The internal rate of return in capital budgeting is a significant financial measure for assessing investment choices. It is the discount rate at which an investment’s Net Present Value (NPV) equals zero. Firms utilise IRR to find out if a project is profitable or not. If the IRR is greater than the required rate of return, then the investment is worthwhile. The internal rate of return approach of capital budgeting is used for comparing various projects and making prudent investment decisions in common usage. This article will describe the formula for IRR, applications, pros, and cons.
What is Internal Rate of Return in Capital Budgeting?
The internal rate of return (IRR) in capital budgeting is the discount rate where the present value of future cash flows equals the investment. It is utilized to measure the profitability of a project over time.
IRR assists the businessman in determining the return on investment. The internat rate of return (IRR) helps in choosing investment projects, with a higher IRR indicating better returns. IRR is particularly useful because unlike NPV which will give you numerical value in $, it can be referred as a ratio or percent(and is hence easier to apply across different projects). The IRR assumes that all future cash flows will be reinvested at the same rate, which can be unrealistic in real-world situations.
For instance, consider that a company is considering two projects. Project A has an investment outlay of ₹10 lakh with an IRR of 18% and Project B also requires ₹10 lakh but has an IRR of 12%. Project A has a higher IRR which means it provides a better rate of return and should be accepted as a superior investment opportunity. IRR helps businesses make data-driven investment decisions, allowing companies to invest their capital for the highest returns possible.
Formula of Internal Rate of Return in Capital Budgeting
The Internal Rate of Return formula is derived from the Net Present Value (NPV) equation by setting NPV to zero.
Internal Rate of Return Example Calculation
A firm is proposing to buy some new equipment of ₹50,00,000. The life of the asset is estimated as four years, and it would yield ₹16,00,000 per annum in profits. In the fifth year, it would be sold for a scrap value of ₹5,00,000.
Meanwhile, another option of investment promises a 10% return rate, which is above the hurdle rate of the company, i.e., 8%. So that the company can utilize its capital in the best possible manner, it should compare both.
Applying the IRR formula from Excel (=IRR()), the internal rate of return for buying equipment would be computed at 13%. Since that rate is in excess of the hurdle rate as well as higher than the alternate investment, then it makes business sense to have the company proceed with buying equipment.
| Year | Cash Flows (₹) | Present Value of Cash Flows (₹) |
| 0 | -50,00,000 | -50,00,000 |
| 1 | 16,00,000 | 14,12,470 |
| 2 | 16,00,000 | 12,46,920 |
| 3 | 16,00,000 | 11,00,770 |
| 4 | 16,00,000 | 9,71,760 |
| 5 | 5,00,000 | 2,68,080 |
| NPV | 0 | |
| IRR | 13% | |
The above table indicates that when the discount rate is 13%, the Net Present Value (NPV) equals zero, which verifies the IRR. The project is financially feasible because the IRR is greater than the hurdle rate of 8%.
Uses of Internal Rate of Return in Capital Budgeting
The internal rate of return method in capital budgeting helps businesses evaluate investment opportunities and compare projects.
Project Evaluation and Selection
Businesses utilize IRR to determine whether a project is worth their time. A project is considered acceptable if the IRR is greater than the overall cost of capital, making it profitable. For example, if the company demands a 10% return and the project has an internal rate of return (IRR) equal to 15%, the company should go ahead with the project, since the return is above the required return.
Comparing Multiple Investment Options
IRR assists companies in comparing different projects and finding the one with the highest profitability. The company considers the IRR of each project and picks the one with the highest return. For instance, if a business is planning an expansion, it can compare the IRR of two locations and select the one that offers the higher return on investment. It helps to businesses corporate resources in an efficient way.
Determining Cost of Capital
The IRR is compared with the weighted average cost of capital (WACC) to evaluate efficiency. If IRR is higher than WACC, the investment will likely be profitable. This is used by businesses to see if a project will produce a greater return than the cost of financing it. It also helps companies keep financially well-off and prevents them from sinking into losses.
Private Equity and Venture Capital Decisions
Investors and venture capital firms use IRR to determine potential gain before investing in startups and private companies. In investing, IRR serves as a reliable guideline, as high IRR means higher expected profits. To illustrate, a venture capital firm may only take the risk and invest in startups with an IRR above 20% in order to minimize their financial risk whilst also maintaining their return.
