How to make more profitable investments? Compute for Internal Rate of Return!

Have you ever heard of the Internal Rate of Return (IRR)? This is an important indicator used in the economic viability analysis of a project and serves to ensure more profitable and safe investments.

After all, no one wants to make an investment without being sure that they will make a profit from it, right? Each and every investment project must be carefully analyzed and, to help in this task, we have the Internal Rate of Return.

You will learn about IRR from the following topics:

• What is the Internal Rate of Return?
• How to compute the Internal Rate of Return?
• Practical example of how to compute IRR,
• Limitations of the Internal Rate of Return,
• Importance of the Internal Rate of Return,
• Become an excellent investor!

What is the Internal Rate of Return?

The Internal Rate of Return (IRR) can be defined as the discount rate that makes the Net Present Value (NPV) of a project equal to zero. The rate corresponds to the present value of anticipated cash inflows with the initial cash outflows.

In other words, the Internal Rate of Return is a metric used to evaluate the return percentage of a project to the company. When finding this rate, it will usually be compared to the Minimum Attractive Rate of Return (MARR) to decide whether or not the project should be accepted.

If the IRR is greater than the MARR, the investment must be accepted, otherwise it will be rejected. In general, companies will give preference to projects that have the greatest difference between the required rate and the internal rate of return.

To better understand the Internal Rate of Return, you should think of it as a project expected growth rate. As such, projects with a much higher IRR than others will have a much better chance of growing.

How can IRR ensure assertive investments?

One of the main applications is in the investments analysis such as establishing new operations or expanding existing ones.

For example, a power company is deciding whether to open a new plant or renovate and expand an existing one. While both options are good for the company, it is likely to choose the option that has the highest internal rate of return.

While IRR is an attractive metric for many, it should always be used in conjunction with NPV (Net Present Value) to get a clearer picture of the value represented by a potential project a company might undertake.

How to compute the Internal Rate of Return?

Computing the Internal Rate of Return is quite simple. The formula used is based on the same formula used to calculate NPV. To find the IRR, equate the NPV (negative cash flows) to zero, as follows:

• NPV = Net Present Value
• Ct = Net cash inflow during the period t
• C0 = Total Initial Investment Costs
• IRR = Internal Rate of Return
• t = The number of time periods

As you may have noticed from the formula, IRR cannot be easily calculated analytically. Therefore, to calculate the internal rate of return we can use a financial calculator, software such as Excel or find out by trial and error.

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Practical example of how to compute IRR

A project has an investment of US$ 325,000.00, which occurred on year zero. Considering an analysis period of 5 years, an annual cash flow of R$ 90,000.00, and a minimum required rate of 9% per year, decide whether the project should be accepted or not.

To do the calculation, just set up a table like the one above and use the (IRR) function in Microsoft Excel, selecting all cash flows (including the initial investment) in the function parameters.

By doing so, we get an internal rate of return equal to 11.93%. In other words, if we analyze the viability of this project only by the IRR, this investment will be approved, as the IRR is greater than the minimum rate required by investors.

Limitations of the Internal Rate of Return

Although Internal Rate of Return is the single most important performance benchmark for private-equity investments and ideal for analyzing capital budgeting projects, it has its limitations.

It is not always good to use this indicator alone, as mentioned earlier. In this way, it is necessary to take into account the interest rate, future cash flows and even the modified internal rate of return (MIRR) compute, as we will understand bellow:

Internal Rate of Return vs Net Present Value

Depending on the initial investment costs, a project may have a low IRR but a high NPV, which means that while the company's rate of return on this project is slow, the project may also be adding a large amount of overall value to the project. organization.

A similar problem arises when using IRR to compare projects of different lengths. For example, a short-lived project might have a high IRR, making it look like an excellent investment, but it might also have a low NPV.

On the other hand, a longer project may have a low IRR, earning returns slowly and steadily, but as mentioned before, it can add a large amount of value to the company over time.

Wrong IRR analysis

Another problem with IRR is not strictly inherent in the metric itself, but rather a common misuse of IRR. It is often stated that IRR assumes that when positive cash flows are generated during the course of a project (and not at the end), the money will be reinvested at the project's rate of return. This can rarely be the case.

Instead, when positive cash flows are reinvested, it will be at a rate that most closely resembles the cost of capital. Incorrectly calculating using IRR in this way can lead to the belief that a project is more profitable than it actually is.

This, along with the fact that long projects with fluctuating cash flows can have several distinct IRR values, has led to the use of another metric called the modified internal rate of return (MIRR).

MIRR adjusts the IRR to correct these problems, incorporating the cost of capital as the rate at which cash flows are reinvested and existing as a single value. Due to the correction that MIRR makes to IRR, a project's modified rate of return will generally be significantly less than the IRR for the same project.

Advantages of using IRR

Evidently, calculating the IRR is of paramount importance for any investment. It is essential that anyone who decides to invest is aware of this indicator.

It is also important to know how to interpret the results obtained from the IRR calculation, so as not to fall into the possible traps that a superficial analysis can generate. A good investor will never use just one financial indicator in his analysis, but a set of them, such as NPV and Payback, for example.

Often, investors will choose projects with a lower internal rate of return, which in the long run will bring considerable benefits from the point of view of adding value to the company.

In addition, it is important to have a good understanding of your own risk tolerance or the company's investment needs, risk aversion, and other options available. How to develop these skills? Get the Lean Six Sigma certification!

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