Internal rate of return (IRR)

Last updated: 17.03.2016

Internal rate of return is method used for investment appraisal that calculates the rate of return that is expected to be achieved by the project. IRR is related with NPV method as it is the discount rate at which NPV is zero.

  • if IRR > target rate (often WACC) → the investment adds value to the company → can be accepted (not necessarily must be, because there can be alternative projects yielding higher IRR or budget can be insufficient)
  • if IRR < target rate (often WACC)  → the investment does not add value to the company → shall be refused

 

IRR formula

 

CF1…..cash-flow of year 1

CF2…..cash-flow of year 2 (33)

 

IRR can alternatively be calculated by interpolation:

  1. Rough estimate of IRR and calculation of NPV with this rate as discount rate.
  2. Calculation of another NPV using following discount rates:
    • if NPV is positive, with a little higher discount rate
    • if NPV is negative, with a little lower discount rate (33)
  3. Calculation of IRR by using the formula:

IRR1 & NPV1...............lower discount rate and its NPV

IRR2 & NPV2...............higher discount rate and its NPV

 

To be drawn by the scheme 

 

 

IRR works well if cash-flows have common distribution, i.e. high cash-outflow at the beginning followed by a series of cash-inflows. But if the cash-flow distribution is uncommon (e.g. negative cash-flow during the project life), it can lead to either to NPV increase with increasing IRR (not decrease) or existence of multiple IRRs. All this can result in wrong decision. NPV should be given priority in decision-making in such cases. (32)

 

Advantages and disadvantages of IRR compared to NPV can be easily derived from article about advantages and disadvantages of NPV.

 

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Sources:

32. Obaidullah Jan, ACA, CFA. NPV vs. IRR (online). Citation date: 19.1.2016. Available from www: http://accountingexplained.com/managerial/capital-budgeting/npv-vs-irr

33. Irfanullah Jan. Internal rate of return (online). Citation date: 19.1.2016. Available from www: http://accountingexplained.com/managerial/capital-budgeting/irr



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