HOW TO EVALUATE INVESTMENTS WITH IRR

IRR stands for Internal Rate of Return. IRR is a powerful financial evaluation tool with many important applications. Its applications include evaluating investments, all-in borrowing costs, and management performance. This article focuses on evaluating investments with IRR.

Rates of return

When we make a commercial investment, we want to enjoy a profit and positive cash flows. So if a proposal is forecasting a loss, we’ll reject it. 

But does that mean we should always accept all proposals that forecast profits and positive cash flows?

No.

Why not?

Profits are not enough

Businesses need to generate profits and positive cash flows. But that alone is not enough. Say we’re managing a profitable operation - Business A - that produces €5 million of positive cash inflows every year. What could possibly be wrong with that? 

Well, depending on how much capital this business is tying up, €5m cash inflows a year might turn out to be a very poor result! 

Let’s see.

How much capital are we using?

What if profitable Business A’s net operating assets are worth €1,000m, i.e. 200 times as much as its annual cash inflows of €5m? Business A is using, and locking away, €1,000m of capital. The owners can’t use any of this capital for any other purpose. 

And we’re only achieving a rate of return on their capital of €5m / €1,000m = 0.5% per year. Our owners could quite likely achieve a greater rate of return - at a similar level of risk - by investing this capital elsewhere.

What does "internal" mean?

The IRR calculation depends on a small number of internal inputs only. Namely forecast cash flows, and their timing. There are no external factors to the calculation of the IRR figure, such as the 0.5% calculated above.

The IRR figure is also independent of any particular investor’s required rate of return.

Is there a simple formula for IRR?

For simple patterns of cash flows, yes. The formula depends on the pattern of cash flows. For example, the IRR of a fixed perpetual annual cash inflow (a perpetuity) returned by an initial investment is calculated as:

IRR = cash inflow / investment

 

For example, as above for Business A:

IRR = €5m / €1,000m 

= 0.5% per year.

= IRR( ) formula

For more complicated patterns of cash flows, we can work out IRR using a well-designed spreadsheet. In Excel, the formula is = IRR( ).

IRR is the cost of capital which - when used to discount all of the cash flows - results in a net present value of zero. The relevant cash flows include the initial investment. We’ll review some more examples, where the cash inflows are not perpetuities, in another article.

Ranking - all other things being equal 

A simple way to use IRR analysis is to rank opportunities and proposals by their IRR, and favour the ones with the highest IRR. For example, let’s extend our example of Business A above, to include two more opportunities.

Business Cash inflow every year (€m) Capital outlay (€m)  IRR per year
A 5 1,000 0.5% (= 5/1,000)
B 60 1,000 6% (= 60/1,000)
C 60 500 12% (= 60/500)

Now ranking the IRR for each business:

Business Cash inflow every year (€m) Capital outlay (€m)  IRR per year Ranking
A 5 1,000 0.5% 3
B 60 1,000 6% 2
C 60 500 12% 1

On this basis, the performance of Business C is the best, based on its highest IRR of 12%. All other things being equal - and assuming no limitations either on capital or on relevant opportunities - we’d favour a commitment to Business C, and similar activities.

How is Business C achieving its superior performance?

Bigger inflows, smaller outflows

Ways to improve investment IRR include:

  1. increasing inflows
  2. decreasing outflows
  3. both at once.

In our simple example with 3 businesses above, Business C’s best IRR of 12% per year resulted from generating the greatest cash inflow per year of €60m and the smallest capital outlay of €500m.

All other things being equal, the best IRR in this simple cash flow structure is achieved by having the highest proportion of annual cash inflow to capital outlay.

Trading off cash flows

Let’s consider a slightly smaller opportunity, Business D. It achieves only two thirds of the annual cash inflows of Business C, namely €60m x 2/3 = €40m.

But it does so with just half the amount of capital that Business C is tying up. Namely €500m x 1/2 = €250m.

Business Cash inflow every year (€m) Capital outlay (€m) IRR per year
C 60 500 12% (= 60/500)
D 40 250 16% (= 40/250)

Business D’s IRR of 16% per year is even better than Business C’s (= 12%). How is Business D achieving this superior result?

Compared with Business C, Business D has a much lower capital outlay. It only needs half the amount of capital. This saving of capital cost more than outweighs the downside of the lower cash inflows, resulting in a superior IRR overall.

Isn't timing everything? 

Timing is indeed very important! One great strength of the IRR measure is that it takes explicit account of the timings of all of our cash inflows and outflows, as well as their amounts.

Other ways to improve investment performance and IRR include, continuing our list from before:

  1. accelerating inflows
  2. delaying outflows
  3. any advantageous trade-off of the timing - or amounts - of inflows, outflows or both.

Hurdle rates

A hurdle rate is an organisation’s minimum IRR, for a given level of risk. All proposals of this level of risk need to meet or exceed the hurdle rate, to be considered further.

Proposals that fail to achieve the hurdle rate are rejected.

Applying a hurdle rate of 15% to our 4 businesses, assuming they all have the same relevant level of risk:

Business IRR per year Hurdle rate Investment decision
A 0.5% 15% Reject
B 6% 15% Reject
C 12% 15% Reject
D 16% 15% Consider

What about risk management?

Absolutely! A fundamentally important consideration in managing all investments is to manage their risks. If we can successfully manage down the risk level for any business activity - for example by applying the ACT’s risk management framework - it may become appropriate to apply a correspondingly lower hurdle rate.

This may bring a proposal into viability. Let’s say we successfully reduce the level of risk for all the opportunities above, so that the appropriate hurdle rate of return for each falls to 10%.

Now applying the lower-risk hurdle rate of 10% to our 4 opportunities:

Business IRR per year Hurdle rate Investment decision
A 0.5% 10% Reject
B 6% 10% Reject
C 12% 10% Consider
D 16% 10% Consider 

Now Business C has become an opportunity we can appropriately consider further, as well as Business D.

Why only "Consider", and not Accept?

Shouldn’t we simply accept all proposals that achieve our hurdle rate of IRR? Why would we only “consider” them?

Because it’s far too simple to accept or reject any proposal based on a single measure. Appropriate due diligence - before investing - means applying a toolkit, or dashboard, of measures, both numerical and qualitative. Then making appropriate assessments overall, based on all of our results.

This principle is sometimes summarised as “Don’t be a one-club golfer.”

Invest time to understand IRR

Encouragement from your colleagues...

"The most surprising thing has been how simple the keys to a better IRR are. They are easy to apply, but most business people wouldn't think to improve the quality of their financial decisions in this way if they hadn't taken the time to understand IRR."

- DF - United States

"Exactly. Just with understanding of this one concept, we can find the answers to so many different questions."

- KA - Germany

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Author: Doug Williamson, FCT

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