Respected Professional Colleague,
A Very Good Morning. Brief note on “Meaning of Internal Rate of Return (IRR)”
It is calculated by taking into consideration the expected cash profit over the period of time on initial outflows. Normally IRR is calculated project specific with the inherent assumption that one day the project will not exist i.e. if we sell the project after some time in future then what will be the pace of return one could generate alongwith taking into consideration the cash profit of all these periods.
IRR = (Initial Outlay) + PV (Cash Profit1 + Cash Profit2 +………..Cash Profit “n” date + WDV of the Fixed Assets in hand on “n” date)
This is an indicator of earning capacity of the project and a higher IRR indicates better prospects of the project. The present investment in the cash flow which is assumed to be negative cash flow and the return (cash inflow) are assumed to be positive cash flows.
Normally IIR >= 18% to 20% is acceptable by bank. It depicts the strength of the project and its earning & repayment capacity at the same time. Better the IRR better rating to the project is assigned. In real terms IRR should be more than Weighted Average Cost of Capital i.e. IRR > WACC, project is profitable. WACC is the average cost of the funds invested in the project.
The promoters invest the money in a project with a view that they will earn higher return. However, if they fail to earn returns over and above WACC, they may take decision either to sell off the project to some other enterprises or scrap the same so that further erosion of capital may be stopped. It may sometime depict the lack of knowledge & managerial skills, adversities created due to change in government policies & environmental issue; product fails to penetrate in the market, technologies changes and several other factors incidental to.
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