MODULE 7 INTERNAL RATE OF RETURN

UNIT LEARNING OUTCOME

At the end of the unit you are expected to:

1. Distinguish between the Internal Rate of Return (IRR) and Net Present Value (NPV).
2. Use the Excel functions (IRR, XIRR, MIRR) to calculate the IRR.
3. Apply the concept of IRR to make a better business decision.

BIG PICTURE IN FOCUS

IRR is one of the many tools used to evaluate the feasibility of projects and investments. Aside from
determining the project's profitability, the IRR evaluates the breakeven rate of return. As a tool, the IRR
helps the business decision to pursue or reject a proposed project. It is recommended that the business
pursue the project if the IRR exceeds the required rate of return.

In computing the IRR, the NPV is set to zero and calculate the discount rate. Unlike other similar tools,
the IRR is calculated through a trial-and-error approach, which is tedious. Fortunately, Excel has a
function for the IRR.

The primary goal of IRR in considering a project is to ascertain the rate of nominal cash inflow at present
value equal to the cash outlay for investment.

METALANGUAGE

In this section, the most important terms relevant to the IRR study and to demonstrate ULO will be
operationally defined to establish a typical frame of reference as to how the text works in your chosen
business career. As you progress in this topic, there are terms you will encounter. Please refer to these
definitions in case you face difficulty in understanding the IRR concepts.

IRR is a tool used to evaluate a project or investment at a discount rate by setting the NPV equal to zero.

XIRR function is used when there is irregular cash flow.

MIRR function is used when the business borrowed funds at a specific rate and reinvested the borrowed
funds at a higher rate.
 ESSENTIAL KNOWLEDGE

The prevailing interest rate (r) dramatically influences the net present value (NPV). For instance, reflected
in the figure below, a manager considers the potential cash flow for Project 1 and 2 suppose the interest
rate is 0.2 (r = 0.2), the Project 2 has a larger NPV, but at r = 0.10, it is Project 1. It is clear that deciding on
the most profitable investment. The NPV is useful to rank investment, which depends on the interest rate.
Investors wanted to have a comprehensive picture of the potential profit of their investment. For
example, if the internal rate of return (IRR) of a project is 15 percent, an investment of P10,000, the
investor expects to receive P1,500 annual cash flow.

We assume that the IRR for project 1 is 35.5 percent, which, if a P500 investment at Time 1, will have an
annual rate of return of 35.5 percent. However, there are specific situations that a project has no IRR or
more than IRR. If this is the case, discussing IRR is useless.

The Excel has a function for calculating the IRR(range of cash flow,[guess]). The guess is a possible
argument but not required. By leaving the "guess" blank, Excel will begin to guess that the project's IRR is
10 percent and then vary the estimates until the NPV is equal to zero (0). If Excel failed to find an interest
rate in which NPV is zero a, #NUM is the return response.

Without using the "guess" function, in cell B5, calculate the IRR(C2: I12), the result is 18 percent. If the
investor uses an annual interest rate of 18 percent, the NPV in Project 1 is zero (0). Also, the IRR of
Project 2 is 24 percent.
A project can have more than one IRR. Thus to check the condition that a project has more than one IRR,
we can try several guesses for the project (form -80 percent to 80 percent). We can try several guesses
for the IRR of Project 1, in cell D8 using the function IRR($C$2:$I$2, A8) from B8 to B9: B15. Since all the
guess in Project 1 produces 18 percent, it shows that the project has a unique IRR of 18 percent. Similarly,
the IRR in Project 2 is outstanding at 24 percent.

Noticeably at 20 percent or less, the IRR is -5 percent, and higher than 20 percent, the IRR is 102
percent. In the case of both interest rate, the NPV is zero (0). However, in project 4, regardless of what
"guess" was used, the IRR is the #NUM. It is an indication that Project 4 has no IRR. A project with
several IRR or none, the concept of IRR is useless. Nonetheless, many firms still use IRR as an essential
tool for ranking investments.
We might deduce that there are conditions that ensure a project will have a unique IRR. The project is
assured of having a unique IRR if the cash sequence contains only one change in sign. For instance, for
Project 2 the sequence of cash flow is “- + + + + +”. However, for Project 3 the sequence of cash flow
changes several times, "- + - +," thus it is difficult to guarantee a unique IRR. The majority of capital
investment (such as plants and equipment) starts with negative cash flow and follows several positive
cash flow. Hence a unique IRR for capital investment projects.

