What is the Internal Rate of Return (IRR)?
Internal rate of return is a capital budgeting calculation for deciding which projects
or investments under consideration are investment-worthy and ranking them. IRR
is the discount rate for which the net present value (NPV) equals zero (when time-
adjusted future cash flows equal the initial investment). IRR is an annual rate of
return metric also used to evaluate actual investment performance.
The IRR Rule (Meaning)
• More generally it is said that the discounted rate that makes NPV of an
investment equals to zero that is IRR.
When NPV is equal to zero means no value is created neither destroyed,
economically it is break-even of investment and so firm is indifferent between
taking and not taking the project.
Based on IRR rule, an investment(project) is acceptable if the internal rate of
return exceeds the required return(hurdle rate). It should be rejected otherwise.
when the IRR is determined, companies compare it with their hurdle rate or
minimum acceptance rate of return (MARR) generally known as cost of capital
calculated through comparing interest on debts, risk and other factors. If the IRR is
higher then hurdle rate, the project will be considered otherwise rejected.
Formula
Advantages and Disadvantages of the IRR Rule
Advantages
The internal rate of return is relatively easy to understand and to calculate using a
spreadsheet. Companies and investors can compare it to other projects and
investments that are under consideration.
Another advantage of using this rule is that it helps companies and investors
account for the time value of money (TVM). This is a concept that states that a
particular amount of money is worth more now than the same sum in the future. As
such, the future cash flow that results from an investment is discounted to its
present value under the IRR rule.
Disadvantages
The IRR doesn't take the actual dollar value of the project or any anomalies in cash
flows into account. If there are any irregular or uncommon forms of cash flow, the
rule shouldn't be applied. If it is, it may result in flawed findings.
Another key disadvantage of the IRR rule is that it is flawed in its assumption
regarding any reinvestments made from positive cash flow—notably, that they are
made at the same internal rate of return. A modified internal rate of return (MIRR)
is sometimes used instead as it assumes that positive cash flows are reinvested at
the firm's cost of capital.
Pros
Easy to calculate and understand
Allows for comparison between other projects and investments
Takes time value of money into account
Cons
Doesn't account for actual dollar value
Doesn't consider anomalies in cash flows
Assumes that reinvestments are made at the same internal rate of return
Practical Applications of Internal Rate of Return
IRR is extensively used in various fields of finance, and its practical applications
include:
Capital Budgeting: Companies use IRR to make decisions on capital
investments, like opening a new location or upgrading existing facilities. For
instance, an energy company may use IRR to decide whether to build a new
power plant or renovate an old one.
Investment Evaluation: Investors apply IRR when evaluating the potential
returns of different investments. A higher IRR compared to alternative
investments often leads to selecting that option for funding.
Real Estate Investments: In the real estate sector, IRR is utilized to gauge the
anticipated returns from property investments over time, allowing
comparisons between potential purchases.
Stock Buybacks: Corporations also employ IRR to analyze decisions on stock
buybacks, ensuring that these repurchases yield a higher return than alternative
investment opportunities.
Example of Internal Rate of Return Calculation
To illustrate the IRR calculation, consider a company that plans to invest $500,000
in a new piece of equipment. It expects to generate the following cash flows over
five years:
Year 1: $160,000
Year 2: $160,000
Year 3: $160,000
Year 4: $160,000
Year 5: $50,000 (sale of equipment)
The IRR can be calculated using financial software or using Excel's IRR function.
For this scenario, the IRR is approximately 13%, indicating that the investment is
expected to yield a return of 13% per annum. This rate can then be compared to the
company's hurdle rate to determine if the investment is worthwhile.
