Internal Rate of Return (IRR)

aj9648

Hi

Could someone please explain what IRR means?.....in noddy terms please!!!

xrjtg

It's probably Internal Rate of Return.

Seems to be roughly equivalent to AER, but applied to more complex investments. The "internal" means that no account is made for the decrease in value of cash due to inflation, or other external factors.

Tammer

Hi,

The very basic explanation is that it's used by accountants in businesses to work out the return the company is getting on the money invested in the business' projects and ventures, given the risk it's taking.

e.g. a company could consider launching a new product line. This could cost, say, £1 million. The accountants work out the IRR to understand the return that the owners of the company will get on this money. If it's too low, say 3%, then the company could be better doing something else with the money - that's when they close product ranges or pull out of markets for example.

aj9648

So an IRR of 110% means what?

ChiefGrasscutter

Blimey.....its complicated
A major capital project will have a start and end date.
As well as revenues from it there will be start up and termination expenses as well as ongoing expenses and possibly major maintenance/upgrade costs mid way.
(I'm talking here about big stuff projects - like an oil refinary)

These projected cash flows in and out of the project are all analysed by the discounted cash flow /net present value method - mathematics basically which aims to project future revenues and expenses into an adjusted sum in "todays money" - the present value.

Each years net values are summed up to produce an overall project net present value (NPV)

Now if at the end of the project you are forecast (in todays terms) to have a net present value of zero then the project will break even....obviously you would like to have a positive net present value and the bigger the better!

You may adjust your projects parameters to do this - cut out the mid way upgrade, sack a few more staff, ---whatever.
Additionally to modifying the projects proposed expenses & revensues, how the project projections pan out depend on what sort of discounted interest rate you are applying to the project calculations.
Now, if you vary this "interest rate" within the mathematics such that at the end date of the project the net present vlaue is exactly zero - then this 'interest rate' value is called the IRR.

So you might have a project that breaks even on the NPV with an IRR of 3%. You the executives can then decided whether to go ahead with the project or do something else. It also depends on what the firm's cost of capital is - ie how much do they have to pay in interest on the money markets (we are thinking multi £10m here) to borrow money - such considerations may well fix the miniumum allowable IRR in any project's analysis.

That was a (brief) lesson in management accounting in 1 minute - whole books are written on this and courses taught in business Schools so the above is a very simplified version.
(Then you can move on to risk analysis of the project paramaters changing.........)

One thing you do learn from these analysis is how important it is to get revenuses coming in in the first years of a project....waiting until it is fully complete and 'mature' and you will loose out on the NPV and the project will be a 'no go'.
Now you understand why software, mobile phones, cars, whatever are put out to retail when they often still have major bugs...and should never be released - it's to get the revenue stream started early.......

aj9648

So essentially to explain to a 12 year old......if I had a £1, I can invest that in the bank and get an interest rate of 10% and next year the £1 will be worth £1.10.

If my investment model tells me that an alternative investment is going to get me more than 10% i.e. IRR >10% then I should go ahead with the investment rather that putting the money in the bank.

So back to my question of 110% IRR - this means that if I invest £1 in an investment, according to the model I am going to get back £2.10 back at the end of the investment?

Is this right?

Wobblydeb

aj9648 wrote: »

So back to my question of 110% IRR - this means that if I invest £1 in an investment, according to the model I am going to get back £2.10 back at the end of the investment?

Is this right?

Yes, on a one year time frame.