What Is the Internal Rate of Return (IRR) Rule?

The internal rate of return rule states that a project or investment may be worth pursuing if its 澳洲幸运5官方开奖结果体彩网:internal rate of return (IRR) exceeds the minimum 澳洲幸运5官方开奖结果体彩网:required rate of return, or 澳洲幸运5官方开奖结果体彩网:hurdle rate. This rule can be useful for companies and investor💧s that want to determine whether to take on a certain ꦜproject or investment or to compare it with others they may be considering. However, it also has some serious limitations, as this article explains.

Understanding the Internal Rate of Return🐠 (IR﷽R) Rule

The IRR rule is a guideline for deciding whether to proceed with a project or investment, on a financial basis. Mathematically, IRR is the rate that would result in the 澳洲幸运5官方开奖结果体彩网:net present value of future cash flows equaling exactly zero.

The higher the projected IRR on an investment—and the greater the amount by which it exceeds the 澳洲幸运5官方开奖结果体彩网:cost of capital—the more net cash it is likely to generate and the more it may be worth pursuing. On the other haღnd, if the IRR is lower than the cost of capital, the rule suggests that the best course of action is to forgo the project or investment.

Businesses often use the IRR rule to evaluate projects in 澳洲幸运5官方开奖结果体彩网:capital budgeting. But it may not always be rigidly enforced. Generally, the higher the IRR, the better. However, a company might prefer a project with a lower IRR because it h✅as other potential benefits, such as contributing to a larger st🐠rategic plan or impeding competition.

A compan🔜y might also prefer a large project with a lower IRR to a small project with a higher rate because of the greater cash flows it will generate in ♓dollar terms.

Advantages and Disadvantages of the IRR Rule

Advantages

The internal rate of return is relatively easy to understand and to calculate u𝔍sing a spreadsheet. Companies and investors can compare it to other projects and investments that are under co📖nsideration.

Another advantage of using this rule is that it helps companies and investors account for the 澳洲幸运5官方开奖结果体彩网:time value of money (TVM). This is a concept that states that a particular amount of money is worth more now than the same sum in the future. As such, the future cash flow that results from an investment is discounted to its present value under the IRR rule.

Disadvantages

The IRR doesn't take the actual dollar value of the project or any anomalies in 澳洲幸运5官方开奖结果体彩网:cash flows into account. If there are any ir༒regular or uncommon forms ofꦜ cash flow, the rule shouldn't be applied. If it is, it may result in flawed findings.

Another key disadvantage of the IRR rule is that it is flawed in its assumption regarding any reinvestments made from positive cash flow—notably, that they are made at the same internal rate of return. A 澳洲幸运⛎5官方开奖结果体彩网:modified🌸 internal rate of return (MIRR) is sometimes used instead as it assumes that positive cash flows are reinvested at the firm's cost of capital.

Example of the IRR Rule

Let's assume that a company is reviewing two projects in which it may invest its money. Management must decide whether to move forward with one, both, or neither of the projects. Its cost of capital is 10%. The cash flow patterns for each project are highlighted in the following table:

The company must 澳洲幸运5官方开奖结果体彩网:calculate the IRR for each project. The initial outlay (period = 0) will be negative. Solving for IRR is an iterative process (where results for each period are summed) using the following equation. The upper case sigma (Σ) denotes summation, or creating terms for each period using the formula that follows the s෴ymbol and then adding the result for each period:

$0 = Σ [ CF_t ÷ (1 + IRR)^t ] - C₀

Where:

• CF = Net cash flow
• IRR = Internal rate of return
• t = Period (from 0 to last period)
• C₀ = The initial outlay

Thꦍe formula looks l💧ike this with the terms in order. The initial outlay is multiplied by -1 because it is money being subtracted from the project:

$0 = [ initial outlay * -1 ] + [ CF₁ ÷ (1 + IRR)¹ ] + [ CF₂ ÷ (1 + IRR)² ] + ... + [ CF_X ÷ (1 + IRR)^X ]

Using the above examples, the company can calculate IRR for each project. In each term, "IRR" must be substituted with an educated guess because the only way to determine the best IRR is through trial and error:

• IRR Project A: $0 = [ (-$5,000) + $1,700 ] ÷ [ (1 + IRR)¹ + $1,900 ] ÷ [ (1 + IRR)² + $1,600 ] ÷ [ (1 + IRR)³ + $1,500 ] ÷ [ (1 + IRR)⁴ + $700 ] ÷ [ (1 + IRR)⁵ ]
• IRR Project B: $0 = (-$2,000) + $400 ÷ (1 + IRR)¹ + $700 ÷ (1 + IRR)² + $500 ÷ (1 + IRR)³ + $400 ÷ (1 + IRR)⁴ + $300 ÷ (1 + IRR)⁵

You can see how this can become manually tedious and prone to errors. Using a spreadsheet simplifies matt🐲🎃ers considerably.

Calculating IRR Using a Spreadsheet

Using these same values in a spreadsheet, you c🍬an use this function:

=IRR(x:y)

Where:

• X is the first cell in a column
• Y is the last cell in the same column
• The initial outlay should be negative

The following table shows the 🅺entries and the function.

In the spreadsheet, enter the following in one cel🧔l:

=IRR(A1:A6)

And in another cell, enter:

=IRR(B1:B6)

In the spreadsheet, project A results in an IRR of 17%, and project B results in an IRR of 5%. Given that the company's cost of capital is 10%, management should proceed with Project A and reject Project B.

The Bottom Line

Whether you're an individual investor or run a company, it's important to deploy your investment capital in a way that makes sense. The internal rate of return rule can be a useful tool for comparing your different options. However, the rule has some downsides that can lead to flawed results, and you don't want to follow it blindly because there may be other issues to consider that it doesn't account for.