In this article, I’ll discuss how to calculate the Internal Rate of Return / IRR and its decision criteria with a practical example. 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.
Companies use five common methods 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 do we make decisions based on the internal rate of return?
- What is WACC?
- What does “IRR > WACC” mean?
- Why do we calculate the Internal Rate of Return (IRR)?
- How do we calculate the IRR?
- The Importance of Lower and Higher Discount Rates:
- The formula for calculating the internal rate of return (IRR) is:
- Understanding how to calculate the Internal Rate of Return (IRR) with a story
- Conclusion
- FAQ
- Additional FAQs About IRR Decision-Making
What is the Internal Rate of Return (IRR)?
Internal Rate of Return (IRR) is the percentage rate of return 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 project’s entire lifetime. That’s it!
How do we make decisions based on the 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 its profits and benefit its shareholders.
- The project is earning more than it costs to finance it (whether borrowing from banks or using shareholders’ money).
You must have this basic knowledge about the Internal Rate of Return (IRR).
Why do we calculate the Internal Rate of Return (IRR)?
- Investment Decision-Making: IRR helps determine whether an investment is worth pursuing. By comparing the IRR to a company’s WACC, the required rate of return, or a “hurdle rate” (the minimum rate of return expected by investors), you can decide 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 favourable, assuming all other factors are equal.
- Risk Evaluation: A higher IRR generally indicates a higher return on investment and potentially more risk. Therefore, IRR can help investors balance risk and return.
How do we calculate the IRR?
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, 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 IRR aims 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).
- Calculating the NPV at both of these rates allows us to estimate the IRR by comparing the NPVs.
- 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 the internal rate of return (IRR) is:
$$ IRR = \text{Lower Rate} + \left( \frac{\text{NPV at Lower Rate}}{\text{NPV at Lower Rate} – \text{NPV at Higher Rate}} \right) \times (\text{Higher Rate} – \text{Lower Rate}) $$
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 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 is considering 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 project’s Internal Rate of Return (IRR).
Step 1: Gather Financial Data
Sarah talks to her accountant, who helps her calculate the cash inflows (money she’ll make) and 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 will likely make.
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 the nearest discount rate that gives a positive NPV.
Step 2: Use the IRR Formula
The formula for IRR that Sarah’s accountant uses is:
$$ IRR = \text{Lower Rate} + \left( \frac{\text{NPV at Lower Rate}}{\text{NPV at Lower Rate} – \text{NPV at Higher Rate}} \right) \times (\text{Higher Rate} – \text{Lower Rate}) $$
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:
\[ IRR = 0.10 + \left( \frac{18,750}{18,750 – (-3,700)} \right) \times 0.10 \]
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 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 will be extra profit left over after she pays off all her debts and returns to her investors, making the project 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 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, making 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. Let me know in the comment box if you need any clarification regarding any part.
Conclusion
In summary, calculating the Internal Rate of Return (IRR) is a powerful tool for evaluating investment projects and making informed financial decisions. By comparing the IRR to the company’s Weighted Average Cost of Capital (WACC), businesses can determine whether a project will likely generate profits beyond its financing costs.
While IRR is a valuable metric, it’s important to remember that it has limitations and should be used with other financial analysis methods, such as Net Present Value (NPV), to ensure a comprehensive understanding of a project’s potential. Whether you’re a small business owner like Sarah or part of a large corporation, mastering IRR calculations can help you identify lucrative investments and drive long-term growth.
If you need further clarification or assistance with your IRR calculations, please reach out in the comments section.
FAQ
1. What is the Internal Rate of Return (IRR)?
The Internal Rate of Return (IRR) is the percentage rate of return an investment or project is expected to generate over its lifetime. It helps assess the potential profitability of a project by answering the question, “What percentage return will I make if I invest in this project?”
2. How do you calculate IRR?
IRR is calculated by determining a project’s Net Present Value (NPV) at two different discount rates. Once the NPVs are calculated, the IRR formula interpolates between the two rates to find the rate where NPV equals zero.
3. What is the difference between IRR and NPV?
IRR is the rate at which the NPV of a project equals zero, while NPV itself represents the current value of a project’s future cash flows after considering a discount rate. NPV provides a dollar profitability value, whereas IRR gives a percentage return.
4. Why is IRR important for decision-making?
IRR helps businesses decide whether a project is financially viable. By comparing IRR with the company’s cost of capital (WACC), you can determine if the project will generate enough returns to justify the investment. If IRR exceeds WACC, the project is typically considered worthwhile.
5. What is the role of WACC in IRR calculations?
The Weighted Average Cost of Capital (WACC) represents the cost of financing a project, combining both equity and debt. It is used as a benchmark when comparing to IRR—if IRR is greater than WACC, the project is expected to be profitable. If IRR is lower than WACC, the project may not generate sufficient returns.
Additional FAQs About IRR Decision-Making
1. Can a project have multiple IRRs?
Yes, in certain cases, a project can have multiple IRRs, especially when cash flows change signs more than once over the project’s life. This can make the IRR calculation less reliable in some situations, and alternative methods like NPV are often preferred.
2. What does it mean if the IRR is less than the required return?
If the IRR is lower than the required return (often the WACC or hurdle rate), the project is expected to be less profitable than its cost of capital. In such cases, the project is typically rejected.
3. How do I interpret a negative NPV in IRR calculation?
A negative NPV at a higher discount rate means the project is not expected to be profitable. The IRR is the rate at which NPV equals zero, so the higher the discount rate that results in a negative NPV, the more cautious you should be about the project’s potential.
4. Can IRR be used to compare different projects?
Yes, IRR is a useful metric for comparing multiple projects. The project with the highest IRR (assuming all other factors are equal) is typically the most attractive investment. However, it’s important to consider project scale, risk, and other financial metrics as well.
5. Is IRR always a reliable indicator of a good investment?
While IRR is a useful tool, it is not foolproof. Its reliability can be compromised in cases of unconventional cash flow patterns or multiple IRRs. Additionally, IRR doesn’t account for the size of the project, which makes it important to also consider NPV and other financial metrics when making investment decisions.