"What managers should know about IRR and why".

Internal rate of return (IRR) is a rate at which the discounted income from investment equals to zero. It is not the ratio between the project’s cash inflow and outflow, it is rather the rate at which the project’s net present value (NPV) is equal to zero.The rate is used as one of the possible indicators that allow to make a conclusion about the project’s profitability. Together with several other coefficients it is used in the discounted cash flow model (DCF) in project management. Discount is the factor that accounts for the risk in the cash flows and expresses numerically the probability that the future cash flows may not be the same as forecasted by the model. The reasons – risks – include interest rate risk, market risk, credit risk and general project risks.To calculate the IRR we need to know the cash flow stream. In order to derive it we need to sum up all of the project’s cash inflows and outflows for the current investment period. Next step is to calculate the present value of the future cash flow streams. We do so by multiplying the net cash flow stream by (1+interest rate on the project) and by the number of years that we expect to run the project. Then we calculate the net present value of the investment which is the difference between the initial investments and the sum of the net cash flows for all of the periods of the project. Then the rate at which the net present value of the investment equals to zero is the project’s IRR. In the same manner the IRR for two projects are calculated and then the project with higher IRR is the more attractive one. Actually the IRR is very useful in comparing a project’s profitability with any other possible alternatives.The general investment decision rule using IRR is the following: if the internal rate of return is greater than the discount rate – market cost of capital – then the project is profitable and worth investing in. If it is the same as the discount rate – there will be zero profit after completion of the project. And, finally, if it is negative – the project should not be taken as its profitability is negative.It is difficult to calculate IRR manually. Therefore the best way to do it is to use Excel and financial calculators.The IRR is a good measure of investment project profitability because it accounts for time value of money, the risk of the cash flow and provides an indication of an increase in value.It also allows assessing whether an investment would yield a better return based on internal standard of return. Finally, it allows comparing investment projects of different nature. One of the deficiencies of IRR is that the equation NPV=0 does not necessarily have one positive root. It can have no roots or have several roots as well. In order to avoid these difficulties, it is better to define IRR …