Internal Rate of Return (IRR)
Foundations of IRR: Net Present Value (NPV)
To understand IRR, one must understand net present value (NPV).
Net present value is calculated by discounting future cash flows by a discount rate, which is the rate a company expects to earn on investments.
How to Calculate IRR | Example
If a project offers $1,000 for 3 years, the present value of future cash flows is not worth $3,000 to the company because it has an expectation that its money should earn money over time.
This concept is known as the “time value of money” (TVM).
Calculating IRR | Case Study
If a company invests $2,000 into a project which offers $1,000 for 3 years at an 8% discount rate, the present value of future cash flows is $2,545.09.
After subtracting the initial investment, the net present value of the project is $545.09, suggesting this is a good investment at the current discount rate.
The internal rate of return is the discount rate that would bring this project to breakeven, or $0 NPV.
In this case, an internal rate of return of 18.95% brings the net present value of future cash flows to 0.
IRR Calculation | Hurdle Rate
A company’s discount rate is typically derived from its cost of capital, or the cost a company pays investors in exchange for capital, either in interest from issued debt or through selling equity in the company.
The weighted average cost of capital often functions as a company’s “hurdle rate,” or the minimum required rate of return.
Because the IRR in our example exceeds the discount rate (or required rate of return), the IRR rule says that management should invest in this project.
IRR Formula Limitations – Opting for the MIRR
It’s important to note that certain assumptions can cause the IRR to become overstated.
For this reason, many investors use the Modified Internal Rate of Return, or MIRR, which account for these assumptions.