The Internal Rate of Return (IRR) is the annual growth rate of an investment. It is used to determine the rate of financial profitability for a prospective investment. When determining the internal rate of return, the net present value is equal to zero.
The IRR is also vital in the computation of discounted cash flow. In this article, we shall look at the concept of the IRR, what it is about, and how to apply it.
How Does Internal Rate of Return Work?
In calculating the internal rate of return, you must factor in the net present value (NPV) and the discount rate. In simple terms, the net present value is the difference between present cash inflows and present cash outflows. If you’re looking to dabble in capital budgeting and investment planning, you’ll need to analyze the net present value.
NPV helps you know the monetary value of time in a business. To use NPV, you should factor in the discount rate. This is so because the wrong discount rate will affect NPV computation negatively. Also, bear in mind that the calculation of NPV involves the estimation of future cash flows which have not been determined. Without these two variables, it is practically impossible to determine the internal rate of return.
What Does IRR Tell You?
In project analysis and investment assessment, the IRR serves as a pointer to the viability of the enterprise. Companies rely on metrics like IRR to know whether or not to embark on any project.
Because the IRR employs future variables, it lets you know whether to put in your capital or not. Before the advent of computers, many people found it almost impossible to compute the IRR. Now, with the availability of computers, you can know the rate at which your investment grows yearly.
When Is IRR Used?
IRR is mainly used for the assessment of budgeted capital. Companies use IRR to analyze and compare new and existing projects. With the use of IRR, they can either move to capital budgeting for the new project or expand existing projects. Take, for example, a manufacturing company for shoes. Using IRR, they can choose to open a new assembly plant or expand an existing one.
IRR is also used to determine whether or not to commence projects. Where the IRR is at par or above the hurdle rate, the company can commence the project. But when the IRR is below the hurdle rate, the company should discontinue the project.
Following the example given above, the manufacturing company can choose to commence processing leather if the IRR Is favorable. But if the IRR is unfavorable, then it is clear that the company will put the leather business aside.
IRR helps companies make decisions regarding reverse share acquisitions. Reverse share acquisition is the process through which a company buys back its issued shares. However, before the company buys these shares, it must compute and analyze the IRR to ensure that repurchase is a good decision. To do this, the IRR will be measured against the IRR arising from the use of funds for alternative processes. If the IRR from the share repurchase is higher, the company shall then buy back the shares.
People can make decisions on their finances by relying on the IRR. Since it is almost impossible to calculate it without a computer, you should compute your IRR using your PC. With this at your disposal, you can evaluate every business/financial situation you’re in and make the best decisions possible.
How To Find the IRR
To find the IRR, you must have in mind that the NPV must be set to zero. This leaves you with the discount rate to solve for. Since the IRR reveals a cash outflow, the initial investment is recorded in the negative. Every other movement in cash afterward may be either positive or negative.
It is challenging and complicated to try calculating your IRR by hand. But using the Excel application on your computer, you can easily calculate and arrive at an accurate IRR value. You will use the “=IRR,” then highlight the initial negative cash outflow and the remaining cash inflows.
Compared to the analytical calculation, which involves working with pre-assigned values, in calculating IRR, you assign the values yourself.
Step by Step Process
To calculate the IRR, you should make use of the algebraic formula, which is expressed thus:
IRR = R1+[(NPV1 x (R2 – R1) ÷ (NPV1 –NPV2)]
R1 = Lower discount rate
R2 = Higher discount rate
NPV1 = Higher net present value (derived from lower discount rate)
NPV2 = Lower net present value (derived from higher discount rate)
To calculate IRR step by step, you need to do the following:
- Set NPV to 0 i.e NPV=0
- Set initial investment as negative
- Subsequent cash flow can be positive or negative. Income and further capital injection decide whether it is positive or negative.
- Calculate your IRR in Excel. This is because manual calculation can be difficult and complicated.
To calculate your IRR in Excel, there are three modes of calculation to follow. They are:
- Excel IRR Function: This involves a standard calculation of all variables in an IRR equation. With this mode, there is an assumption that all payment periods are the same. That is, all periods under calculation are equal.
- Excel XIRR Function: This function is more accurate in operation. This is because it takes into account the different periods. It also requires specific data for those periods, meaning that the level of accuracy will be significantly higher.
- Excel MIRR Function: This function shares similarities to the Excel IRR Function. The difference lies in the fact that Excel MIRR Function takes into account some other values. Values such as borrowing costs for the initial investment and reinvested cash flow causing coming interest are considered.
