Internal rate of return - a brief

Respected Professional Colleague,

A Very Good Morning. Brief note on “Meaning of Internal Rate of Return (IRR)”

Internal Rate of Return depicts return on investment from a project over the period of its life. In real terms it’s a discount rate which forces Present Value of Inflows equal to Cost.

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.

Mr. Ayush could you clarify a few of my concerns on IRR

Theoretically i know about IRR. It is the discount rate that generates a zero net present value for a series of future cash flows. I also read that IRR for an investment is the percentage rate earned on each Re invested for each period it is invested. I dont get the point behind discounting the future cash flows.

If IRR is 10% does it mean the company is earning 10% after recovering the cost of the project (initial outflow). Also, suppose the IRR for a project is 10% (for 3 years). Does it mean that the company will have a return of 10% so suppose it wishes to borrow from a financial institution the rate of interest payable should be less than 10% for the venture to be profitable? And whether it means that 10% return will be earned by the company over a period of 3 years or in each of the 3 years individually?

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