This post should be read by marketers in conjunction with the earlier one that explains Net Present Value.
IRR partners with NPV as another tool in the investment choice toolbox. Both use as their basis, the forecasting of cashflow to make choices between investment options. While there are potentially a whole menu of influences over making decisions about investment options, cash as we know is the lifeblood of any business, and the measure least open to ‘management manipulation’, so should be in the mix.
The Internal Rate of Return, is the discount rate that would result in the net present value of a project to be zero. In effect, you are ‘solving’ for the discount rate that is used in the Net present Value calculation.
The discount rate best used in the Net Present Value calculations can be uncertain, we live in volatile times, and IRR is a means of calculating the rate given a set of investment parameters.
Businesses should set out to understand the rate at which the project breaks even, so the IRR is the interest rate at which the NPV of all cash flows from an investment equals zero. Your investment break even.
IRR enables a ranking of projects by their rates of return to be done, rather than just relying on the NPV of the cash required. However, relying on IRR in isolation has a downside: it does not measure the absolute size of the investment. A small investment might deliver a very attractive IRR, but be not as strategically attractive as a larger one that positions the business for growth. These are judgements made outside the straight financial calculations, which are just tools to compare.
As with any mathematical modelling tool, an IRR calculation it also suffers from the ‘garbage in garbage out’ syndrome. Therefore the the most important part of the investigation is to understand and critically analyse the assumptions made, rather than just relying on the numbers Excel spits out to make the decision for you.
Trackbacks/Pingbacks