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A major application of IRR is to determine the attractiveness or viability of projects or investments, and to choose the best project or investment among different alternatives.
An investment becomes attractive for investors, or a project becomes viable for a business if the internal rate of return of the investment or project is greater than the cost of capital, which is the established minimum acceptable rate of return by deploying that capital elsewhere. For instance, an investment of $10,000 to start a retail store might have an IRR of 10 percent. The same amount of $10,000 invested in fixed deposit may yield 6 percent, making investment in the retail business a more attractive preposition. The same amount, if invested in the stock market might however provide returns of 12 percent, making the alternative of investing in the stock market more attractive than starting the retail business.
The uses of IRR extend to ranking projects or various alternatives in terms of their attractiveness. The higher a project's internal rate of return, the more attractive such investment become for investors, or the more desirable it becomes to undertake a project. For instance, the IRR of the proposed retail store being 10 percent and the IRR of a proposed daycare center being 15 percent, starting a day care center makes better sense than starting a retail outlet, other things such as risks and external environment factors remaining equal.
IRR is a primary factor that companies consider when starting a business. For instance, if the IRR of construction projects remains high, more and more entrepreneurs take up this attractive business preposition and the economy may witness a construction boom. On the other hand, if input costs increase and the IRR for construction business become low, denoting reduced profits, the construction industry may stagnate even if external environment conditions such as the state of the economy remains favorable.
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There are many ways to determine the IRR of investments. One simple method of calculating and choosing the best alternative by IRR is by using a spreadsheet such as MS-EXcel or any online IRR and MIRR calcualtors available. The steps include
- list the cash flow, either positive or negative, of the investment, year wise in rows.
- calculate the net present value of future returns from the investment at the end of the row using the formulae (Future Value)/(1 + Interest Rate)^number of years below the cash flow rows
- identify the IRR as the percentage of discounted interest at which the net present value of the total returns from the investment becomes zero, by changing the interest rate in the equation.
- compare the IRR with the available rate of return for alternative investment such as bank deposit, or in case of comparing projects or investments, repeat steps 1 to 3 in the next column for the next project or investment.
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IRR is a good capital budgeting tool to determine the viability of a single project, to compare two investments or projects of similar size, type, duration, and nature, and analyze venture capital and private equity investments where there are several cash investments into the project, but only one cash outflow at the end of the project
Applying IRR to rank the attractiveness of mutually exclusive projects has severe limitations. Projects with higher initial investments tend to have a lower IRR compared to projects with lower initial investments. Option for the project with lower initial investment may be a distorter as the project with higher initial investment may have a better Net Present Value and increase shareholder wealth better. This is because IRR overstates the annual equivalent rate of return by assuming reinvestment of cash flows of the project at the same rates of return as the initial investment, which rarely holds true for large projects.
The Modified Internal Rate of Return (MIRR) attempts to remove this drawback of IRR by assuming reinvestment of the positive cash flows at the cost of capital rather than at the IRR rate. The Net Present Value method is an alternative method to rank the attractiveness of mutually exclusive projects.
The drawbacks and limitations of IRR notwithstanding, it remains one of the most popular tools to determine the attractiveness of projects and investments.
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- Baker, Samuel, L. “The Internal Rate of Return." University of South Carolina. Retrieved from http://hadm.sph.sc.edu/courses/econ/irr/irr.html on 10 November 2010
- Sigman, Karl. “Internal rate of return, bonds, yields." Retrieved from http://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-bonds.pdf on 11 November 2010.