We are simply looking at the difference between the two NPV’s.

So if one of the is +10 and the other is -5 then the difference is 15
If one of them is +10 and the other is +5 then the difference is 5
If one of them is -5 and the other is -15 then the difference is 10.

Hi John, thank you for this lecture. I got a bit stuck working through my text book and couldn’t see how to get the answer (no explanation in text). I see it now – very simple

No!
Different guesses will give a slightly different answer (and that is fine) but it will only be slightly different. 18.38% is much too much different!!!

At 13% you should have got an NPV of +1170.
We already have that at 10% the NPV is +6660.
So over a change of 3%, the NPV falls by 5490 (6660 – 1170).

So the IRR is 10% + (6660/5490) x 3% = 13.64%

(or, if it more obvious to you, IRR = 13% + (1170/5490) x 3% = 13.64%)

Dear John,
Can you please let me know the brief meanings for “cost of capital”? I have searched on net but they are not giving a good brief understanding

Though I am aware of concept but I cant make proper meanings of it.

It is the cost to the company of their long-term finance – effectively the interest that they are having to pay on their borrowings.

The long term finance borrowed from debt lenders will involve paying interest.
The long-term finance raised from shareholders does not involve paying interest, but shareholders will be requiring dividends and that is effectively like paying interest.

(You have posted this under a lecture on internal rate of return, but there is no direct connection. You should watch my introductory F9 lecture and also my lectures on Cost of Capital itself.)

Technically IRR is the rate at which NPV becomes zero. So if the current COC used to appraise the project is more than IRR means NPV will become negative which will lead to rejection. At the same time a current COC used for the appraisal below IRR will give a positive NPV which will lead to acceptance. So if the current return rate is more than IRR means should we reject the project. Please correct me if i am wrong.

Yes – the definition of the IRR is that it is the rate of interest at which the NPV is zero.

What you have written is correct (although your next to the last sentence says ‘the current return rate…..’. You mean ‘the current cost of capital….’ (But you already said that earlier )

Thanks Sir Its a Great Lecture, However I was confused at the part where you instead of subtracting a Positive and Negative NPV you added them, but in the end of the lecture in different example You Subtracted Both Positive NPVs to get IRR, is this a trick or a formula? Anyways thanks sir

I Remember When I was in school and when I was taught Algebric Division, The Sign of the Second number was changed whenever we try to add or subtract For E.g we wrote +20 and below it +15 but in algebric division rule we change the sign of second number i.e now it is -15 so we subtract 15 from 20, Similarly in Vice Versa +25 is written and below -10 so we change the sign of second number i.e +10 so we added both 25 + 10. hmm now I think I Understood,its the same rule which applies here Thank you Sir

Thanks alot!
Yes The formula is kinda hard to remember, especially during the exams u could get confused with the symbols. This method is simpler and easier to understand.

Dear john
I was practicing opentution practice math number 7 OPERA LTD,here I have a few questions as follows:

1.while doing part a why have not we calculated the average rate of return for current year?we calculated it normally and then we compared with the forecasted average rate of return.should not we calculate the average rate of return for current year and then compare it with the average return of the project proposed?i mean why not both are average rate?

2.why did not we include the 2m scrap value while calculating capital employed.should not it be included in the final year as a cash inflow?or it has something to do it with depreciation??pls make my understanding clear on this matter.

3.why did not we calculated the t0?we started from year 1,but should not we been make the initial capital employed at the t0 and then the first addition in the year 1?
4.while calculating the average capital why did not we follow the formula that is initial capital+scrap / 2.?

my questions could have been silly but Im really looking forward to have a reply from you to make my understanding clear.
Thanks in advance.

Thanks you for the lecture.. I practised the June 2009 paper question 2. Im getting an IRR of 14,22% at a DF of 15%. The answer is giving a IRR of 18.22% when they discount at 20%. Does this mean my answer is wrong? there is a difference of 4% in the IRR.

If you discount at 15% the NPV is +126,931 and so the IRR must be higher than 15%.

We already know that at 10% the NPV is +366,722.

And so over a change of 5 percentages, the NPV falls from +366,722 to +126,931 which is a fall of 239,791

Starting from 15% we need the NPV to fall by 126,931 to get to zero, and so the IRR = 15% + (126931/239791 x 5%)

This comes to an IRR of 17.65%. (It is still a bit different from the examiners answer but the difference is small and is because it is not a linear relationship. This would still get full marks.)

clss says

Hi

Is the video working properly? I cannot get past 3.13 minutes, at 3.13 it then skips back to 3.08,

John Moffat says

The video is working fine. Go to the support page (the link is above) and you will find help there.

aliimranacca007 says

if 1 NPV IS + AND 1 – we add both …if both + we subtract ..if both negtive then we also subtract ?

John Moffat says

Don’t simply learn a rule – you must make sure you understand what is happening and then you don’t need a rule.

aliimranacca007 says

according to rule +,-= – but in Q you make add both , +,+= + , -,- = +

John Moffat says

We are simply looking at the difference between the two NPV’s.

So if one of the is +10 and the other is -5 then the difference is 15

If one of them is +10 and the other is +5 then the difference is 5

If one of them is -5 and the other is -15 then the difference is 10.

awesome wajid says

John this lecture isn’t opening, maybe file has corrupted!! All other lectures r working fine, Sir

opentuition_team says

this lecture works OK too, reload the page.. clear cache if needed..

fahim231 says

This is by far the best way to calculate the IRR. Thanks John that was great.

skelf says

Hi John, thank you for this lecture. I got a bit stuck working through my text book and couldn’t see how to get the answer (no explanation in text). I see it now – very simple

John Moffat says

You are welcome – I am pleased that it is making sense

hope says

Nice lecture, the NPV and IRR is making sense to me now. Thanks alot John.

