Using Internal Rate of Return

The internal rate of return (IRR) evaluation method is akin to net present value because it is also based on the discounted cash flow principle. When using NPV, however, you always assign a discount rate. In the IRR method, you derive a discount rate through trial-and-error calculation. The IRR method attempts to determine the internal rate of return of a proposed capital investment by calculating the discount rate needed to bring the NPV to zero. Then, if the calculated rate of return is greater than the average cost of capital, the project is acceptable. If not, the project is rejected.

By using a derived discount rate rather than an assigned rate, the IRR method eliminates one of the possible misuses of the NPV approach: arbitrarily using an unjustified hurdle rate. Nevertheless, the IRR method is still vulnerable to the basic flaws found in any evaluation system tied to discounted cash flow: namely, the wide margin for error in forecasting cash flows.
Even with these caveats in mind, however, the IRR can be a useful tool in measuring the rate of return of a capital investment project. Once developed, an internal rate of return can be compared to that for other projects and to your company’s overall objectives, as well as the cost of capital.


Net
Cash Discount
Factor Present
Value Discount
Factor Present
Value
Year Flow at 11% at 11% at 12% at 12%
0 ($60,000) — ($60,000) — ($60,000)
1 15,000 .901 13,515 .893 13,395
2 15,000 .812 12,180 .797 11,955
3 15,000 .731 10,965 .712 10,680
4 17,500 .659 11,532 .636 11,130
5 20,000 .593 11,860 .567 11,340
$22,500 $ 52 ($ 1,500)


Illustration: Assume that ABC Company is considering a $60,000 capital investment in new equipment. Expected cash flows are the same, but this time we will be using the IRR evaluation method. From prior NPV calculations, we know that the internal rate of return is somewhere between 11 percent, where a narrow profit was recorded, and 12 percent, which would certainly produce a loss. (See box for the IRR calculation.)

To find the exact rate, we interpolate. First, take the difference between the NPV at 11 percent and the NPV at 12 percent. In this case, the difference is $1,552. Next, divide the positive NPV of $52 by the $1,552 difference. Then add the quotient to the lower discount rate to get the internal rate of return, which equals 11.03 percent. In the IRR method, the higher the internal rate of return, the better. Therefore, with an 11.03 percent rate of return and average capital costs of only 8.8 percent, the ABC Company would be well advised to give this project close consideration.

➤ Observation: These are sound reasons for you to use all three capital spending evaluation methods described previously when preparing a capital budget. For instance, a payback analysis of the ABC Company project would disclose, at the outset, that this was a medium-risk project, with payback calculated in a little less than four years. In addition, the NPV analysis indicates that the new machinery will more than return its initial investment in the next five years. Finally, the project’s IRR stands well above the company’s hurdle rate.

Because the project measures up favorably under all three evaluation scales, ABC Company management can be fairly confident that it will contribute to profits over the next several years. In short, there is no need for you to pick and choose among the three evaluation techniques. Each is designed to give you a different insight, and you can profit from using all three. Equally important, by looking at the investment from three angles, you avoid placing too much emphasis on one narrow fact.

The
As we have pointed out, a hurdle rate is the minimum acceptable rate of return for a capital spending project. Originally, the average cost of capital rate was considered the hurdle rate because no firm can afford to earn less than its capital costs for long. Over time, however, the concept of hurdle rates has changed. All-inclusive, company-wide hurdle rates are giving way to a more flexible approach. Some hurdle rates are classified according to risk; others are assigned according to informal guidelines; still others are related to the company’s strategic goals.

As a result, there are no hard-and-fast rules for setting a hurdle rate. It should depend on your company’s objectives, the risk factor inherent in your business and the strength of your company’s financial underpinnings. Nevertheless, you should keep some basic considerations in mind when deciding on a suitable hurdle rate for a proposed project.

1. It should be based on reality. This may sound obvious, but in far too many firms, the hurdle point is the result of an arbitrary management decision. In some cases, the hurdle point is too high and results in lost investment opportunities. In others, it is set too low, which usually leads to a strain on profits. Your hurdle rate should always be close to your average cost of capital. You should consider the overall trend of capital costs. If, for instance, inflation and rising interest rates are likely to push capital costs higher, you may want to compensate by raising your hurdle rate.

2. It should bear some relationship to risk. Your hurdle rate should be adjusted to compensate for the risks inherent in the project. The hurdle rate for low-risk projects need not be as high as the rate for projects with above-average risks. This includes internal risks, such as familiarity with the process, market or facility. More importantly, it includes external risks: the state of the economy, the outlook for interest rates, inflation, the business climate and so forth.

3. It should be current. No hurdle rate should ever be set in stone. As financial markets change, your cost of capital will change with them. Review your hurdle rate at least once a year, and in volatile times, consider revising it every six months. As a matter of fact, it is common practice among major companies to calculate average capital costs on an annual basis. The information is then usually passed along to the various operating divisions or departments, with each determining its own hurdle rate.