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Internal Rate of Return (IRR) Rule

Internal Rate of Return (IRR) Rule
BusinessCorporate Finance and AccountingFinancial Ratios

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

The internal rate of return (IRR) rule states that a project or investment ought to be sought after assuming its IRR is greater than the base required rate of return, otherwise called the hurdle rate.

Figuring out the Internal Rate of Return (IRR) Rule

Basically, the IRR rule is a guideline for choosing whether to continue with a project or investment. The higher the projected IRR on a project — and the greater the amount it surpasses the cost of capital — the more net cash the project generates for the company. Significance, in this case, the project looks beneficial and management ought to continue with it. Then again, assuming the IRR is lower than the cost of capital, the rule declares that the best course of action is to forego the project or investment.

Numerically, IRR is the rate that would result in the net present value (NPV) of future cash flows approaching precisely zero.

Investors and firms utilize the IRR rule to assess projects in capital budgeting, however it may not necessarily in every case be unbendingly authorized. Generally, the higher the IRR, the better. In any case, a company might favor a project with a lower IRR in light of the fact that it has other immaterial benefits, for example, adding to a greater strategic plan or blocking competition. A company may likewise favor a bigger project with a lower IRR to a lot more modest project with a higher IRR in view of the higher cash flows generated by the bigger project.

While companies normally follow the ends offered by the internal rate of return (IRR) rule, different contemplations —, for example, the size of the project and whether the project adds to a bigger strategy or goal of the company — may lead to management choosing to continue with a project with a low IRR.

Illustration of the IRR Rule

Expect a company is checking on two projects. Management must choose whether to push ahead with one, both, or neither of the projects. Its cost of capital is 10%, The cash flow designs for each are as follows:

Project A

  • Initial Outlay = $5,000
  • Year one = $1,700
  • Year two = $1,900
  • Year three = $1,600
  • Year four = $1,500
  • Year five = $700

Project B

  • Initial Outlay = $2,000
  • Year one = $400
  • Year two = $700
  • Year three = $500
  • Year four = $400
  • Year five = $300

The company must ascertain the IRR for each project. Initial outlay (period = 0) will be negative. Tackling for IRR is an iterative interaction utilizing the following equation:

$0 = \u03a3 CFt \u00f7 (1 + IRR)t

where:

  • CF = Net Cash flow
  • IRR = internal rate of return
  • t = period (from 0 to last period)

-or then again-

$0 = (initial outlay * - 1) + CF1 \u00f7 (1 + IRR)1 + CF2 \u00f7 (1 + IRR)2 + ... + CFX \u00f7 (1 + IRR)X

Utilizing the above models, the company can compute IRR for each project as:

IRR Project A:

$0 = (- $5,000) + $1,700 \u00f7 (1 + IRR)1 + $1,900 \u00f7 (1 + IRR)2 + $1,600 \u00f7 (1 + IRR)3 + $1,500 \u00f7 (1 + IRR)4 + $700 \u00f7 (1 + IRR)5

IRR Project A = 16.61 %

IRR Project B:

$0 = (- $2,000) + $400 \u00f7 (1 + IRR)1 + $700 \u00f7 (1 + IRR)2 + $500 \u00f7 (1 + IRR)3 + $400 \u00f7 (1 + IRR)4 + $300 \u00f7 (1 + IRR)5

IRR Project B = 5.23 %

Considering that the company's cost of capital is 10%, management ought to continue with Project An and reject Project B.

Features

  • The internal rate of return (IRR) rule states that a project or investment ought to be sought after assuming that its IRR is greater than the base required rate of return, otherwise called the hurdle rate.
  • A company may not inflexibly follow the IRR rule in the event that the project has other, less substantial, benefits.
  • The IRR Rule assists companies with choosing whether or not to continue with a project.

FAQ

Is Using the IRR the Same As Using the Discounted Cash Flow Method?

Indeed. Utilizing IRR to acquire net present value is known as the discounted cash flow method of financial analysis. The IRR (internal rate of return) is the interest rate (otherwise called the discount rate) that will bring a series of cash flows (positive and negative) to a net present value (NPV) of zero (or to the current value of cash invested). Investors and firms use IRR to assess whether an investment in a project can be justified.

How Is the IRR Rule Used?

Basically, the IRR rule is a guideline for choosing whether to continue with a project or investment. Inasmuch as the IRR surpasses the cost of capital, the higher the projected IRR on a project, the higher the net cash flows to the company. Then again, assuming the IRR is lower than the cost of capital, the rule declares that the best course of action is to forego the project or investment.

Will Firms Always Follow the IRR Rule?

The IRR rule may not necessarily be unbendingly authorized. Generally, the higher the IRR, the better. Notwithstanding, a company might favor a project with a lower IRR, as long as it actually surpasses the cost of capital, since it has other immaterial benefits, for example, adding to a greater strategic plan or obstructing competition. At last, companies consider a number of factors while choosing whether to continue with a project. There might be factors that offset the IRR rule.