Internal Rate of Return (IRR)

An Analyst's guide to IRR

What is Internal Rate of Return (IRR)?

Internal Rate of Return (IRR) is the discount rate that makes the net present value (NPV) of a project zero. In other words, it is the expected rate of return that will be earned on a project or investment.

When calculating IRR, expected cash flows for a project or investment are given, and the NPV equals zero. The initial cash investment for the beginning period will equal to the present value of the future cash flows of that investment.

Once the IRR is determined, it is then compared to the company’s hurdle rate or cost of capital. If the IRR is higher than or equal to the cost of capital, the company would accept the project (assuming this is the sole basis for the decision. In reality there are many other quantitative and qualitative factors that are considered in an investment decision.).

 

What is the IRR formula?

 

Internal Rate of Return (IRR) formula

 

 

Calculating the IRR can be done in three ways:

  1. Using the IRR function in Excel or other spreadsheet programs
  2. Using a financial calculator
  3. Using an iterative process where the analyst tries different values of IRR until the NPV equals to zero.

 

Example of Calculating the IRR

Here is an example of how to calculate the Internal Rate of Return (IRR).

A company is deciding whether to purchase new equipment that costs $500,000. Management estimates the life of the new asset to be 4 years and expects it to generate an additional $160,000 of annual profits. In the 5th year, the company plans to sell the equipment for its salvage value of $50,000.

Meanwhile, another similar investment option can generate a 10% return, which is higher than the company’s current hurdle rate of 8%. The goal is to make sure the company is making better use of its cash.

To make a decision, the IRR for investing in the new equipment is calculated below.

Excel was used to calculate the IRR of 13%, using the function, =IRR(). From a financial standpoint, the company should make the purchase, because the IRR is both greater than the hurdle rate and the IRR for the other alternative investment.

 

IRR internal rate of return table

 

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What is the IRR used for?

Companies take on various projects to increase its revenue or cut down costs. A great new business idea may require investing in the development of a new product to achieve this goal.

In capital budgeting, senior leaders would like to know the return on these investments, and the IRR is one method that allows them to compare and rank projects based on their yield, and the one with the highest IRR is usually preferred.

Internal Rate of Return (IRR) is widely used in analyzing investments for private equity and venture capital, which involves multiple cash investments over the life of the business and a cash outflow at the end through an IPO or sale of the business.

As mentioned earlier, investment analysis requires you to examine both the NPV and IRR, along with other indicators such as the payback period to select the right investment. Also, it’s important to have a good understanding of your own or the company’s investment needs, risk aversion and other available options.

 

Disadvantages of IRR 

Unlike the NPV, the IRR doesn’t give you the return on initial investment in terms of real dollars. For example, knowing an IRR of 30% alone doesn’t tell you if it’s 30% of $10,000 or 30% of $1,000,000.

Using it exclusively can lead you to make poor investment decisions, especially if comparing two projects with different durations.

Let say a company’s hurdle rate is 12%, and one-year project A has an IRR of 25% whereas five-year project B has an IRR of 15%. If the decision will be solely based on IRR, it would be an unwise decision to choose project A over B, just because it has a greater return.

Another very important point about the Internal Rate of Return (IRR), is that it assumes all positive cash flows of a project will be reinvested at the same rate as the project, instead of the company’s cost of capital. Therefore, IRR may not accurately reflect the profitability and cost of a project.

An analyst will alternatively use a modified internal rate of return (MIRR) to arrive at a more accurate measure.

 

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