Internal rate of return IRR, it is to exactly know the rate of return of a project where the cash flows are fairly predictable. The reliability is conditioned by the investment amount and accuracy of the cash flows that the investments bring.
Higher an internal rate the more the project is possible to add value to the firm. Even thought NPV and IRR are similar they totally differ in what they really convey. IRR is the annually compounded growth rate (CAGR) that makes the present value zero, which is far away from the currency discount in NPV method. The currency value of the project at present can be found only by using Net present value, the return a project can produce is conveyed by Internal rate of return.
This method bequeaths, in what rate the present value of cash inflow each year can nullify the initial cash outflow, the investment. If the project life is higher the IRR demanded is lower and the vice versa. The method answers with what return the subsequent cash flows produce in order to fulfil the initial investment i.e., making the net present value to zero. (Net present value is the amount of investment made today apart from evaluating the project’s usefulness)
How is IRR calculated?
IRR formula: Initial investment = total cash flow discounted at the rate of IRR
Assume Company purchases a machinery for $1 million that produces $200,000 for the first two years and finally $900,000
Payback method and IRR
In an ideal payback method, the resulting value it when the cash flows equal the investment amount. The same is the IRR is implying how much is gained in a year as a rate of return. Payback method lacks the efficiency of actual dollar value, discounting is eliminated, which makes it a simple subtraction with the amount of investment. IRR doesn’t deal with present values so the discount rate has no influence on the outcome.
When to undertake a project
Weighted Average Cost of Capital (WACC) brings out the cost of capital that is raised in a particular combination of debt, equity or by issuing preferred shares. The cost varies according to the target debt to equity of the firm. Whenever the IRR is greater than WACC, the project can be undertaken to profit. IRR is a is a popular metric to use, but meant to be used with other determining factors.
Compounding Annual Growth Rate and IRR
Both the metrics are similar as far as the outcomes are concerned. The cash flows accounted in the method is a net value of the period’s cash flow, i.e., the cash flows occurring in the same year (that are needn’t be discounted). In case of CAGR, the rate of return is only the payments from the investment apart from the capital gains tax which is neither excluded nor considered for an investment.
While considering different projects in a capital efficient situation trade offs come into play to decide which one produces the extraordinary return. The risk of the project is considered especially if the decision is to be made between different asset classes. Imagine buying a land and purchasing machines with external lending, or renting a place purchasing the machine with the present cash.
Scope of IRR
- For mutually exclusive projects IRR tend to rank them that are different from NPV.
- A mathematical dilemma, since the equation is a polynomial expansion multiple IRRs are obtained, A no IRR problem can also occur, where the project might be profitable when the NPV method is used.
- IRR doesn’t assure the reinvestment return to be same as the former. Whenever a project is expanded in capacity the risks should be well forecasted to maximize returns. Even NPV method is
- Companies use IRR metrics as trade off between projects. If the other project demands lesser initial capital, it is chosen irrespective of IRR outcome.
- After the forecast of cash flows, the IRR is known. In real, Internal Rate of Return has a high possibility of deviating from the calculations, a cumulative effect of drastic fluctuations in the cash flows decreases IRR which affects the decision making in tradeoffs between similar projects.