Real Estate and Infrastructure Investments
Real estate developers and infrastructure companies use the IRR method to evaluate the long-term profitability of projects. It guarantees that expenditure on properties, roads, and buildings yields returns that match the initial costs. For example, a property developer planning construction of an apartment project will only proceed if the IRR is at least 18%. A higher IRR validating better long-term development.
Advantages of IRR in Capital Budgeting
The IRR is a helpful capital budgeting tool for companies to understand investment profitability. This process involves discounting future cash flows, which makes NPV a reasonable approach for using it as a tool for comparing projects and making good financial decisions. Following are the advantages of internal rate of return in capital budgeting.
Considers Time Value of Money
Unlike the payback period, which does not take future cash flows into account, IRR provides a more precise estimate of investment profitability. It also adjusts returns depending on when they are received. This gives businesses an insight into what an investment is truly worth over time. This ensures much better financial planning for long-term projects.
Easy to Compare Projects
IRR returns an uncomplicated percentage, great for comparing multiple investment opportunities. Companies may fast assess which project will deliver the greatest return. This approach allows decision-makers to quickly select lucrative investments. It eliminates the complication of comparing projects with different cash flow patterns.
Useful for Long-Term Investments
IRR is particularly useful for projects that provide returns over several years (i.e. infrastructure, real estate, corporate) since cash inflows and outflows can be staggered over long periods. It mandates businesses to invest in sustainable projects. Companies can predict profits and assess long-term profitability. That explains the selection of projects such that the future growth is maximized.
Considers the Entire Cash Flow
IRR, on the other hand, accounts for all cash inflows and outflows, not just the return of the initial investment during the payback period. It adds an important dimension to your understanding of an investment’s performance. Total profitability allows businesses to accurately assess business performance. It guarantees that future returns should not be sweet disregarded from the financial analysis.
Supports Capital Budgeting Decisions
Companies rely on IRR for expansion projects, acquisition of new ventures, and physical asset investments like infrastructure, as it facilitates judicious allocation of resources. It’s an integral part of financial planning. This allows businesses to prioritize projects with high returns for better growth. Such approach helps to prevent from investing in your projects that will not deliver needed returns.
Disadvantages of IRR in Capital Budgeting
While the Internal Rate of return (IRR) is a useful tool when it comes to capital budgeting, there are limitations that may affect investment decisions. The IRR is used to measure the profitability of potential investments but it may not present the full picture. Thus, these are the disadvantages of internal rate of return in capital budgeting.
Assumes Reinvestment at IRR
IRR assumes that all cash flows are reinvested at the same rate, which is not the case in the real world most of the time. Real reinvestment rate may be greater or lesser. This can result in an overestimation of profitability. In order to compute the investment and future cash flows accurately, companies must take a hard look at what alternative reinvestment rates would look like.
Ignores Project Scale
An IRR of over 20% does not automatically mean that the project is more profitable, because it does not take the size of the project into account. A small investment may have an IRR of 30%, but produce less total profit than a large investment with an IRR of 20%. Total returns, not percentages, must be compared by businesses. The wrong project size leads to bad investment decisions.
Multiple IRRs for Non-Conventional Cash Flows
Suppose a project has varying cash flow signs (+/−), then it may produce multiple IRRs which may confuse. This occurs in large-cost projects midway through the investment. Businesses could have a problem in understanding the accurate IRR. To get a clearer financial picture, NPV should be used with IRR.
Cannot Compare Projects with Different Durations
Some may be 5 years long, others 10, and naturally, IRRs will differ. While a short-term project can produce more IRR, it may not be as valuable in the long run. Investment horizons need to align with project time horizons for business decision-making. NPV is one of the most important factors to consider to compare projects more accurately.
Internal Rate of Return in Capital Budgeting FAQs
What is the formula for internal rate of return in capital budgeting?
IRR is calculated using: =∑Ct/(1+IRR)t−C0
In what way does IRR assist in capital budgeting?
IRR assists companies in identifying whether a project is profitable and worth investing in.
What are the benefits of IRR?
It takes into account time value of money, is simple to compare, and incorporates all cash flows.
What is a good IRR for investment?
A good IRR is subject to the industry standard and risk factors, but higher IRR is better in general.
What is the major drawback of IRR?
IRR takes reinvestment at the same rate, which is usually not realistic.
