Management’s main goal is creating shareholder value. Achieving this requires capital budgeting decisions that give positive expected returns, also known as the Internal Rate Of Return (IRR).
Calculation of IRR
Interestingly enough, calculation of internal rate of return first requires the formula for Net Present Value (NPV) of a project. When we refer to “project” we assume it means any capital budgeting decision management faces.
Ct = net cash flow during period t
C0 = total investment costs
r = discount rate
t = number of periods
We solve for r, which is the discount rate. Additionally, we do this buy setting NPV = 0. This cannot be done analytically, so we use software, or trial and error methods.
How To Interpret IRR
Furthermore, internal rate of returns are paramount in management’s course for their respective business. Management looks for projects with the highest IRR because it is the most efficient use of their capital.
Additionally, any rate of return over US T-Bills, or potentially purchase of the company’s own stock, creates value for shareholders. The actual rate of return often differs from that of the calculated IRR. However, this metric gives management an idea of which avenue to explore.
IRR In Business
Any rate of return over the company’s cost of capital theoretically warrants pursuit of the project. However, companies often set a required rate of return in order for management to move forward. This is the minimal accepted rate of return for a project.
For example, imagine a farming company that requires capital-heavy equipment. This equipment needs maintenance which is not free. The choice arises, to fix old equipment or buy new equipment? This is precisely where IRR helps management make the right decisions. Each choice is expressed numerically through IRR, making the decision clearer.
IRR is a powerful metric which companies use to grow their profitability and market share. Investors or analysts should keep close tabs on management’s decisions and if they are using their capital efficiently.