What is IRR?
IRR, short for internal rate of return, is a metric used to show the profitability of a potential project or investment. Companies use it in capital budgeting when deciding where to invest their money. IRR is frequently used in the real estate industry to evaluate an investment.
In addition to projects, IRR can be calculated on other assets, including stocks and bonds.
IRR and NPV are typically used in tandem with each other, but they are not the same. IRR measures a rate of return as a percentage and NPV shows how much wealth is created from a project in dollars.
The internal rate of return is actually the discount rate that makes the NPV of a project equal to zero.
IRR should not be confused with the cost of capital. The IRR on a project is not the same as a company’s cost of capital. An IRR is an internal rate of return, meaning the return is dependent on the project’s own cash flows.
Despite the praise and how commonly it is used, IRR is not perfect. We’ll go into the details in the post.
IRR and the cost of capital (or required rate of return) are both considered in investment analysis. IRR is compared the cost of capital in the IRR Rule.
The IRR rule is one guideline for deciding whether to move forward with an investment or project.
If the IRR of a potential investment exceeds the company’s cost of capital, the project is attractive. If the IRR is less than the cost of capital, money would be better invested elsewhere where it can achieve a higher return.
IRR Formula and Calculation
Calculating the internal rate of return by hand is no easy task. It requires using the NPV formula, setting NPV equal to zero, and solving for the rate, which will be the IRR.
The calculation would likely require many iterations to arrive at the IRR value that sets NPV exactly equal to zero.
- CF0 = Initial investment
- CF1, CF2, CF3…CFn = Cash flows
- n = Individual period
- N = Holding period of investment
- NPV = Net Present Value
- IRR = Internal Rate of Return
Let’s consider a project that requires an upfront investment of $300,000.
The project is expected to bring in $75,000 in positive cash flows in years 1-4. In the 5th year, the project will have a final cash flow of $125,000 due to the sale of the investment.
The screenshot above shows that the IRR would be 11.8%. While the equation looks neat and clean, calculating this by hand would be cumbersome and inefficient.
The more efficient ways to calculate IRR is to use Microsoft Excel or a financial calculator.
Excel has a built-in function for IRR. The syntax is straightforward:
List out the cashflows and the corresponding time periods those cash flows were earned. The initial investment will be at time 0 since it happens at the start of the project.
Type in your IRR function and select the cash flows. The [guess] argument is optional and unnecessary for this example. After selecting the cash flow values, press enter. It’s that easy.
We can calculate IRR conveniently using a financial calculator. Let’s walk through the keystrokes needed to calculate IRR with a TI Business Analyst II Plus.
Press the CF button and clear out the cash flows so you have a clean slate.
Enter 300,000 for CF0 and hit the +/- sign to make the number negative since this is the $300,000 initial outlay.
Hit enter and the down arrow. For C01 enter 75,000. Hit enter and the down arrow.
F01 will be the frequency that the cash flow occurs. In our example, the project brings in $75,000 for years 1-4. For this reason, we will enter 4 for C01. Hit enter and down again.
For C02, enter in 125,000. Hit enter and down. For F02, enter in 1 since this only occurs one time.
Hit enter, then the IRR button, then the CPT button to compute IRR. The calculator will show 11.84 for 11.84%.
|[CF] [2nd] [CLR WORK]||Clears memory||CFO = 0.00|
|300,000 [+/-] [ENTER]||Initial cash investment||CFO = -300,000|
|[↓] 75,000 [ENTER]||Period 1 cash flow||C01 = 75,000|
|[↓] 4 [ENTER]||Frequency of cash flow 1-4||F01 = 4.0|
|[↓] 125,000 [ENTER]||Period 5 cash flow||C02 = 125,000|
|[↓] 1 [ENTER]||Frequency of cash flow 5||F02 = 1.0|
|[IRR][CPT]||Computes IRR||IRR = 11.84|
Importance of IRR
The internal rate of return is an important metric used and analyzed to determine the profitability of a potential investment. The “rate” in the internal rate of return is the rate of growth an investment is expected to generate.
This investment can be a stock, a bond, a project, a real estate asset, and even an investment in an entire company. Venture capital and private equity firms use IRR to evaluate companies for potential investment.
Knowing what the IRR is on an investment will allow you to benchmark that return against a company’s cost of capital and against other investment options.
If a project exceeds the cost of capital, it can be considered for investment. If it doesn’t exceed the cost of capital, it can be discarded from the list.
