For businesses, especially small to medium businesses, the internal rate of return (IRR) is a valuable method to highlight the best projects to invest in, to then generate enough income to cover the initial investments, while also maintaining preferrable profit margins. We’re here to help you figure out IRR, how to use it and what it can give you, in the simplest way possible, so you can understand in the easiest way possible.
Internal Rate of Return (IRR) meaning
IRR is the percentage of financial returns that a project will generate for you over a certain period that will be enough to cover the initial investment you put into that project. And you get the IRR, when the Net Present Value (NPV) – which is the numerical difference between the money coming in (cash inflow) and the money going out (cash outflow) over a period of time – is equal to zero.
Now, with NPV, there’s something called a discount rate. The discount rate is the percentage of money that you’d expect to get on your investment over the course of that project and in the future. IRR is the discount rate as it’s a part of the NPV formula, but IRR is what you get after trial and error calculations by replacing the given discount rate (this will be clearer later on).
Once you’ve done all the calculations, and the IRR is higher than the original discount rate, then that means your investment in the project will be profitable for you. Meaning that you will receive enough income (and possibly more) that will cover the initial cost of investment and therefore, you technically make a profit. Or at the bare minimum, you break even but still don’t lose money.
Internal Rate of Return formula
Don’t worry. It’s not as hard as you might think it is. Okay so let’s break it down:
C = cash flow in a given period
C0 = initial amount of investment
t = the number for the time periods
r = discount rate
Internal Rate of Return calculation and example
This is how you calculate IRR, step-by-step:
You first calculate the NPV by putting the given discount rate of the project and all the other values into the given formula accordingly.
See whether the NPV is positive or negative. You want it positive to proceed further.
Then, to calculate the IRR, you set the NPV to zero. Through trial-and-error, you’ll replace the given discount rate with a different one, until you get to a discount rate that, after the calculation, gives you an NPV that’s closest to zero.
If the IRR is higher than the given discount rate, and the NPV is positive, this means that for you, the project is worth investing in.
Alright, now that you have the general idea of how calculating the IRR works, let’s look at an example of its application. Consider this:
SKY GROUP is presented with an opportunity to grow its business. This comes in the form of a new project. The initial investment would cost the company $400,000. It will take them 4 years to pay it off with an 8% discount rate. The project will generate $40,000 in the first year, $80,000 in the second, $160,000 in the third and $259,600 in the fourth. SKY GROUP is now thinking if the investment project is feasible with that discount rate.
So what you have is:
C0 = -$400,000 (this is always negative because it’s cash outflow)
C1 = $40,000
C2 = $80,000
C3 = $160,000
C4 = $259,600
t = 4
r = 0.08 (8%)
Let’s see what the NPV is with the given discount rate:
NPV = $23,451.06
Now we replace the given discount rate with our assumed IRR = 10% and set the NPV = 0,
We will literally get a break-even point for the project. The project has a positive NPV and an IRR higher than the discount rate. This makes the project a profitable investment for SKY GROUP. And so they decide to go forward with the investment.
How to calculate Internal Rate of Return using excel
But don’t fret! You don’t have to calculate it manually every single time. You have Excel to help you out. This is how you get Excel to do all the IRR calculating for you:
1. Cash inflows and outflows in a standard format
Key in the cash inflows and outflows into a standardized format.
2. Apply the IRR formula in excel
Then, you apply the IRR formula into Excel for it to use.
3. Compare IRR with the discount rate
Finally, you just compare the IRR with the initial discount rate.
The advantages of Internal Rate of Return
These are some of the advantages that you’re to gain from IRR:
1. Simple to understand
IRR is easy to use and understand. The calculations aren’t that complex and are simple enough for you to use to compare and consider various projects’ worth.
2. Works well with multiple evaluation factors
IRR is also useful for other evaluation factors for your business, such as budgeting, like when you’re considering either to buy new or to repair. IRR compares the positives and negatives of many other business factors and by remembering its usefulness for many other parts of your business, you can maintain a healthy finances.
3. Considers the time value of money
You’re calculating the present value of future cash flows equals the required capital investment. In other words, the cash flows in the future are taken into consideration. Giving them equal weight in value.
4. Hurdle rate not required
The hurdle rate is the required rate of return that investors can accept in order for them to fund a project. IRR doesn’t require this. Projects are simply favored if their IRR exceeds estimated capital costs.
5. Provides for maximizing overall profitability
The aim of IRR is to generate as much profit as possible. You maximize profit potential with IRR comparing the positive and negative outcomes of projects. And doing so is quick by using the IRR method as compared to others.
The disadvantages of Internal Rate of Return
But, of course, there a few downsides to IRR:
1. Ignores size and scope of projects
The size of a project doesn’t equally translate into the IRR. A smaller project can present a higher IRR than a much larger project. This is because IRR only compares cash flows to the amount of capital. But if you only use the IRR method, your business can also lose out on long-term projects that could offer better cash flow over time.
2. Ignores future costs within the calculation
While you’re seeing what you’re getting in the future, you don’t see what you’re spending in the future. IRR doesn’t account for any future costs that can affect the estimated profits. Fuel and maintenance costs, for example, vary over time. So the projected future cash flow might not be that accurate.
3. Ignores reinvestment rates
IRR assumes that those future cash flows can be reinvested at the same rate as the IRR. this isn’t true as the IRR you’ll get can be quite high in comparison. Reinvestment opportunities with similar returns are at best, minimal.
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