The IRR internal rate of return is one of the key indicators of the investment attractiveness of a business plan. This indicator is paid attention to when analyzing any business plan. The internal rate of return in its economic essence is such a rate of interest, under which the expected income will be equal to the spent finances. In other words, this is the estimated rate, which is equal to the zero cost of the project. This indicator allows you to calculate the maximum percentage at which the funds invested in the project can be returned.
The internal rate of return is determined using special computer programs or financial calculators.
Also, this percentage can be calculated empirically, substituting various discount values into the equation. For these purposes, it’s good to use the “Parameter Selection” tool, which is built into Microsoft Excel.
When the indicator of the internal rate of return of a project exceeds the size of the planned investment or at least equals it, then such a project is accepted and considered promising. And when the IRR is less than the amount of invested capital, the project is rejected due to loss-making.
Thus, the internal rate of return can be considered a kind of barrier to risky projects or those that have low returns.
However, this rule applies only at a constant rate of return. There are projects that bring losses at first. However, then, after some time, they go on self-sufficiency and begin to bring constant profit. In this case, you will have to be patient in order to get a positive result from investing.
In addition, there are projects that involve unequal revenues of finances in equal periods of time. In this case, the IRR indicator is determined empirically, since you need to find a percentage that will lead to zero current value. That is, there is no increase in the value of the enterprise, but its price does not fall.
The internal rate of return as an economic indicator has its positive and negative points. The advantage of IRR is that in addition to calculating the level of profitability, it allows you to compare projects of different durations and different scales. When comparing, use the key parameters:
- degree of risk;
- project implementation time;
- the amount of invested funds.
However, the IRR indicator also has three main disadvantages.
Firstly, the calculation assumes that the rate at which positive financial flows are reinvested is equal to the internal rate of return. If the IRR is close to the rate of reinvestment of the enterprise, then this does not lead to problems. For example, the IRR indicator of an attractive business plan is 70%. This suggests that all project income will be reinvested at a rate of 70%. However, the likelihood that the company has such annual financial capabilities that provide profitability at the specified level is very small. In such conditions, the internal rate of return of a project overestimates the result of investments. To address this shortcoming, a modified MIRR rate of return indicator can also be calculated.
The second drawback is the difficulty in determining the amount of investment income in absolute terms (dollars, rubles).
Thirdly, if the business plan involves alternating financial flows, then there is a high probability of calculating the wrong IRR value.
It should be remembered that when using IRR, only those investment projects are analyzed in which revenues cover costs, that is, the ratio of revenues to expenses exceeds 1. The IRR value must be compared with the interest rate, and when justifying the IRR , tax, inflation and risk adjustments are taken into account project.