Using Internal Rate of Return as a Measure to Evaluate an Investment

Internal rate of return (IRR) is applied to evaluate an investment’s attractiveness by using discounted cash flow analysis to consider the time value of money. It is the interest rate at which the net present value (NPV) of an investment’s negative and positive cash flow equals zero. The rule of thumb when evaluating an investment is to accept those with an IRR greater than the opportunity cost of capital.

Calculating IRR Using NPV

Investors must understand the concept of discounting to calculate IRR, which can be viewed simply as compounding interest. Calculating IRR is an iterative, trial and error process and is always expressed as a percentage. When the result is less than the hurdle rate, an IRR represents a loss to shareholders. However, an IRR above the hurdle rate signifies a return on investment and increases shareholder wealth. Utilizing NPV to calculate IRR involves ranking investment proposals that are equal to the present value of future net cash flows.

Pros and Cons of Using of IRR

Ease of comparison makes IRR attractive, and it works best for investments that have an initial cash outflow followed by one or more cash inflows. Other benefits include:

• Time value of money. Considering the timing of all future cash flows gives each cash flow an appropriate weight by discounting the time value of money.
• Simplicity. IRR is a simple metric to calculate, and it provides a manageable means to compare various investments.
• No hurdle rate. Because IRR can be calculated independently of hurdle rates, investors can compare individual estimated cost of capital to the selected IRR.

There are limitations to using IRR to evaluate investments, such as:

• Multiple rates of return. For investments with multiple IRRs or no IRR at all, evaluation requires more than one change in sign for the cash flow stream.
• Discount rate changes. If the discount rate changes annually, it’s impossible to apply the IRR rule of accepting investments if the IRR is greater than the cost of capital.
• IRRs do not add up. Investments must be combined into one business case or evaluated on an incremental basis because IRRs cannot be added together.

Investors should think of IRR as the projected rate of growth an investment can potentially generate.

The Bottom Line

Investments with an IRR greater than the cost of capital add value to the firm. If the investments you are considering have very different timing of costs and benefits, then the IRR rule may steer you to the wrong investment. Ideally, you should utilize the NPV curve to evaluate an investment effectively.