IRR Meaning
IRR is a method of valuing investment attractiveness based on possible annual income growth. While using IRR in determining whether an investment is acceptable or not, alternative with higher IRR is taken. Investments with higher IRR than the costs of capital are acceptable.
The name, internal, denotes exclusion of external factors like inflation, financing risks, the cost of capital, and the risk-free rate. The internal rate of return is considered a superior method of valuing an investment since it discounts future value of money.
Concept of Internal Rate of Return
Measuring the rate of return on investment is crucial to any investment decision. This helps in determining the amount of return that is to be expected on any individual investment or a couple of them, considering a definite timeframe.
With knowledge on future possible incomes, a company can forecast its capital growth and ensure a steady return on capital invested over the years.
The internal rate of return is usually used together with the hurdle rate, which is the minimum amount of inflow the company needs to generate. Resultant IRR is compared against the hurdle rate to determine the project’s acceptability.
Calculating Internal Rate of Return
The following rules should be adhered to when calculating the internal rate of return:
- NPV should always be set to zero (IRR is the rate at which investment’s NPV = 0).
- The project’s initial investment should be negative as it represents cash going out.
- The subsequent cash flows can either be negative or positive regarding the cash flow.
IRR Formula
| 0(NPV) = CF0 + CF1 / (1 + IRR) ^1 + . . . + CFn / (1 + IRR) ^n |
Where
N = period of holding
CF0 = Year zero cash outflow
CFn = Present value for cash inflows
IRR= internal rate of return
Examples of Internal Rate of Return
IRR Example one:
An investor made an investment of $500 and expected to gain $570 in the following year. Calculate the internal rate of return for the investor.
Solution
The invested amount (cash outflow) = $500. This is the initial amount treated as a negative cash flow.
Period of time of investment = 1 year
Cash flow at the end of the period = $570
Using the internal rate of return formula,
0 = CF0 + CF1/ (1+IRR) 1
0 = -$500 + 570/ (1+IRR) 1
500 + 500 × IRR = 570
IRR = 70/500
IRR = 0.14 = 14%
Thus, the internal rate of return on the investment will be 14%.
Note:
$500 is a negative value (-$500) in the formula because it is a cash outflow.
IRR Example two:
A Company decides whether it should buy a piece of equipment worth $300,000, which would last for three years and bring in $150,000 of additional profit within the specified period. The company also can sell the piece of equipment at a scrap later on for $10,000. Using IRR, the company can determine whether the equipment bought is a better use of its cash than the other investment option, generating a return of about 10% (hurdle rate).
Solution
Here is how the IRR equation looks in this scenario:
| 0 (NPV) = -$300,000 + [$150,000/(1 + IRR)] + [$150,000/(1 + IRR)2] + [$150,000/(1 + IRR)3] + [$10,000/(1 + IRR)4] |
From above alculations, IRR is:
0(NPV) = 24.3% or 0.243
24.31% if the interest rate would make the NPV zero.
If you were to substitute IRR in the formula, the sum would have been:
| 0(NPV) = -$300,000 + [$150,000/(1 + 0.2431)] + [$150,000/(1 + 0.2431)2] + [$150,000/(1 + 0.2431)3] + [$10,000/(1 + 0.2431)4] |
| 0(NPV) = -$300,000 + ($150,000/1.2431) + ($150,000/1.5453) + ($150,000/1.921) + ($10,000/2.3879) |
| 0(NPV) = -$300,000 + 120,666.08 + 97,074.81 + 78,084.33 + 4,187.78 = 0 |
The above project should be accepted because the IRR is more than the hurdle rate. If the IRR is less than the hurdle rate, the project should be rejected.
Please note:
The formula for calculating IRR is always complex, and in major cases, it is calculated using the excel IRR function. Therefore, the IRR of 23.4% is based on trial and error.
Since the company’s internal rate of return is higher, it may pursue investing in the piece of property.
What Is a Good IRR?
Generally, a good internal rate of return should always be positive. This indicates the investment would generate some value over the period of investment. However, a negative internal rate of return indicates that the combination of time and profit may be less ideal to be undertaken.
The Rule of Internal Rate of Return
The rule states that an investment whose internal rate of return is greater than the hurdle rate (the minimum rate of return) is accepted, and a project whose IRR is less than the hurdle rate is not accepted.
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