Understanding Internal Rate of Return, Its Advantages and Disadvantages
A technique for determining the profitability of a possible investment is to use the internal rate of return (IRR). The discount rate is what causes an investment's net present value to be zero. The internal rate of return method is used in capital budgeting analysis as well as discounted cash flow (DCF) analysis. Let’s look at internal rate of return in greater detail.
The original investment in the project is equivalent to the present value of future cash flows when calculating the internal rate of return, thus, making the NPV = 0.
The IRR should be compared with the project's minimum necessary rate of return. As an illustration, if the computed IRR is found to be higher than the minimum required rate of return, the project should be approved. However, if it is found to be lower, the project should not be taken up.
The following three suppositions are taken into consideration while calculating any project's internal rate of return:
The investments made will be kept until they reach maturity.
Reinvestment will be made with the interim cash flows.
All cash flows occur regularly.
IRR: The formula
IRR is the interest rate at which all cash flows have zero net present value (NPV). The present value of cash inflows (estimated profit) minus the present value of cash outflows (estimated expenditure) over a given period is known as the net present value. The present value of inflows and outflows is equalised when NPV is set to zero. This simplifies the IRR computation. The following is the formula for internal rate of return:
Where CF0 = Initial investment
NPV = Net Present Value
IRR = Internal Rate of Return
N = Total Number of Periods
n = Number of periods
To calculate internal rate return, a formula similar to NPV is used. Analysts calculate IRR by using various applications, such as Microsoft Excel. There is a financial function in MS-Excel that uses periodic cash flows to calculate IRR. IRR is calculated using the following formula:
IRR = Cash Flows / (1+r)n − Initial Cost of the Project
An ideal rate of return is one where the present value of cash flow meets the cost of the investment. A project is deemed lucrative if it can generate this rate.
What is the Internal Rate of Return used for?
Internal rate of return is helpful for businesses when assessing stock buyback plans. The research must demonstrate that the company's stock is a better investment — that is, has a higher IRR — than any other use of the cash.
IRR can be used by individuals while making financial decisions, such as comparing various insurance policies based on their premiums and death benefits. Policies with the same premiums and a high IRR are far more rewarding. Life insurance has an IRR that is frequently above 1,000 per cent in the first few years of the policy. It then gradually gets smaller.
The money-weighted rate of return on investment is calculated using the IRR formula (MWRR). By taking into account all variations in cash flows throughout the investment period, including sales proceeds, the MWRR aids in calculating the rate of return required to start with the initial investment amount.
Advantages of IRR
The finest feature of internal rate of return is that it takes time value of money into account. The value of money received today is greater than the value of money to be received tomorrow. This is so because the funds obtained now can be invested and used to produce cash flows that will support new businesses in the future.
Additionally, unlike capital budgeting, IRR does not require a hurdle rate. This is because businesses evaluate the IRRs of several projects to determine the best investment strategy. Simply determining whether a project's internal rate of return exceeds its costs can determine whether or not it is worthwhile.
Disadvantages of IRR
The objective of IRR is to ascertain the anticipated cash flow from the capital injected. It doesn't take into account possible expenses like fuel and maintenance prices, which change over time. As a result, future profits suffer.
Another disadvantage is that it assumes that future cash flows can be invested at the same internal rate of return,
A third disadvantage is that the figures obtained by IRR can be pretty high. Moreover, calculations are both time-consuming and tedious.
Making investment decisions based only on internal rate of return can be risky, especially when comparing two projects with different durations. Consider this example of IRR. This is a scenario in which a company's hurdle rate is 12 per cent. Project A has a one-year IRR of 25 per cent. But, Project B has a five-year IRR of 15 per cent. If IRR is the only factor taken into consideration, Project A will be foolishly chosen above project B.
There are situations when the initial investment has a low IRR but a high NPV. It occurs on projects that give profits at a slower rate. Yet these projects may gain by raising the organization's overall worth. As a result, basing choices solely on IRR numbers is harmful.
Additionally, people believe that after a project generates positive cash flows throughout its life, the money will be reinvested at the project's rate of return. But this hardly ever happens. Instead, positive cash flows are reinvested at a rate that reflects the cost of the capital used. A false positive is produced when the internal rate of return is misinterpreted. Thus, a project appears to be more financially successful than it is in reality.
Q. What does IRR teach you?
Ans. The effectiveness of investment is shown by its internal rate of return. The option with the greatest likelihood of success is chosen. As a result, it is a crucial tool for investment planning and capital budgeting.
Q. What does a favourable IRR mean?
Ans. The investment opportunity is superior to alternative possibilities if the internal rate of return is high. But equally important factors are the amount of original investment, the hurdle rate, and the time it takes to reach the break-even point.