Internal Rate of Return (IRR)
An Analyst's guide to IRR
An Analyst's guide to 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 be equal to the present value of the future cash flows of that investment (cost paid = present value of future cash flows. Hence, the net present value = 0).
Once the internal rate of return is determined, it is typically compared to a company’s hurdle rate or cost of capital. If the IRR is greater 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.), and if it’s lower than the hurdle rate it would be rejected.
Calculating the internal rate of return can be done in three ways:
Here is an example of how to calculate the Internal Rate of Return.
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.
Companies take on various projects to increase their 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 returns on these investments, and the internal rate of return is one method that allows them to compare and rank projects based on their yield, and the one with the highest internal rate of return is usually preferred.
Internal Rate of Return 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 flow at the end through an IPO or sale of the business.
Thorough investment analysis requires an analyst to examine both the net present value (NPV) and internal rate of return, along with other indicators such as the payback period to select the right investment. Since it’s possible for a very small investment to have a very high rate of return, investors and managers will sometime intentionally pick lower return but higher dollar value opportunities, as they have more of an impact. Also, it’s important to have a good understanding of your own risk tolerance, or the company’s investment needs, risk aversion and other available options.
Let’s look at an example of a financial model in Excel to see what the internal rate of return number really means.
If an investor paid $463,846 (which is a negative cash flow, shown in cell C178) for a series of positive cash flows as shown in cells D178 to J178, the IRR they would receive is 10%. This means the net present value of all these cash flows (including the negative outflow) is zero, and thus only the 10% rate of return is earned.
If the investors paid less than $463,846 for all same additional cash flows their IRR would be higher than 10%. Conversely, if they paid more than $463,846 their IRR would be lower than 10%.
The above screenshot is from CFI’s M&A Modeling Course.
Unlike net present value, internal rate of return 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 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, internal rate of return 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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