07-02-2009, 09:57 PM
<b>The internal rate of return (or IRR)</b> is a common financial valuation metric used by financial analysts to calculate and assess the financial attractiveness / viability of capital intensive projects or investments.
As the IRR is normally easier to understand than the result of a discounted cash flow (DCF) analysis (i.e. the net present value or NPV) for non-financial executives, it is often used to explain and justify investment decisions, although a good financial modeler should know that the IRR is after all an estimated value, especially when calculated in Excel, and should be used in conjunction with other financial metrics such as the NPV and comparable valuation multiples when presenting a business or investment case.
So what exactly is the IRR? The IRR is the interest rate that makes the net present value of all cash flow equal to zero. In financial analysis terms, the IRR can be defined a discount rate at which the present value of a series of investments is equal to the present value of the returns on those investments.
All projects or investments with an IRR that has been calculated in a financial modeling exercise to be greater than the Weighted Average Cost of Capital (or WACC) should technically be considered as financially viable and accepted.
When choosing between projects or investments whose outcomes or performance are absolutely independent of one another, a good financial modeler should deem the project or investment with the highest calculated IRR to be the most financially attractive, so long as we continue to keep in mind that the IRR value also needs to be higher than the WACC.
<b>Calculation</b>
Calculation of IRR is best explained at
http//en.wikipedia.org/wiki/Internal_rate_of_return
As the IRR is normally easier to understand than the result of a discounted cash flow (DCF) analysis (i.e. the net present value or NPV) for non-financial executives, it is often used to explain and justify investment decisions, although a good financial modeler should know that the IRR is after all an estimated value, especially when calculated in Excel, and should be used in conjunction with other financial metrics such as the NPV and comparable valuation multiples when presenting a business or investment case.
So what exactly is the IRR? The IRR is the interest rate that makes the net present value of all cash flow equal to zero. In financial analysis terms, the IRR can be defined a discount rate at which the present value of a series of investments is equal to the present value of the returns on those investments.
All projects or investments with an IRR that has been calculated in a financial modeling exercise to be greater than the Weighted Average Cost of Capital (or WACC) should technically be considered as financially viable and accepted.
When choosing between projects or investments whose outcomes or performance are absolutely independent of one another, a good financial modeler should deem the project or investment with the highest calculated IRR to be the most financially attractive, so long as we continue to keep in mind that the IRR value also needs to be higher than the WACC.
<b>Calculation</b>
Calculation of IRR is best explained at
http//en.wikipedia.org/wiki/Internal_rate_of_return
