If you come across a business proposal, project or some investment proposal, then the first step would be to judge the profitability of that proposal in the long run. It is necessary to ascertain that the project or the investment proposal in question will prove to be beneficial in future. The obvious question comes then, is there any way to ascertain this, so that we can make an informed decision? The good thing is that there are various methods used to determine the profitability of an investment. Most of these methods take into account the time value of money. Internal Rate of Return (IRR) is one of such methodology which is used to analyze, whether the investment proposal or the project in question will be profitable? Let us learn more about Internal Rate of Return (IRR) in this article.

What is Internal Rate of Return (IRR)?

Internal Rate of Return (IRR) is a financial parameter which is used to determine the profitability of an investment, project or the business proposal. In other words, it is the discount rate that makes the net present value (NPV) of a project zero. You can also say that it is the expected annual rate of return, that has to earned from an investment or a project.

In this method, the IRR of the project or investment is calculated using the formula, as mentioned below. It is then compared with the cost of capital or the interest rate.

If the IRR is greater than or equal to the cost of capital, it means that the proposal is worth accepting and will be profitable.

In the IRR is less than the cost of capital, it means that it is now wise to go ahead with the proposal.

How the Internal Rate of Return (IRR) calculated?

Where,

There are following ways to calculate internal rate of return (IRR):

(i) Using the Formula

We can use the above formula. Just put the NPV value equal to zero and solve the equation to get the IRR.

The initial investment is always negative because it is an outflow from your pocket.

The other subsequent cash flows should be positive or negative, depending on what the project delivers in the future.

Please note that the calculation of IRR is not easy because of the nature of the formula. IRR can be calculated iteratively using the trial or error method using this formula.

(ii) The other way to calculate IRR is using software program, such as Excel

Calculating IRR using Excel

Calculating IRR using excel sheet is very easy. All you need is cash flows from the project including initial investment. Please note that the initial investment will always be negative as it represents the cash outflow from your pocket. The subsequent cash flows may be positive or negative depending what the project generates in future. The IRR function can be found in the by clicking on the Formulas Insert (fx) icon. Alternatively, you can type ‘=IRR(

Then select first cash flow and drag up to the last cash flow.

Then close the bracket and hit ‘Enter’.

You will get the value of IRR.

Example:

Calculate IRR for the given cash flows using the excel sheet:

Step 1: Write the values of cash flows against each year as shown below in two columns. It is important here to note that the cash flow in year 2023 is negative since it represent cash outflow (investment made in the first year).

Step 2: Type the following in an empty cell say in B7:

=IRR(

The internal rate of return (IRR) formula will appear as shown below.

Step 3: Click the first cash flow (B2) and drag up to the last cash flow, i.e. cell B6 and then close the bracket. Hit key ‘enter’ finally. The IRR value will appear in the last cell, i.e. in B7. You can see here that the IRR value of the cash flows given in the problem is 42%.

Example 2: Calculate the IRR for the following series of cash flows-

Solution:

Step 1:

Step 2:

Step 3:

We can see that the IRR of the above set of cash flows is 5%.

It means that we have invested $150000 initially, i.e. in the 0 year (which is shown as negative value in year 0). We are not getting anything in the years 1,2 & 3 but $180000 in forth year, as shown in the table above. The sum we got is accumulated at the rate of 5% (IRR is 5%). It means that 5% of the return in our investment is accumulated every year (although we didn’t receive anything in these years) and it became $180000 in forth year.

Let us understand this from the following illustration:

We can see that the investment of $150000 in the first year increased by 5% every year and became approx. 180000 (the error is attributed to round off) in the last year and we got approx. 180000 in the fourth year.

From the above, it can be concluded that IRR is the discount rate which makes net present value (NPV) of the given set of cash flow equal to zero.

Where the Internal Rate of Return (IRR) used?

(a) The internal rate of return may be useful in many ways, some of which are described below:

(b) It is useful for the companies in selection of projects. If the company have various options to choose, the project having greatest IRR will be an obvious choice.

(c) For the individuals, IRR may help in deciding the best investment option. The investment having the maximum IRR will be more profitable.

(d) IRR is also used to evaluate stock buyback programs. A company may have some fund by which it can repurchase its own shares or the same fund may be used to buy stocks of some other companies. The investment having the  better IRR will be more profitable.

Which IRR is acceptable for a given project or business proposal?

Every project or investment has an acceptable rate (also called discount rate of hurdle rate) of return, which is obviously more than the cost of capital. A good IRR is one that is higher than the minimum acceptable rate of return.

For e.g., if your minimum acceptable rate of return is 12% and the IRR is 10% from an investment, then it is not a good IRR. On the other hand, if the IRR is 15%, then it will be considered a good IRR and you may go ahead with the proposal.

Limitations of IRR

(1) The timings of the cash flow can affect the profitability of an investment, but it may not be always reflected by the IRR. It means that two different cash flows can give you same IRR but the profitability of both the cash flows may be different. If you will decide solely on the basis of IRR then it may not always be a right decision.

(2) Comparing two projects of different durations solely on the basis of IRR may lead to poor investment decision.

For e.g., let us assume that a company’s acceptable rate of return is 8%. It has to choose from two projects:

If the IRR is the sole decision criteria, then you will choose project A. But the project B is more profitable because it is of longer duration. So, it can be concluded from the above that IRR ignores the project duration.

(3) IRR assumes that the cash flows are reinvested at the same rate as the project, instead of the cost of capital. Hence, IRR may not give a true picture of the profitability.

Conclusion

The Internal Rate of Return (IRR) is a method which is used to determine the return on an investment. The more is IRR, better will be the investment. It is very useful for the companies to decide where to invest their capital. A company may have different options to invest. A project or the investment having the highest IRR will be the obvious choice for the company. However, there are some limitations of this method. You should therefore be careful before deciding an option solely based on IRR.

Also read: Using the Time Value of Money Concept in Business Decisions