IRR is a prominent technique for evaluation of big projects and investment proposals widely used by management of the company, banks, financial institution etc for their various purposes. The calculation of an IRR is little tricky. It is advantageous in terms of its simplicity and it has certain disadvantages in the form of limitations under certain special conditions.
Internal Rate of Return (IRR) Definition
The internal rate of return is a discounting cash flow technique which gives a rate of return that is earned by a project. We can define the internal rate of return as the discounting rate which makes a total of initial cash outlay and discounted cash inflows equal to zero. In other words, it is that discounting rate at which the net present value is equal to zero.
Internal Rate Return (IRR) Explanation with Example
Explanation of internal rate of return with an example would probably create a better and correct picture in mind.
Suppose a company is investing in a simple project which will fetch five thousand dollars in the next three years and the initial investment in the project is say ten thousand dollars. The internal rate of return is 23.38%. It makes the decision making very simple. We just need to compare these percentage returns to the one which we can get by investing somewhere.
Calculation of Internal Rate of Return using a Formula / Equation
We have stated the IRR of 23.38% above in our example. We will understand the calculation using the same example and find out the stated IRR. Formula / Equation of IRR is stated below:
Initial Cash Outlay + Present Value of all Future Cash Inflows = 0
- -10,000 + 5000 / (1 + IRR)1 + 5000 / (1 + IRR)2 + 5000 / (1 + IRR)3 = 0
Finding out the IRR from above equation is not a simple equation solving exercise. We need to use either trial and error method or interpolation method to find out the required IRR which makes equation equal to zero. Trial and error is a method in which you keep trying arbitrary values to equate the equation whereas interpolation method is more scientific. We find two extreme values which give value of equation greater than zero and less than zero. See below.
|Year||Cash Flows||At 18%||At 25%|
IRR = 25 – (25-18) * 240 / (871.36 + 240) Or,
IRR = 18 + (25-18) * 871.36 / (871.36 + 240)
The will give an answer of 23.49% which almost same as 23.38%. We can find quite exact percentage by using a formula in Microsoft Excel. The formula used is “IRR”.
Interpretation of IRR and Project Acceptance Criterion
IRR makes the decision making very simple. We just need to compare the IRR percentage to the one which we can get by investing somewhere or some other benchmarks which are decided by the management of evaluator. A project that is not able to get its investment back, this method will give a negative percentage. This is commonly called as Negative IRR.
Advantage and Disadvantages of Internal Rate of Return Method of Evaluating the Projects
The major advantage of IRR method of evaluating the project is that it simply tells what the project under concern will return in terms of percentage. Now the evaluator only needs to decide with which rate to compare it with. We do not need to decide a hurdle rate in advance. A mistake in deciding hurdle rate will not affect the result of this method.
The major disadvantage of internal rate of return are its problem in analyzing a non-conventional project where cash flow stream has various positive and negative cash flows in various years. In this situation, it will give Multiple Internal Rate of Return (IRR). Another problem is that it does not consider the dollar value. The business of a roadside vendor who hardly earns his leaving will have higher IRR than a very big and stable business. The vendor must be earning say 1000 dollar a year whereas the profit of that big business may be in millions.