What Is Internal Rate of Return (IRR)?
The internal rate of return is a method used in financial analysis to estimate the
profitability of potential investments. The internal rate of return is a discount
rate that makes the net present value (NPV) of all cash flows equal to zero
in a discounted cash flow analysis.
IRR calculations rely on the same formula as NPV does. Keep in mind that the
IRR is not the actual dollar value of the project. It is the annual return that
makes the net present value equal to zero.
Generally speaking, the higher an internal rate of return, the more desirable an
investment is to undertake. IRR is uniform for investments of varying types and,
as such, IRR can be used to rank multiple prospective investments or projects on
a relatively even basis. In general, when comparing investment options whose
other characteristics are similar, the investment with the highest IRR would
probably be considered the best.
KEY TAKEAWAYS
Internal rate of return (IRR) is the annual rate of growth an investment is
expected to generate.
IRR is calculated using the same concept as NPV, except it sets the NPV
equal to zero.
IRR is ideal for analyzing capital budgeting projects to understand and
compare potential rates of annual return over time.
Understanding IRR
The ultimate goal of IRR is to identify the rate of discount, which makes
the present value of the sum of annual nominal cash inflows equal to the initial
net cash outlay for the investment. There are several methods that can be used
when seeking to identify an expected return, but IRR is often ideal for analyzing
the potential return of a new project that a company is considering undertaking.
You can think of the internal rate of return as the rate of growth an investment is
expected to generate annually. Thus, it can be most similar to a compound
annual growth rate (CAGR). In reality, an investment will usually not have the
same rate of return each year. Usually, the actual rate of return that a given
investment ends up generating will differ from its estimated IRR.
What Is IRR Used For?
In capital planning, one popular scenario for IRR is comparing the profitability of
establishing new operations with that of expanding existing ones. For example,
an energy company may use IRR in deciding whether to open a new power plant
or to renovate and expand a previously existing one. While both projects could
add value to the company, it is likely that one will be the more logical decision as
prescribed by IRR. Note that because IRR does not account for changing
discount rates, it's often not adequate for longer-term projects with discount rates
that are expected to vary.
IRR is also useful for corporations in evaluating stock buyback programs. Clearly,
if a company allocates a substantial amount to a repurchasing its shares, the
analysis must show that the company's own stock is a better investment—that is,
has a higher IRR—than any other use of the funds, such as creating new outlets
or acquiring other companies.
IRR may also be compared against prevailing rates of return in
the securities market. If a firm can't find any projects with IRR greater than the
returns that can be generated in the financial markets, it may simply choose to
invest money into the market. Market returns can also be a factor in setting a
required rate of return.
Limitations of the IRR
IRR is generally most ideal for use in analyzing capital budgeting projects. It can
be misconstrued or misinterpreted if used outside of appropriate scenarios. In the
case of positive cash flows followed by negative ones and then by positive ones,
the IRR may have multiple values. Moreover, if all cash flows have the same sign
(i.e., the project never turns a profit), then no discount rate will produce a zero
NPV.
Within its realm of uses, IRR is a very popular metric for estimating a project’s
annual return. However, it is not necessarily intended to be used alone. IRR is
typically a relatively high value, which allows it to arrive at an NPV of zero. The
IRR itself is only a single estimated figure that provides an annual return value
based on estimates. Since estimates in both IRR and NPV can differ drastically
from actual results, most analysts will choose to combine IRR analysis with
scenario analysis. Scenarios can show different possible NPVs based on varying
assumptions.
As mentioned, most companies do not rely on IRR and NPV analysis alone.
These calculations are usually also studied in conjunction with a
company’s WACC and a RRR, which provides for further consideration.
Companies usually compare IRR analysis to other tradeoffs. If another project
has a similar IRR with less upfront capital or simpler extraneous considerations
then a simpler investment may be chosen despite IRRs.
In some cases, issues can also arise when using IRR to compare projects of
different lengths. For example, a project of short duration may have a high IRR,
making it appear to be an excellent investment. Conversely, a longer project may
have a low IRR, earning returns slowly and steadily. The ROI metric can provide
some more clarity in these cases, though some managers may not want to wait
out the longer time frame.
IRR Example
Assume a company is reviewing two projects. Management must decide whether
to move forward with one, both, or neither of the projects. Its cost of capital is
10%, The cash flow patterns for each are as follows:
Project A
Initial Outlay = $5,000
Year one = $1,700
Year two = $1,900
Year three = $1,600
Year four = $1,500
Year five = $700
Project B
Initial Outlay = $2,000
Year one = $400
Year two = $700
Year three = $500
Year four = $400
Year five = $300
The company must calculate the IRR for each project. Initial outlay (period = 0)
will be negative. Solving for IRR is an iterative process using the following
equation:
$0 = Σ CFt ÷ (1 + IRR)t
where:
CF = Net Cash flow
IRR = internal rate of return
t = period (from 0 to last period)
-or-
$0 = (initial outlay * -1) + CF1 ÷ (1 + IRR)1 + CF2 ÷ (1 + IRR)2 + ... + CFX ÷ (1 +
IRR)X
IRR Project A:
$0 = (-$5,000) + $1,700 ÷ (1 + IRR)1 + $1,900 ÷ (1 + IRR)2 + $1,600 ÷ (1 +
IRR)3 + $1,500 ÷ (1 + IRR)4 + $700 ÷ (1 + IRR)5
IRR Project A = 16.61 %
IRR Project B:
$0 = (-$2,000) + $400 ÷ (1 + IRR)1 + $700 ÷ (1 + IRR)2 + $500 ÷ (1 + IRR)3 +
$400 ÷ (1 + IRR)4 + $300 ÷ (1 + IRR)5
IRR Project B = 5.23 %
Given that the company's cost of capital is 10%, management should proceed
with Project A and reject Project B.
