IRR is the discount rate at which the NPV (net present value) of the project under consideration becomes zero. Another definition is the rate at which project cash flows are recovered. It is clearly no profit no loss situation or break-even point. So, we can say it is the rate of return of the project under consideration. It is one of the most common methods to evaluate the capital budgeting projects. Project which has high rate of return as compared to IRR should be undertaken.
Condition for IRR
Present value of cash outflows = Present value of cash inflows
If internal rate of return is higher than the cut-off rate decided by the management, then the project can be undertaken.
Application of IRR
IRR is widely used in various industries such as insurance companies, housing loans, car loans etc.
Formula
[ { CF1 / (1 + R) ^ 1 } + { CF2 / (1 + R) ^ 2 } + { CF3 / (1 + R) ^ 3 } + …… ] – Initial Investment = 0
Where:
R = discount rate
CF1 = Cash Flow of Period One
CF2 = Cash Flow of Period Two
CF3 = Cash Flow of Period Three
By setting NPV equal to zero as shown in the formula above, once can calculate IRR. But, this is not possible because of the powers attached to the discount rates. So, it is not possible to calculate IRR like this.
How to Calculate IRR
The best method to calculate IRR is by trial and error. We can use different discount rates to find out Net Present Value. At a discount rate, where NPV comes equal to or nearby zero, we will choose that discount rate as IRR.
Example
A small toy manufacturer is thinking of installing a new plant for toy’s production. This will result in an increase of 30 % in the production capacity. This new plant will require initial investment of $ 100,000. The cash outflows in first, second and third year are $ 30,000, $ 40,000 and $ 70,000 respectively.
Required
Find out IRR using trial and error method.
Solution
Now, we will calculate NPV at various discount rates as follows:
@ 10 % – NPV = $ 12,922.61
@ 15 % – NPV = $ 2,358.84
@ 16 % – NPV = $ 434.62
@ 17 % – NPV = $ (1432.49)
As you can see above that we have calculated NPV at various discount rates. At 16 % discount rate, NPV is close to zero, while at 17 % it is coming in negative. So, we can take IRR equals to 16 %.
IRR ≈ 16 %