How to Calculate Internal Rate of Return (IRR) & take proper decision based on it

In this blog, I’ll talk about how to calculate internal rate of return and its decision criteria with a practical example. We know that capital budgeting is the process companies use to decide on investments in new projects. When a company has many potential investment ideas, it needs methods to evaluate which projects are worth pursuing. 

There are five common methods companies use to determine whether to accept or reject investment projects, one of which is calculating the Internal rate of return (IRR) of a project.

Table of Contents

• What is the Internal Rate of Return (IRR)?
• How to make decisions based on internal rate of return?
• What is WACC?
• What does “IRR > WACC” mean?
• Why do we calculate Internal Rate of Return (IRR)?
• How do we calculate the IRR?
• The Importance of Lower and Higher Discount Rates:
• The formula for calculating internal rate of return (IRR) is:
• Understanding how to calculate the Internal Rate of Return (IRR) with a story

What is the Internal Rate of Return (IRR)?

Internal Rate of Return (IRR) is the percentage rate of return that a project or investment is expected to generate. It answers the question “If I invest money into this project what percentage of profit will I make over its entire lifetime?”

Example of Internal Rate of Return (IRR) Definition: Imagine you’ll start a project by investing $100 today for five years. The IRR will tell you what percentage return you’ll make over the entire lifetime of the project. That’s it!

How to make decisions based on internal rate of return?

If IRR > WACC, the project’s rate of return is greater than its costs. Accept the project or else reject the project.

What is WACC?

In simple terms, WACC is the company’s cost of borrowing money or using money from its investors.

What does “IRR > WACC” mean?

When you calculate the IRR of a project, you’re figuring out the percentage return the company expects to make from that project.

If the IRR (project return) is greater than WACC (the company’s cost of capital), it means that:

• The company will not only cover its costs but also have extra money left over, which can increase profits for the company and benefit its shareholders.
• The project is earning more than it costs to finance it (whether that’s borrowing from banks or using shareholders’ money).

This is the basic knowledge you must know about Internal Rate of Return (IRR).

Why do we calculate Internal Rate of Return (IRR)?

• Investment Decision-Making: IRR helps to determine whether an investment is worth pursuing. By comparing the IRR to a company’s WACC or the required rate of return or a “hurdle rate” (the minimum rate of return expected by investors), you can make decisions about whether to proceed with the project.
• Comparing Projects: When you have multiple investment options, IRR allows you to compare them directly. The investment or project with the highest IRR is typically more favorable, assuming all other factors are equal.
• Risk Evaluation: A higher IRR generally indicates a higher return on investment, but also potentially more risk. Therefore, IRR can help investors balance risk and return.

How do we calculate the IRR?

The process of calculating the Internal Rate of Return (IRR) involves finding the Net Present Value (NPV) at two different discount rates—a lower discount rate and a higher discount rate. This process helps us estimate the IRR more accurately. Let’s break this down step by step.

Step-by-Step Process:

Understanding NPV:

• NPV (Net Present Value) tells us the current value of a series of future cash flows (both incoming and outgoing) after considering a discount rate (interest rate).
• The discount rate represents the time value of money (money today is worth more than money in the future).
• If NPV = 0, it means the project earns exactly the return needed to cover its costs (this is what IRR does).
• If NPV > 0, the project is profitable (brings in more than its cost).
• If NPV < 0, the project is not profitable (costs more than it brings in).
  If you want to learn the process of calculation of NPV you can read the blog “How to Calculate Net Present Value (NPV) & its Decision Criteria”

Why Use Two Discount Rates?

• The goal of the IRR is to find the discount rate at which the NPV equals zero.
• However, we don’t know this exact rate from the start. To find it, we test the project’s NPV at two different discount rates:
  • One lower rate (a reasonable assumption of return).
  • One higher rate (a conservative assumption).
• By calculating the NPV at both of these rates, we can estimate the IRR by seeing how the NPVs change between the two rates.
• This helps narrow down the range in which the IRR lies.

The Importance of Lower and Higher Discount Rates:

Lower Discount Rate:

• This represents a more optimistic scenario, where the return is likely higher.
• We calculate NPV at this lower rate to see if the project has a higher positive value (a profitable scenario).

