Here the equation is solved for the discount rate, k*, which produces a zero net present value or causes the sum of the discounted future receipts to equal the initial cost. That discount rate is the internal rate of return earned by the project.

Because the net present-value equation is complex, it is difficult to solve for the actual internal rate of return on an investment without a computer or sophisticated calculator. For this reason, trial and error is sometimes employed. One begins by arbitrarily selecting a discount rate. If it yields a positive NPV, the internal rate of return must be greater than the discount rate used, and another higher rate is tried. If the chosen rate yields a negative NPV, the internal rate of return on the project is lower than the discount rate, and the NPV calculation must be repeated using a lower discount rate. This process of changing the discount rate and recalculating the net present value continues until the discounted present value of the future cash flows equals the initial cost. The interest rate that brings about this equality is the yield, or internal rate of return on the project.

Using trial and error, an electronic financial calculator, or a spreadsheet software program such as Microsoft Excel, the internal rate of return for the SVCC investment project is IRR = 25.1 percent. Because this IRR exceeds the 15 percent cost of capital, the project is attractive and should be undertaken. In general, internal rate of return analysis suggests that projects should be accepted when the IRR > k and rejected when the IRR < k. When the IRR > k, the marginal rate of return earned on the project exceeds the marginal cost of capital. As in the case of projects with an NPV > 0 and PI > 1, the acceptance of all investment projects with IRR > k will lead management to maximize the value of the firm. In instances in which capital is scarce and only a limited number of desirable projects can be undertaken at one point in time, the IRR can be used to derive a rank ordering of projects from most desirable to least desirable. Like a rank ordering of all NPV > 0 projects from highest to lowest PIs, a rank ordering of potential investment projects from highest to lowest IRRs allows managers to effectively employ scarce funds.

payback period

Number of years required to recover initial investment

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