Gregory says

Dear John, i tried another cost of capital of 13% instead of 15% and got IRR= 18.38%. will this also be correct ?

Gregory says

at 12% sorry

John Moffat says

No!

Different guesses will give a slightly different answer (and that is fine) but it will only be slightly different. 18.38% is much too much different!!!

At 13% you should have got an NPV of +1170.

We already have that at 10% the NPV is +6660.

So over a change of 3%, the NPV falls by 5490 (6660 – 1170).

So the IRR is 10% + (6660/5490) x 3% = 13.64%

(or, if it more obvious to you, IRR = 13% + (1170/5490) x 3% = 13.64%)

Gregory says

thank you sir

Queenie says

Great lecture really helped me to understand the concept of NPV & IRR! Thank you John your a fab lecturer!

acca2050 says

Dear John,

Can you please let me know the brief meanings for “cost of capital”? I have searched on net but they are not giving a good brief understanding

Though I am aware of concept but I cant make proper meanings of it.

Many Thanks

John Moffat says

It is the cost to the company of their long-term finance – effectively the interest that they are having to pay on their borrowings.

The long term finance borrowed from debt lenders will involve paying interest.

The long-term finance raised from shareholders does not involve paying interest, but shareholders will be requiring dividends and that is effectively like paying interest.

(You have posted this under a lecture on internal rate of return, but there is no direct connection. You should watch my introductory F9 lecture and also my lectures on Cost of Capital itself.)

acca2050 says

I am grateful to you for coming to my confusion and being so quick. I do apologize for the mistake.

Many Thanks

krish says

Dear sir,

Technically IRR is the rate at which NPV becomes zero. So if the current COC used to appraise the project is more than IRR means NPV will become negative which will lead to rejection. At the same time a current COC used for the appraisal below IRR will give a positive NPV which will lead to acceptance. So if the current return rate is more than IRR means should we reject the project. Please correct me if i am wrong.

John Moffat says

Yes – the definition of the IRR is that it is the rate of interest at which the NPV is zero.

What you have written is correct (although your next to the last sentence says ‘the current return rate…..’. You mean ‘the current cost of capital….’ (But you already said that earlier )

hamzaharoon says

Thanks Sir Its a Great Lecture, However I was confused at the part where you instead of subtracting a Positive and Negative NPV you added them, but in the end of the lecture in different example You Subtracted Both Positive NPVs to get IRR, is this a trick or a formula? Anyways thanks sir

John Moffat says

We need to look at the difference between the NPV’s.

The difference between (for example) +10 and -5 is 15. However the difference between +10 and +5 is 5.

Hope that makes sense

hamzaharoon says

I Remember When I was in school and when I was taught Algebric Division, The Sign of the Second number was changed whenever we try to add or subtract For E.g we wrote +20 and below it +15 but in algebric division rule we change the sign of second number i.e now it is -15 so we subtract 15 from 20, Similarly in Vice Versa +25 is written and below -10 so we change the sign of second number i.e +10 so we added both 25 + 10. hmm now I think I Understood,its the same rule which applies here Thank you Sir

Rana Mateen says

Peerless,the legend moffat.

sdmaalex says

Thanks alot!

Yes The formula is kinda hard to remember, especially during the exams u could get confused with the symbols. This method is simpler and easier to understand.

leonmatthew says

Dear john

I was practicing opentution practice math number 7 OPERA LTD,here I have a few questions as follows:

1.while doing part a why have not we calculated the average rate of return for current year?we calculated it normally and then we compared with the forecasted average rate of return.should not we calculate the average rate of return for current year and then compare it with the average return of the project proposed?i mean why not both are average rate?

2.why did not we include the 2m scrap value while calculating capital employed.should not it be included in the final year as a cash inflow?or it has something to do it with depreciation??pls make my understanding clear on this matter.

3.why did not we calculated the t0?we started from year 1,but should not we been make the initial capital employed at the t0 and then the first addition in the year 1?

4.while calculating the average capital why did not we follow the formula that is initial capital+scrap / 2.?

my questions could have been silly but Im really looking forward to have a reply from you to make my understanding clear.

Thanks in advance.

John Moffat says

Sorry to be a nuisance , but please can you copy and paste this question to the Ask the Tutor forum.

(The reason is that I do not have time to answer now and it will disappear from the list. I will answer when I get back from work)

fzinyemba says

Dear John

Thanks you for the lecture.. I practised the June 2009 paper question 2. Im getting an IRR of 14,22% at a DF of 15%. The answer is giving a IRR of 18.22% when they discount at 20%. Does this mean my answer is wrong? there is a difference of 4% in the IRR.

Thanks you

John Moffat says

Your answer is wrong

If you discount at 15% the NPV is +126,931 and so the IRR must be higher than 15%.

We already know that at 10% the NPV is +366,722.

And so over a change of 5 percentages, the NPV falls from +366,722 to +126,931 which is a fall of 239,791

Starting from 15% we need the NPV to fall by 126,931 to get to zero, and so the IRR = 15% + (126931/239791 x 5%)

This comes to an IRR of 17.65%. (It is still a bit different from the examiners answer but the difference is small and is because it is not a linear relationship. This would still get full marks.)

maggiemdeza says

good and straight forward lecture, thanks Mr. Moffat.