See also:
Valuation Methods
Net Present Value Method
NPV versus IRR
Time Value of Money
Net Present Value (NPV) vs Payback MethodDefinition Internal Rate of Return
The Internal Rate of Return method is the process of applying a
discount rate that results in the present value of future net cash flows equal to zero. This is the base internal rate of return calculation formula and will be described later in this wiki. Internal rate of return assumes that cash inflows are reinvested at the internal rate. Investment projects with a return greater than the
cost of capital or hurdle rate should be accepted. The greater the internal rate of return the more attractive the investment. Below is the IRR hurdle rate comparison.
IRR > hurdle rate, accept the investment
IRR < hurdle rate, reject the investment
IRR = hurdle rate, the investment is marginal
The internal rate of return meaning is described in more detail below.
Internal Rate of Return Explaination
Internal Rate of Return is a method to compare and evaluate different investments based on their cash flows. A proper internal rate of return calculation provides an interest rate equal to the total gains expected from a given investment. After discovering the internal rate of return for one project other IRRs can be compared in order to find the most valuable investment choice. Additionally, one compares an internal rate of return to the weighted average cost of capital of a project to decide whether the investment will create profit. IRR also accounts for the time value of monitary gains. It is generally used to evaluate a series of cash flows but can also be applied for other needs. Many equity investors, including angels and venture capitalists, have a required rate of return which must be met or exceeded by the IRR of a company seeking investment.This ensures the investment is warrants the associated risk and will provide the cash flows necessary for profit.
Internal Rate of Return Formula
The internal rate of return formula can be found algebraically by using the Net Present Value formula below. In this:
NPV = (CF 1 / (1 + r) ^1) + (CF 2 / (1 + r)^2) + (CF 3 / (1 + r) ^ 3) + ...
Where:
NPV = Net Present Value
CF 1, 2, or 3 = Cash flow in period 1, Cash flow in period 2, Cash flow in period 3, etc.
r = The Rate of Return
The rate of return (r) for which NPV = 0 is the internal rate of return calculator. So, if:
0 = (Cash flow in period 1 / (1 + IRR) ^1) + (Cash flow in period 2 / (1 + IRR)^2) + (Cash flow in period 3 / (1 + IRR) ^ 3) + ...
Where:
NPV = Net Present Value
CF 1, 2, or 3 = Cash flow in period 1, Cash flow in period 2, Cash flow in period 3, etc.
IRR = Internal Rate of Return
Internal rate of return can be found algebraically using this method as the IRR calculator. Below is a common internal rate of return calculation example.
Internal Rate of Return Example
An internal rate of return example is quite common in capital markets. The internal rate of return explaination below will be seen by anyone seeking angel, venture capital, equity mezzanine, or other forms of
equity financing.
Techco has developed a revolutionary online shopping cart for e-commerce. It believes that, with an investment for marketing expenses, the company concept can be quickly grown to profitibility.
Capco is a venture capital firm that invests in early-stage companies that serve the business to business market. Capco invests only in companies with an existing product and an expectation of quick return on equity. They use the internal rate of return method and only invest in companies which currently have a rate of return of 30% or more. So, their IRR hurdle is 30%.
Initial Investment -$5000
Cash flow in Year 1 $1,000
Cash flow in Year 2 $3,000
Cash flow in Year 3 $6,000
Techco and Capco had a great first meeting. Techco would love to gain marketing expertise and funding from the Capco team. Capco appreciates the experience of the Techco management team, feels the company concept fits well into their field of interest, and knows that this investment has the growth potential necessary. The only concern is whether Techco can yield the required IRR calculation of 30%.
To make the final decision Techco and Capco run this IRR formula calculation as an internal rate of return financial calculator:
0 = -$5000 + ($1000 / (1 + IRR) ^1) + ($3,000 / (1 + IRR) ^ 2) + ($6,000 / (1 + IRR) ^ 3)
IRR = 32.979%
Techco and Capco mutually come to the conclusion that Techco's IRR is 32.979%. Capco is confident that since Techco's internal rate of return model is currently above 30% it will probably grow with additional marketing. Capco and Techco, because of this, decide to become partners.
Private equity markets regularly deal with the above internal rate of return formula example and IRR formula calculation. As a matter of survival they must have a strong grasp of the IRR definition, IRR formula, and IRR limmitations.
Limitations of Internal Rate of Return
The
internal rate of return calculation assumes that cash flows are reinvested each year at a constant rate. For those internal rate of returns that are high (greater than 25%) it is impractical to think that you will find alternative investments at that same higher rate. This limitation is the biggest drawback to using the internal rate of return method. In order to compensate for the high return of the internal rate of return calculation the
Modified Internal Rate of Return (MIRR) was created so that the annual cash flows are reinvested at a lower, more probable reinvestment rate.
Another limitation is that IRR calculation does not work well when cash flows fluctuate between positive and negative over the life of the project. Finally, the IRR method does not discriminate between the size of the projects. All of these are common internal rate of return limitations.