(a) When the annual net cash flows are equal over the life of the assets: Firstly, find out present value Factor by dividing initial outlay (cost of the investment) by annual cash flow, i.e.,
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Present Value Factor = Initial Outlay/Annual Cash Flow
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The consult present value annuity tables with the number of years equal to the life of the asset and find out the rate at which the calculated present value factor is equal to the present value given in the table
(b) When the annual cash flows are unequal over the life of the asset: In case annual cash flows are unequal over the life of the asset, the internal rate of return cannot be determined according to the technique suggested above. In such cases, the internal rate of return is calculated by hit and trial and that is why this method is also known as hit and trial yield method.
We may start with any assumed discount rate and find out the total present value of cash outflows which is equal to the cost of the initial investment where total investment is to be made in the beginning. The rate, at which the total present value of all cash inflows equals the initial outlay, is the internal rate of return. Several discount rates may have to be tried until the appropriate rate is found. The calculation process may be summed up as follows:
(i) Prepare the cash flow table using an arbitrary assumed discount rate to discount the net cash flows to the present value.
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(ii) Find out the Net Present Value by deducting from the present value of total cash flows calculated in (i) above the initial cost of the investment.
(iii) If the Net Present Value (NPV) is positive, apply higher rate of discount.
(iv) If the higher discount rate still gives a positive net present value, increase the discount rate further until the NPV becomes negative.
(v) If the NPV is negative at this higher rate, the internal rate of return must be between these ‘ two rates.