Internal Rate of Return

[Shaun @ Tru6]

Can anyone explain internal rate of return?

also net present value?

as these pertain to a small and growing company?

What are they? What do they say about a company? What are good/bad metrics if there are any?

[recycled sixtie]

internal rate of return is such that the rate of return from a project is for example 5% after all expenses and taxes. Putting the same $ in the bank might give 1% after taxes. Then it would make sense to do that internal project in a company because you get more return on investment.

Present value principle means that a $1 today is worth more than a year from now because that same $1 is subject to inflation over one year. So future cash flows have to be discounted to present values to get more accurate comparisons. I dont pretend to be an accountant but I have done enough bus. a/c courses to understand the principles. If you are contemplating starting or buying a bus. get help with these kind of valuations. Kind of like getting a PPI on a Porsche before u buy it.

[Dottore]

Shaun: These are really very basic concepts for anyone running their own business. There are Idiot's Guides out there to business finance and valuation. Would be well worth reading.

[Seahawk]

Dottore is correct. Don't worry...my business partner, who has an aero degree, decided to go to the Sloan Executive MBA course after a year of trying to catch up on the lexicon of business.

Also, PM me your email and I will send you the checklist I use in my company for due diligence across the spectrum of business related areas.

You don't have to use every block, but it is very helpful should you ever want to sell.

[icemann427]

Edited from Wiki for you in attempt to make it more understandable.


IRR

The internal rate of return on an investment or project is the "annualized effective compounded return rate" or "rate of return" that makes the net present value (NPV) of all cash flows (both positive and negative) from a particular investment equal to zero.
In more specific terms, the IRR of an investment is the discount rat at which the net present value of costs (negative cash flows) of the investment equals the net present value of the benefits (positive cash flows) of the investment.

Internal rates of return are commonly used to evaluate the desirability of investments or projects. The higher a project's internal rate of return, the more desirable it is to undertake the project. Assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first.

A firm (or individual) should, in theory, undertake all projects or investments available with IRRs that exceed the cost of capital. Investment may be limited by availability of funds to the firm and/or by the firm's capacity or ability to manage numerous projects.

Uses

Because the internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment.

An investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return or cost of capital. In a scenario where an investment is considered by a firm that has equity holders, this minimum rate is the cost of capital of the investment (which may be determined by the risk-adjusted cost of capital of alternative investments). This ensures that the investment is supported by equity holders since, in general, an investment whose IRR exceeds its cost of capital adds value for the company (i.e., it is economically profitable).

NPV

In finance, the net present value (NPV) or net present worth (NPW) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PV’s) of the individual cash flows of the same entity. In the case when all future cash flows are incoming (such as coupons and principal of a bond) and the only outflow of cash is the purchase price, the NPV is simply the PV of future cash flows minus the purchase price (which is its own PV). NPV is a central tool in discounted cash flow (DCF) analysis, and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met.

The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount curve and outputs a price; the converse process in DCF analysis - taking a sequence of cash flows and a price as input and inferring as output a discount rate (the discount rate which would yield the given price as NPV) - is called the yield, and is more widely used in bond trading.

The rate used to discount future cash flows to the present value is a key variable of this process.

A firm's weighted average cost of capital (after tax) is often used, but many people believe that it is appropriate to use higher discount rates to adjust for risk or other factors. A variable discount rate with higher rates applied to cash flows occurring further along the time span might be used to reflect the yield curve premium for long-term debt.

Another approach to choosing the discount rate factor is to decide the rate which the capital needed for the project could return if invested in an alternative venture. If, for example, the capital required for Project A can earn five percent elsewhere, use this discount rate in the NPV calculation to allow a direct comparison to be made between Project A and the alternative. Related to this concept is to use the firm's Reinvestment Rate. Reinvestment rate can be defined as the rate of return for the firm's investments on average. When analyzing projects in a capital constrained environment, it may be appropriate to use the reinvestment rate rather than the firm's weighted average cost of capital as the discount factor. It reflects opportunity cost of investment, rather than the possibly lower cost of capital.

An NPV calculated using variable discount rates (if they are known for the duration of the investment) better reflects the real situation than one calculated from a constant discount rate for the entire investment duration.

