Internal rate of return (IRR)
[Lorenzo Incarnato s220426]
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Abstract
The Internal Rate of Return (IRR) is a powerful discounted cash flow method used in capital budgeting and corporate finance to estimate and evaluate the profitability of potential investments. Keeping in mind the formula for the Net present value (NPV), the IRR is defined as the discount rate that makes the present value of the costs (negative cash flows) of an investment equal to the present value of the benefits (positive cash flows). In other words, the IRR is the discount rate that gives a net present value of zero when applied to the expected cash flow of a project. This rate of return is called internal because the formula predicts a rate that depends only on the project, more precisely on the project's cash flows, and does not depend on external factors such as market interest rates or inflation[1]. One of the main advantages in using the internal rate of return to evaluate project investments, compared to other methods such as the Payback period or the Benefit-cost ratio, is that IRR reflects the time value of money[2]. In general, due to the relationship between NPV and IRR, the higher the Internal Rate of Return of a project, the more desirable the investment to be made. This article shows also the limitations of the internal rate of return; however, when the IRR is unique, it provides relevant information about the return on investment and is also used as a measure of investment efficiency. In fact, according to academic research[3], three-quarters of Chief Financial Officers use the IRR method to evaluate capital projects.
Time value of money
100,000 $ today equals 100,000 $ in a year?
The answer to this question is NO, and this paragraph explains why a certain amount of money available today is worth more than having the same amount in the future. In short, the time value of money (TVM).
A certain amount of money available today does not correspond to the same amount in the future because, in finance, the present value could be invested and grow based on the interest rate, generating more money in the future. This relation between the same amount of money available on two different dates, today and in the future, is called the Time Value of Money. Before answering the initial question, it is necessary to briefly underline three fundamental terms about investments:
- the Present value (PV): the sum of money available today that can be invested [$];
- the Interest rate (r): the amount of interest due per period, as a proportion of the amount deposited/borrowed [%]
- Future value (FV): is the value of a current asset (present value) at a future date based on an assumed rate of growth (interest rate) [$].
So, it is easy to understand that the answer to the initial question (Is $ 100,000 the same value today in a year?) is: NO. In fact, applying the formula of the future value (FV):
Hence, a certain sum available in the present could be invested and grow according to the interest rate. The amount of money cumulated in the meantime is the Time Value of Money, mathematically TVM = FV - PV.
IRR: definition and formula
Decision criteria
IRR in practice
Internal Rate of Return (IRR) vs Return on Investment (ROI) vs Net Present Value (NPV)
Limitations
Bibliography
- ↑ BERNHARD, Richard H. Discount methods for expenditure evaluation-a clarification of their assumptions. The Journal of Industrial Engineering, 1962, 13.1: 19-27.
- ↑ Haight, Joel M.. (2012). Principles of Industrial Safety - 5.2.5 Net Present Worth. American Society of Safety Professionals. Retrieved from https://app.knovel.com/hotlink/pdf/id:kt012IGYO2/principles-industrial/net-present-worth
- ↑ John R. Graham and Campbell R. Harvey, “The theory and practice of corporate finance: Evidence from the field,” Duke University working paper presented at the 2001 annual meeting of the American Finance Association, New Orleans.
