Internal Rate of Return (IRR)
What is the Internal Ratio of Return (IRR)?
The Internal Rate of Return (IRR) is the discount rate that renders the net value (NPV) of a project null. It is also the expected compound annual rate for return on investment or project.
The IRR is the expected cash flow for a project/investment. This is calculated, and the NPV equals 0. In other words, the initial cash investment will equal the present value future cash flow for that investment. (Cost paid = future cash flows and therefore the net value = 0.
After the internal rate is calculated, it is often compared to its hurdle rates or cost-of-capital. The company will accept the project as a worthwhile investment if the IRR is higher than or equal to capital cost. This assumes that this is the only basis for the decision.
Many qualitative and quantitative factors must be considered when making an investment decision. The IRR must not be lower than the hurdle rate, or it will be rejected.
What is the IRR Formula?
There are three methods to calculate the internal rate of returns:
- Use the IRR, XIRR function within Excel or any other spreadsheet program (see below).
- Use a financial calculation
- An iterative process where the analyst attempts different discount rates until the net profit is zero. (Goal View in Excel can be used for this).
A Practical Example
Here’s an example of how to calculate your Internal Rate of Return.
The company is considering buying new equipment, which will cost $500,000. The new asset will last for four years, according to management. It is expected to bring in $160,000 annually in profits. The company intends to sell the equipment at a salvage value of $50,000 in the fifth year.
Another similar investment option could yield a 10% return. This is higher than the current hurdle rate of 8.8%. This is to ensure that the company makes the most of its cash.
Below is the IRR calculation for investing in new equipment.
Excel was used to calculate 13% IRR using the function = IRR(). The IRR of 13% is greater than the hurdle rate and more than the IRR for alternative investments. Therefore, the company should purchase the shares.
What is the Internal Return Rate Used for?
Businesses take on different projects to grow their revenue or reduce costs. For example, a great business idea might require investing in developing and producing a product.
Senior leaders want to know the expected return on capital investments when budgeting. One method they can use to rank projects is the internal rate of return. The best investment is the one with the highest return on investment.
The Internal Rate of Return is widely used to analyze private equity or venture capital investments. This involves multiple cash investments over a company’s life and a cash flow at its end through an IPO.
An analyst must examine the net value (NPV) and the internal rate to make the best investment decision. Investors and managers may choose to invest a smaller amount of money but a higher absolute return.
It’s also important to understand your risk tolerance, the investment needs of your company, risk aversion and any other options.