Remember: The goal of a company is to maximize shareholder wealth
For a company, capital budgeting and capital allocation are important for the growth of the firm and its value. The goal of a company is to maximize shareholder wealth, and the IRR metric is one of the metrics management will consider when analyzing options.
IRR can be used to determine if the better option for a company would be to build and open new operations/projects or expand on current ones. The choice with the higher IRR could be the better option.
Maybe the company is considering buying back stock from shareholders. By looking at the IRR of an investment in new operations versus the expected IRR of an investment in the company’s stock, the company may determine that the higher IRR would be achieved through stock buybacks.
If investing $1 billion in a new corporate building yields an IRR of 14% and the stock is expected to have an IRR of 20%, the $1 billion should be allocated to the stock.
It is important to emphasize that the internal rate of return shouldn’t be used alone to come to a decision of moving forward with or killing a deal.
A complete investment analysis requires the examination of many variables and multiple financial metrics including NPV, return on investment, cash on cash return, and payback period.
Things to Note When Analyzing IRR
When using IRR in decision making, it isn’t as simple as investing in all projects that have an IRR greater than the company’s cost of capital. Although this is the basis of the IRR rule, there are other things that need to be taken into consideration as well.
Rate of return vs absolute return (NPV)
The rate of return and absolute return in dollars need to be looked at together in the decision making process. There are often situations when a company would prefer to accept a lower IRR on a larger project than a higher IRR on a smaller project.
For example, let’s say we have two projects we are looking at. Project A has an IRR of 20% and Project B has an IRR of 10%. Project A seems like the best choice, right?
Well, not necessarily. Project A has an initial investment of $50,000 and Project B has an investment of $5,000,000. Although the company realizes returns at a slower rate with Project B, the 10% return on Project B will bring in more absolute dollars to the firm than the 20% earned on Project A.
To an extent, a company will want to accept projects with an NPV that adds the most value to the firm. They want projects that “move the needle.”
Projects with different lengths of duration
When comparing projects, analyze the duration of the projects. Depending on the variables to the IRR formula, an investment with a shorter duration and higher IRR could appear to be more promising than an investment with a longer duration and lower IRR.
You’ll need to analyze the cash flows earned over time and at the end of the investment. The investment with the lower IRR could have the higher NPV by the end of the investment. With a longer duration, lower IRR and larger NPV, you can characterize the investment as one that earns returns slow and steadily.
Capital rationing, IRR, and NPV
IRR and NPV need to be used in tandem with each other. Neither should be used alone to come to a final decision.
Capital rationing is a limit set for the amount of money that can be invested. This needs to be kept in mind when considering investment options.
If a firm has a capital rationing of $1,000,000 to allocate towards investment, choosing an investment that requires $900,000 in funds and has an IRR of 10% will achieve a higher NPV than an investment that requires $100,000 in funds and has an IRR of 15%. However, nearly all the funds in the capital rationing will be used in the first scenario.
A company might not want to allocate all their funds to one investment. An option could be to pursue several projects with higher IRRs and lower NPVs so the total investment amount from their capital rationing brings in a higher NPV.
The rate cash flow is reinvested at (MIRR)
The IRR calculation assumes that all positive cash flows from an investment are reinvested at the same rate as the project, instead of the cost of capital of the firm. Because of this assumption, it’s possible the internal rate of return can be inaccurate and overstated. An overstated return can lead to costly capital budgeting mistakes.
To more accurately predict the profitability of an investment or project, one could use the modified internal rate of return (MIRR).
The MIRR formula assumes that positive cash flows are reinvested at the firm’s cost of capital and the initial outlays are funded at the company’s financing cost.
For these considerations, it is said that MIRR is more accurate than IRR.
Excel also has a function to calculate MIRR.
Below, you will see two tables for the same project. The cash flows are identical.
The project shows and IRR of 20% and an MIRR of 15%. MIRR accounts for the company’s financing cost of 5% and reinvests positive cash flows at the company’s cost of capital of 8%.
The result is a lower return. Seeing a 15% return versus a 20% return could be the deal breaker on choosing to invest in this project.
IRR is a useful financial metric to help determine an investment’s profitability. The investment could be in a project, piece of real estate, a company, and even a stock or bond.
IRR equips analysts and investors with a tool to compare projects and decide which one they should pursue.
Although the IRR rule states that a company should pursue any project that exceeds the company’s cost of capital, it should not be the only factor to base a decision on.
IRR is not perfect and does have its drawbacks. The best thing to do is to conduct a thorough investment analysis considering all variables and multiple financial metrics and financial ratios.