The Excel is a very powerful tool which every entrepreneur must use for the evaluation and the feasibility of the projects. In today’s post, I will discuss the Internal Rate of Return or in the short form, the IRR.
The Internal Rate of Return is the rate of return which makes the Net Present Value of all the cash flows from a project or an investment to zero. It is generally used to measure the attractiveness of the investment or the project.
Let me suppose you invest in any of the projects of your field or choice. How do you know that it a profitable project that will give you the higher return than the cost of capital? The IRR is one such tool which lets you know the internal rate of return of your project. It deals with the periodic cash flows.
The value of IRR cannot be calculated analytically rather we use hit and trial method to calculate this value.
Why use IRR ?
Example: A company ABC is planning to purchase a machinery worth $ 4,00,000 and is expecting to generate the positive cash flows of $ 1,20,000 per year for the next four years. In the 5th year, the management is planning to dispose it off at $ 40,000. The machinery must generate 8% annual return to cross the company’s hurdle rate.
And after putting the values in the formula given above, the value of IRR comes to be 10.6 %. The value of IRR is determined through hit and trial method and when I use the above formula, it is quite tedious.
But if I calculate the same using excel then it is quite easy and fast. So, let us calculate the IRR in the excel sheet. The syntax for IRR in the excel is as follows:
IRR (values, [guess])
The values part:
Calculating in Excel
Arrange all the cash flows for the specific period as follows:
The negative and red colored value indicates the cash outflow.
Leave the guess part blank.
You can see the above screenshot that the IRR value is greater than the Hurdle rate, hence the project is acceptable and feasible. You can compare the two projects with the same duration.
However, the IRR has one major disadvantage as it does not disclose the amount of initial investment. What I mean to say that it does not tells whether it is 15% on $ 4,00,000 or 15% on $ 10,00,000, therefore taking decision merely on IRR is not always advisable.
Let me explain it further, investment in project offering 15% return on $ 4,00,000 of the investment is more suitable for a small company which has less cash to invest than a project offering 20% on $ 10,00,000 of the initial investment.
Therefore, you need to keep all these points in mind while evaluating the IRR of the project and taking the final decision as the entrepreneur.