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Interpreting the Internal Rate of Return Formula
Internal Rate of Return (IRR) is a financial measure used to evaluate projected cash flow results and to compare the feasibility of a project/investment. IRR is generally used with other financial measures such as Net Present Value (NPV) and Return on Investment (ROI). IRR is defined as the discount rate at which you can ensure that your investment makes more money than its actual cost. In other words, it is the rate at which NPV is zero. If the IRR value is less than the cost of capital, then the project should be rejected Else, the project can be accepted.
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Developing the Internal Rate of Return Formula
1. Make a list of all the cash flows involved in the project. The money received is denoted as a positive value and the money invested is denoted by a negative value. The money invested generally includes the initial investments and other additional deposits which are invested at the start of the project. The money received generally includes the profits earned and the ending balance.
Based on this, the internal rate of return formula can be devised as follows:
where CF represents the cash flow generated in each time period; n represents the last time period and r represents the IRR value.
2. It is not easy to calculate IRR without the use of a financial calculator or Excel program. If calculating manually, one has to make use of the trial and error method. Microsoft Excel has the IRR equation programmed into it as a function. To use Excel, enter the cash flows in one column, highlight the same and evaluate using the “IRR” function.
3. Once the IRR is calculated, it is important that one understands how to interpret the results. The IRR is a percentage value. For a future investment, if the IRR is positive, then, the investment is expected to give returns. A zero IRR indicates that the project would break even.
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Uses of IRR
When comparing projects which have equal risks, IRR is a very useful tool. Corporations use the IRR formula to compare capital projects. Consider the example of a corporation which is evaluating the utility of a new investment in a plant versus extension of the existing plant. Here, the corporation calculates the IRR for both scenarios and the project which has the highest IRR is considered as a better option, assuming that all other factors are equal.
Corporations also make use of the IRR formula in evaluating stock buyback programs.
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Limitations of IRR
The biggest limitation of the IRR formula is that it assumes that the cash flows reinvested into the project at the same discount rate. In an actual project, this rarely happens, especially in long term projects. Also, the IRR formula does not differentiate between the sizes of the projects.
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