What It Measures
Technically, the interest rate that makes the present value of an investment’s projected cash flows equal to the cost of the project; practically speaking, the rate that indicates whether or not an investment is worth pursuing.
Why It Is Important
The calculation of internal rate of return (IRR) is used to appraise the prospective viability of investments and capital projects. It is also called dollar-weighted rate of return.
Essentially, IRR allows an investor to find the interest rate that is equivalent to the monetary returns expected from the project. Once that rate is determined, it can be compared to the rates that could be earned by investing the money elsewhere, or to the weighted cost of capital. IRR also accounts for the time value of money.
How It Works in Practice
How is IRR applied? Assume, for example, that a project under consideration costs $7,500 and is expected to return $2,000 per year for five years, or $10,000. The IRR calculated for the project would be about 10%. If the cost of borrowing money for the project, or the return on investing the funds elsewhere, is less than 10%, the project is probably worthwhile. If the alternate use of the money will return 10% or more, the project should be rejected, since from a financial perspective it will break even at best.
Typically, management requires an IRR equal to or higher than the cost of capital, depending on relative risk and other factors.
The best way to compute an IRR is by using a spreadsheet (such as Excel) or financial calculator, which do it automatically, although it is crucial to understand how the calculation should be structured. Calculating IRR by hand is tedious and timeconsuming, and requires the process to be repeated to run sensitivities.
If using Excel, for example, select the IRR function. This requires the annual cash flows to be set out in columns, and the first part of the IRR formula requires the cell reference range of these cash flows to be entered. Then a guess of the IRR is required. The default is 10%, written 0.1.
If a project has the following expected cash flows, then guessing IRR at 30% returns an accurate IRR of 27%, indicating that if the next best way of investing the money gives a return of –20%, the project should go ahead.
| Now | –2,500 |
| Year 1 | 1,200 |
| Year 2 | 1,300 |
| Year 3 | 1,500 |
Tricks of the Trade
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IRR analysis is generally used to evaluate a project’s cash flows rather than income because, unlike income, cash flows do not reflect depreciation and therefore are usually more instructive to appraise.
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Most basic spreadsheet functions apply to cash flows only.
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As well as advocates, IRR has critics who dismiss it as misleading, especially as significant costs will occur late in the project. The rule of thumb that “the higher the IRR the better” does not always apply.
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For the most thorough analysis of a project’s investment potential, some experts urge using both IRR and net present value calculations, and comparing their results.
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