Higher Discount Rate:

• This represents a more conservative or pessimistic scenario, where the return is likely lower.
• We calculate NPV at this higher rate to see if the project remains positive (or if it becomes negative), showing the risks at a lower return.

After calculating the NPV at both rates, we use the IRR formula to estimate the discount rate (IRR) at which the project’s NPV would be zero.

The formula for calculating internal rate of return (IRR) is:

This internal rate of return formula works because:

• If the NPV is still positive at a lower rate but starts to shrink at a higher rate, you know that the actual IRR (where NPV = 0) lies somewhere between those two rates.

• The formula helps you to interpolate the exact rate (IRR) by proportionally dividing the difference between the two NPVs.

Understanding how to calculate the Internal Rate of Return (IRR) with a story

Sarah’s Café Expansion Plan!

Sarah owns a small café that’s doing well, and she’s thinking about expanding to a second location. However, opening a new café requires a lot of money upfront for things like rent, equipment, and hiring new staff. 

Before Sarah makes this big decision, she wants to know if expanding her business will be a good investment. To do that, she needs to calculate the Internal Rate of Return (IRR) of the project.

Step 1: Gather Financial Data

Sarah talks to her accountant, who helps her calculate the cash inflows (money she’ll make) and cash outflows (money she’ll spend) for the new café over the next few years. They estimate how much money she’ll invest upfront and how much profit she’s likely to make in the future.

Estimating the cash flow of a project is not the main concern here, however, if you want to know how to estimate the cash flow of a project, you can read the blog “Estimation of Cash Flows in Capital Budgeting”

Next, Sarah chooses two discount rates to calculate the Net Present Value (NPV) of the project at each rate:

• Lower Rate: 10% (her accountant thinks this is a reasonable return)
• Higher Rate: 20% (to see how the project would perform under more conservative assumptions)

Using these two rates, the accountant calculates the NPV:

• NPV at 10% (lower rate): $18,750
• NPV at 20% (higher rate): -$3,700

Note that, you must take the higher discount rate that results in a negative NPV in order to calculate IRR, but the discount rate must not vary or differ that much it must be as close as its nearest discount rate which gives a positive NPV.

Step 2: Use the IRR Formula

The formula for IRR that Sarah’s accountant uses is:

Let’s break this down:

• Lower Rate = 0.10 (or 10%)
• Higher Rate = 0.20 (or 20%)
• NPV at Lower Rate = 18,750
• NPV at Higher Rate = -3,700

Now Sarah’s accountant starts filling in the formula:

So, after calculation, we found that the IRR is approximately 0.1835 or 18.35%

Step 3: Making a Decision with IRR

Sarah now has an IRR: of 18.35%. She needs to compare this to her cost of financing, also known as the WACC (Weighted Average Cost of Capital). Her accountant estimates that Sarah’s WACC (the average return her investors and lenders expect) is 15%.

Here’s what Sarah knows now:

• IRR = 18.35%
• WACC = 15%
  Since the IRR (18.35%) is higher than the WACC (15%), Sarah’s project will make more money than it costs to finance. This means there’s extra profit left over after paying off all her debts and returns to her investors. The project is likely to be profitable.

Sarah’s Decision:

Because the IRR is higher than the WACC, Sarah knows that the expansion project will generate a good return and bring in more profits than it costs to fund the project. Based on this, Sarah decides to move forward with opening her second café.

Why This Story Makes Sense for the IRR Equation:

• The Lower Rate (10%): Represents Sarah’s first assumption of a reasonable return.

• The Higher Rate (20%): This represents a more conservative scenario to see if the project still works well under different conditions.

• The NPV values: Tell Sarah how much the project is worth at these different rates.

By plugging everything into the formula, Sarah finds the IRR (18.35%), which shows her how much she can expect to earn from the project each year. Since this IRR is higher than her financing cost (15%), she can confidently say that the project will boost her profits and add value to her business.

The calculation of IRR also has some major flaws which makes the NPV calculation better. Please read the blog “Six Reasons Why is NPV Better than IRR | NPV VS IRR“

I hope the article explained the whole Internal Rate of Return (IRR) calculation process and how to make decisions based on this. If you need any clarification regarding any part, let me know in the comment box.