Internal Rate of Return - IRR

Internal Rate of Return sounds like something medical. Something in the neighborhood of colonoscopies and other loving invasions.

Well, you know what a return is on an investment: you invest a dollar and it returns, say, 10 percent a year for 7 years and change. Per the rule of 72, it’ll double.

IRR refers to the growth rate of capital invested in a given project, usually as it relates to a company’s allocation of its precious cash resources to invest for growth in the future. IRR is just about the compound rate of return an investor (and that investor can be your company investing in an internal project) needs to receive in order for the dough to be worth spending in the first place. Think about it like a financial hurdle you have to jump over.

The difficult part of an IRR calculation revolves around some notional percent return that you have to receive in order for that project "to be worth doing." Why do you need a 10% return versus 15%? Why not 20 or 30%? When you do your cash-invested-and-cash-returned calculations, are you considering the "hidden" values in doing this deal?

Like...investing in emus, who produce colored eggs in hopes of igniting a new Easter fad. That enhances the brand value of your emu meat, whether it works or not. So...there is kind of an echo effect in surfacing hidden benefits that aren’t necessarily part of the cash-on-cash return when companies make IRR calculations for investing their cash.

The hurdle rate element that companies use in IRR calculations is kind of arbitrary, but the discipline is good, and pretty simple. If you're investing $250 million in a new battery plant for your drones, then you'd better get a lot more than $250 million of value back from it, right?

Go back to our favorite Rule of 72. If you needed a 12% return, it would say that the value of your $250 million has to be $500 million 6 years later.

And there are likely foundational frames around "needing" that 12% number. In real life, if you're a financial manager in a big fat company, you're going to have competition. That is, you'll have other players who want to invest money in their projects over yours.

So you'll have to demonstrate on paper that your project has a higher investment return than theirs. And if you're good, you'll cover the hidden risks and strategic values as part of your pitch.

So what was our IRR on the project we just outlined in the battery plant?

Well, we laid out $250 million and we get back...a lot. Like, multiples of $250 million. There are a bunch of ways to think about IRR, but let's figure out the years it takes to double our money, and we can then get to the rate of return with our handy dandy Rule of 72. We got back all of our money in about 3 years. But the gifts keep on giving. It's not like the battery plant is useless after 3 years. In fact, it should keep "dividending batteries" for decades, and with the plant fully paid off in 3 years, everything else is gravy. Lots and lots of creamy, electrified gravy.

That’s 250 mil back to us after 3 years. And then things continue. Let's say that, in year 4, we get $110 million of battery value and $120 million in year 5, and $130 million in year 6. Add 'em up and, well...even with our discount rate, we've pretty much more than doubled our money again. And how long can a battery plant last? Maybe 20 years? And what about the side door business of selling our battery capacity to others? If we did that, then wow...we could make $200 million a year or more from this plant.

And this doesn't even count the strategic value of likely having bankrupted our would-be competitors, who sell an inferior product for almost twice the price. What if we wanted to just sell the battery plant in n years? It might go for a billion bucks or more. So, what do the cash flows look like here? We'll just start at our all-in with interest costs of $250M as our year 1.0 starting point. And we're going to ignore interest charges here, because the calculation begins with the launch of the plant as year 1.

Spectacular project. We generated almost half a billion bucks in cash along the way—and then sold the whole plant for over a billion dollars at the end. The key element you have to grok with regard to IRR is that the return has to be positive for a project to be greenlit. That is, if you take into account the cost and opportunity cost of capital, the risk-adjusted net present value, and the strategic "hidden" elements, then IRR has to be a positive dollar amount to be worth doing.