Internal Rate of Return - IRR

Categories: Company Management

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.

Related or Semi-related Video

Finance: What is IRR?5 Views

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Finance Allah Shmoop what is I r r This is

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an ear And nope it has nothing to do with

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ai r r Instead I r r stands for internal

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rate of return Yeah All right So what does that

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mean While internal rate of return sounds like something medical

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right Like something in the neighborhood of colonoscopies and other

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loving invasions by the dock Well you know what a

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return is on an investment You invest a dollar and

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I'll say it returns ten percent a year for seven

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years and changed seven point two years for the rule

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of seventy two While then it'll double I R r

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refers to the growth rate of capital invested in a

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given project Usually as it relates to a company's allocation

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of their precious cash resource is to invest for growth

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in themselves in the future I r is just about

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the compound rate of return and investor And that investor

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can be your company investing in an internal project that

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that investor needs to receive in order for the dough

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to be worth spending in the first place Think about

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it like a financial hurdle You have to jump over

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the difficult part of an IRA Our calculation revolves around

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some notional percent return that you have to have in

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order for that project to be you know worth doing

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Like why do you need a ten percent return versus

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a fifteen percent Why not twenty or thirty Well when

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you do your cash invested and cash return calculations are

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you considering the hidden values in doing this deal Like

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investing in the IMU set You know who produced colored

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eggs in hopes of igniting a new Easter fad that

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enhances the brand value of your IMU Meet whether it

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works or not Vegans aside like who wouldn't want blue

01:38

pink and green IMU meat So there's kind of an

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echo effect in surfacing hidden benefits that aren't necessarily part

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of the cash on cash Return calculations When companies make

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those ire our calculations for investing their precious cash well

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The hurdle rate element that companies use in Iraq calculations

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is kind of arbitrary but the discipline is good and

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pretty simple If you're investing two hundred fifty million dollars

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in a new battery plant for your drones well then

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you'd better get a lot more than two hundred fifty

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million dollars of value back from it Right So go

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back to our favorite rule of seventy two thinking here

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if you needed a twelve percent return Well it would

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say that the value of your two hundred fifty million

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dollars has to be worth at least five hundred million

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dollars to you six years later And there are likely

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foundational frames around meeting that twelve percent number Like in

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real life if you're a financial manager in a big

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fat company you're going tohave competition That is you'll have

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other players who want to invest money in their projects

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over yours Like you have a drone painting a project

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and you have a drone management in a drone life

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insurance products and all those people want the company's cash

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to build their product over yours or their project anyway

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So you'll have to demonstrate on paper to your boss's

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boss's boss that your project has ah higher I r

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r than theirs And if you're good you'll cover the

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hidden risks and strategic values as part of your pitch

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Okay here's the math So what was our IRA and

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the project We just outlined the battery plant Well we

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laid out two hundred fifty million bucks and we get

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back a lot like multiples of two hundred fifty million

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dollars There are a bunch of ways to think about

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IRA but let's figure out the years it takes to

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well first double our money and we can then get

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to the rate of return with our handy dandy rule

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of seventy two We've got back all our money in

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about three years but the gifts keep on giving It's

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not like the battery plant is useless after three years

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right Like it's saved us a lot of one hundred

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forty million in year one and then eighty and year

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to and then maybe on seventy eighty fifty some number

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in your three So we've gotten all two hundred fifty

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million dollars of value back in just three years and

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the battery plant is still functioning In fact it should

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keep dividend ing batteries for decades And with the plant

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fully paid off in just three years well everything else

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it gives back is pretty much gravy lots and lots

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of creamy electrified gravy It's a hundred fifty mil back

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to us after three years and then things continue like

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Let's say in year four we get one hundred ten

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million dollars of battery value and then one twenty in

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year five one thirty in Year six or something like

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that Adam all up and well even with our discount

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rate like valuing them for today's dollars one point one

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two to the six powers how we divide back that

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hundred thirty million years Six And that's how we do

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it That's what it looks like So how long can

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this battery plant last Maybe twenty years And what about

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the side door business of selling our battery capacity to

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others Well if we did that then wow we could

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make two hundred million dollars a year or more from

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this plant And this doesn't even count the strategic value

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of likely having bankrupted our would be editors who sell

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an inferior product for almost twice the price So what

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if we wanted to just then sell the battery plant

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in some number of years Then it might go for

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a billion dollars or more so than what the cash

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flows look like in our hierarchy Talc Well you got

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whatever the first three years where we got all our

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money back and change and then a few more years

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of milking and then a few more years after that

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Then we sold it for a billion dollars in your

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ten or something like that But regardless in this case

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this is a spectacularly good project We generated almost half

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a billion bucks let's say in cash along the way

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and then sold the whole plan for over a billion

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dollars At the end We'll the key element you have

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to grow up with Regard to IRA is that the

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return has to be positive for a project to be

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green lit positive meaning higher than the hurdle rate That

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is if you take into account the cost and opportunity

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cost of the capital you're deploying the risk adjusted net

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present value in the strategic hidden elements will then IRA

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has to be a positive dollar amount worth doing In

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this case we started with that twelve percent per year

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comp on return figure as our minimum bass case to

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deem a project worthy of green lighting So the new

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opportunity looked a delicious WE green lit it and well

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if all goes well you'll be a swimming in colored 00:05:42.521 --> [endTime] IMU meat

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