An expert always looks for the correct tool so when evaluation of a project is required. The finance expert will sit down to calculate the internal rate of return. The internal rate of return is the benchmark rate against, which the return of the project under consideration is compared. Internal rate of return helps the evaluator to choose the most profitable projects from the available projects.
Thus, the understanding of the internal rate of return is crucial in the financial decision making. So for a finance student it will be a help & useful in understanding the internal rate of return, its computation and the use in financial decision making. Lot of Mergers & Aquisitions happen after using IRR to judge different projects.
Meaning of Internal Rate of Return (IRR)
The internal rate of return is defined as the return, which, if applied to discount the cash flows, would result in zero net present value. In other words, the net present value of a project’s cash flows worked out based on the internal rate of return would always be zero. The decision based on the internal rate of return is taken by comparing it with the cost of capital. In case, if the internal rate of return is higher than the cost of capital, the project should be accepted, otherwise it should be rejected. For example, if the project’s internal rate of return is 10% and the cost of capital is 8%, the project should be accepted.
Computation of IRR
Let us see the computational part. The mathematical computation of IRR is simple when the amounts of cash inflows over the year are same. it starts to get more complicated when the amounts of cash inflows differ from time to time. However, this computational complexity can be reduced with the use of Excel in the computation of IRR. Using the Excel, one is required to input the required data in the Excel sheet and apply the Excel function to get the results in minutes. The computation of IRR is demonstrated in the in table given below:
Year |
Equal Cash Flows |
Unequal Cash Flows |
0 |
-100,000.00 |
-100,000.00 |
1 |
30,000.00 |
20,000.00 |
2 |
30,000.00 |
30,000.00 |
3 |
30,000.00 |
40,000.00 |
4 |
30,000.00 |
50,000.00 |
5 |
30,000.00 |
20,000.00 |
Formula |
IRR(B7:B12) |
IRR(B7:B12) |
Result |
15.24% |
16.91% |
From the table given above, it can be observed that the internal rate of return is 15.24% in the case when the cash inflows are equal and 16.91% in the case of unequal cash inflows. Now, these above computed internal rate returns are to be compared with the cost of capital. Suppose, the cost of capital is 12%, the project should be accepted as the internal rate of return is higher than the cost of capital.
Limitations of IRR
IRR does have some limitations like everything else. Sometimes the limitation of IRR may cause the results of IRR to be misleading at times resulting into wrong selection of the projects. For example, the project with an IRR of 100% having a cash outflow of $5 and inflows of $10 will be preferred over the project with an IRR of 10% having a cash outflow of $1000 and inflows of $100. This decision based on IRR would be grossly wrong as it would result in lower income.
Apart from this limitation, the IRR method may also result in multiple solutions, making it difficult for the decision maker to select the appropriate one. This might get a finance student really confused. Because of this reason someone screwed up their intership at Google.
Let us understand in Brief
The internal rate of return, has been discussed in this blog along with importance. The discussion has been sequentially arranged to first clarify the meaning of the internal rate of return and then computation of IRR followed of the limitations of the IRR. The computation of IRR is a bit complicated if done without the use of computer resources. The use of Excel makes it very simple to calculate the IRR, which has been demonstrated with the help of an example in this paper. Further, the use of IRR has certain limitations, which have been described with the help of an example.
This blog is written by Bella Williams , who is private tutor in Information Technology at Expert Assignment Help and loves working with students to help them out with IT assignments and software packages for their capstone projects. She breathes and lives around international students and understands their problems. She also conducts educational tours for students during vacation.