Internal rate of return

Internal rate of return IRR is one of the key indicators of the investment attractiveness of the business plan. On this indicator pay attention to the analysis of any business plan. The internal norm of profitableness on the economic essence is such size of the interest rate under condition of which the expected income will be equal to the spent finance. In other words, this is the settlement rate, which is equal to the zero cost of the project. This indicator allows you to calculate the amount of the maximum interest at which the funds invested in the project can be returned.

The internal rate of return is determined by means of special computer programs or financial calculators.

Also, this percentage can be calculated experimentally, substituting various discount values into the equation. For these purposes, it is good to use the tool "Parameter Selection", which is built into Microsoft Excel.

When the indicator of the internal rate of return of a project exceeds the size of planned investments or is at least equal to it, then such a project is adopted and considered promising. And when the IRR is less than the invested capital, the project is rejected because of the loss.

Thus, we can consider the internal rate of return as a kind of barrier for risky projects or those that have a low profitability.

However, this rule operates only at a constant rate of return. There are projects that initially cause losses. However, then, after a while, they come to self-sufficiency and begin to bring a constant profit. In this case, you will have to be patient to get a positive result from investing funds.

In addition, there are projects that involve unequal income of finance in equal periods of time. In this case, the IRR is determined empirically, because you need to find a percentage that will lead to a zero current value. That is, there is no growth in the value of the enterprise, but its price does not fall either.

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 duration and different scale. When comparing, use the key parameters:

- degree of risk;

- time of project implementation ;

- the amount invested.

However, the IRR indicator also has three main disadvantages.

First, in the calculation it is assumed that the rate at which positive financial flows are reinvested is equal to the internal rate of return. In the event that the IRR indicator is close to the rate of reinvestment of the enterprise, this does not lead to problems. For example, the IRR indicator of an attractive business plan is equal to 70%. This assumes that all income from the project will be reinvested at a rate of 70%. However, the probability that the firm has such annual financial opportunities that provide profitability on the specified level is very small. In such conditions, the internal rate of return of the project overstates the result of investment. To address this shortcoming, a modified MIRR rate 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 an incorrect IRR value.

It should be remembered that when using IRR, only those investment projects are analyzed that have revenues that cover costs, that is, the ratio of revenues to expenditures exceeds 1. The value of the IRR should be compared with the interest rate, and when justifying the IRR, amendments to taxes, inflation and risks for Project.