Financial Valuation Concepts – The Internal Rate of Return (IRR)
The internal rate of return (or IRR) is a common financial valuation metric used by financial analysts to calculate and assess the financial attractiveness / viability of capital intensive projects or investments.
As the IRR is normally easier to understand than the result of a discounted cash flow (DCF) analysis (i.e. the net present value or NPV) for non-financial executives, it is often used to explain and justify investment decisions, although a good financial modeler should know that the IRR is after all an estimated value, especially when calculated in Excel, and should be used in conjunction with other financial metrics such as the NPV and comparable valuation multiples when presenting a business or investment case.
So what exactly is the IRR? The IRR is the interest rate that makes the net present value of all cash flow equal to zero. In financial analysis terms, the IRR can be defined a discount rate at which the present value of a series of investments is equal to the present value of the returns on those investments.
All projects or investments with an IRR that has been calculated in a financial modeling exercise to be greater than the Weighted Average Cost of Capital (or WACC) should technically be considered as financially viable and accepted.
When choosing between projects or investments whose outcomes or performance are absolutely independent of one another, a good financial modeler should deem the project or investment with the highest calculated IRR to be the most financially attractive, so long as we continue to keep in mind that the IRR value also needs to be higher than the WACC.
Modified Internal Rate Of Return (MIRR)
The modified IRR (MIRR) is said to reflect the profitability of a project or investment more realistically than an IRR. The reason why this is so is because the IRR assumes the cash flow from an investment or project to be reinvested at the IRR, whereas the modified IRR assumes that all cash flows to be reinvested at the investor’s / firm’s cost of capital.
The MIRR is used extensively in real estate financial analysis due to the nature and timing of cash flows and investments for real estate investments.
Dividend IRR
The ongoing financial returns to investors who own and retain the equity of a business or project is essentially by way of financial / cash dividend payouts.
As equity investors are typically last in rank in the cash flow waterfall, and therefore face the greatest risk of not being paid should the investment turn sour when compared to holders of other forms of ownership in the same investment, equity investors would therefore expect the highest return.
The dividend IRR is therefore used extensively by equity investors to calculate and measure the discount rate at which the present value of cash dividend payouts equal the present value of equity investments.
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… is because the IRR assumes the cash flow from an investment or project are reinvested at the IRR, …
The IRR does NOT assume that the cash flow (benefits) from an investment or project is reinvested at the IRR. The benefits are paid out of the project as determined by the cash flow.
If you can reinvest the benefits at the IRR, then this does not change the IRR of the project.
William, well spotted and just the check and balance we needed to ensure our content remains of the highest quality.
We have made the necessary edits to the article to make it more concise, and that line now reads “the IRR assumes the cash flow from an investment or project to be reinvested at the IRR”.
This is a very interesting point that you have raised, as it seems that many other sites such as Investopedia and others may have also made the same editorial error. This may potentially be misleading to many corporate finance / financial modeling practitioners and learners.
article is really intresting and useful.
Ball park formula for IRR…example investor put in $1 Million and gets a preferred return for 5 years of 10 percent of his/her monies. At the end of 5 years project sells and net cash flow or cashs proceeds from sale after debt service and expenses paid is $ 5 Million….at IRR of 25 percent on the investment money, how much of the $5 Million has to be paid to the investor realizing that the investor was being paid 10 percent annually for 5 years?
Is there a ball park formula to use without using all sorts of tables and discounted cash flows? Again, any rule of thumb? Anyway, please advise. Thank you.
The article is of great importance for people interested in cost-benefit analysis.
You have done a great job and the explanation is quite simple and understandable.
make the article more simpler so that an non commerce graduates would also be in a better position to understand it
nice one, but please make it simpler so that even a dummy can understand .. thanks
any one know about the detail of IRR calculation? please advice.Thanks
can anyone show an example of IRR when the CF’s for certain years are postive and negative ? thanks
pls give details of ratios under each classified ratio and show how it works independently and dependently for easy understanding.
can anyone explain how to tackle a problem when NPV fluctuates from negative to positive even if discount rate is increased. IRR in this case also keep fluctuating.
any one know about the detail of IRR calculation? please advice.Thanks
irr = A + {a*(B-A)/a+b
where
A = thelower discount rate whoch gives the +ve npv
B = the higher discount rate which gives the-ve npv
a = the value of the +ve npv
b = the value of the -ve npv
please note that a and b should be added toghether as the negative sign in b is ignored.
