Internal Rate of Return
IRR is expected return of a capital budgeting project. When NPV is zero then required return equals IRR. It means, the IRR is the discount rate where total present value of all cash inflows is equal to total present value of all cash outflows (hence making Net Present Value (NPV) equals to zero). So, we can define Internal Rate of Return (IRR) as the discount rate that makes the NPV zero.
IRR is an indicator of yield of an investment. A project is accepted if its IRR is greater than minimum acceptable return. This minimum accepted return may be WACC . If a company earns more than its cost of capital on a project, accepting project will add value to the company.
Calculating IRR:
We know that Net Present Value (NPV) is calculated as:
NPV = C0 + C1/(1+r) + C2/(1+r)^2 + …. + Cn/(1+r)^n
Where C0, C1, C2 …. Are cash flows for period 0, 1, 2,…..
r is discount rate.
If we make NPV =0 and calculate for r , this r is Internal rate of Return (IRR)
There is no direct method to calculate this r. Hit and trial method is used to calculate IRR.
IRR can be calculated in Excel spreadsheet also using Excel formula IRR.
Why IRR?
IRR is used in capital budgeting because of its simplicity. In IRR, no assumption is made. Managers prefer IRR because a single entity Rate of Return is calculated without making any assumption. If this return is higher than required rate of return, project is accepted otherwise project is rejected.
IRR method does not employ concept of required rate or return or cost of capital while calculating IRR. It itself provides a rate of return project would offer. Now it is up to managers to see if that expected rate of return is acceptable or not. Managers decide a minimum required rate of return which can be cost of capital or something more than cost of capital. IRR provides a platform where different projects can be compared and selected/rejected.
Example : Let us consider a project with an initial cash outlay of $ 40,000 and cash inflows each year are $ 10,000 over the next 5 years. We have to calculate IRR of this project.
We can calculate IRR using Microsoft Excel. Enter all cash outflows and inflows into cells A1 to A7 as follows:
A1 = - 40000, A2= +10000, A3= +10000, A4= +10000, A5=+10000, A6= +10000, A7= 10000.
We can calculate IRR by using formula =(IRR(A1:A7) in excel. IRR = 13%
Here, if company’s cost of capital is 10%, this project can be accepted as it gives return of 13%. If company’s cost of capital is 15%, this project should not be accepted.
Limitations of IRR:
IRR method is simple but it is not the best method in choosing a project. IRR method has certain limitations. IRR method should not be used when two projects are mutually exclusive. Another limitation of IRR is, it involves complicated calculations. Also, IRR method produces multiple rates which can be confusing. The biggest drawback of IRR method is, assumes that all intermediate cash flows are reinvested at the IRR which is not true with practical circumstances.
In spite of these limitations, IRR method is very popular and widely used in choosing projects.