What does the Internal Rate of Return (IRR) Rule mean?
The internal rate of return (IRR) rule says that a business or project should be done if its IRR is higher than the hurdle rate or the minimum required rate of return. It has to do with the internal rate of return, which is the rate of return needed to break even or the net present value (NPV). Many businesses and investors use this rule to help them decide if they should invest in or work on a specific project. It also helps them compare it to other projects or investments they are thinking about.
How to Use the Internal Rate of Return (IRR) Rule
The IRR rule is a general way to determine if a project or business is worth going ahead with. In math terms, IRR is the rate at which the net present value of future cash payments equals zero.
The project makes the company have more net cash if the expected internal rate of return (IRR) is high and the amount is above the cost of capital. So, management should proceed with the project if it looks like it will make money. If the IRR is less than the cost of capital, on the other hand, the rule says that the best thing to do is to turn down the project or investment.
People and businesses use the IRR rule to determine whether a project is exemplary in capital planning. Some people may not always follow it strictly, though. Most of the time, a bigger IRR is better. Even so, a company might choose a project with a smaller IRR if it has other, less tangible benefits, like helping with a more prominent strategic plan or making it harder for competitors to do business.
A company might also choose a more extensive project with a lower IRR over a smaller project with a higher rate because the more significant project will bring in more cash.
The internal rate of return rule usually tells companies what to do. However, management may decide to go ahead with a project even though the IRR is low if other factors, like the size of the project and how it fits into the company’s overall strategy or goal, are more critical.
Good and Bad Things About the IRR Rule
The pros
It’s usually easy for people who use it to figure out and understand the internal rate of return rule. It’s easy for businesses and investors to figure out and compare other projects and assets they are considering.
Another good thing about this rule is that it helps investors and businesses understand the time value of money (TVM). It means that a certain amount of money will be worth more now than in the future. The IRR rule says that the future cash flow from an investment is not worth as much as its present value.
Pros and cons
The IRR rule doesn’t look at how much the project is worth or any strange cash flow patterns. The rule shouldn’t be used if money comes in or out in strange ways. If it is, it could lead to the wrong conclusions.
There is another big problem with the IRR rule: it assumes that any investments made with good cash flow have the same internal rate of return. This is not true.
Pros
- Simple to figure out and understand
- It lets you compare other purchases and projects.
- Think about how much money is worth over time
Cons
- It doesn’t take into account real dollar value
- Doesn’t look at strange changes in cash flows
- If purchases are made again, they will have the same internal rate of return.
A Case of the IRR Rule
Let’s say a business is deciding between two projects and where to put its money. They have to pick which project to move forward with and whether to proceed with both projects. The cost of cash for it is 10%.
For each job, the company needs to figure out the IRR. The first payment (period = 0) will be less than zero. Using the following equation, you can solve for IRR over and over again:
$0 = CFt plus (1 + IRR)t
In what place?
CF stands for “net cash flow.”
Inside return rate, or IRR
Period (from 0 to last period) is equal to t.
-or-
$0 = (starting cost x -1) + CF1 ÷ (1 + IRR)\�1 plus CF2 times (1 plus IRR)2, 3, 4, and 5 times CFX times (1 plus IRR)
The company can figure out the IRR for each project by using the examples above:
IRR for 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 for Project B: $0 = (-$2,000) + $400 x (1 + IRR)1 + $700 ÷ (1 + IRR)2 + $500 ÷ (1 + IRR)3 + $400 ÷ (1 + IRR)4 + $300 ÷ (1 + IRR)5
The IRR for Project A is 16.61%, and the IRR for Project B is 5.23%.
Since the company’s capital cost is 10%, managers should move forward with Project A and turn down Project B.
Does the IRR Rule work like the discounted cash flow method?
Yes, the discounted cash flow way of financial analysis is what you use in IRR to get net present value. People sometimes call this interest rate the discount rate. The internal rate of return is the interest rate that will bring a set of positive and negative cash flows to a net present value of zero, or the cash invested right now. IRR allows investors and businesses to determine if they should put money into a project.
How do you use the Internal Rate of Return Rule?
People use the IRR rule to help them decide if they want to proceed with a project or business. Given that the expected IRR is higher than the cost of capital, a project with a higher IRR will bring in more net cash for the company. In this case, it would be wise for the business to proceed with the project or investment. The rule says that the best thing to do is not to do the project or business if the IRR is less than the cost of capital.
Do companies always stick to the internal rate of return rule?
People may not always follow the IRR rule to the letter. Most of the time, a bigger IRR is better. A business may choose a project with a smaller IRR if it still makes more money than it costs to borrow. That’s because it has other, less obvious benefits, like helping with a bigger strategy plan or making it harder for competitors to do well. When companies decide to proceed with a project, they look at several factors. There could be things that are more important than the IRR rule.
Conclusion
- The internal rate of return rule says that a business or project should be done if its IRR is higher than the hurdle rate or the minimum required rate of return.
- The IRR Rule helps businesses decide if they want to proceed with a project.
- Firms shouldn’t always stick to the IRR rule if the project has other, less obvious benefits.