This is very wonderful, it is actually a treasured treasure. I am a Researcher in the agricultural sector but am highly interested in understanding financial management principles. I am currently doing project management and it includes within it financial management. I was struggling with my assignments due to my limited knowledge of accountancy particularly understanding the financial language (concepts). I searched the internet for explanations to some meanings then I came across your explictly clear info that helped me a grate deal.
Bravo
I need to know what could be the IRR in following case.
In year 1 i invest 100 and on 5th year i get back 284 what could be the IRR and how get it pls tell me formule in Excel
i have aproblem about different IRR equity and IRR Project. Please clear me about its, if there is example its verry good
Good breif information to recollect during examination time
regares
All cash flows do not include interest payments / dividend pay outs. I hope taxes are included in cash outflows.
What should be the optimum IRR? For Service oriented company IRR is 95%, is it OK?
Your cooperation will be appriciated….
when u have 4projects $000(assuming cost of capital is 16%)
year0 year1 year2 year3
A -5266 2500 2500 2500
B -8000 0 0 10000
C -2100 200 2900 0
d -1975 1600 800 0
a.how do i assess the most viable project using IRR assuming their is no capital rationing.
b.which is the most viable project if they r mutually exclusive.
c,using profitability index which is the most viable project
what is each project internal rate of return?
Year Project A Project B
0 $100,000 $100,000
1 32,000 0
2 32,000 0
3 32,000 0
4 32,000 0
5 32,000 200,000
each has a 11 percent
I was terribilly confused with the exchange in comments between William Little and Financial Modeling Guide regarding the disagreement with the statement “the IRR assumes the cash flow from an investment or project ARE reinvested at the IRR, …” and the correction made “the IRR assumes the cash flow from an investment or project TO BE reinvested at the IRR”. I am relatively new to the study of DCF so I went on a mad search to understand the difference and why such a difference can lead to a misunderstanding of IRR and possible misuse. My initial thoughts were that whether it IS reinvested or assumed TO BE reinvested the end result is that at some time it will be reinvested and assuming a reinvestment at a rate higher than what is accually possible and/or dictated by the market can lead to a misleading IRR comparable to WACC. But I found an article that adds a much more academic explanation to William Little’s point. http://findarticles.com/p/articles/mi_6765/is_4_8/ai_n31127178/?tag=content;col1
yes off course you have really made very good effort and i got new information about modified and dividend IRR that is really new and interesting to me
any one know about the detail of IRR calculation? please advice.Thanks
any one know about the detail of IRR calculation and NPV please advice.Thanks
really helpfull.i have a problem with getting the real rate of return of a loan.”a bank disburses a loan as follows;9million today,3 million and 2million at the end of year 2 and 4 respectively.the loan was paid in in 6 annual instalments of 2 million at the beginning of year 6.subsequent installments increase by 2 million each from the previous one.given a rate of inflation of 4.5% per annum during the period.what is the annual real rate of retun for this loan?
question: what is the exit point for any given business?
how to calculate IRR in a commercial venture of a luxury hotel. further how to take the terminal value in case Investor calculates the IRR based on the period upto which the money lend is repaid back i.e. if money is invested for a period of 7 years. Investor will calculate IRR on the basis of 7 years receipt. But the project still have terminal value. How to take that and calculate in such a scenario? Kindly deliberate.
Jan 19th, 2009 at 6:55 am
[...] metrics that have been traditionally used for this process: the net present value (NPV) and the internal rate of return (IRR), along with a secondary derivative of the IRR – the modified internal rate of return [...]
Oct 28th, 2009 at 2:01 am
[...] When the project NPV is zero, the rate at that point of time is considered to be its Internal Rate of Return (IRR). [...]