- Describe the internal rate of return method
Your company is looking at purchasing a new machine for the production facility. You have narrowed it down to two choices. Each has a similar cost, but different net cash flows. Which one is a better investment for your company? Remember your time value of money as we work through this process! Are you ready? This might be complicated!!
This method goes back to the time-value of money. By looking at the rate of return we expect on an investment over the life of the investment, we can figure out the internal rate of return. So, this method uses the discount rate that equals the present value of cash outflows with cash inflows, resulting in a net present value of zero. This is a complicated topic, so let’s look at an example.
Hupana Running Company is looking at a machine that will attach the soles of the shoes in less time, with less utility cost than the current machine. This machine will cost $20,000, have a useful life of 5 years with zero salvage value. It will save the company $5,500 a year in labor and utility costs. So to calculate the internal rate of return on this purchase, we look at the following formula:
In this case the machine costs $20,000 (the investment) and will save us $5,500 (annual net cash flow) in wages and utilities:
3.6364= $20,000/$5,500 so we can use 3.6364 from our present value table. (Note: You are going to want to print this to use for your test questions!)
We need to look at 5 periods, as that is the useful life of our machine, then move across to 3.6364. We find that the internal rate of return on this piece of equipment is between 11% and 12%, since our factor falls between those two. So, we are making between 11% and 12% on our investment with this purchase.
We could then look at various options to determine the best one for Hupana Running Company!
For additional practice check out this example of the internal rate of return method.
- Internal Rate of Return. Authored by: Freedom Learning Group. Provided by: Lumen Learning. License: CC BY: Attribution