Example of IRR
Initial Investment = $2,500
Year One = $1,700
Year Two = $1,800
Year Three = $1,500
Year Four = $1,500
Year Five = $700
Initial Investment = $2,000
Year One = $400
Year Two= $700
Year Three = $500
Year Four = $400
Year Five = $300
The formula is expressed as:
IRR = R1+[(NPV1 x (R2 – R1)% ÷ (NPV1 –NPV2)
It can also be expressed as:
$0 = (initial outlay * -1) + CF1 ÷ (1 + IRR)1 + CF2 ÷ (1 + IRR)2 + … + CFX ÷ (1 + IRR)X
IRR = Internal Rate of Return
CF = Cash Flow
X = is the number of years
Using this formula, the IRR can be calculated thus:
$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 = 16.61%
$0 = (-$2,000) + $400 ÷ (1 + IRR)1 + $700 ÷ (1 + IRR)2 + $500 ÷ (1 + IRR)3 + $400 ÷ (1 + IRR)4 + $300 ÷ (1 + IRR)5
IRR = 5.23%
On the strength of these calculations, the company will go-ahead to commence work on Project X.
What Is a Good IRR?
An Internal Rate of Return is considered good when it matches or surpasses the hurdle rate. In this case, the corporate annual hurdle rate plays a part in determining which is a good IRR and which is a bad IRR.
The hurdle rate is equal in valence to the company’s cost of capital, which is the sum of the costs of debt and equity. Once the returns reach the minimum rate of return acceptable, then it is a good IRR.
High Internal Rate of Return
A high IRR shows that the minimum acceptable rate of return was matched or surpassed. Once this is the case, the company will commence the project.
Low Internal Rate of Return
A low IRR shows that the hurdle rate was not attained. This means that the company will no longer commence the project. Companies facing such a situation always leave the project or business.
Internal Rate of Return & Other Key Metrics
IRR is not the only metric for the measure of cash flow. It is unique for calculating cash flow by year. There are other metrics that many businesses employ. We shall look at them briefly.
Weighted Average Cost of Capital (WACC)
The Weighted Average Cost of Capital (WACC) is the percentage expression of the after-tax capital cost on average. Many companies prefer that it stays low. If it is low, then the costs of financing will also drop.
About IRR, the ideal situation in a business is where it is greater than the WACC. This ensures that the costs of financing the investment are covered.
While IRR is a business and investment analysis technique, WACC is the average future cost of funds that is expected.
Return on Investment (ROI)
This is one of the metrics for the measurement of investment performance. In comparison to IRR, ROI is more common across businesses. This is because IRR can not be calculated manually. While ROI focuses on the total growth from the company’s inception to the end, IRR focuses on the annual growth rate.
Advantages of Internal Rate of Return
There are so many reasons for which IRR is the perfect metric for your project investment analyses. Here are some reasons why it’s the best metric for use:
Time Value of Money
The time value of money is significant even when cash flow is even or uneven. This way, you can use these monetary time value specifics to track information, analyze it and make the needed changes.
For an individual with no background in finance, the concept of IRR is easy to understand. Such a person can also clearly grasp how IRR affects his business and his financial position. This is of great help as understanding will pave the way for wiser business decisions.
No Rate of Return
There is no need whatsoever to fix the cost of capital or the rate for cut-off. Therefore, the rate of return is only assumed, and IRR does not even factor it in.
Criticisms of Internal Rate of Return
IRR, just like any investment performance metric, has its flaws. Some of them are listed below.
Assumption of Reinvestment Rate
The assumption of reinvestment rate with IRR is, at best unrealistic. Assuming a variable is the height of inaccurate but wishful thinking. It doesn’t help the business, as these assumptions will not give you a clear idea of what the business needs.
Economies of Scale
Ignoring the dollar value of things is a pitfall that should be avoided. In carrying out calculations, it is essential to pay attention to the actual legal tender and observe or cushion any effects it may have.
Duration of Project
The IRR system does not factor in the different time durations between two different projects. This way, the results from calculations will be nothing short of error.
Mix of Negative & Positive Cash Flows
Having an outlook that focused on more than one rate of return loses sight of the cash flow for the project. Whether the cash flow is negative or positive, it might lead you into a Multiple IRR trap, so keep your eyes sharp.
What to Keep in Mind When Using IRR
In utilizing the IRR metric, you have to keep in mind that the Net Present Value must be set to zero. The initial investment must also be negative. Generally, IRR is used to ascertain the yearly growth of the business. Other metrics and rates apply to different types of projects.
For stocks and bonds, the Rate of Return will apply as the primary metric. Return on Investment covers the growth of the business from its inception to the end of the business. In essence, all rates apply in different ways and different scenarios. The point is to know when to use which.
Maximizing investor performance in business is a pretty daunting task. However, it is also essential to make educated decisions. Consult your financial advisor to maximize investment benefits and returns. No time is late, so join in.