AMIS 212: Introductory Managerial Accounting Chapter 14, Module 3 AMIS 212 – Professor Marc Smith Chapter 14, Module 3 Chapter 14, Module 3 Slide 1 AMIS 212Introductory Managerial AccountingProfessor Marc SmithCHAPTER 1 MODULE 1Chapter 14 Module 3 Hi everyone, welcome back. Now that we have spend a good bit of time talking about the NPV or net present value, in this module let’s talk about the second capital budgeting technique known as the internal rate of return. Let’s go ahead and get started. Please move to the next slide with me.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 3 AMIS 212 – Professor Marc Smith Chapter 14, Module 3 Slide 2 Internal Rate of Return (IRR)The internal rate of return (IRR) represents theactual or real rate of return generated by an investment projectChapter 14 Module 3: IRR The internal rate of return or IRR represents the actual or real rate of return generated by an investment project. Now we’ve already talked a little bit about this idea of the real rate of return. If you remember back to the previous module when we worked Example 1 together and we came up with a NPV…I believe it was $383. And is asked you for that project, was the real return greater or less than 20% which was the cost of capital. And everybody agreed it was greater than 20% because the NPV was positive. And then when we talked and we said do we think it is a lot greater than 20% or just a little greater than 20%? And we decided it was probably just a little bit larger than 20% because the NPV was kind of small.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 3 AMIS 212 – Professor Marc Smith Chapter 14, Module 3 It was still positive but kind of small. And at that time I said well, we really haven’t learned how to come up with the exact real rate of return yet but we will. And now we are at that point. That real rate of return is called the internal rate of return. Now go to the next slide with me. Slide 3 General decision rule . . .If the Internal Rate of Return is . . . Then the Project is . . . Equal to or greater than the minimum required rate of return (cost of capital) . . .Acceptable. Less than the minimum required rate of return (cost of capital) . . . . . . . . . . . . . .Rejected. Chapter 14 Module 3: IRR The basic decision rule that is followed when employed the IRR capital budgeting method…if the internal rate of return is greater than or equal to the minimum acceptable rate of return known as the cost of capital then you do the project. Because that means the real return that is being earned is either exactly equal to the smallest acceptable return or greater than the smallest acceptable return.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 3 AMIS 212 – Professor Marc Smith Chapter 14, Module 3 For those projects where the internal rate of return or IRR is less than the minimum acceptable return, the cost of capital, you don’t do them. You reject them because you are not earning a high enough of return to justify doing the project. Now go ahead to the next slide with me. Slide 4 If IRR > cost of capital, the project earns a returnthat is larger than the minimum acceptable returnand the NPV > 0 ACCEPT If IRR < cost of capital, the project earns a returnthat is smaller than the minimum acceptable returnand the NPV < 0 REJECTIf IRR = cost of capital, the project earns a returnthat is exactly equal to the minimum acceptablereturn and the NPV = 0 ACCEPTChapter 14 Module 3: NPV & IRR And to calculate the IRR…to come up with the IRR, we’re going to need to know one very, very important relationship. And that relationship exists between the IRR and the net present value. In situations where the IRR is greater than the cost of capital…now we just saw those are accept decisions because the real rate of return is greater than the minimum acceptable return. And in those cases, your NPV will always be positive.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 3 AMIS 212 – Professor Marc Smith Chapter 14, Module 3 So in order to do these calculations I think it is important to understand these relationships first. Anytime where you a have a IRR greater than the cost of capital, that means the NPV is positive. And that is why we accept the project. For situations where the IRR is less than the cost of capital that means that the minimum acceptable return is the one that is greater. The project does not earn a return that is higher than the minimum acceptable return. And that means the NPV would be negative and that is why it is a reject decision. And in those rare cases where the IRR is exactly equal to the cost of capital that means that the rare return that is being earned is exactly equal to the minimum acceptable return. That is why we do the project. We’re earning the smallest acceptable return we can earn. And in those cases, when the IRR equals the cost of capital the net present value is exactly equal to 0. I see those relationships as important. You want to understand how the IRR and NPV sort of work together or interrelate with one another. Please move to the next slide.AMIS 212: Introductory Managerial Accounting Chapter 14, Module 3 AMIS 212 – Professor Marc Smith Chapter 14, Module 3 Slide 5 To calculate the IRR  2-step process:1. Calculate the IRR Factor = Initial Investment Annual Cash Inflows2. Use the IRR Factor and the present value of an annuity table to determine the IRRChapter 14 Module 3: IRR In order to calculate the internal rate of return it is going to be a 2 step process for you. In step 1 you calculate what is called the internal rate of return factor. The factor is equal to the initial investment