Okay, it’s been years, but what does the IRR tell me?
Say I have a project that gives a 40% IRR, does that mean I am earning 40% annually on my invested capital?
It doesn’t seem to be the case as the calculations does not come out this way. Someone please explain to me then what does the IRR tell me? What does that 40% mean?
It seems that IRR is only useful when comparing to another IRR, is that right? It does not tell me anything about my return on my investment, is that correct?
IRR means Internal Rate of Return . It is the return that is likely to be earned with the invested capital and projected cashflows over a period of time . If It is greater than the cost of capital you should go for the project otherwise not.
the technical definition of IRR is “the discount rate that gives you a 0 NPV”. Or alternately, it’s the rate that makes the PV of the inflows equal to the PV of the outflows.
Intuitively, it’s the annual return on any invested funds. But there’s a strong caveat - it assumes that you can reinvest all intermediate cash flows at the IRR. To see what this means, assume you had a 5-year project with a 10% IRR. Take all cash inflows and reinvested them until year 5. Then take any cash outflows and discount them to time zero. You now have two lump sums - one at time zero and one at time 5. If you calculate the interest rate implied by those two cash flows it woud also be 10%.
There are two schools of thought about the interim cash outflows from an investment in an IRR calculation.
One, as busprof described quite well, is that you treat the cash outflows as if they are still part of the original investment; given that, they would, as he points out, have to earn the IRR until the end of the investment for the investment as a whole to earn a return equal to the IRR. This is the more common viewpoint.
The other is to treat the outflows as if the cash is no longer invested in the project. In that case, the reinvestment rate is irrelevant, and the IRR represents the return on investment for the amount of cash remaining in the project. This view is consistent with IRR calculation (i.e., discounting the cash flows to the beginning of the project, not projecting them to the end of the project). I prefer this approach.