Internal rate of return (IRR)

Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright 2011 by Marty J.Schmidt.Revised 3 March 2012.

The Meaning of Internal Rate of Return (IRR) as a Cash Flow Metric

IRR analysis begins with a cash flow stream, a series of net cash flow figures expected from the investment (or business case scenario). Summarized graphically, an investment cash flow stream might look like this:

Each bar represents the net of inflows and outflows for one period (here, each period is two months) and the complete set cash flow events is called a cash flow stream. This cash flow stream, by the way, is a typical investment curve result.The negative bars at the outset and the positive bars in later years, show that the investment initially brings costs exceeding incoming benefits, but if things go as hoped, incoming benefits should soon outweigh the costs. Another scenario in the same case might show a different cash flow profile. IRR metrics for each scenario can be compared to help decide which scenario is the better business decision. Other things being equal, the scenario (or investment) with the higher IRR is the better choice.

Internal Rate of Return (IRR) Explained and Determined With an Example

As the word "return" in its name implies, an IRR view of the cash flow stream is essentially an investment view: money will be paid out and compared to returns. Instead of a simple ratio between inflows and outflows (as with ROI), the IRR compares returns to costs by asking: "What is the discount rate that would give the cash flow stream a net present value of 0?" The interest rate that answers that question is the IRR for the cash flow stream. That definition, however, is often less than fully satisfying to most people, especially when hearing it for the first

time. Many people ask: "What does that tell me? How does IRR compare to other metrics such as NPV? To ROI? Clearly, understanding IRR first calls for a simple understanding of the concepts present value, net present value (NPV), and the role of the discount rate (interest rate percentage) in determining NPV. To see how this definition is applied, consider two competing investments in computer equipment. Each calls for an initial cash outlay of $100, and each returns a total a $200 over the next 5 years making a net cash flow gain of $100 in each case. But the timing of the returns is different, as shown in the table below (Case A and Case B), and therefore the present value of each years return is different. The sum of each investments present values is the investment's Net Present Value. Using a discount rate (interest rate) of 10% for the discounting, we find: CASE A Timing Now Year 1 Year 2 Year 3 Year 4 Year 5 Total Net Cash Flow $100.00 $60.00 $60.00 $40.00 $20.00 $20.00 Net CFA = $100.00 Present Value $100.00 $54.54 $49.59 $30.05 $13.70 $12.42 NPVA = $60.30 Net Cash Flow $100.00 $20.00 $20.00 $40.00 $60.00 $60.00 Net CFB = $100.00 CASE B Present Value $100.00 $18.18 $16.52 $30.05 $41.10 $37.27 NPVB = $43.12

Comparing the two investments, the early large returns in Case A lead to a better net present value (NPV) than the later large returns in B. Note especially the Total line for each present value column in the table. This total is the net present value (NPV) of each cash flow stream. If the investment choice were based solely on NPV, other things being equal, the one with the higher NPV (Case A) is the better investment. You can take this as a signal that Case A will also have the higher IRR. IRR asks a different question of the same two cash flow streams. Instead of proposing a discount rate and finding the NPV of each stream (as with NPV), IRR starts with the net cash flow streams and finds the interest rate (discount rate) that produces an NPV of zero for each. The easiest way to see how this solution is found is with a graphical summary:

These curves are based on the Case A and Case B cash flow figures in the table above. Here, however, we have used nine different interest rates, including 0.0 and 0.10, on up through 0.80. As you would expect, as the interest rate used for calculating NPV of the cash flow stream increases, the resulting NPV decreases. For Case A, an interest rate of 0.38 produces NPV = 0, whereas Case B NPV arrives at 0 with an interest rate of 0.22. Case A therefore has an IRR of 38%, Case B an IRR of 22%. Which is the better Investment? Other things being equal, and using IRR as the decision criterion, the one with the higher IRR is the better choice. Another way to think of IRR is this: IRR tells you just how high inflation rates have to go in order to eliminate the present value of this investment.

For the Case A cash flow, the prevailing inflation rate would have to rise all the way to 38% to make this investment worthless. The Case B investment would become worthless if interest rates rose to 22%.

Instead of finding a graphical solution for IRR, most people today use Microsoft Excel or a preprogrammed calculator. In either case, the software uses an arbitrarily chosen discount rate to find NPV for a given cash flow stream, and then keeps changing the rate until it finds a rate that produces a 0 NPV. This occurs very quickly, so that the IRR result seems to appear as soon as the data are entered .

IRR Re-Defined: Why is it called Internal Rate of Return?

Unfortunately, the textbook IRR definition only explains how to find an IRR but not what it represents. IRR's real meaning is easier to understand in terms of investment costs and returns, when there are

1. A cost of using the funds to make the investment (financing costs) and 2. Gains from re-investing the investment returns when they arrive The example below shows how IRR can be defined as the interest rate that balances these two factors.

