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Internal rate of return (IRR)
Md. Al-Amin:
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What it is:
Internal rate of return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero.
Internal rate of return is used to evaluate the attractiveness of a project or investment. If the IRR of a new project exceeds a company’s required rate of return, that project is desirable. If IRR falls below the required rate of return, the project should be rejected.
How it works/Example:
The formula for IRR is:
0 = P0 + P1/(1+IRR) + P2/(1+IRR)2 + P3/(1+IRR)3 + . . . +Pn/(1+IRR)n
where P0, P1, . . . Pn equals the cash flows in periods 1, 2, . . . n, respectively; and
IRR equals the project's internal rate of return.
Let's look at an example to illustrate how to use IRR.
Assume Company XYZ must decide whether to purchase a piece of factory equipment for $300,000. The equipment would only last three years, but it is expected to generate $150,000 of additional annual profit during those years. Company XYZ also thinks it can sell the equipment for scrap afterward for about $10,000. Using IRR, Company XYZ can determine whether the equipment purchase is a better use of its cash than its other investment options, which should return about 10%.
Here is how the IRR equation looks in this scenario:
0 = -$300,000 + ($150,000)/(1+.2431) + ($150,000)/(1+.2431)2 + ($150,000)/(1+.2431)3 + $10,000/(1+.2431)4
The investment's IRR is 24.31%, which is the rate that makes the present value of the investment's cash flows equal to zero. From a purely financial standpoint, Company XYZ should purchase the equipment since this generates a 24.31% return for the Company --much higher than the 10% return available from other investments.
A general rule of thumb is that the IRR value cannot be derived analytically. Instead, IRR must be found by using mathematical trial-and-error to derive the appropriate rate. However, most business calculators and spreadsheet programs will automatically perform this function.
[Click here to see How to Calculate IRR Using a Financial Calculator or Microsoft Excel]
IRR can also be used to calculate expected returns on stocks or investments, including the yield to maturity on bonds. IRR calculates the yield on an investment and is thus different than net present value (NPV) value of an investment.
Why it Matters:
IRR allows managers to rank projects by their overall rates of return rather than their net present values, and the investment with the highest IRR is usually preferred. Ease of comparison makes IRR attractive, but there are limits to its usefulness. For example, IRR works only for investments that have an initial cash outflow (the purchase of the investment) followed by one or more cash inflows.
Also, IRR does not measure the absolute size of the investment or the return. This means that IRR can favor investments with high rates of return even if the dollar amount of the return is very small. For example, a $1 investment returning $3 will have a higher IRR than a $1 million investment returning $2 million. Another short-coming is that IRR can’t be used if the investment generates interim cash flows. Finally, IRR does not consider cost of capital and can’t compare projects with different durations.
IRR is best-suited for analyzing venture capital and private equity investments, which typically entail multiple cash investments over the life of the business, and a single cash outflow at the end via IPO or sale.
http://www.investinganswers.com/financial-dictionary/investing/internal-rate-return-irr-2130
munna99185:
Internal Rate of Return (IRR) is the discount rate often used in capital budgeting that makes the net present value of all cash flows from a particular project equal to zero. Generally speaking, the higher a project's internal rate of return, the more desirable it is to undertake the project. As such, IRR can be used to rank several prospective projects a firm is considering. Assuming all other factors are equal among the various projects, the project with the highest IRR would probably be considered the best and undertaken first. You can think of IRR as the rate of growth a project is expected to generate. While the actual rate of return that a given project ends up generating will often differ from its estimated IRR rate, a project with a substantially higher IRR value than other available options would still provide a much better chance of strong growth. IRRs can also be compared against prevailing rates of return in the securities market. If a firm can't find any projects with IRRs greater than the returns that can be generated in the financial markets, it may simply choose to invest its retained earnings into the market.
[Source: http://www.investopedia.com]
Sayed Farrukh Ahmed
Assistant Professor
Faculty of Business & Economics
Daffodil International University
tanzina_diu:
The discount rate that forces the PV of a project’s future cash inflows, to be equal the PV of its total cost. Equivalently, the rate that forces the NPV to equal zero is internal rate of return.
Procedure to calculate IRR
1. Given the inflows and cash outflow, choose a discount rate at random and calculate the project NPV.
2. If the NPV is positive, choose a higher discount rate and calculate the project NPV
3. If the NPV is negative, choose a lower discount rate and calculate the project NPV
4. Make adjustment through Interpolation or Trial-and-error method to find out accurate Internal Rate of Return
IRR > Cost of capital (Requited rate of return) – Accept the project
IRR < Cost of capital (Requited rate of return) - Reject the project
IRR = Cost of capital (Requited rate of return) – Indifferent
Advantages
It recognizes Time Value of Money
It considers all cash flows occurring over the entire life of the project to calculate the rate of return
The discount rate is easily comparable to the project cost of capital
It provides a rate of return which is indicative of the profitability of the project
It is consistent with shareholder’s wealth maximization goal
It is easily understandable to the business executive
Disadvantages
It is not easy to use, understand, and calculate
Complex trial-and-error technique
It provides misleading and inconsistent result when the NPV of a project does not decline with the discount rate
It also fails to indicate a correct choice between mutually exclusive projects under certain situation
It does not hold value additivity principle.
Though it does not use the concept of required rate of return yet, It provides decisions by comparing with that
Sometimes it provides multiple rates that creates confusion
It is determined based on the assumption that all intermediate cash inflows are reinvested at IRR
tanzina_diu:
IRR Method:
A method of ranking investment proposals using the rate of return on an investment calculated by finding the discount rate that equals the PV of future cash inflow to the PV of cash outflow
Economic Rationality of IRR Method
o The IRR on a project is its expected rate of return
o If the IRR exceeds the cost of fund used to finance the project, a surplus remains after paying for the capital and these surplus accruals to the firm’s shareholder
o Taking on a project that is IRR exceeds cost of capital increases share holder’s wealth.
tanzina_diu:
Multiple IRR
There is one other situation in which the IRR approach may not be usable-when projects with nonnormal cash flows are involved. A project with nonnormal cash flow can create multiple IRR (more than one IRR). A project has normal cash flows if it has one or more cash outflows (costs) followed by a series of cash inflows. If, however, a project calls for large cash out flow sometime during or at the end of its life, then the project has nonnormal cash flows. When we try to find out the IRR on the basis of nonnormal cash flows, we must get more than one IRR, which are called Multiple IRR.
For example: Suppose, if we invest Tk. 16,00,000 in a gas field, after one year we get TK 100,00,000 cash inflow but at the next year TK 10000000 cash outflow occurs for an accident. Therefore, the project’s expected net cash flows are as follows:
Expected Net cash flows
Year 0 End of year 1 End of year 2
-16 lakh. +100 lakh. -100 lakh.
Now we can calculate the IRR by using the values in the formulae-
-16 lac 100 lac -100 lac
(1+IRR)0 (1+IRR)1 (1+IRR)2
If we solve this equation, we will find NPV=0 when IRR = 25% and also when IRR = 400%. Therefore, the IRR of the investment is both 25 and 400 percent and that are multiple IRR.
So, in this situation, it is very difficult to make decision by using IRR method.
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