Internal Rate Of Return IRR - definition & overview

The Internal Rate of Return (IRR) is a financial metric that is widely used in capital budgeting and investment planning. It is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. IRR calculations rely on the same formula as NPV does.

The IRR can be defined 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 estimated IRR value than other available options would still provide a much better chance of strong growth.

Understanding the Internal Rate of Return (IRR)

The IRR is one of the most popular metrics for project analysis and if understood well, can lead to better business decisions. The IRR is the discount rate at which the net present value of future cash flows from an investment equals zero. In other words, if we compute the present value of future cash flows from a particular project for different discount rates, we get a curve. The rate at which this curve crosses the zero line on the graph is the IRR.

The IRR is also called the breakeven interest rate because it identifies the maximum interest rate at which an investment becomes less desirable. If the IRR of a project exceeds the required return, the project is considered a good investment. If not, it's not worth taking on the risk.

Calculating the IRR

The IRR can be calculated using the following formula:

0 = P0 + P1/(1+IRR) + P2/(1+IRR)^2 + P3/(1+IRR)^3 + . . . + Pn/(1+IRR)^n

Where:

P0, P1, . . . Pn equals net cash inflows during periods 1 through n

IRR equals the project's internal rate of return

This formula is complex because it includes the IRR in the denominator of the fraction. Therefore, the IRR cannot be calculated directly; instead, it must be found using mathematical trial-and-error or software programs with financial functions.

Uses of the IRR

IRR 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.

IRR works best for evaluating whether one should make a large capital outlay to get cash flows later, such as building a new factory or launching a new product line. It's less effective for decisions that aren't linked to future cash flows, such as choosing between marketing strategies or human resources policies.

Limitations of the IRR

While the IRR is a powerful tool in the financial analyst's toolbox, it does have its limitations. One of the main issues with the IRR is that it can give you multiple answers or no answer at all. This is because it is calculated by setting the net present value equal to zero, and solving for the discount rate (which is the IRR). If the cash flows are unconventional, meaning the cash flows change direction more than once, there can be more than one rate that will make the NPV equal to zero, thus resulting in multiple IRRs.

Another limitation of using the IRR method is that it does not account for the project size when comparing projects. Cash flows of high-value projects are likely to be reinvested at the cost of capital, which is likely to be lower than the calculated IRR. This reinvestment can make smaller projects with a shorter duration more appealing than they should be.

Multiple IRRs

When a project's cash flows take on an unconventional pattern, the IRR approach may provide multiple rates of return. This means that more than one IRR can be found for the same project. The multiple IRR problem occurs when the cash flows during the life of a project cross the horizontal axis more than once.

For example, suppose a two-year project with an initial outlay of �$500 and expected future cash flows of �$1,800 and then -�$1,300. This means that the cash flow stream changes direction from negative to positive to negative. In this case, there are two IRRs: 43.48% and 292.72%, which would lead to confusion in decision making.

IRR and Non-Conventional Cash Flows

A project with a mix of positive and negative cash flows might have multiple IRRs, or no IRR at all. This is known as the multiple IRR problem, and it's one of the reasons why people might prefer to use the modified internal rate of return (MIRR) instead of the regular IRR.

The MIRR solves the multiple IRR problem by assuming that positive cash flows are reinvested at the firm's cost of capital. Therefore, MIRR is the rate at which the present value of a project's cost equals the present value of the benefits, where the cash flows are compounded at the firm's cost of capital.

IRR in the Context of Small Businesses

For small businesses, understanding the concept of IRR is crucial for making informed decisions about potential investments or projects. The IRR serves as a gauge for the profitability of the potential investment. If the IRR is greater than the cost of capital, the project or investment could be considered a good choice.

However, small businesses should also be aware of the limitations of using IRR. The IRR rule may not always offer the most accurate decision criteria given the specific cash flow patterns of a project, or if the firm plans to reinvest the cash inflows at a rate other than the IRR.

IRR and Capital Budgeting

Small businesses can use the IRR in capital budgeting. Capital budgeting is a process that companies use to evaluate which large projects they should pursue. If they calculate a project’s IRR to be greater than the rate at which they discount cash flows, then they will likely proceed with the project.

However, if a company is considering two or more mutually exclusive projects, the decision rule of taking the project with the highest IRR may not always give the correct decision. This is because the IRR method does not consider the project size when comparing projects. Therefore, a smaller project with a shorter time span may have a higher IRR than a larger project that generates more total profits.

IRR and Financing

Small businesses can also use the IRR to consider different financing options. For example, consider a firm is considering two options to finance its operations: a bank loan with a fixed interest rate or a line of credit with a variable interest rate. The IRR can be used to find the break-even point where the two financing options result in the same net present value of costs. This can help a firm choose between different financing options.

However, the IRR rule may not provide the right decision when comparing mutually exclusive projects. This is because the IRR method does not consider the financing of the project, which could be a source of risk. Therefore, when comparing two financing options, the firm should also consider the potential risks of each option, such as the risk of default or the risk of interest rate changes.

Conclusion

The Internal Rate of Return (IRR) is a useful financial metric that small businesses can use to evaluate the profitability of potential investments or projects. However, it has its limitations, such as the possibility of multiple IRRs and its inability to consider the project size or financing method. Therefore, while the IRR can serve as a good starting point in the decision-making process, small businesses should also consider other financial metrics and factors when making decisions.

Despite its limitations, the IRR is a popular metric because it can give businesses a simple snapshot of the potential profitability of a project or investment. By comparing the IRR to the cost of capital, businesses can gauge whether a project or investment is worth pursuing. Therefore, understanding the IRR and its limitations can help small businesses make informed decisions and maximize their profitability.