In the example, an initial cash outflow (Present) represents investment costs. Each year after that, the investment brings in positive cash flow returns, shown in the blue cells for Years 1 through 5. Excel's IRR function (in the cell below Year 5) determines that the interest rate 9.874% produces an NPV of 0 for the cash flow stream in blue. The IRR for this cash flow stream is 9.874%. Consider first the interest to be earned by re-investing the incoming cash flows from Years 1 through 5. If each incoming return were reinvested with compounded interest for the remainder of the five years, at an annual interest rate of 9.874%, the total five year gains (inflows + interest earned) would be 320.30. Now, assume that the initial cash outflow of 200 (in the blue cell under "Present") is borrowed, or financed at the same 9.874% per anum rate. The example shows how the total cost of this investment (cash outflow plus financing costs) is also 320.30 This example should begin to suggest a reason that financial people look to IRR and often base decisions on it. In reality, most companies would borrow funds at a rate close to their own cost of capital, not at the IRR rate. In the eyes of the financial specialist, therefore, an investment with an IRR above the real cost of borrowing (above the current cost of capital) is seen as a net gain, because the cost of the investment is lower than the return rate. Another reason that IRR is a favorite metric for people trained in finance, is that IRR (disguised under a different name) is a central concept in evaluating bond investments. If the IRR exercises above remind you of something you have seen beforesolving an NPV equation for an interest rateit is likely you are already familiar with the concept yield to maturity (YTM) as used in

bond investing. IRR and YTM are mathematically the same concept, with only a slight difference in definition . YTM is the interest rate, i, that satisfies this version of the NPV equation: Bond Purchase Price = FV1 / (1+ i )1 + FV2 / (1+ i )2 + ... + FVn / (1 + i )n The definition formula for IRR simply moves "Purchase Price" to the right of the equal sign, leaving behind a "0" on the left, and creating an immediate cash outflow on the right (calling the immediate outflow FV0), The formula then asks for the same i that solves the equation: 0 = FV0 + FV1 / (1+ i )1 + FV2 / (1+ i )2 + ... + FVn / (1 + i )n Given the same cash inflows and outflows, the same value of i solves both equations. For this reason, people trained in finance often turn to the IRR as a metric for evaluating and comparing potential business investments, even when the investments are quite different in nature. The projected IRR for, say, an investment in a marketing program can be compared directly with the YTM of a potential bond investment.

Lease vs. Buy and Other Inappropriate Uses of IRR

As a decision criterion, IRR is most trustworthy when the cash flow profiles of decision options are similar, and where an initial cash outflow is followed primarily by a series of cash inflows. When the cash flow profiles of competing options are quite different, however, IRR can become either useless or misleading. In a "Lease vs. Buy" comparison, for instance, the "Buy" option typically has a high initial cash outflow, to buy an asset. Then, in the remaining years of the asset's life, there should be cash inflows as the asset earns returns. The "Lease" option typically has almost the same net returns projected, but reduced slightly by the periodic leasing fees, with a very small initial cash outlay. As a result, the IRR for the lease option can be extremely high, e.g., 2,500% or 5,000% or more, whereas the "Buy" option for the same asset comes with an IRR of something like 25% or 30%. A decision based solely in IRR would always choose leasing as the better business decision. However, in the Lease vs. Buy decision, other factors can be more important, such as the impact on the company's asset base, tax consequences, and flexibility to upgrade or replace assets. For more explanation of this difference, varieties of IRR (such as Modified IRR, or MIRR), and more examples of IRR pitfalls, but suffice it to say here that the large difference in IRRs is due to the difference in cash flow profiles for the two options.

Further IRR Considerations

In deciding whether or not to include an IRR in a business case summary, here are some points to remember:

Other things being equal, the action or investment alternative with the highest IRR is the better investment. Generally, the higher the IRR, the better the returns relative to cost, and the lower the risk. IRR says nothing about the magnitude of the return. A tiny investment or expenditure may lead to a magnificent IRR. An alternative action with a smaller IRR might still be preferred if it brings in a much larger net cash flow, or DCF. IRR has the most meaning when there is an initial net cash outflow, followed by at least one period with a net positive cash inflow. IRR cannot be calculated with outflows only, or inflows only; IRR is thus not applicable to "cost only" analyses (such as the typical cost of ownership analysis). IRR can be quite misleading if there is no large initial cash outflow. It is possible to find a negative IRR rate with some cash flow streams. It is also possible to find cash flow streams with two or more IRRs (two or more interest rates that produce NPV=0 for the same cash flow stream). In such cases, the meaning is difficult or impossible to interpret, even for financial specialists.