The Internal
Rate of Return (IRR) is the discount rate that generates a zero net
present value for a series of future cash flows.....This essentially means that
IRR is the rate of return that makes the sum of present value of future cash
flows and the final market value of a project (or an
investment) equal its current market value.
Internal
Rate of Return provides a simple ‘hurdle rate’, whereby any project
should be avoided if the cost of capital exceeds this rate. Usually a financial
calculator has to be used to calculate this IRR, though it can also be
mathematically calculated using the following formula:
In the
above formula, CF is the Cash Flow generated in the specific
period (the last period being ‘n’). IRR, denoted by ‘r’ is to be calculated by
employing trial and error method.
Internal
Rate of Return is the flip side of Net Present Value (NPV), where
NPV is the discounted value of a stream of cash flows, generated from an
investment. IRR thus computes the break-even rate of return
showing the discount rate, below which an investment results in a positive NPV.
A simple decision-making
criteria can be stated to accept a project if its Internal Rate of
Return exceeds the cost of capital and rejected if this IRR is less than the
cost of capital. However, it should be kept in mind that the use of IRR may
result in a number of complexities such as a project with multiple IRRs or no
IRR. Moreover, IRR neglects the size of the project and assumes that cash flows
are reinvested at a constant rate.
The Modified
Internal Rate of Return (MIRR) is an other financial measure used to
determine the attractiveness of an investment.
In IRR
calculations, positive cash flows are assumed to be 'paid' instantly to the
investor who can use them immediately to reinvest on a new project. But in
reality, the positive cash flows are not paid instantly to the investors, but
rather kept by the 'project management entity' (ie: venture capital firm,
department owning the project...) until the end of the project.
The
Modified Internal Rate of Return assumes that the positive cash flows are
immediately re-invested until the end of the project. To make these
calculations, it is common practice to use the weighted average cost of
capital as interest rate on the positive cash flows.
