When faced with multiple investment opportunities, projects, or initiatives, how can you determine which option will be most profitable for your business?
This is a common conundrum that business owners come across. Especially when you have a limited amount of resources, you want to make sure every investment decision is worth it.
One metric to help you make this decision is the internal rate of return (IRR) produced by each option.
So, what is the IRR and how can you calculate it? Continue reading below as we discuss how to use the IRR to make informed financial decisions and simple calculation methods that won’t require a refresh of your high school math class.
What is the internal rate of return (IRR)?
The internal rate of return (IRR) is the expected annual growth of an investment.
It helps you understand when you’ll break even on an investment – either in a personal or business setting.
More specifically, the IRR represents the rate that makes the net present value (NPV) of future cash flows from the investment equal to zero – meaning when you get out exactly what you put in.
As we’ll discuss in further detail below, the IRR is a helpful tool that enables companies to make capital budgeting decisions.
When comparing two or more investment opportunities, companies will generally select the one that produces the highest IRR.
What is the IRR used for?
Businesses commonly use the IRR to compare and rank different investment opportunities, initiatives, and capital planning.
For example, you may be interested in expanding your product portfolio. You have ideas of three new product lines you could add. However, you only have the resources to pursue one of them.
While you can weigh your options subjectively based on what you think customers will like best or what you’re most interested in, using the IRR can provide more concrete evidence pointing to the better choice.
In this scenario, you could calculate the IRR for each, and the product line with the highest IRR would be the best option financially.
Plus, many organizations have established a required rate of return (RRR). This represents the minimum return that the company will accept.
So, if the calculated IRR of a project or investment falls below the RRR, the company will reject it, as this may indicate it won’t be a profitable endeavor. This is generally referred to as the IRR Rule.
Potential limitations of IRR
IRR is helpful for making investment and capital planning decisions. However, it shouldn’t be the sole metric you use to project future returns.
The IRR typically deviates from the actual returns an investment will produce. In the real world, an investment generates varied returns from year to year given macroeconomic conditions and other factors.
In contrast, the IRR is only based on one discount rate, which can make for some variation with actual results over the years.
For this reason, IRR is better used to compare two or more investments or initiatives side by side, with all other factors considered equal.
In addition, the accuracy of the calculation hinges on how well you’re able to predict the future cash flows of the investment or project.
The IRR formula
The IRR formula is fairly complex, and not something that you’ll generally want to complete by hand.
The IRR formula is as follows:
In this formula:
- IRR = Internal rate of return
- t = The total number of periods
- Ct = Net cash inflow during period t
- C0 = The total investment cost
The calculation for IRR is based on the net present value formula. But, in this case, you’ll set the NPV as zero and solve for the IRR.
This is because you want to find the point where the investment’s future cash flows equal exactly what you invested in the project, representing your break even point.
Calculating the IRR using this formula requires a trial and error approach. In other words, you’ll need to keep guessing what the IRR could be until you find a value that makes the NPV of future cash flows equal to zero.
You may also use a financial calculator with time value of money functions to more easily find the IRR.
These generally aren’t too expensive. However, there can be a slight learning curve to get comfortable keying in the values in the proper order and with the right buttons.
For many, the easiest option is to use spreadsheets, which we’ll cover in more detail below.
How to calculate IRR in Excel
It’s much more practical to calculate the IRR using a spreadsheet program rather than by hand.
In fact, there’s even an IRR function already programmed into both Excel and Google Sheets. Here are the steps you’ll take to calculate IRR with a spreadsheet:
- Open a spreadsheet, and in one column, list out the number of time periods that you’d like to account for. (The list should start with 0, representing when you make the initial investment.)
- Enter all the expected cash flows from a given investment in the next column. These values should be written chronologically, corresponding to the time period whe they’re expected. (The first cash flow will always be negative, representing the initial cash outlay.)
- Choose a cell where you’d like the IRR to appear. Enter ‘=IRR’ then hit the tab button on your keyboard to populate it into the cell.
- To complete the function, enter the cell values where your cash flow data is entered. In this case, cash flow data is shown in cells B2 through B7. (The proper syntax for this in a spreadsheet is B2:B7.)
- Upon pressing enter, the spreadsheet will automatically complete the necessary iterations to find the rate in which the NPV of all cash flows equals zero. In this scenario, it’s equal to 15%, which is the IRR.
Example: Using the IRR to make business decisions
To illustrate the value of IRR, let’s take a look at what it might look like for a company to use the IRR to make real capital budgeting decisions.
For example, a company that’s deciding between two separate product line expansions may use the internal rate of return to determine which would be the most profitable for the business.
Product A requires a larger initial investment than Product B. However the expected cash flows between the two also differ. Using the IRR, we can see which will have a greater annual growth rate, showing which will meet its break even point quicker.
Here are the details for Product A:
- Initial investment: $600,000
- Annual cash flows: $175,000 for 5 years
We can use the IRR formula in a spreadsheet to complete the calculation, as shown in the table below, which gives us an IRR of 14%.
We can compare this with Product B, which has the following details:
- Initial investment: $500,000
- Annual cash flows: $140,000 for 5 years
Using the formula in a spreadsheet, we find the IRR of Product B to be 12%, as shown below:
So, even though Product A requires a larger investment, it’s expected to generate a higher annual return, turning a profit more quickly than Product B would.
Assuming this company’s required rate of return is lower than 14%, it would choose to proceed with the expansion of Product A.
What is considered a good IRR?
Each company will have its own threshold for what’s considered a “good” IRR. The general rule of thumb is that an IRR is acceptable if it’s above the company’s RRR, whether that’s 6% or 16%.
This value will typically vary depending on a company’s industry and the perceived risk of a given project or investment.
For instance, companies operating in a highly competitive and high-growth field, like startups, might seek out a higher IRR than a company in a stabler market.
Similarly, companies with a greater risk appetite might not be interested in an investment that offers an IRR of 12%. At the same time, this return might seem appealing to organizations with a more conservative risk tolerance.
What's the difference between IRR and ROI?
After learning more about IRR, you might wonder what’s the difference between this metric and the return on investment (ROI).
While they can both be used to measure the performance of a given project or investment, they go about it in different ways.
Notably, the ROI measures the change in the value of an investment from the beginning to the end. It’s a much simpler calculation, gauging the amount of profit or loss generated over a certain period, relative to the initial investment.
The IRR calculation is a bit more complex, because it considers the time value of money. In this way, it can be a more accurate reflection of an investment’s return.
Let’s see how the two compare side by side for the same scenario.
Let’s say you invest in a project with an initial outlay of $20,000, and you receive the following cash inflows over the following three years:
- Year 1: $8,000
- Year 2: $8,000
- Year 3: $8,000
Your total returns would equal $24,000 after the three years.
Using the formula of:
ROI = Total Return – Initial Investment x 100
Initial Investment
Your ROI for the project would be:
ROI = $24,000 – $20,000 x 100
$20,000
ROI = $4,000 x 100
$20,000
ROI = 0.2 x 100
ROI = 20%
In the same scenario, we could use a spreadsheet to calculate the IRR, which would look like:
Again, the IRR takes into account the annualized returns based on when each of the cash flows occur.
On the other hand, the ROI offers a basic measure of the total return of the investment over the three years, without being concerned with the specific timing.
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