Calculate NPV in terms of currency. Then express IRR in terms of the percentagereturn a firm expects the capital project to return. Academic evidence suggests that the NPV Method is preferred over other methods since it calculates additional wealth and the IRR Method does not.

IRR Method

The IRR Method cannot be used to evaluate projects where there are changing cash flows . For example, an initial outflow followed by in-flows and a later out-flow, such as may be required in the case of land reclamation by a mining firm. However, the IRR Method does have one significant advantage. Managers tend to better understand the concept of returns stated in percentages. They find it easy to compare to the required cost of capital.

NPV vs IRR Comparison

While both the NPV Method and the IRR Method are both DCF models and can even reach similar conclusions about a single project, the use of the IRR Method can lead to the belief that a smaller project with a shorter life and earlier cash inflows. This is preferable to a larger project that will generate more cash. Applying NPV using different discount rates will result in different recommendations. The IRR method always gives the same recommendation.

Are you in the process of selling your company? The first thing to do is to identify “destroyers” that can impact your company’s value.

The Real Options Approach allows for flexibility and encourages constant reassessment based on the riskiness of the project’s cash flows. It is also based on the concept of creating a list of value-maximizing options to choose projects from. In fact, management can, and is encouraged, to react to changes that might affect the assumptions that were made about each project being considered prior to its commencement, including postponing the project if necessary. It is also noteworthy that there is not a lot of support for this method among financial managers at this time.

Both IRR and NPV are rates which assign value to your company. If you’re looking to sell your company, then download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value.

Strategic CFO Lab Member Extra

Access your Exit Strategy Checklist Execution Plan in SCFO Lab. The step-by-step plan to get the most value out of your company when you sell.

Click here to access your Execution Plan. Not a Lab Member?

IRR > hurdle rate, accept the investment IRR < hurdle rate, reject the investment IRR = hurdle rate, the investment is marginal

The internal rate of return meaning is described in more detail below.

Internal Rate of Return Method Explanation

Internal Rate of Return is a method to compare and evaluate different investments based on their cash flows. A proper internal rate of return calculation provides an interest rate equal to the total gains expected from a given investment. After discovering the internal rate of return for one project other IRRs can be compared in order to find the most valuable investment choice. Additionally, one compares an internal rate of return to the weighted average cost of capital of a project to decide whether the investment will create profit. IRR also accounts for the time value of monetary gains. It is generally used to evaluate a series of cash flows but can also be applied for other needs. Many equity investors, including angels and venture capitalists, have a required rate of return which must be met or exceeded by the IRR of a company seeking investment. This ensures the investment warrants the associated risk and will provide the cash flows necessary for profit.

The rate of return (r) for which NPV = 0 is the internal rate of return calculator. So, if:

0 = (Cash flow in period 1 / (1 + IRR) ^1) + (Cash flow in period 2 / (1 + IRR)^2) + (Cash flow in period 3 / (1 + IRR) ^ 3) + …

Where: NPV = Net Present Value CF 1, 2, or 3 = Cash flow in period 1, Cash flow in period 2, Cash flow in period 3, etc. IRR = Internal Rate of Return

Internal rate of return can be found algebraically using this method as the IRR calculator. Below is a common internal rate of return calculation example.

Strategic CFO Lab Member Extra

Access your Flash Report Execution Plan in SCFO Lab. The step-by-step plan to create a dashboard to measure productivity, profitability, and liquidity of your company.

Click here to access your Execution Plan. Not a Lab Member?

For example, Techco has developed a revolutionary online shopping cart for e-commerce. It believes that, with an investment for marketing expenses, the company concept can be quickly grown to profitability.

Capco is a venture capital firm that invests in early-stage companies that serve the business to businessmarket. Furthermore, Capco invests only in companies with an existing product and an expectation of quick return on equity. They use the internal rate of return method and only invest in companies which currently have a rate of return of 30% or more. So, their IRR hurdle is 30%.

Techco and Capco had a great first meeting. Techco would love to gain marketing expertise and funding from the Capco team. Capco appreciates the experience of the Techco management team, feels the company concept fits well into their field of interest, and knows that this investment has the growth potential necessary. The only concern is whether Techco can yield the required IRR calculation of 30%.

IRR Calculation

To make the final decision, Techco and Capco run the following IRR formula calculation as an internal rate of return financial calculator:

Techco and Capco mutually come to the conclusion that Techco’s IRR is 32.979%. As a result, Capco is confident that since Techco’s internal rate of return model is currently above 30%, it will probably grow with additional marketing. Capco and Techco, because of this, decide to become partners.

Private equity markets regularly deal with the above internal rate of return formula example and IRR formula calculation. As a matter of survival, they must have a strong grasp of the IRR definition, IRR formula, and IRR limitations.

Limitations of Internal Rate of Return

The internal rate of return calculation assumes that you will reinvest cash flows each year at a constant rate. For those internal rate of returns that are high (greater than 25%), it is impractical to think that you will find alternative investments at that same higher rate. This limitation is the biggest drawback to using the internal rate of return method. In order to compensate for the high return of the internal rate of return calculation, the Modified Internal Rate of Return (MIRR) was created so that the annual cash flows are reinvested at a lower, more probable reinvestment rate.

If you’re looking to sell your company in the near future, download the free Top 10 Destroyers of Value whitepaper to learn how to maximize your value. Don’t let the destroyers take money away from you!

Strategic CFO Lab Member Extra

Access your Exit Strategy Checklist Execution Plan in SCFO Lab. The step-by-step plan to get the most value out of your company when you sell.

Click here to access your Execution Plan. Not a Lab Member?