The IRR – internal rate of return – is considered a core component of corporate finance and capital budgeting. Businesses use this to figure out which discount rate makes the current value of future after-tax cash flow equal to the upfront cost of a capital investment.
To make it easy, it means what discount rate results in the net present value (NPV) of a project to reach $0?
If investments require capital, that’s used somewhere else. The IRR refers to the lowest level of return from a project that is considered acceptable to justify the investment being made.
Understanding how to calculate IRR may seem impossible, but the guide here is designed to help make it a bit easier.
Understanding the IRR Rule
If you have a project that’s expected to create an IRR that is greater than the rate used for discounting cash flows, the project is said to add value to a business. However, if the IRR is under the discount rate, it will destroy any potential value.
The decision process used to reject or accept a project is referred to as the IRR rule.
Pros and Cons of Using IRR for Valuing Projects
An advantage offered by IRR is it normalizes returns. Since it is expressed in percentage form, everyone will understand what 30% rate means. The other option is a hypothetical dollar equivalent, which is how NPV is shown.
While this is true, there are some disadvantages to using IRR for valuing projects.
It is best to choose the project showing the highest NPV rather than the highest IRR. That’s because all financial performance is measured using dollars.
If you are dealing with two projects that have similar risks, such as:
- Project 1 with 25% IRR
- Project 2 with 50% IRR
You may choose the one with the highest IRR. However, Project 1 has the higher NPV because it’s longer-term. This means Project 1 should be picked even though the IRR is lower. It’s necessary to examine all factors to ensure the right decision is made.
Another issue with IRR is that it makes the assumption you can keep reinvesting any type of incremental cash flow at the same IRR. In some cases, this isn’t possible.
A better approach is to use the Modified IRR or MIRR. This assumes the reinvestment of any future cash flow at reduced discount rates.
How to Calculate IRR
It is not easy to derive IRR. The best way to calculate it by hand is through the process of trial and error. That’s because you are trying to arrive at the rate that makes NPV equal zero.
What this means is that your first step is to calculate the NPV.
The formula used for this (in simplified terms) is:
- NPV=(Current value of expected future cash flows) – (Current value of invested cash)
When these are further evaluated, each of the period’s after-tax cash flow at the time is “t,” which is discounted by a certain rate “r.” When you combine all the discounted cash flows will be offset by your initial investment. This provides you with the NPV.
To discover what the IRR is, you must “reverse engineer” the value of “r.” The goal is to ensure that the end result for the NPV is zero.
You can find an array of financial calculators to help you with these calculations. There are also special functions included in the Excel program to help you calculate IRR.
To figure out the IRR of any project, the first step is to determine the initial cost, which is your capital investment. At this point you determine any potential cash flows in the future. In almost every situation, this input data is more difficult to figure out than the actual calculation.
Understanding the Importance of IRR
With IRR, managers can figure out what projects will add more value to the business. This helps them figure out which ones should be taken on.
The benefit of expressing project values in rate form is the hurdle this offers. If the financing costs are less than what the rate of return is, then the project will add value.
However, there are disadvantages, too. For example, the IRR will only be as accurate as the assumptions. This means that higher rates don’t always mean the highest value project when it comes to dollars.
There are several projects that may have the IRR, but significantly different returns. This is often because of the size of the cash flow, timing, or the total amount of leverage being used.
An IRR analysis usually assumes constant reinvestment rates, too. These could be higher than more conservative reinvestment rates.
Getting Help with IRR
For some businesses, it will be necessary to seek the help of a professional to determine IRR. It is best to find a company with industry experience.
This is going to ensure the desired results and figures are found.
How to Calculate IRR: Now You Know
As you can see, there are several factors to consider when calculating IRR. Using the information here provides a good starting point; however, more insight may be needed.
If you require assistance or insight, contact us. You can get started on our website and find out why our services and solutions are rated so highly. Our team is here to answer any questions you have and ensure you are making the right decisions for your business.
Being informed is the best way to fully understand IRR and what it offers.
