Internal Rate Of Return

INTERNAL RATE OF RETURN

The internal rate of return (or IRR) is a common financial valuation metric used by financial analysts to calculate and assess the financial attractiveness / viability of capital intensive projects or investments.

As the IRR is normally easier to understand than the result of a discounted cash flow (DCF) analysis (i.e. the net present value or NPV) for non-financial executives, it is often used to explain and justify investment decisions, although a good financial modeler should know that the IRR is after all an estimated value, especially when calculated in Excel, and should be used in conjunction with other financial metrics such as the NPV and comparable valuation multiples when presenting a business or investment case.

So what exactly is the IRR? The IRR is the interest rate that makes the net present value of all cash flow equal to zero. In financial analysis terms, the IRR can be defined a discount rate at which the present value of a series of investments is equal to the present value of the returns on those investments.

All projects or investments with an IRR that has been calculated in a financial modeling exercise to be greater than the Weighted Average Cost of Capital (or WACC) should technically be considered as financially viable and accepted.

When choosing between projects or investments whose outcomes or performance are absolutely independent of one another, a good financial modeler should deem the project or investment with the highest calculated IRR to be the most financially attractive, so long as we continue to keep in mind that the IRR value also needs to be higher than the WACC.

Modified Internal Rate Of Return (MIRR)

The modified IRR (MIRR) is said to reflect the profitability of a project or investment more realistically than an IRR. The reason why this is so is because the IRR assumes the cash flow from an investment or project to be reinvested at the IRR, whereas the modified IRR assumes that all cash flows to be reinvested at the investor’s / firm’s cost of capital.

The MIRR is used extensively in real estate financial analysis due to the nature and timing of cash flows and investments for real estate investments.

Dividend IRR

The ongoing financial returns to investors who own and retain the equity of a business or project is essentially by way of financial / cash dividend payouts.

As equity investors are typically last in rank in the cash flow waterfall, and therefore face the greatest risk of not being paid should the investment turn sour when compared to holders of other forms of ownership in the same investment, equity investors would therefore expect the highest return.

The dividend IRR is therefore used extensively by equity investors to calculate and measure the discount rate at which the present value of cash dividend payouts equal the present value of equity investments.