What is Internal Rate of Return? Definition
The Internal Rate of Return (IRR) is the discount rate that delivers a
net present value of zero for a series of future cash flows. It is an
Discounted Cash Flow (DCF) approach to valuation
and investing. As is Net Present Value (NPV).
IRR and NPV are widely used to decide which investments should be undertaken,
and which investments not to make.
Difference of IRR and NPV
The major difference is that while Net Present
Value is expressed in monetary units (Euro's or Dollars for example),
the IRR is the true interest yield expected from an investment expressed as
Internal Rate of Return is the flip side of Net Present Value and is based
on the same principles and the same calculations. NPV shows the value of a
stream of future cash flows discounted back to the present by some percentage
that represents the minimum desired rate of return, often your company's cost
of capital. IRR, on the other hand, computes a break-even rate of return.
It shows the discount rate below which an investment causes a positive NPV
(and should be made). And above which an investment causes a negative NPV
(and should be avoided). It's the break-even discount rate, the rate at which
the value of cash outflows equals the value of cash inflows.
Many people find the percentages of IRR easier to understand than Net Present
Value. Another benefit from IRR is that it can be calculated without having
to estimate the (absolute) cost of capital.
The IRR approach
When IRR is used, the usual approach is to select the projects whose IRR
exceeds the cost of capital (often called hurdle rate when used in
the IRR context). This may seem simple and straightforward at first sight.
However a major disadvantage of using the Internal Rate of Return instead
of Net Present Value is that if managers focus on maximizing IRR and not NPV,
there is a significant risk in companies where the return on investment is
greater than the Weighted Average Cost of Capital (WACC):
that managers will not invest in projects that are expected to earn more than
the WACC, but less than the return on existing assets. IRR is a true indication
of a project's annual return of investment only when the project generates
no interim cash flows - or when those interim investments can be invested
at the actual IRR.
The aim of the value-oriented manager should be to invest in any project
that has a positive NPV! If IRR usage is unavoidable, then managers are advised
to use so called Modified IRR (which, while not perfect, at least allows
to set more realistic interim reinvestment rates) and additionally to keep
a close look on interim cash-flows, especially if they are biased to the beginning
of the project period (the distortion is bigger then).
In other words: the aim should not be to maximize the Internal Rate
of Return, but to maximize Net Present Value.
Book: Aswath Damodaran
- Investment Valuation: Tools and Techniques for Determining the Value.. -
Book: James R.
Hitchner - Financial Valuation: Applications and Models -
Book: Steven M.
Bragg - Business Ratios and Formulas : A Comprehensive Guide -
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