Projects should add financial value to an organisation. This Project Internal Rate of Return blog is part of a set of four blogs looking at the financial methods of assessing projects
I wrote about project selection in an earlier blog, however that blog over-viewed both financial and non-financial methods for project selection.This blog will look at the advantages and problems with these financial methods.
Project Internal Rate of Return
Internal Rate of Return (IRR) is a second discounted cash technique which takes into consideration the ‘Time Value’ of money. Have a look at my previous blog on the Net Present Value (NPV) method as a refresher on discounted cash techniques.
Essentially, the IRR is the discount rate, that if used in an NPV calculation would produce a zero NPV result. So whereas the NPV calculation gives a figure (based on the discount rate percentage), the IRR calculation provides a percentage.
Calculating the Internal Rate of Return
Calculating the IRR involves a complex equation, and even the use of complex polynomial equations, requiring a computer package for accurate results.
Approximate results can be obtained by using linear interpolation between two estimated discount rates. The closer these rates are to the actual IRR, then the more accurate the answer will become.
Internal Rate of Return Example
The following is an example of a project investment appraisal. All values in £1000’s.
In order to calculate the IRR, we choose (any) two discount factors, and calculate the NPV for each:
Following this, we can represent these values graphically:
We can then use this straight line (note how it approximates the actual result) to interpolate the IRR:
Therefore the IRR in this example is approximately 10.7%.
Problems using the Internal Rate of Return Method
As has already been suggested, either a computer is required, or an understanding of how the linear interpolation method approximates the answer.
Similar to the other financial methods, it should be remembered that all future incomes and savings are estimated – and that these estimates might be wrong!
With all projects, there are other factors that should be considered when making a judgement.
Using the Internal Rate of Return Method
Organisations usually specify a minimum IRR %age that must be achieved for project approval. In the case of my time at Land-Rover, when owned by BMW, all new vehicle projects had to achieve 26% IRR. Any project not achieving this figure would not proceed.
All of these project finance techniques are shown in this video playlist:
Despite the complications, the IRR is used to provide a percentage “return” for a project.
The IRR method is a discounted cash-flow technique. It requires some assistance in the calculations from a spreadsheet, and an understanding of how it approximates answers.