Internal rate of return (IRR)
For a working spreadsheet example of internal rate of return calculations, download the free financial metrics tool (click here).
Like discounted cash flow (DCF), the IRR is a cash flow summary that has been adjusted to reflect the time value of money, but its meaning is a little less obvious than DCF. Nevertheless, IRR is a widely used concept, and it is frequently an important criterion in evaluating or comparing investments or purchases. As the word "Return" indicates, the IRR view of the cash flow stream is essentially an investment view: money will be paid out in order to bring in gains. The higher an investment’s IRR, the better the investment’s return relative to its cost.
IRR has a simply stated definition: "The IRR for an investment is the discount rate for which the total present value of future cash flows equals the cost of the investment." It is the interest rate, that is that produces a 0 NPV. You may still wonder just how to evaluate that, or how to apply it to a specific "investment" or purchase. Probably the best way to grasp IRR quickly is with the help of the graph below.
These curves are based on the same Case A and Case B cash flow scenarios presented under discounted cash flow. Here, however, we have used nine different interest rates, including 0 and 0.10, on up through 0.80. As you would expect, as the interest rate used for calculating Net Present Value of the cash flow stream increases, the resulting NPV decreases. For Case A, an interest rate of 38% produces NPV or DCF = 0, whereas Case B hits 0 with an interest rate of 22%. Case A therefore has an IRR of 38%, Case B an IRR of 22%. Which is the better Investment? Other things being equal, the one with the higher IRR.
Now, would an investment with an IRR of, say 75% be a better investment? The answer is YES. Another way to think of IRR is this: IRR tells you just how high interest rates would have to go in order to "wipe out" the value of this investment. For the Case A cash flow, the prevailing interest rate would have to rise all the way to 38% to make this investment worthless. The Case B investment would become worthless if interest rates rose to 22%.
In deciding whether or not to include an IRR in a business case summary, here are some points to remember:
- Other things being equal, the action or investment alternative with the highest IRR is the better investment. Generally, the higher the IRR, the better the returns relative to cost, and the lower the risk.
- IRR says nothing about the magnitude of the return. A tiny investment or expenditure may lead to a magnificent IRR. An alternative action with a smaller IRR might still be preferred if it brings in a much larger net cash flow, or DCF.
- IRR has the most meaning when there is an initial net cash outflow, followed at least one period with a net positive cash inflow. IRR cannot be calculated with outflows only, or inflows only; IRR is thus not applicable to "cost only" analyses (such as the typical cost of ownership analysis).
- IRR can be quite misleading if there is no large initial cash outflow. For instance, when comparing a "Lease" scenario with a "Buy" scenario for new computing equipment, the "Buy" alternative may show an IRR of, say 30%-70%, whereas the "Lease" approach may have an IRR in the thousands. This is because leasing may not involve much of an initial cash outlay. IRR is more appropriate for comparing alternatives that have roughly similar patterns of inflows and outflows.
For a working spreadsheet example of internal rate of return calculations, download the free financial metrics tool (click here).
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