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IRR Animation Tool

• Understanding this tool

  • This tool appears daunting at first, but let's look at it together.  First, turn to page 318 in your Foundations of Finance textbook.  Here you will find example 10.3.  Let's look at example 10.3 together, shall we?  In looking at this example, you will see that you are being asked to compute the IRR for a project that has the following initial outlay and then Free Cash Flows as noted below:

    Initial outlay -$10,010
    FCF in year 1 1,000
    FCF in year 2 3,000
    FCF in year 3 6,000
    FCF in year 4 7,000

     

    If you open the IRR animation tool above, then enter these values where it says "project 2."  Under "0" you will enter the initial outlay of -10,010.  Under "1" you will enter 1000, etc.  Once you have entered all of the values check the check box next to project 2.  This tells the animation tool that you want to include this project in your graph.  Now, class...look at the graph.  The vertical axis shows Net Present Value (NPV) and the horizontal axis shows the discount rate or the Internal Rate of Return (IRR) for the project.  For this project, your IRR is displayed as 19% over on the right side of the tool on the same line where you entered your investment & free cash flow information.  If you compare this to the procedure in the book for a calculator provided in the example, you will find that their result was also 19%.  (It's like magic, isn't it?  )

     

    Notice several things:

    1.  You are not required to enter a "guess."  This number is just a starting point for the mathematical algorithm, but if you have a guess, enter it.

    2.  The initial numbers that were in the graph were a lot smaller, so when you click on project 2 to show your new project, the project one line looks a lot different.  This is because the scale of the graph automatically adjusts to show the new information that contains much larger values.  

    3.  You can "uncheck" a project to remove it from your graph.

     

    Now, please turn to page 319 in your Foundations of Finance textbook.  Here you will find an explanation of the relationship between IRR and NPV.  Once you have read this, you will hopefully have an understanding of the