Internal Rate of Return - IRR

When companies have to compare multiple projects against each other, they commonly employ the use of IRR, or internal rate of return, to create a level playing field to evaluate each project against.  Internal rate of return refers to the yield of an investment, or the compounded rate of return on investment.  While the net present value aims to understand the gain in terms of currency, IRR aims to understand the profitability of the project in terms of percentages.  IRR is the discount rate that will bring the net present value formula to 0. 

Calculating Internal Rate of Return (IRR)


Calculating the IRR can prove to be a very difficult task without a financial calculator or computer.  If you do not have either one of those, you will basically be trying to net the NPV formula to 0 using arbitrary discount rates.  A financial calculator can give you a very accurate approximation of what the IRR should be. 

Drawbacks of the IRR


The largest drawback of using the IRR lies in its assumption that all cash flows will be reinvested at the calculated IRR.  It is not very reasonable to assume that you will be able to reinvest all cash flows at the IRR, especially when it is very high.  It may also be impossible to reinvest all cash flows back into the project which then overstates returns.  For projects with a very high IRR, NPV may be a more accurate calculation.  It is reasonable and more conservative to assume that the company will be able to earn the weighted average cost of its capital on its' reinvested capital rather than a potentially very high rate of return that could result from an IRR calculation.  Now, there are exceptions.  For example, projects with a positive NPV, by definition, are earning an interest rate higher than their cost of capital; therefore, it may be reasonalbe to assume a higher rate of return that is suggested by IRR may be reasonably achievable.

Secondly, when cash flows are erratic, fluctuating from negative to positive, IRR gets confused.  In these cases, there may be multiple IRRs which lowers the usefulness of this number. 

Finally, IRR does not consider the cost of capital use to fund the project and therefore should not be used to compare projects with varying lengths.  The Modified IRR will do a much better job of this as it includes the cost of capital in its calculation.
Tim Ord
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Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...

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