Internal Rate of Return (IRR) -ALL YOU NEED TO KNOW

Saturday Brain Storming Thought (97) 22/01/2021 -COMPILED BY ER AVINASH KULKARNI

Internal Rate of Return (IRR)

Internal rate of return is the discounting rate where the total of initial cash outlay and discounted cash inflows are equal to zero

In other words, it is the discounting rate at which the net present value (NPV) is equal to zero

Net Present Value (NPV)

It is the difference between the present value of cash inflows and the present value of cash outflows over a period of time

NPV is used in capital budgeting and investment planning to analyze the profitability of a projected investment or project

PV = FV / (1+r)n

PV = net present value
FV = future value
r = interest rate
n = number of years

Net Present Value = add the present values you receive and subtract the present value you pays

Interpretation of IRR

IRR is defined as the discount rate at which you can ensure that your investment makes more money than it actual cost
Odette IRR value is less than the cost of capital, then the project should be rejected

IRR Rule

IRR rule is a guideline for deciding whether to proceed with the project or investment

The rule states that a project should be pursued if the IRR is greater than the minimum required rate of return

Approximate IRR

1) double money in 1 year – IRR 100%

2) double your money in 2 years – IRR 41%

3) double your money in 3 years – IRR 26%

4) double your money in 4 years – IRR 19%

5) double your money in 5 years – IRR 15%

Meaning of zero IRR

IRR zero means NPV zero

ie no profit no loss or the highest capital cost a project can bear in order to not loss money

Advantages of IRR

1) time value of money is being considered while calculating IRR

2) simple to interpret after the IRR is calculated

Easy to visualize by manager

3) no requirement of finding hurdle rate / required rate of return

4) managers make rough estimate of required rate of return

Disadvantages of IRR

1) economies of scale is ignored

2) impractical implicit assumption of reinvestment rate at the IRR itself for remaining period of the project

3) dependent or contingent project are being ignored while calculating IRR

4) mutually exclusive projects are ignored

5) different terms of project is not considered by IRR method

6) a mix of positive and negative future cash flows

7) if later cash inflows are not sufficient to cover initial investment calculation of IRR is not possible

8) what will increase in wealth is not possible to be measured by IRR

Time value of money (TVM)

TVM is the concept that money you have now is worth more than the identical sum in the future due to its potential earning capacity

This core principle of finance holds that provided money can earn interest, any amount of money is worth more the sooner it is received

Computation of IRR

IRR = [ (cash flows) / (1+r)i ] – initial investment

Cash flows = cash flows in the time period

r = discount rate

i = time period

Modified internal rate of return (MIRR)

MIRR considers cost of capital, and is intended to provide a better indication of a projects profitable return

It applies a discount rate for borrowing cash, and the IRR is calculated for the investment cash flows

MIIR is used, which has an assumed reinvestment rate, usually equal to the projects cost of capital

Average internal rate of return (AIRR)

AIRR approach, based on the intuitive notion of mean that solves the problem of IRR

Incremental internal rate of return (Inc-IRR)

It is an analysis of the financial return to an investor or entity where there are two competing investment opportunities involving different amount of investment

The analysis is applied to the difference between the costs and revenues of the two investments

Return on investment (ROI) vs Internal rate of return (IRR)

Meaning

1) ROI is the increase or decrease in an investment made over a set period

2) IRR is discount rate that makes NPV of cash flows from specific period as zero

Usage

1) ROI is useful to find out the performance of an investment made for short term

2) IRR is useful for calculating long term return

Formulae

1) ROI = [ (expected value – original value) / original value ] X 100

2) IRR = Current invest – future NPV @ IRR rate = zero

Complexity

1) ROI does not take future value of money, this calculation becomes relatively easy

2) IRR is bit CV implementation as it considers several factors into consideration

Similarities in ROI and IRR

1) both represent the average annual return on investment

2) both can be used for backward looking evaluation of a completed investment as well as forward looking estimate of performance
3) both can be expressed in terms of percentage