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IRR PPT

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Shanu.lodha
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73 views

IRR PPT

Uploaded by

Shanu.lodha
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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IRR –

Internal
Rate of
Return

By Shanu Lodha
Definition of IRR

• IRR, or internal rate of return, is a metric used in financial analysis to


estimate the profitability of potential investments. It is a method of
quantifying the merits of a project or investment opportunity.
Significance of IRR

• The higher the IRR, the better the return of an investment. As the
same calculation applies to varying investments, it can be used to
rank all investments to help determine which is the best. The one
with the highest IRR is generally the best investment choice.
Comparison of IRR with other investment evaluation
metrics

When making investment decisions, it is crucial to consider


various financial metrics to evaluate the potential return on
investment (ROI) and assess the feasibility of a project. The
internal rate of return (IRR) is one such metric that is widely
used in financial analysis. However, it is essential to compare
IRR with other metrics to gain a comprehensive understanding
of the investment's profitability and risks like
NPV (Net present value )
ROI (Return on Investment)
Principles of IRR Calculation

• Time value of Money - The time value of money (TVM) is the concept
that a sum of money has greater value now than it will in the
future due to its earnings potential.
• Cash Flow - Cash flow is the movement of money in and out of
a company. Cash received signifies inflows, and cash spent is
outflows.
• DCF - Discounted cash flow (DCF) refers to a valuation method that
estimates the value of an investment using its expected future
cash flows.
Methods for Calculating IRR

• Manually - (Future Value ÷ Present Value)^(1 ÷ Number of


Periods) – 1
• Financial calculator -A financial calculator or business calculator is an
electronic calculator that performs financial functions commonly
needed in business and commerce. It has an option to calculate IRR by
feeding in cash inflows and outflows.
• Spreadsheet or excel - you can use the Insert Function command to add the IRR
function, or you can break out component cash flows and calculate each step of
the IRR formula individually. The syntax for the IRR function in Excel is IRR(values,
[guess]), where "guess" is an optional argument.
Apply IRR calculations to real-life investment scenarios

• The IRR rule states that if the IRR on a project or


investment is greater than the minimum RRR—typically
the cost of capital, then the project or investment can
be pursued.
• Conversely, if the IRR on a project or investment is
lower than the cost of capital, then the best course of
action may be to reject it.
Real Life scenario

• Assume a project has an initial investment of Rs 1,000 and is


expected to generate cash flows of Rs 200, Rs 300, and Rs 400 over
the next three years.
• The project's IRR would be calculated as follows: IRR = [Rs 200 + Rs
300 + Rs 400] / [3 * Rs 1,000] = 0.14 In this example, the project has
an IRR of 14%.
• You should use the internal rate of return (IRR) when you are trying to
compare different investments. The IRR is a good way to measure the
return of an investment, as it considers the timing of the cash flows.
Investments Where IRR Helps to Judge
Performance

• Mutual fund SIPs


• Unit Linked Insurance Plans (ULIPs)
• Monthly Income Plans (or IDCW Mutual Funds)
• Market-linked pension plans
• National Pension Scheme (NPS)
Example

• A company is deciding whether to purchase new equipment that costs $500,000.


Management estimates the life of the new asset to be four years and expects it to
generate an additional $160,000 of annual profits. In the fifth year, the company plans
to sell the equipment for its salvage value of $50,000.

• Meanwhile, another similar investment option can generate a 10% return. This is higher
than the company’s current hurdle rate of 8%. The goal is to make sure the company is
making the best use of its cash.

• To make a decision, the IRR for investing in the new equipment is calculated below.

• Excel was used to calculate the IRR of 13%, using the function, =IRR(). From a financial
standpoint, the company should make the purchase because the IRR is both greater
than the hurdle rate and the IRR for the alternative investment.
Calculation
Advantages of IRR

• Time value of money − IRR considers the time value of money. It states that a
rupee today will be worth more than a rupee tomorrow. By considering the time
value of money, IRR makes a correct assumption about profitability. In fact, IRR
saves enough wealth by considering the time value of money.
• Measurement of profitability − IRR considers all cash flows to correctly measure
the profitability of an investment proposal. This provides a comprehensive
measurement of profitability as future cash inflow and outflow estimates are
considered. By including cash flow features, IRR takes the view of the entire life of a
project to measure profitability in the long-term future.
• Increase in Shareholders’ value − IRR aims to maximize the shareholders’
wealth by considering all aspects related to shareholders’ wealth maximization
rules. It is by large one of the most promising features of IRR because every
investment needs to prioritize shareholders’ wealth creation and maximization.
Disadvantages of IRR

• Multiple Rates of Return − According to IRR, an investment project may have different
and multiple rates of return. Having more than one rate not only increases the complexity of
the calculation, but it also creates a dilemma where choosing the best project becomes
critical. Therefore, having multiple rates of returns is one of the prominent demerits of IRR.
• Failing to identify the best project in case of mutually exclusive ones − IRR may fail
to identify the best project if there are mutually exclusive projects on the horizon. Not being
able to identify the better project means there may be large losses in the future for which
IRR estimation becomes flawed and non-competitive in nature.
• Value additivity does not hold good − Unlike NPV, value additivity doesn’t hold good for
IRR. This means that the IRR for a larger project need not be equal to the sum of all smaller
subsidiary projects. In addition of smaller projects’ IIRs are incapable to produce the IRR of
the larger project, it is not possible to calculate the value of IRR of the larger projects even if
we know the smaller IRRs. This creates a big issue in applying and calculating IRRs in both
theory and practice.
Excel formula for explaining IRR
calulation
Thank You

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