Every investor uses variety of tools to analyze the profitability of the investment. Internal rate of return (IRR) is one such ratio; which helps investors to make investment decisions. IRR helps to measure the profitability of the project.
Internal rate of return is a ratio which equates the present value of cash inflows (Benefits) with present value of cash outflows (Costs). IRR can also be termed as a ratio for which NPV (Net Present Value) of an investment is zero. Remember Cash outflows should be considered negative whereas cash inflows should be considered positive. For most of the projects first cash flow is generally negative.
The rate is “internal” because it depends only on the cash flows of the investment; no external data are needed. As a result, we can apply the IRR concept to any investment that can be represented as a series of cash flows. In the study of bonds, we encounter IRR under the name of yield to maturity.
Breaking Down IRR: Internal rate of return makes the “Net Present Value” of the project equal to zero. IRR can be represented mathematically with the following equation.
While calculating IRR it is always assumed that interim cash inflows can be invested exactly at IRR. Let us suppose that IRR for a project is 10% and if we can re-invest interim cash inflows at less than 10% then project will result into return less than 10%; whereas in cash inflows can be invested more than 10% then project rate of return would be higher than 10%.
How IRR helps to decide on profitability of the project: IRR is calculated either in comparison to cost of capital or in comparison to opportunity cost. While quantifying the profitability of a single project; management compares the IRR with cost of the capital. Let us suppose that while making investment decision; company has to borrow money at 10% from market; that makes minimum required return equal to 10%. Management would invest only if probable IRR from the project is more than 10% or at-least should be equal to 10%, otherwise company would decide not to invest in the project.
Let us suppose if IRR of the project is 12%; which means discounting cash inflows at 12% will make NPV equal to zero; Whereas discounting cash-inflows at cost of capital (10%) gives NPV more than zero. Now consider if IRR of the project is 8%; which means 8% discounting would result into NPV equal to zero. In this case if discount cash inflows at 10% will result into negative NPV.
So if IRR is higher than Cost of capital project is profitable otherwise investment will result into losses.
Opportunity cost is another way to decide if a company should invest in the project or not. For example IRR of the project is 10% whereas bank interest rate is 12% then company is better positioned while depositing money with bank.