1.2.1.5 Internal Rate of Return (IRR)
One of the biggest mistakes made both by investors and by the companies in which they invest 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 somewhere else. Internal rate of return is a method of calculating the average annualized yield of a series of cash flows associated with an investment. Once this rate is calculated, the investor or company can then compare it against other choices of how to use funds over the same period and decide whether or not to make the investment.
A simple example might be a company that wants to build a new plant now, which will cost $10,000,000 to build and is expected to yield $3,000,000 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, we see:
NPV = -$10 + 3/(1+r) + 3/(1+r)2 + 3/(1+r)3 + 3/(1+r)4 + 3/(1+r)5
The IRR is the rate at which the equation is equal to zero. It turns out that if we plugged this into an IRR calculator, the rate that results 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