This article explains the concept of a Internal Rate of Return or IRR. After assimilating it, you will be able to understand the basics of this financial indicator.
What is the Internal Rate of Return?
Internal Rate of Return (IRR) is the expected return on an investment that companies can do. The profitability of potential investments is calculated and the level and timing of the cash flows of both the potential returns of the investment and all the expenditures involved are taken into account. This is also known as discounting. Another name for IRR is ‘economic rate of return‘ (ERR), which clarifies the regaining of the investments. The internal return makes the net present value of all cash flows from an investment, also known as Net Present Value (NPV), equal to zero. Thus, IRR calculations are based on the same formula as that of NPV.
With IRR it is assumed that the minimal returns which can be achieved with a project, are at least equal to the amount invested across the duration of the project. However, external factors such as inflation or interest rates are not taken into account, though a small shift can already lead to major changes. Additionally, it is necessary to make the collection of cash flows cash, so that the value can be determined. The percentage that is used to determine the cash value is called the discount rate.
Thus the IRR is a capital budget in which the cash value of future cash flows of the investment must be equal to all costs that come with the investment. The discount rate is an efficiency concept of the total collection of cash flows, spread over several years. If IRR comes out higher than the minimal desired return on investment and if it also offers minimal risk, the investment is viewed as valuable. If the contrary proves true, and the IRR comes out lower than the minimal desired return on the investment, this is a sign that the investment isn’t worthwhile. If the IRR is higher than the minimal desired return on the investment, but the risk is too high, there is doubt, and a recalculation will determine whether or not to invest.
Internal Rate of Return is therefore a great tool to show if a project is worth pumping money into. When comparing two projects, the outcome of one of them can have a higher IRR and therefore deliver more returns on the investment. However, IRR doesn’t take the cost of the capital into account, which means that projects can not always be compared with each other in an equivalent way. It is also important to keep in mind the cash flows that are sometimes positive and sometimes negative, resulting in multiple IRR’s. In general, one can assume that the higher the return on investment of a project is, the more logical and lucrative it is to really execute that project. When using Internal Rate of Return, multiple projects can be compared and ranked, giving the most profitable projects right of way.
IRR gives insight in the growth speed that a project is expected to generate. The project with a substantially higher Internal Rate of Return offers the best chance of strong growth. IRR is also used to compare the profitability of potential new projects with the expansion and/or adaptation of older, already existing projects. For example, a waste processing company can use Internal Rate of Return to calculate the best investment; extend the old system with new environmentally friendly incinerators, or invest in the construction of a completely new installation that meets all current environmental requirements. Obviously both options will add specific value to the company, but the result of the Internal Rate of Return will be decisive in making the right choice.
When it is hard for companies to find projects with an Internal Rate of Return that is larger than the returns that can be generated on the financial markets, they can also decide to invest the retained earnings in the market. Like this, IRR’s can also be compared to the current return rates on the effects market.
Theoretically, every project with an Internal Rate of Return that is higher than the invested capital costs, will be profitable. This means that it is attractive for organisations to invest in such projects and to execute them. It even ensures that organisations are guided by this in making their strategic long-term planning. For investment projects, a compulsory return is therefore often determined in advance. This counts as a minimal acceptable return rate, which determines what the investment in question must yield to make it worthwhile.
It’s Your Turn
What do you think? How do you apply the Internal Rate of Return in your business life? Do you recognize the practical explanation or do you have more additions? What are your success factors for conducting financial calculations such as the Internal Rate of Return?
Share your experience and knowledge in the comments box below.
- Dudley, C. L. (1972). A note on reinvestment assumptions in choosing between net present value and internal rate of return. The Journal of Finance, 27(4), 907-915.
- Hagemann, H. (1990). Internal rate of return. In Capital Theory (pp. 195-199). Palgrave Macmillan, London.
- Magni, C. A. (2010). Average internal rate of return and investment decisions: a new perspective. The Engineering Economist, 55(2), 150-180.
- McAuliffe, R. E. (2006). Internal Rate of Return. Wiley Encyclopedia of Management.
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