IRR (Internal Rate of Return) is a yardstick to calculate or estimate the rate of return for an investment in the future. It is a discount rate which makes NPV (net present value)of all cash flow (positive and negative) funds equivalent to zero in an analysis of discounted cash flow. However, one should not mistake it for the investment return of history or past.
Here, the term internal in IRR signals that it does not include external factors like cost of capital, several financial risks, inflation, risk-free rate etc. It is commonly called (DCFROR). Interestingly, IRR and NPV depend on the same formula for calculations.
Know What is IRR
An IRR on an investment or project is the rate or annual return of the return that compiles NPV of radical cash flows from investments compeer to none or nil. Subsequently, the internal rate of return has been designed for accounting the time preference of investments and funds. A return on investment offered when received on a specific time holds more value than the similar return received later on. Thus, the latter would harvest lesser IRR compared to the former provided all factors remain equal.
Uses of IRR
IRR has a vibrant and wide purpose of serving in the financial market. It has several uses:-
- Management of capital: Big business houses and corporates utilise IRR for evaluating and calculating stock buyback programs and price of issued equities. If a shareholder receives a massive internal rate of return in comparison to acquisition projects or candidate capital investment projects, then the repurchase of shares motion ahead.
- Saving: In reference to savings, IRR is referred to as the effective interest rate. Also, in the case of loans, it is commonly known as EIR.
- Private stocks or equities: From the perspective of limited partners, IRR is brought into use for private equities. It measures the general partner’s overall performance as an investment manager.
- Investment benefits: The single most substantial use for corporates of IRR is to find how profitable capital projects are in terms of ROR (Rate of Return). It is used in capital budgeting. For example, based on each project’s IRR, a corporate will collate an existing extension of a plant against investments in a novice plant. The undertaking of a project is directly proportional to the rate of IRR. Higher the IRR better the chances of claiming a project.
- Expanding NPV: An IRR indicates the profitability factor, quality, efficiency, harvest and other elements of investments. However, NPV differentiates from it ultimately, which denotes the addition of magnitude with a stake or growth in the net value.
- Application of IRR: Any sort of investment is acceptable for the application of IRR if the reason behind it is to leverage the value of a firm. However, the profitability as per the IRR must be bigger than the minimum threshold for the acceptable rate of return.
- Cost of capital: The available minimum rate used to maximise the valuation of any firm is the cost of capital. It means that the new capital project’s IRR must be more than the cost of capital of a company because then only the net present value will be positive.
Disadvantages of Using IRR
- Financial publications use IRR for misleading facts.
- NPV and IRR yield different results, and the latter doesn’t conform to its terms and conditions.