3.5.9.3. Internal Rate of Return
One of the biggest mistakes a company may make when investing in different projects is not comparing what they’ll earn against what it costs them to earn it. This is especially true when you reflect on the idea of opportunity cost, which is the realization that using money one place means that you are not using it elsewhere. Internal rate of return (IRR) is a method of calculating the average annualized yield of a series of estimated cash flows. By calculating this rate, a company can then compare this rate against other choices of how to use its money over the same period and decide whether it wants to make this investment or not.
A simple example might be a company that wants to build a new plant now, which will cost $10 million to build and is expected to yield $3 million in new revenue each year for the next five years.
The IRR of a project is the rate at which the project has an NPV of zero. So if we were to examine the NPV equation for this project:
The IRR is the rate at which this equation is equal to zero. It turns out that if we plugged this into an IRR calculator, the rate that comes out is 15.24%. This means the building of this factory represents a 15.24% internal rate of return on the company’s investment. Not too bad. But if the company thinks it can earn 20% by investing its money in more advertising for its existing products or it is going to cost more than 15.24% to borrow the money needed to build the factory, then it may want to reconsider this investment. Note that the exam will not ask you to calculate the IRR, because you won’t be able to do it on the simple calculator that they will provide you with. Instead, understand its general meaning.
The IRR is often used to value investments that have known future payments (also called cash flows), such as bonds, annuities, equipment, and different types of acquisitions.
Note: To justify making an investment, an investment’s internal rate