Dictionary of Accounting Terms by Jae K. Shim

Author:Jae K. Shim
Language: eng
Format: epub
Publisher: Barron's Educational Series, Inc.
Published: 2014-03-15T04:00:00+00:00

Estimated life

10 years

Annual cash inflows

$ 3,000

Cost of capital (minimum required of return)

10%

Set up the following equality (I = PV):

$16,200 = $3,000 × PV

Then PV = $16,200/$3,000 = 5.400, which stands somewhere between 12% and 14% in the 10-year line of table 4 in the back of the book. Because the investment’s IRR (13.15%) is greater than the cost of capital (10%), the investment should be accepted.

The IRR method is easy to use as long as cash inflows are even from year to year. Where cash flows are uneven, the IRR can be determined by using Excel.

Excel has a function IRR(values, guess). Excel considers negative numbers as cash outflows such as the initial investment, and positive numbers as cash inflows. Many financial calculators have similar features. Suppose you want to calculate the IRR of a $12,950 investment (the value “–12,950” entered in year 0, followed by 10 monthly cash inflows of $3,000). Using a guess of 12% (the value of 0.12), which is in effect the cost of capital, your formula would be @IRR(values, 0.12) and Excel would return 19.15%, as shown below.

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