IRR or internal rate of return is a metric to calculate project revenue without considering external economic factors. This tool is more useful when used for comparative analysis rather than a single, isolated value. It helps in making better investment decisions and smarter project choices.
For a career in investment banking, it is vital to know the details of a variety of financial tools, one of them being the IRR. Here's your guide to know its definition, calculation, benefits and drawbacks, and much more.
Defining Internal Rate of Return
Internal rate of return or IRR is a tool in financial analysis, which helps to estimate the profitability or revenue from a potential investment venture. It is a discount rate at which the return from any project is equal to its original investment value. Thus, this tool helps to achieve a break-even point by equalising the total cash inflow and outflow and helps to determine the most profitable project.
Internal rate of return works to make the net present value or NPV zero, thus ensuring a break even. It can be calculated by the following formula:
The simplest way to calculate the internal rate of return is to use Microsoft Excel, which is one vital tool taught in any investment banking course. The ideal way to determine IRR is the trial and error method, where you have to take various discount rates to make NPV zero. It is in the character of IRR that you cannot calculate it analytically, but rather use trial and error methods.
Given are the steps to calculate IRR:
- Take the project's offered discount rate to calculate NPV.
- Fill the remaining values in the formula.
- Check if the value is positive, only then proceed to the next step.
- Now the NPV is taken as zero. In the formula, fill in an assumed discount rate by trial and error method. This will give an NPV value very close to zero.
- Finally, compare the Discounted Rate with IRR. If the NPV is positive, and the IRR is higher than Discounted Rate, then you can invest in the venture.
What is the purpose of IRR?
Internal rate of return helps in the comparative analysis of projects and helps to determine which project offers the highest revenue. It further helps in understanding whether it is profitable to establish fresh operations or expand the existing ones.
For instance, if you have a textile shop, you can use IRR to determine whether you should open a new branch or renovate and expand the already existing shop. Both avenues can be worthwhile for the investor. However, the comparison proves that either one is more profitable and logical.
What Factors Can Affect IRR?
Given below are some vital factors which affect IRR:
- Market Momentum
- The overall strength of the economy
- The strategic position of the project
- Business performance
- Overall debt level
Benefits of Internal Rate of Return
IRR is a valuable kit for analysing the profitability of potential investments. Before enrolling in an investment banker course it is vital to know the importance of internal rate of return. Here are its advantages:
Ease of use
It is a simple calculation tool that helps the investor compare and consider potential projects. Furthermore, the investor can also use IRR for budgeting and generate funds for purchasing fresh equipment instead of repairing it.
Doesn't incorporate the hurdle rate
The cost of capital or hurdle rate is the required return rate which is agreed upon by the investors towards funding a project. Being subjective in nature, hurdle rate is always an estimated value, and thus can cause incorrect values. IRR doesn't require a hurdle rate like capital budgeting and is thus more accurate.
The time value of money is considered
Money loses worth over time, and thus present money is more valuable than money to be received in the future. This is because the present money that you have can be invested towards future ventures. IRR regards this money value.
Drawbacks of Internal Rate of Return
Although IRR is simple and easy to use, it's not free from drawbacks. Here are its disadvantages:
Disregards project size
The internal rate of return calculates a project's profitability irrespective of its size. IRR simply compares cash flow to the total volume of capital outlay responsible for the cash flows. This proves to be a disadvantage in projects demanding different capital outlay levels, wherein the tool can make smaller ventures more attractive.
Future costs are ignored
IRR completely disregards any future costs which can affect the project's profitability. For instance, if you want to invest in a car, and in the future the fuel price rises, then it will significantly affect the profit margins.
Internal Rate of Return and Return on Investment: Key Differences
Internal rate of return and return on investment are both crucial tools covered in any banking course. For an attractive career in banking and finance, it is important to know the difference between the two. ROI or return on investment will inform you about the total growth of your investment. However, IRR talks about the annual growth rate of a project. For a single year, the two values are the same but change significantly over a longer time span.
Internal rate of return also ends up putting NPV or net present value of the cash flows as 0 in a discounted cash flow analysis. Meanwhile, this is not the case with the CFROI (cash flow return on investment) valuation metric.
Internal rate of return is a useful tool, which helps in making justifiable financial decisions. It helps companies determine which investment would earn them the highest revenue and thus helps them in business growth.
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