10,000
Year 2 20,000
Year 3 40,000
What is the Internal Rate of Return (IRR) on this project?
Step 1—Try 15% Step 2—Try 16%
15% Disc. Discounted 16% Disc. Factor Discounted
Year Cash Flow Factor Cash Flow Factor Cash Flow
0 (50,000) 1.0000 (50,000) 1.0000 (50,000)
1 10,000 .8696 8,696 .8621 8,621
2 20,000 .7561 15,122 .7432 14,864
3 40,000 .6575 ______ 26,300 .6407 ______ 25,628
Net Present Value ______
118 ______
(887)
The IRR lies between 15% and 16% (because the NPV becomes 0 between
these two discount rates).
Step 3—interpolate for a more exact answer.
NPV at 15% 118
NPV at 16% ______ 887
Difference 1005
Therefore, IRR 15% 118/1005 15% .117 15.117% _______
Exhibit 7.3
Example of an Internal Rate of Return (IRR) Calculation
While these rates are shown for illustrative purposes only and do not necessarily
reflect rates that would be appropriate for a particular business, the concept
of requiring higher rates of return for riskier projects is one that should be incorporated
into the company’s thinking.
Another element of risk is the fact that results of a future investment cannot
be known for certain, and there exists the possibility of numerous possible cash
flow outcomes for a given opportunity. Applying a probability to each of the reasonably
possible outcomes and weighting these outcomes by their probability of
occurrence develops a most-likely-result scenario. For example:
Weighted
DCF Probability DCF
Optimistic $20,000 .25 $5,000
Most probable 15,000 .70 10,500
Pessimistic (5,000) .05 ______ (250)
Expected Outcome $15,250
______