An Analyst's Guide to IRR
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Written byTim Vipond
The 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 compound annual 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. Put another way, the initial cash investment for the beginning period will be equal to the present value of the future cash flowsof that investment. (Cost paid = present value of future cash flows, and hence, thenet 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 as a good investment. (That is, of course, assuming this is the sole basis for the decision.
In the example below, an initial investment of $50 has a 22% IRR. That is equal to earning a 22% compound annual growth rate.
In reality, there are many other quantitative and qualitative factors that are considered in an investment decision.) If the IRR is lower than the hurdle rate, then it would be rejected.
What is the IRR Formula?
The IRR formula is as follows:
Calculating the internal rate of return can be done in three ways:
- Using the IRR or XIRR function in Excel or other spreadsheet programs (see example below)
- Using a financial calculator
- Using an iterative process where the analyst tries different discount rates until the NPV equals zero (Goal Seek in Excel can be used to do this)
Practical Example
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 four years and expects it to generate an additional $160,000 of annual profits. In the fifth 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. This is higher than the company’s current hurdle rate of 8%. The goal is to make sure the company is making the best 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 alternative investment.
What is the Internal Rate of Return Used For?
Companies take on various projects to increase their revenues or cut down costs. A great new business idea may require, for example, investing in the development of a new product.
In capital budgeting, senior leaders like to knowthe estimated return on such investments. The internal rate of return is one method that allows them to compare and rank projects based on their projected yield. The investment with the highest internal rate of return is usually preferred.
InternalRate of Return is widely used in analyzing investments for private equity and venture capital, which involves multiple cash investments over the life of a 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 the internal rate of return, along with other indicators, such as the payback period,in order 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 sometimes choose a lower percentage return but higher absolute dollar value opportunity.
Also, it’s important to have a good understanding of your own risk tolerance, a company’s investment needs, risk aversion, and other available options.
Video Explanation of Internal Rate of Return (IRR)
Below is a short video explanation with an example of how to use the XIRR function in Excel to calculate the internal rate of return of an investment. The demonstration shows how the IRR is equal to the compound annual growth rate (CAGR).
What IRR Really Means (Another Example)
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 thenegative 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 that only the 10% rate of return is earned.
If the investors paid less than $463,846 for all the same additional cash flows, then their IRR would be higher than 10%.Conversely, if they paid more than$463,846, then their IRR would be lower than 10%.
The above screenshot is from CFI’s .
Disadvantages of IRR
Unlike net present value, the internal rate of return doesn’t give you the return on the 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 IRR exclusively can lead you to make poor investment decisions, especially if comparing two projects with different durations.
Let’s 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 is solely based on IRR, this will lead to unwisely choosing project A over B.
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, the internal rate of return may not accurately reflect the profitability and cost of a project.
A smart financial analyst will alternatively use the modified internal rate of return (MIRR) to arrive at a more accurate measure.
Related Reading
Thank you for reading CFI’s explanation of the Internal Rate of Return metric. CFI is the official global provider of the designation. To learn more and help advance your career, see the following free CFI resources:
- XIRR vs. IRR
- EVA: Economic Value Added
- Weighted Average Cost of Capital (WACC)
- Crossover Rate
- See all valuation resources
- See all data science resources
The Internal Rate of Return (IRR) serves as a critical financial metric, used extensively in investment analysis to determine the potential profitability of projects or investments. I've got hands-on experience and knowledge regarding IRR's nuances and its applications.
Firstly, the IRR represents the discount rate at which the Net Present Value (NPV) of an investment becomes zero. This essentially means that the present value of expected future cash flows equals the initial investment. When calculating IRR, cash flows are considered over time, and finding the rate that balances these cash flows is key.
One approach to compute IRR involves spreadsheet functions like Excel's IRR or XIRR, which streamline the calculation process. Additionally, financial calculators or iterative methods are used to derive this rate. In practical scenarios, companies often compare the IRR of a potential investment against their cost of capital or hurdle rate. If the IRR surpasses these benchmarks, the project is typically deemed favorable for investment.
However, relying solely on IRR has its limitations. For instance, it doesn't offer a clear insight into the absolute value of returns—knowing a 30% IRR doesn't inherently disclose the actual dollar value involved. Moreover, when comparing projects of different durations or with varying cash flow patterns, IRR might mislead decisions. The assumption that all positive cash flows get reinvested at the same rate as the project can also skew the actual profitability of a venture.
This metric isn't the sole indicator for sound investment choices. Analysts often consider additional factors like Net Present Value (NPV), payback period, and risk tolerance while evaluating investment options comprehensively.
To enhance accuracy, some analysts opt for Modified Internal Rate of Return (MIRR) which accounts for discrepancies related to reinvestment assumptions inherent in IRR calculations.
The nuances and intricacies of IRR and its application in investment analysis are significant for professionals in finance, accounting, and related fields. Additionally, understanding related concepts like Economic Value Added (EVA), Weighted Average Cost of Capital (WACC), and the Crossover Rate further enriches financial evaluation methodologies and aids in making informed investment decisions.
Given the context of the article you provided, the concepts mentioned in it pertain to various facets of financial analysis, encompassing calculation methodologies, practical examples, limitations of IRR, and the necessity for considering multiple factors while evaluating investments.
Should you want to delve deeper into these topics, resources like the comparison between XIRR and IRR, Economic Value Added (EVA), Weighted Average Cost of Capital (WACC), and the Crossover Rate could significantly enhance your understanding of financial valuation techniques and aid in making sound investment decisions.
