Published On:Thursday, 22 December 2011
Posted by Muhammad Atif Saeed
Internal Rate of Return
IRR overview:
- The internal rate of return (IRR) is the DCF rate of return that a project is expected to achieve. It is the discount rate at which the NPV is zero.
- If the IRR exceeds a target rate of return, the project would be worth undertaking.
- The IRR can be estimated from a graph of the project's NPV profile. The IRR can be read from the graph at the point on the horizontal axis where the NPV is zero.
- The IRR Interpolation formula is:
- The IRR method has a number of disadvantages compared with the NPV method.
- It ignores the relative size of the investments
- There are problems with its use when a project has non-conventional cash flows or when deciding between mutually exclusive projects
- Discount rates which differ over the life of a project cannot be incorporated into IRR calculations.
Internal rate of return (IRR) is the rate that makes the present value of the future cash flows equal to the initial cost or investment. In other words, it is the discount rate that gives a project a $0 NPV.
Another discounted cash flow (DCF) technique for appraising capital projects involves calculating the internal rate of return (IRR). The IRR is a relative measure (%) in contrast to the absolute (£) measure resulting from NPV calculations.
The IRR is the DCF rate of return (DCF yield) that a project is expected to achieve, in other words the discount rate at which the NPV is zero.
If the IRR exceeds a target rate of return, the project would be worth undertaking.
Advantages:
- The main advantage is that the information it provides is more easily understood by managers, especially non-financial managers. 'The project will be expected to have an initial capital outlay of £100,000, and to earn a yield of 25%. This is in excess of the target yield of 15% for investments' is easier to understand than 'The project will cost £100,000 and have an NPV of £30,000 when discounted at the minimum required rate of 15%'.
- A discount rate does not have to be specified before the IRR can be calculated. A hurdle discount rate is simply required which is then compared with the IRR.
Disadvantage:
- If managers were given information about both ARR and IRR, it might be easy to get their relative meaning and significance mixed up.
- It ignores the relative size of investments. Both projects below have an IRR of 18%.
- When discount rates are expected to differ over the life of the project, such variations can be incorporated easily into NPV calculations, but not into IRR calculations.
- There are problems with using the IRR when the project has non-conventional cash flows or when deciding between mutually exclusive projects
