The Internal Rate of Return (IRR) method is based on discounting. It is very similar to the NPV method mentioned and explained in my previous blog. Here, instead of discounting the expected net cash flows by a rate of return, it estimates what rate of return is required to ensure that the total NPV equals the total initial cost.
A rate of return that is lower the standard accepted rate at a company would be rejected.
Example
Source: Dyson J, 2010, "Accounting for non-accounting students", Pearsons Education UK
We can see that the IRR method is similar to NPV method. The initial cost of the project has to be estimated as well as future cash flows. The net cashflows are being discounted by the net present value using below discount tables.
Source: Dyson J, 2010, "Accounting for non-accounting students", Pearsons Education UK
The main difference is that the rate of return needs to be estimated in order to give an NVP equal to the initial cost of the investment.
We may have difficulty to deciding on which rate of return to choose so that one will give positive NPV and another one negative NPV.
The main advantages of the IRR methods are that the emphasis is placed on liquidity, attention is given to timing of net cash flows and appropriate rate of return does not have to be calculated. This method gives a clear percentage return on investment.
Difficulties may be that it is not easy to understand, it is difficult to determine two rates and the method gives only an approximate rate of return. By as non-accountants we do not need to worry of the details.
The use
Internal rate of return is a metric used in financial analysis to estimate profitability of potential investments. It is essentially a discount rate that makes the NPV of all cash flows equal to zero in a discounted cash flow analysis.
Generally speaking, the higher the internal rate of return the more desirable the investment. It is used for various projects and the investment with the highest IRR probably would be considered the best.
The initial IRR is the annual rate of growth that the investment is expected to generate. The ultimate goal is to estimate the rate of discount. It makes the present value of the sum of nominal cash inflows equal to initial cash outflow of the investment. It is ideal for analysing capital budgeting projects to understand annual revenue over time. It also helps to determine which capital project to use on various assets.
Using the IRR function in Excel make it easier. Excel does the necessary work for us and arrives at the rate that we are seeking to find. We only need to combine our cashflow, initial outflow and IRR function.
For example, IRR cashflows that are known. Let's assume that company is assessing profitability of Project A. That requires £250,000 cash. It is expected to generate £100,000 cashflow in the first year and £50,000 for each year of the next 4 years.
Source: Jason F, 2023, "Internal Rate of Return (IRR) Rule: Definition and Example" Investopedia
The ultimate goal of IRR is to estimate the rate of discount, which makes the present value of the sum of cash inflows equal to the initial net cash outlay of the investment. IRR is often ideal for analysing the return of new projects that a company is planning to undertaking. It compares profitability of new operations with that expanding existing operations. For example on whether to open a new power plant or renovate an existing power plant.
ITT is not often adequate for long-term projects with discount rates that are expected to vary.
IRR is also used for evaluating stock bulk-buy programs. If we allocate substantial funding to repurchasing shares then the analysis must show that the company's own stock is a better investment and has higher IRR.
Bibliography:
Jason F, 2023, "Internal Rate of Return (IRR) Rule: Definition and Example" Investopedia
Dyson J, 2010, "Accounting for non-accounting students", Pearsons Education UK
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