An Inside Look At Internal Rate Of Return
by Linda Grayson
The
internal rate of return
(IRR) is frequently used by corporations to compare and decide between capital
projects, but it can also help you evaluate items in your own life, like lotteries and investments.
The IRR is the interest rate (also known as the
discount rate
) that will bring a series of cash flows (positive and
negative) to a
net present value
(NPV) of zero (or to the current value of cash invested). Using IRR to obtain net
present value is known as the
discounted cash flow method
of financial analysis. Read on to learn more about
how this method is used. (For more insight, read the
Discounted Cash Flow Analysis
tutorial.)
IRR Uses
As we mentioned above, one of the uses of IRR is by corporations that wish to compare capital projects. For
example, a corporation will evaluate an investment in a new plant versus an extension of an existing plant based
on the IRR of each project. In such a case, each new capital project must produce an IRR that is higher than the
company's
cost of capital
. Once this hurdle is surpassed, the project with the highest IRR would be the wiser
investment, all other things being equal (including risk).
IRR is also useful for corporations in evaluating stock
buyback
programs. Clearly, if a company allocates a
substantial amount to a stock buyback, the analysis must show that the company's own stock is a better
investment (has a higher IRR) than any other use of the funds for other capital projects, or than any acquisition
candidate at current market prices. (For more insight on this process, read
A Breakdown Of Stock Buybacks
.)
Calculation Complexities
The IRR formula can be very complex depending on the timing and variances in
cash flow
amounts. Without a
computer or financial calculator, IRR can only be computed by trial and error. One of the disadvantages of
using IRR is that all cash flows are assumed to be reinvested at the same discount rate, although in the real
world these rates will fluctuate, particularly with longer term projects. IRR can be useful, however, when
comparing projects of equal risk, rather than as a fixed return projection.
Calculating IRR
The simplest example of computing an IRR is by using the example of a mortgage with even payments. Assume
an initial mortgage amount of $200,000 and monthly payments of $1,050 for 30 years. The IRR (or implied
interest rate) on this loan annually is 4.8%.
Because the a stream of payments is equal and spaced at even intervals, an alternative approach is to discount
these payments at a 4.8% interest rate, which will produce a net present value of $200,000. Alternatively, if the
payments are raised to, say $1,100, the IRR of that loan will rise to 5.2%.
The formula for IRR, using this example, is as follows: