Internal Rate of Return for Business Case Development

The internal rate of return (or IRR) is a great metric for evaluating business cases and investment opportunities.  It’s related to the Net Present Value of expected cash flows for an investment in that its the discount rate at which the NPV is zero.  The reason the IRR is such a good impartial evaluation technique is that typically your finance department will set some minimum IRR against which all potential business investments are judged based on what they expect from a rate of return standpoint for other investments they undertake with equal risk.  Certainly there are other things that go into evaluation and decision making from product investment standpoint (buy back time for instance), but the IRR is a good starting point.

IRR also doesn’t take into consideration external rates of return (interest rates, alternative investments, etc.) or even the total monetary gain of the investment explicitly with its calculation, however, it implicitly provides a measure of risk based its result.

What does that mean?  Basically, the higher the IRR the better the investment option.  It’s pretty easy to just blindly accept what your financial calculator or Excel formulas spit out for your IRR, but I like to fundamentally understand why a *higher* rate is better.  From a mathematical standpoint, lets consider what a present value is:

Cash Flow/(1 + discount rate)^number of periods

The discount rate is essentially the IRR when looking a PV formula as I defined it above:

0 = CF/(1 + r)^n

Basically, the larger the denominator relative to the numerator, the smaller the evaluated result is.  The opposite holds true of course.  The smaller the denominator the larger the evaluated result.

So, why do we want a smaller result (i.e. a higher discount rate/IRR)?

The basic principle behind the time value of money with regards to why we use a discount rate in the first place is to evaluate future uncertain cash flows against certain present cash flows.  Using the risk of receiving that cash flow in the future and what interest I could earn on the cash flow if I received it today over that same period of not receiving (otherwise known as the opportunity cost of capital) it allows an apples-to-apples comparison of my options. So, the answer to the question of “why a smaller cash flow for IRR is desirable” is, if we were doing an strict NPV calculation, we of course would prefer to have a lower discount rate because that would create a larger return on our investment all things being equal.  In the case of IRR, we are actually measuring the BUFFER we have between what our actual NPV discount rate is (say, risk free investment rate + inflation) and how large the discount rate has to be before the investment is a no-gain, a.k.a. NPV = zero.

Again, this gets back to why your finance department or CFO would set a minimum IRR/hurdle rate for any investment to be considered — its a measure of the risk they are willing to take relative to the macroeconomic forces in the world they have no control over.

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Jason is an technical business professional who has deep hands-on technical experience as a software engineer and architect and has leveraged this experience to transition from project leadership into product management. He holds a MS in Computer Science from Northeastern University and an MBA from Babson College. He is continuously striving to learn and experience new challenges.

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Posted in Entrepreneurship, Product Management

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