In real business, environment firms have several projects with a single IRR. Previously, if the firm has a
unique IRR and higher than the annual cost of capital, we can claim that the project can increase its
value. For instance, 10 percent is the cost of capital of a firm. Thus project 1 and Project 2 can increase
the value of the company.

For example, the firm is deciding on two projects with unique IRR. It is straightforward to claim that we
should choose the project with a higher IRR in demonstrating that this assumption can lead us to a wrong
decision. Inspect the figure below for Project 5 and 6 with an IRR of 40 and 50 percent, respectively.
Naturally, using the higher IRR to measure the better project, we will choose Project 6. Recall that the
NPV of a Project adds to the value of the company. Project 5, with a higher NPV, is better than Project 6.
Hence between the two projects Project 5 is a better choice. The problem with IRR is that it does not
consider the scale of the project. Based on a peso-per-peso investment, Project 6 is better than Project 5.
Again, Project 5 brings more value to the firm.
Not all days are created equal. There are instances that the cash flow of the business is irregular. The
Excel functions to apply the concept of IRR, the XIRR function with syntax XIRR(cash flow, dates, [guess]).
During irregularly spaced dates, the XIRR can determine the IRR. Similar to the IRR function, "guess," is
optional. Reflected in the figure below is the use of the XIRR function.

The XIRR(F79: F82, E79: E82) showed that the IRR of Project 7 is -90.539 percent.
There is a difference between the rate of the business borrowed funds and the rate of reinvested funds
in various situations. Implicitly, the IRR assumes that the rate of the business browed and reinvested funds
is equal to the IRR. An investor who knows the borrowed funds rate and the rate of reinvested funds can
use the modified internal rate of return (MIRR) function, which can calculate a discount rate that
composed the NPV of the investor's entire cash flow equal to zero (0). The MIRR includes the loan payback,
proceeds of the reinvestment funds with the given rates. Excel has a function for the MIRR(cash flow
values, borrowed rate, reinvested rate). The computed MIRR is always unique. For example, an investor
borrowed P520,000 today and received a cash flow: Year 1: P250,000; Year 2: 120,000; Year 3: 100,000;
Year 4: 150,000; Year 5: 80,000. The investor can borrow at 10 percent annually and decide to reinvest at
12 percent annually

Hence the project has a MIRR of 12 percent and IRR of 13 percent.

 LET’S CHECK

1. Compute the IRR of all the proposed projects below:

Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7

(200,000.00) 70,000.00 10,800.00 25,000.00 13,000.00 22,000.00 11,000.00

Consider the project's cash flow above, with the annual cost of capital 0.20 compute the IRR. Will you
invest in these projects?

Project B

Year 1 Year 2 Year 3

(40,000.00) 20,000.00 40,000.00

Project C

Year 1 Year 2 Year 3

150,000.00 (300,000.00) 250,000.00

2. With the listed dates and cash flow of the project, are you willing to proceed?

11/19/2019 12/3/2019 1/14/2020 2/28/2020 3/8/2020 5/16/2020 9/23/2020

-350000 90000 75000 65000 50000 45000 39000
 LET’S ANALYZE

1. Consider the two proposed projects below, with a 15 percent cost of capital. Calculate the NPV
and IRR of each project. Decide the project that adds value to the firm. Choose only one project
to implement.

Year 1 Year 2 Year 3 Year 4

Project
1 (40,000.00) 11,000.00 21,000.00 25,000.00
project
2 (80,000.00) 36,000.00 36,000.00 36,000.00

2. A newly graduate AIS student decided to invest P10,000 in her retirement funds for the next 40
years. For the next 30 years, the investment 15 percent, and in the last ten years, will earn 5
percent. Calculate the IRR and NPV in the 30 and 40 years.

SELF-HELP

The articles below can help us better understand the IRR, hence making us a better business decision-
maker. The first article identifies the similarities and differences between IRR and ROI. The second
article further discusses the concept and association between the NPV and the IRR.

Return on Investment vs. Internal Rate of Return: What's the Difference?

https://www.investopedia.com/articles/investing/111715/return-investment-roi-vs-internal-rate-
return-irr.asp

What is the Internal Rate of Return (IRR)?

https://corporatefinanceinstitute.com/resources/knowledge/finance/internal-rate-return-irr/
 IN A NUTSHELL

Well done, you have succeeded in understanding the application of IRR to use in tandem with the NPV
to evaluate a project or investment. As a decision-making tool, the IRR cannot stand alone; it needs
other devices such as ROI and NPV. Please enumerate at least three similarities and differences between
IRR and ROI and between IRR and NPV.

1.

2.

3.