Internal Rate of Return (IRR)
Internal Rate of Return (IRR) is used to assess the profitability of investments or potential investments in the long run. This is referred as ‘ Internal Rate of Return’ because all the external factors such as Inflation are ignored for the calculation. Economic Rate of Return and Discounted Cash Flow of Return are other titles used for the same.
IRR calculation uses the same NPV equation to identify the IRR. This is done by setting NPV to zero and focusing the calculation on finding r.
- NPV = Net Present Value ( Set it as 0)
- Ct = net cash inflow during the period t
- Co= total initial investment costs
- r = discount rate
- t = number of time periods
Importance of IRR for decision making.
The IRR calculated using the above formula, shall be used to evaluate projects and investments for capital budgeting purposes. Higher IRR indicates that higher Cash amount by which it exceeds the cost of capital invested. This means a higher net cash flow can be achieved by the investment. Hence firms shall be able to use this formula to identify the net cash flows of projects, compare the net cash flows and make relevant business decisions based upon it.
But there can be certain implications when using IRR, such as the calculation may be harder than ROI (Return On Investment) calculation — which calculates the total return while IRR denotes the annual growth. IRR also comes with the assumption that the cash is reinvested to at the same discount rate which may not be true as various external factors influence on the discount rate over a period of time. NPV can be used to calculate cash flows separately with different discount rates and may be more valid for investments which takes a longer period of time. When comparing several projects, though there may be low IRR, there can be other intangible benefits. Example: When selecting an eco friendly project over another project with higher IRR.
As a conclusion, IRR is a vital calculation to be made when considering potential investments to identify the net cash flow of the investments. A new formula called MIRR is also available, after adjusting for Risk Free Interest Rate to do such calculations. It is advised that instead of depending solely on IRR. the firms need to consider market analysis with ROI and NPV for Capital Budgeting purposes.