Internal rate of return: features of the metric
Implementing a project always involves a number of nuances, the most important of which is the financial aspect. Investors want to receive a return that exceeds their investment. The internal rate of return (IRR) is a useful tool for this purpose. It is a discount rate that equates the net present value of the project to zero. In simple terms, the IRR shows the break-even point where cash inflows correspond to cash outflows. IRR is the main approach used for capital budgeting. With its help, the cost of the project can be reduced to real financial indicators, allowing you to predict future steps.
Interrelation with other metrics
Do not confuse the internal rate of return on investment (IRR) with the return on investment (ROI). The latter is a metric of the total percentage return, calculated over the life of the project. The IRR helps estimate the annual growth rate and how quickly investments accumulate. For example, a project with an IRR of 18%. However, the IRR does not take into account external factors, including:
- inflation rates;
- market conditions;
- discount rates that apply to the entire company.
This isolated assessment allows for reliable results when comparing projects. In this case, the analysis is based solely on internal cash flow models.
IRR’s reliability is complemented by another metric: net present value (NPV). Together, these two indicators provide the most complete information. Net present value estimates the total value of all cash flows. This metric shows whether the project will generate more income than the investment.
How to calculate the indicator
Experts and stakeholders use two formulas to calculate IRR:
- The standard approach is based on NPV when it is equal to zero. This approach takes into account a specific period and the cash flows for each period, as well as the initial investment. The second formula sums all cash flows with an adjustment for time and the desired rate of return.
0 = CF₀ + CF₁/(1+IRR)¹ + CF₂/(1+IRR)² + … + CFₙ/(1+IRR)ⁿ
What each part of the formula means:
CF₀ — the initial investment. It is usually a negative number because money is spent on launching the project.
CF₁, CF₂, …, CFₙ — the future cash flows that the project will generate (revenue or cost savings).
(1+IRR)ⁿ — a way to take into account that money today is worth more than the same money in the future. The farther in the future the income is, the less “weight” it has in the calculation.
- A simplified result can be obtained based on future value and current investment indicators. The number of periods is also taken into account.
IRR = (FV / PV)^(1/n) — 1, where FV is the future value, PV is the initial investment, and n is the number of years or periods.
When evaluating the indicator, one should always take into account the context and goals set by the interested parties. Otherwise, the result will not provide the necessary understanding.
