Internal Rate of Return

When you evaluate a new product or service idea, and you are conducting a financial analysis of the new
opportunity, you estimate future sales and cost forecasts and come up with the following timeline of
cash flows:

Year: 0 1 2 3 4

Cash Flows: ($80,000) $25,000 $30,000 $35,000 $10,000

You need to be able to answer a very simple question: what is the project’s expected Return on
Investment? This is also called the project’s Internal Rate of Return. There are other financial metrics as
well, that speak to the project’s breakeven point and the project’s expected profitability, but a project’s
IRR is one of the most common characteristics that companies use across the board: large or small,
mature or new.

The concept here is quite simple. You invest a sum of funds today in an idea or project, and you get
something back later. So say you invest $200 today and the project returns $250 to you in a year’s time.
The rate of return for the year on the project is: [250-200] / 200, or 25%. So 25% will be the project’s
IRR in this small example. Another way to look at it is, what rate of return will the $200 grow at to pay
you back $250 in a year. So we can set this up as a mathematical model:

$200 is called the present value [what the investment costs today]

$250 is called the future value [what the investment is worth later]

We put this into the following form: Present Value * (1+IRR) = Future Value

In our example: 200 * (1+IRR) = 250. Another way to view the math is by starting with the timeline:

Year: 0 1
200 = ​ 250
$
(1+IRR)

Regardless, we solve and end up back at our 25%! Now let’s turn back to our more complex multi-year
project:

Year: 0 1 2 3 4

Cash Flows: ($80,000) $25,000 $30,000 $35,000 $10,000

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And let’s recreate the mathematical mess:

Year: 0 1 2 3 4
$80,000 = ​$25,000 + ​$30,000 + ​$35,000 + ​$10,000
(1+IRR) (1+IRR)​2​ (1+IRR)​3​ (1+IRR)​4

As you might see, we can’t just use the mathematical model because our cash flows occur over multiple
years, which means that we have to account for this in the formula. Our formula adjusts for this by
putting an exponent into the model to correspond to the year each cash flow occurs. So now we cannot
employ algebra to simply solve for the IRR. So now what?

Two solutions, a tedious one and an easy one. First, the tedious solution. Simply plug in a “guess” for a
rate and see how close you get to solving the formula. For example, say you “guess” that the project’s
IRR is 8%. You plug in 0.08 everywhere you see “IRR” above and end up with: $80,000 = $84,003. So
that guess of 8% cannot be correct. Then you guess 12% and plug 0.12 everywhere you see “IRR” above
and end up with: $80,000 = $77,505. Then you guess 10.4% and plug 0.104 everywhere you see “IRR”,
and you end up with: $80,000 = $80,000 so 10.4% is indeed the project’s IRR!

Of course, we can use technology to help us with this. You can search online for “IRR Calculator” and
find sites where you enter in the cash flows and the IRR will pop up. Know that in some of these you
enter the initial investment as a positive and in others, as a negative. There’s no common convention –
it’s just an artifact of how it is programmed in. If I ask you how much you spent on your shoes, you
would probably give me a positive number such as $30 or $80, even though it is an outflow. Same here,
how much does the project cost? $80,000. But it is an outflow: ($80,000). In spreadsheet programs, it
is usually entered in as a negative:

More importantly, we now want to be able to use the IRR to help us make decisions. This
project has an IRR of 10.4% which translates to an annual return figure. Is this good or bad? Your
experience may help you here. Or, if we know the cost of our funding, we can determine if this is
acceptable. Say your investors need a rate of return of 12%. This project will fall short. If it is a safer
project that can secure investors who desire a return of 8%, for example, the project is expected to

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exceed those financial expectations. So the steps will be to first calculate the IRR, and second, we want
to compare the IRR to the cost of funding. This will help us determine whether the project is expected
to create value.

So overall, the IRR is fairly straight-forward. It does have a couple of possible issues. The first is that if
the cash flows change signs multiple times, you will get multiple IRRs. Both are accurate, unfortunately,
and we can adjust the IRR if this occurs (search online for “modified internal rate of return” if you are
interested). More common is the issue where we need to compare projects of different size.

Say you have a small project that costs $1,000 today and has an inflow next year of $1,300. This project
will have an IRR of 30% and will earn $300 in one year.

And you have a larger project that costs $10,000 today and has an inflow next year of $12,000. This
project will have an IRR of 20% and will earn $200 in one year. To sum:

Small Project Large Project

IRR 30% 20%
Profit in One Year $30 $200

So if we use IRR to rank the projects, we would move forward with the smaller project, with the higher
IRR. If we use “profit”, then the larger project looks better. So now what? This is an “it depends” one.
First, we are assuming that the cost of funding is lower than 20% per year so they are both financially
viable. And we need to pick only one. Second, we are assuming that we can’t just do ten small projects,
for example (and scale up). Then we turn to investors, who generally think about the dollars they are
earning as opposed to a strict rate of return. I was involved with a business this year that had 800%
growth in revenue…but the number was very small to begin with so the percentage growth was
distorted. At the same time, if I had an investment that returned $100,000 this year, that could sound
terrific, but not if the investment was ten million dollars, for example. So we would likely use multiple
measures if we had to choose between alternative projects. Finally, below is a summary guide of the
benefits and drawbacks of the IRR measure.

Key benefits of the internal rate of return measure:

● Objective measure and benchmark

● Incorporates all relevant cash flows for consideration
● Takes investor expectations and opportunity costs into account
● Common and used often for companies of all shapes and sizes
● Promotes a good mindset and model for determining drivers of value creation

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Key weaknesses of the internal rate of return measure:

● Not as easy to compute or understand, but fairly straight-forward to explain to others as a

Return on Investment (or ROI) since that is much more common
● Not necessarily a good measure of the project’s liquidity
● Could suffer from multiple solutions or a scale “problem”

BPET.FINx © 2017 Mark Potter. All rights reserved.