For some professional investors, their investment funds are committed to target a specified rate of return. In such cases, that rate of return should be selected as the discount rate for the NPV calculation. In this way, a direct comparison can be made between the profitability of the project and the desired rate of return.
To some extent, the selection of the discount rate is dependent on the use to which it will be put. If the intent is simply to determine whether a project will add value to the company, using the firm's weighted average cost of capital may be appropriate. If trying to decide between alternative investments in order to maximize the value of the firm, the corporate reinvestment rate would probably be a better choice.

Using variable rates over time, or discounting "guaranteed" cash flows differently from "at risk" cash flows may be a superior methodology, but is seldom used in practice. Using the discount rate to adjust for risk is often difficult to do in practice (especially internationally), and is difficult to do well. An alternative to using discount factor to adjust for risk is to explicitly correct the cash flows for the risk elements using NPV or a similar method, then discount at the firm's rate.

NPV in Decision Making

NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, if Rt is a positive value, the project is in the status of discounted cash inflow in the time of t. If Rt is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e. comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected.

[Rich76_911s]

I learn best following through an example vs. reading an explination so here is my example for you:

First let's answer what is present value. Say what is the present value of receiving $500,000 in two years, if interest rates are at 5%?

The present value equation is: Present value = (Amount being received) / (1+interest rate)^Raised to the # of periods

The present value is how much you should pay for one payment of $500,000 in two years @ a 5% interest rate is:
[(500,000)/(1+.05)^2] = $453,514 <--- Receiving this today is equivalent to receiving $500,000 in two years. (IF interest rates are 5%.)


If instead of one payment you have a series of cash flows going into the future, say:

Year 0: -$1,000,000 (your initial cash purchase price)
Year 1: $300,000
Year 2: $200,000
Year 3: $400,000
Year 4: $450,000
Year 5: $525,000

We are going to find the present value (what they are worth today) of each of those cash flows and sum them up.

Year 0: is worth exactly -1,000,000 it is todays value
Year 1: is [(300,000)/(1+.05)^1) = 285,714
Year 2: is [(200,000)/(1+.05)^2) = 181,405
Year 3: is [(400,000)/(1+.05)^3) = 345,535
Year 4: is [(450,000)/(1+.05)^4) = 370,216
Year 5: is [(525,000)/(1+.05)^5) = 411,351

The net present value of this series of cash flows is:
-1,000,000 + 285,714 + 181,405 + 345,535 + 370,216 + 411,351 = 594,221

So a million dollar investment today will net you $594,221 in profit.

The internal rate of return (IRR) is the interest rate that makes the series of cash flows worth zero. So instead of using 5%, we are finding the interest rate that would be the breakeven point for this series of cash flows.

The math to find IRR is simply setting all those equations above up without an interest rate and setting the NPV to zero, then solving for the interest rate. (MUCH EASIER DONE ON A CALCULATOR, or in excel)

IRR of the example is: 21.915%
**So if you go up to my equations above and replace each "1+.05" with "1+.219" the net present value should equal ZERO

What this is telling you is if you can borrow at below 21.9% my example would be a profitable enterprise.

[s_wilwerding]

A good way to look at IRR (or return on invested capital, or return on equity) is to say that the money going into your business needs to earn a certain rate of return. With the most simple example, say that your business is financed entirely from a bank loan at 10% - that means that every dollar you spend better be generating more than 10%, otherwise there is no point to your business (unless you're trying to turn a large fortune into a small one).

It gets a little more complicated when you add in owner equity, but look at it this way. The money that you invest in your business COULD go to other places - you buy a CD from the bank at 1%, buy government bonds, stocks, etc. - if you're going to put the money into the business, it should earn more of a rate of return than the alternatives.

Any business should figure out their cost of capital, and make sure that projects they undertake have an IRR higher than that.

[daepp]

My $.02.

Let's say your operations, after taxes, grow your assets (say your checking account) by 1.5% from Jan to Dec. That's your IRR, and it;s important as you might be able to invest your money in something else (with less risk perhaps) and achieve the same earnings. Say a 5 year muni bond would make you 3 percent, if you cannot get your IRR up it would be better to buy the bond.

PV example: Say you are owed 100K, and you are being paid 5% interest on the loan. I havent done the math, but what if you could get your money back faster, before the end of the note. The PV would tell you the amount to accept today rather than wait for those payments over time.

[Shaun @ Tru6]

Thank you Gentlemen for all your help. Finishing up the business plan for our prospective investors this weekend.

Paul, will send a PM, thank you.